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EX-32.1 - EXHIBIT 32.1 - Zscaler, Inc.zsexhibit321q1fy1910q.htm
EX-31.2 - EXHIBIT 31.2 - Zscaler, Inc.zsexhibit312q1fy1910q.htm
EX-31.1 - EXHIBIT 31.1 - Zscaler, Inc.zsexhibit311q1fy1910q.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_____________________________________
FORM 10-Q
_____________________________________
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 31, 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: 001-38413
_____________________________________
ZSCALER, INC.
(Exact Name of Registrant as Specified in Its Charter)
_____________________________________
Delaware
(State or other jurisdiction of
incorporation or organization)
 
 
 
26-1173892
(I.R.S. Employer
Identification Number)
 
 
110 Rose Orchard Way
San Jose, California 95134
(Address of Principal executive offices)
 
 
Registrant’s telephone number, including area code: (408) 533-0288
___________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files) Yes ý No  ¨
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
¨
 
 
 
 
Accelerated filer
¨
Non-accelerated filer
ý
 
 
 
 
Smaller reporting company
¨
(Do not check if a smaller reporting company)
 
 
 
 
 
Emerging growth company
ý
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. ý
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨ No  ý
As of November 30, 2018, the number of shares of registrant’s common stock outstanding was 122,250,116




ZSCALER, INC.
Table of Contents
 
 
Page No.
PART I. FINANCIAL INFORMATION
 
 
 
 
 
 
PART II. OTHER INFORMATION
 



SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including but not limited to, statements regarding our financial outlook and market positioning. These forward-looking statements are made as of the date they were first issued and were based on current expectations, estimates, forecasts and projections as well as the beliefs and assumptions of management. The words "believe," "may," "will," "potentially," "estimate," "continue," "anticipate," "intend," "could," "would," "project," "plan," "expect" and similar expressions that convey uncertainty of future events or outcomes are intended to identify forward-looking statements.
These forward-looking statements include, but are not limited to, statements concerning the following:
our future financial performance, including our expectations regarding our revenue, cost of revenue, gross profit or gross margin, operating expenses (including changes in sales and marketing, research and development and general and administrative expenses), and our ability to achieve, and maintain, profitability;
market acceptance of our cloud platform;
the effects of increased competition in our markets and our ability to compete effectively;
our ability to maintain the security and availability of our cloud platform;
our ability to maintain and expand our customer base, including by attracting new customers;
our ability to develop new solutions, or enhancements to our existing solutions, and bring them to market in a timely manner;
anticipated trends, growth rates and challenges in our business and in the markets in which we operate;
our business plan and our ability to effectively manage our growth and associated investments;
beliefs and objectives for future operations;
our relationships with third parties, including channel partners;
our ability to maintain, protect and enhance our intellectual property rights;
our ability to successfully defend litigation brought against us;
our ability to successfully expand in our existing markets and into new markets;
sufficiency of cash to meet cash needs for at least the next 12 months;
our ability to comply with laws and regulations that currently apply or become applicable to our business both in the United States and internationally;
the attraction and retention of qualified employees and key personnel; and
the future trading prices of our common stock.

1


These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in "Risk Factors" elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment, and new risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements and you should not place undue reliance on our 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.
You should read this Quarterly Report on Form 10-Q in conjunction with the audited consolidated financial statements and related notes in our Annual Report on Form 10-K for the fiscal year ended July 31, 2018 filed with the Securities and Exchange Commission, or the SEC, on September 13, 2018.

2



PART I. FINANCIAL INFORMATION
Item. 1 Financial Statements
ZSCALER, INC.
Condensed Consolidated Balance Sheets
(in thousands, except per share amounts)
(unaudited)
 
October 31,
2018
 
July 31,
2018
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
42,786

 
$
135,579

Short-term investments
271,254

 
162,960

Accounts receivable, net
49,228

 
61,611

Deferred contract acquisition costs
16,387

 
16,136

Prepaid expenses and other current assets
11,949

 
10,878

Total current assets
391,604

 
387,164

Property and equipment, net
24,132

 
19,765

Deferred contract acquisition costs, noncurrent
39,591

 
39,774

Other noncurrent assets
2,767

 
1,078

Total assets
$
458,094

 
$
447,781

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
4,573

 
$
4,895

Accrued expenses and other current liabilities
14,925

 
12,313

Accrued compensation
18,686

 
23,393

Liability for early exercised stock options
1,249

 
1,561

Deferred revenue
144,472

 
140,670

Total current liabilities
183,905

 
182,832

Deferred revenue, noncurrent
20,807

 
23,353

Other noncurrent liabilities
1,204

 
1,360

Total liabilities
205,916

 
207,545

Commitments and contingencies (Note 6)

 

Stockholders’ Equity
 
 
 
Preferred stock; $0.001 par value; 200,000 shares authorized as of October 31, 2018 and July 31, 2018; no shares issued and outstanding as of October 31, 2018 and July 31, 2018

 

Common stock; $0.001 par value; 1,000,000 shares authorized as of October 31, 2018 and July 31, 2018; 122,106 and 119,764 shares issued and outstanding as of October 31, 2018 and July 31, 2018, respectively
122

 
119

Additional paid-in capital
455,761

 
438,392

Notes receivable from stockholders

 
(2,051
)
Accumulated other comprehensive loss
(317
)
 
(124
)
Accumulated deficit
(203,388
)
 
(196,100
)
Total stockholders’ equity
252,178

 
240,236

Total liabilities and stockholders’ equity
$
458,094

 
$
447,781

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

3


ZSCALER, INC.
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts)
(unaudited)
 
Three Months Ended October 31,
 
2018
 
2017
Revenue
$
63,298

 
$
39,861

Cost of revenue
12,099

 
8,271

Gross profit
51,199

 
31,590

Operating expenses:
 
 
 
Sales and marketing
36,545

 
26,928

Research and development
13,186

 
8,809

General and administrative
10,131

 
7,130

Total operating expenses
59,862

 
42,867

Loss from operations
(8,663
)
 
(11,277
)
Interest income, net
1,590

 
195

Other expense, net
(188
)
 
(27
)
Loss before income taxes
(7,261
)
 
(11,109
)
Provision for income taxes
327

 
289

Net loss
$
(7,588
)
 
$
(11,398
)
Accretion of Series C and D redeemable convertible preferred stock

 
(2,530
)
Net loss attributable to common stockholders
$
(7,588
)
 
$
(13,928
)
Net loss per share attributable to common stockholders, basic and diluted
$
(0.06
)
 
$
(0.45
)
Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted
120,587

 
30,793

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

4


ZSCALER, INC.
Condensed Consolidated Statements of Comprehensive Loss
(in thousands)
(unaudited)
 
Three Months Ended October 31,
 
2018
 
2017
Net loss
$
(7,588
)
 
$
(11,398
)
Other comprehensive loss, net of tax:
 
 
 
Unrealized net losses on available-for-sale securities
(193
)
 

Other comprehensive loss
(193
)
 

Comprehensive loss
$
(7,781
)
 
$
(11,398
)
The accompanying notes are an integral part of these condensed consolidated financial statements.


5


ZSCALER, INC.
Condensed Consolidated Statements of Redeemable Convertible Preferred Stock and
Stockholders’ Equity (Deficit)
(in thousands)
(unaudited)
For the three months ended October 31, 2018:
 
Redeemable Convertible
Preferred Stock
 
 
Common Stock
 
Additional
Paid-In
Capital
 
Notes
Receivable
From
Stockholders
 
Accumulated Other Comprehensive Loss
 
Accumulated
Deficit
 
Total
Stockholders’ Equity
 
Shares
 
Amount
 
 
Shares 
 
Amount  
 
Balance as of July 31, 2018

 
$

 
 
119,764

 
$
119

 
$
438,392

 
$
(2,051
)
 
$
(124
)
 
$
(196,100
)
 
$
240,236

Cumulative effect of accounting change

 

 
 

 

 
(300
)
 

 

 
300

 

Issuance of common stock upon exercise of stock options

 

 
 
2,350

 
3

 
9,793

 

 

 

 
9,796

Repurchases of unvested common stock

 

 
 
(8
)
 

 

 

 

 

 

Repayments of principal amount on notes receivable from stockholders

 

 
 

 

 

 
1,905

 

 

 
1,905

Accrued interest on notes receivable from stockholders, net of repayments

 

 
 

 

 

 
146

 

 

 
146

Vesting of early exercised stock options

 

 
 

 

 
290

 

 

 

 
290

Stock-based compensation

 

 
 

 

 
7,586

 



 

 
7,586

Other comprehensive loss

 

 
 

 

 

 

 
(193
)
 

 
(193
)
Net loss

 

 
 

 

 

 

 

 
(7,588
)
 
(7,588
)
Balance as of October 31, 2018

 
$

 
 
122,106

 
$
122

 
$
455,761

 
$

 
$
(317
)
 
$
(203,388
)
 
$
252,178

For the three months ended October 31, 2017:
 
Redeemable
Convertible
Preferred Stock
 
 
Common Stock
 
Additional
Paid-In
Capital
 
Notes
Receivable
From
Stockholders
 
Accumulated Other Comprehensive Loss
 
Accumulated
Deficit
 
Total
Stockholders’ Equity
(Deficit)
 
Shares
 
Amount
 
 
Shares 
 
Amount  
 
Balance as of July 31, 2017
72,501

 
$
200,977

 
 
32,359

 
$
18

 
$
18,734

 
$
(7,878
)
 
$

 
$
(162,016
)
 
$
(151,142
)
Cumulative effect of accounting change

 

 
 

 

 
438

 

 

 
(438
)
 

Accretion of Series C and D redeemable convertible preferred stock

 
2,530

 
 

 

 
(2,530
)
 

 

 

 
(2,530
)
Issuance of common stock upon exercise of stock options

 

 
 
423

 
1

 
1,210

 

 

 

 
1,211

Repurchases of unvested common stock

 

 
 
(549
)
 

 

 
214

 

 

 
214

Accrued interest on notes receivable from stockholders, net of repayments

 

 
 

 

 

 
(46
)
 

 

 
(46
)
Vesting of early exercised stock options

 

 
 

 

 
548

 

 

 

 
548

Stock-based compensation

 

 
 

 

 
1,733

 



 

 
1,733

Net loss

 

 
 

 

 

 

 

 
(11,398
)
 
(11,398
)
Balance as of October 31, 2017
72,501

 
$
203,507

 
 
32,233

 
$
19

 
$
20,133

 
$
(7,710
)
 
$

 
$
(173,852
)
 
$
(161,410
)
The accompanying notes are an integral part of these condensed consolidated financial statements.

6


ZSCALER, INC.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
 
Three Months Ended October 31,
 
2018
 
2017
Cash Flows From Operating Activities
 
 
 
Net Loss
$
(7,588
)
 
$
(11,398
)
Adjustments to reconcile net loss to cash provided by operating activities:
 
 
 
Depreciation and amortization expense
2,170

 
1,921

Amortization expense of acquired intangible assets
95

 

Amortization of deferred contract acquisition costs
4,324

 
2,868

Stock-based compensation expense
7,586

 
1,733

Other
(317
)
 
(47
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable
12,383

 
8,621

Deferred contract acquisition costs
(4,392
)
 
(4,208
)
Prepaid expenses and other assets
(1,138
)
 
(686
)
Accounts payable
(768
)
 
(2,065
)
Accrued expenses and other liabilities
2,110

 
755

Accrued compensation
(4,707
)
 
(3,493
)
Deferred revenue
1,256

 
1,647

Net cash provided by (used in) operating activities
11,014

 
(4,352
)

 
 
 
Cash Flows From Investing Activities
 
 
 
Purchases of property and equipment
(5,414
)
 
(4,010
)
Capitalized internal-use software
(356
)
 
(534
)
Acquired intangible assets
(1,480
)
 

Purchases of short-term investments
(137,429
)
 

Proceeds from maturities of short-term investments
29,333

 

Net cash used in investing activities
(115,346
)
 
(4,544
)
 
 
 
 
Cash Flows From Financing Activities
 
 
 
Payments of costs related to initial public offering
(230
)
 
(1,443
)
Proceeds from issuance of common stock upon exercise of stock options
9,796

 
1,211

Repurchases of unvested common stock
(22
)
 
(3,090
)
Repayments of notes receivable from stockholders
1,905

 

Net cash provided by (used in) financing activities
11,449

 
(3,322
)
 
 
 
 
Net decrease in cash, cash equivalents and restricted cash
(92,883
)
 
(12,218
)
Cash, cash equivalents and restricted cash at beginning of period
136,147

 
88,546

Cash, cash equivalents and restricted cash at end of period
$
43,264

 
$
76,328

 
 
 
 
Supplemental Disclosure of Cash Flow Information:
 
 
 
Cash paid for income taxes
$
517

 
$
141

Supplemental Disclosure of Noncash Investing and Financing Activities:
 
 
 
Net change in purchased equipment included in accounts payable and accrued expenses
$
786

 
$
(41
)
Accretion of Series C and D redeemable convertible preferred stock
$

 
$
2,530

Repurchases of unvested common stock by cancellation of indebtedness
$

 
$
214

Vesting of early exercised common stock options
$
290

 
$
548

Net change in deferred offering costs, accrued but not paid
$
(230
)
 
$
971

Reconciliation of cash, cash equivalents and restricted cash within the consolidated balance sheets to the amounts shown in the statements of cash flows above:
 
 
 
Cash and cash equivalents
$
42,786

 
$
75,760

 Restricted cash, current
186

 
180

 Restricted cash, non-current
292

 
388

 Total cash, cash equivalents and restricted cash
$
43,264

 
$
76,328

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

7


ZSCALER, INC.
Notes to Unaudited Condensed Consolidated Financial Statements
Note 1. Business and Summary of Significant Accounting Policies
Description of the Business
Zscaler, Inc. ("Zscaler," the "Company," "we," "us," or "our") is a cloud security company that developed a platform incorporating core security functionalities needed to enable users to safely utilize authorized applications and services based on an organization’s policies. Our solution is a purpose-built, multi-tenant, distributed cloud security platform that secures access for users and devices to applications and services, regardless of location. We deliver our solutions using a software-as-a-service ("SaaS") business model and sell subscriptions to customers to access our cloud platform, together with related support services. We were incorporated in Delaware in September 2007 and conduct business worldwide, with presence in North America, Europe and Asia. Our headquarters are in San Jose, California.
Reverse Stock Split
In March 2018, our board of directors approved an amendment to the Company's amended and restated certificate of incorporation effecting a 2-for-3 reverse stock split of the Company's issued and outstanding shares of common stock and convertible preferred stock. The reverse stock split was effected on March 1, 2018. All issued and outstanding share and per share amounts included in the accompanying condensed consolidated financial statements have been adjusted to reflect this reverse stock split for all periods presented.
Initial Public Offering
In March 2018, we completed our initial public offering ("IPO") of common stock, in which we sold 13,800,000 shares. The shares were sold at an IPO price of $16.00 per share for net proceeds of $205.3 million, after deducting underwriters' discounts and commissions of $15.5 million. In connection with the IPO, we incurred offering costs of $6.5 million which were recorded in stockholders’ equity as a reduction of the net proceeds received from the IPO. Immediately prior to the closing of the IPO, all our outstanding shares of convertible preferred stock were automatically converted into 72,500,750 shares of common stock on a one-to-one basis.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States ("U.S. GAAP") and applicable regulations of the Securities and Exchange Commission ("SEC") regarding interim financial reporting, and include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Certain information and note disclosures normally included in the financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to the applicable required disclosures and regulations of the SEC. Therefore, these unaudited condensed consolidated financial statements and accompanying footnotes should be read in conjunction with the Company's audited consolidated financial statements and related notes in its Annual Report on Form 10-K for the fiscal year ended July 31, 2018 (the "Fiscal 2018 Form 10-K"), as filed with the SEC on September 13, 2018.


8


Interim Unaudited Condensed Consolidated Financial Statements
The accompanying condensed balance sheet as of July 31, 2018 was derived from the audited financial statements as of that date. The accompanying interim condensed consolidated financial statements, including the consolidated balance sheets as of October 31, 2018 , the consolidated statements of operations for the three months ended October 31, 2018 and 2017, the consolidated statements of comprehensive loss for the three months ended October 31, 2018 and 2017, the consolidated statements of cash flows for the three months ended October 31, 2018 and 2017, the consolidated statement of redeemable convertible preferred stock and stockholders’ (equity) deficit for the three months ended October 31, 2018 and 2017 are unaudited. The related financial data and the other financial information disclosed in the accompanying notes to these condensed consolidated financial statements are also unaudited. These interim unaudited condensed consolidated financial statements have been prepared on a basis consistent with our annual consolidated financial statements and, in our opinion, include all normal recurring adjustments necessary to state fairly our quarterly results. The results of operations for the three months ended October 31, 2018 are not necessarily indicative of the results to be expected for the fiscal year ending July 31, 2019 or for any other future fiscal year or interim period.
JOBS Act Extended Transition Period
We are an emerging growth company ("EGC") as defined in the Jumpstart Our Business Startups Act of 2012 (the "JOBS Act"). As an EGC, the JOBS Act allows us to take advantage of specified reduced reporting requirements that are otherwise generally applicable to public companies, including, but not limited to, delayed adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. We have irrevocably elected not to avail ourselves of the extended transition periods available under the JOBS Act for complying with new and revised accounting standards and, therefore, we are subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.
Use of Estimates
The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates, judgments and assumptions that affect the amounts reported and disclosed in the financial statements and accompanying notes. Such estimates include, but are not limited to, the determination of revenue recognition, deferred revenue, deferred contract acquisition costs, valuation of acquired intangible assets, the period of benefit generated from our deferred contract acquisition costs, allowance for doubtful accounts, valuation of common stock options and stock-based awards, useful lives of property and equipment, useful lives of acquired intangible assets, loss contingencies related to litigation and valuation of deferred tax assets. Management determines these estimates and assumptions on historical experience and on various other assumptions that are believed to be reasonable. Actual results could differ significantly from these estimates, and such differences may be material to the condensed consolidated financial statements.
Fiscal Year
Our fiscal year ends on July 31. References to fiscal 2019, for example, refer to our fiscal year ending July 31, 2019.
Significant Accounting Policies
Our significant accounting policies are discussed in the "Index to Consolidated Financial Statements, Note 1. Business and Summary of Significant Accounting Policies" in the Form 10-K for the fiscal year ended July 31, 2018, filed with the SEC on September 13, 2018 (the "Fiscal 2018 10-K"). There have been no significant changes to these policies that have had a material impact on our condensed consolidated financial statements and related notes for the three months ended October 31, 2018. The following describes the impact of certain policies.

9


Revenue Recognition
We adopted Accounting Standards Codification ("ASC") Topic 606, Revenue From Contracts With Customers ("ASC 606") on August 1, 2017, using the full retrospective transition method.
Disaggregation of Revenue
Subscription and support revenue is recognized over time and accounted for approximately 99% and 98% of our revenue for the three months ended October 31, 2018 and 2017, respectively.
The following table summarizes the revenue by region based on the shipping address of customers who have contracted to use our cloud platform:
 
Three Months Ended October 31,
 
2018
 
2017
 
Amount
 
% Revenue
 
Amount 
 
% Revenue
 
(in thousands, except percentage data)
United States
$
29,807

 
47
%
 
$
18,986

 
47
%
Europe, Middle East and Africa (*)
27,394

 
43
%
 
17,664

 
44
%
Asia Pacific
4,789

 
8
%
 
3,124

 
8
%
Other
1,308

 
2
%
 
87

 
1
%
Total
$
63,298

 
100
%
 
$
39,861

 
100
%
(*) Revenue from the United Kingdom represented 10% and 11% of the total revenue for three months ended October 31, 2018 and 2017, respectively.
The following table summarizes the revenue from contracts by type of customer:
 
Three Months Ended October 31,
 
 
2018
 
2017
 
 
Amount
 
% Revenue
 
Amount
 
% Revenue
 
 
(in thousands, except percentage data)
Channel partners
$
60,019

 
95
%
 
$
36,171

 
91
%
 
Direct customers
3,279

 
5
%
 
3,690

 
9
%
 
Total
$
63,298

 
100
%
 
$
39,861

 
100
%
 
Contract Balances
Contract liabilities consist of deferred revenue and include payments received in advance of performance under the contract. Such amounts are recognized as revenue over the contractual period. For the three months ended October 31, 2018 and 2017, we recognized revenue of $53.8 million and $34.1 million, respectively, that was included in the corresponding contract liability balance at the beginning of these periods.

10


Remaining Performance Obligations
The typical subscription and support term is one to three years. Most of our subscription and support contracts are non-cancelable over the contractual term. However, customers typically have the right to terminate their contracts for cause, if we fail to perform. As of October 31, 2018, the aggregate amount of the transaction price allocated to remaining performance obligations was $411.2 million. We expect to recognize 54% of the transaction price over the next 12 months and 97% of the transaction price over the next three years, with the remainder recognized thereafter.
Costs to Obtain and Fulfill a Contract
We capitalize sales commissions and associated payroll taxes paid to internal sales personnel that are incremental to the acquisition of channel partner and direct customer contracts. These costs are recorded as deferred contract acquisition costs in the condensed consolidated balance sheets.
The following table summarizes the activity of the deferred contract acquisition costs:
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)
Beginning balance
$
55,910

 
$
34,662

Capitalization of contract acquisition costs
4,392

 
4,208

Amortization of deferred contract acquisition costs
(4,324
)
 
(2,868
)
Ending balance
$
55,978

 
$
36,002

 
 
 
 
Deferred contract acquisition costs, current
$
16,387

 
$
10,815

Deferred contract acquisition costs, noncurrent
39,591

 
25,187

Total deferred contract acquisition costs
$
55,978

 
$
36,002

Sales commissions accrued but not paid as of October 31, 2018 and July 31, 2018, totaled $3.6 million and $10.0 million, respectively, which are included within accrued compensation in the condensed consolidated balance sheets.
Deferred Offering Costs
Deferred offering costs consisted of fees and expenses incurred in connection with our IPO, including legal, accounting, printing and other IPO-related costs. Upon completion of our IPO, deferred offering costs totaling $6.5 million were reclassified to stockholders' equity (deficit) as a reduction of the net proceeds received from the IPO.
Recently Adopted Accounting Pronouncements
In January 2017, the Financial Accounting Standard Board ("FASB") issued Accounting Standard Update ("ASU") No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. The amendment was issued to clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions of assets or businesses. This standard provides a screen test to determine when a set (inputs and processes that produce an output) is not a business. The screen requires that when substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. We adopted this standard as of August 1, 2018, and it did not have a material impact to our consolidated financial statements.

11


In May 2017, the FASB issued ASU No. 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting, which provides clarity in applying the guidance in Topic 718 around modifications of share-based payment awards. We adopted this standard as of August 1, 2018, and it did not have a material impact to our consolidated financial statements.
In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The new standard eliminates the diversity in practice related to the classification of certain cash receipts and payments for debt prepayment or extinguishment costs, the maturing of a zero-coupon bond, the settlement of contingent liabilities arising from a business combination, proceeds from insurance settlements, distributions from certain equity method investees and beneficial interests obtained in a financial asset securitization. We adopted this standard as of August 1, 2018 using the retrospective transition method, and it did not have a material impact to our consolidated financial statements.
In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, which requires that amounts generally described as restricted cash or restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. We adopted this standard as of August 1, 2018 using the retrospective transition method and we have adjusted our prior period condensed consolidated statement of cash flows to conform to the current presentation.
In June 2018, the FASB issued ASU No. 2018-07, Compensation—Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, which simplifies the accounting for equity awards granted to nonemployees. For public business entities, it is effective for fiscal years beginning after December 15, 2018, and interim periods therein. Early adoption is permitted. We early adopted this standard as of August 1, 2018 using the prospective transition method, which resulted in a cumulative-effect adjustment of $0.3 million recognized within stockholders' equity, as a reduction of additional paid-in capital against accumulated deficit, on the adoption date.
In August 2018, the FASB issued ASU No. 2018-15, “Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract,” 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 new standard requires capitalized costs to be amortized on a straight-line basis generally over the term of the arrangement, and the financial statement presentation for these capitalized costs would be the same as that of the fees related to the hosting arrangements. For public business entities, this standard is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption is permitted. We early adopted this standard as of August 1, 2018 using the prospective transition method, and it did not have a material impact to our consolidated financial statements.
In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, "Disclosure Update and Simplification," amending certain disclosure requirements that have become redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders' equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders' equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. The final rule is effective November 5, 2018. We early adopted this requirement as of August 1, 2018, presenting the activity of the stockholder's equity accounts in the accompanying condensed statements of redeemable convertible preferred stock and stockholders' equity (deficit) for the periods presented.

12


Recently Issued Accounting Pronouncements Not Yet Adopted
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) ("ASU 2016-02"), which requires lessees to recognize most leases on their balance sheets that do not meet the definition of a short-term lease but recognize the expenses on their statements of operations in a manner similar to current accounting rules. In July 2018, the FASB issued ASU 2018-10, Leases (Topic 842), Codification Improvements ("ASU 2018-10"), which clarifies certain adoption provisions of the new leases standard such as the application of implicit rate, lessee reassessment of lease classification and certain transition adjustments. In addition, in July 2018, the FASB issued ASU 2018-11, Leases (Topic 842), Targeted Improvements ("ASU 2018-11"), which allows for the adoption of ASU 2016-02 to be applied at the beginning of the year of adoption, as opposed to at the beginning of the earliest year presented in the financial statements. These standards are effective for fiscal years beginning after December 15, 2018, with early adoption permitted. We are currently evaluating the effect of these standards; however, we anticipate the most significant effects will relate to the recognition of right-of-use assets and lease liabilities arising from our real estate and data center operating leases that do not meet the definition of a short-term lease on the adoption date and providing qualitative and quantitative disclosures in the notes to the condensed consolidated financial statements.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU amends guidance on reporting credit losses for assets held at amortized cost basis and available-for-sale debt securities to require that credit losses on available-for-sale debt securities be presented as an allowance rather than as a write-down. The measurement of credit losses for newly recognized financial assets and subsequent changes in the allowance for credit losses are recorded in the statements of operations. For public business entities, it is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. We are currently evaluating the potential impact of this standard on our consolidated financial statements.
Note 2. Cash Equivalents and Short-Term Investments
Cash equivalents and short-term investments consisted of the following as of October 31, 2018:
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 

Fair Value
 
(in thousands)
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
23,418

 
$

 
$

 
$
23,418

U.S. treasury securities
3,997

 

 

 
3,997

Total cash equivalents
$
27,415

 
$

 
$

 
$
27,415

 
 
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
U.S. treasury securities
$
135,512

 
$

 
$
(97
)
 
$
135,415

U.S. government agency securities
39,285

 

 
(65
)
 
39,220

Corporate debt securities
96,774

 

 
(155
)
 
96,619

Total short-term investments
$
271,571

 
$

 
$
(317
)
 
$
271,254

 
 
 
 
 
 
 
 
Total cash equivalents and short-term investments
$
298,986

 
$

 
$
(317
)
 
$
298,669


13


Cash equivalents and short-term investments consisted of the following as of July 31, 2018:
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 

Fair Value
 
(in thousands)
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
74,408

 
$

 
$

 
$
74,408

U.S. treasury securities
17,488

 

 

 
17,488

U.S. government agency securities
1,999

 

 

 
1,999

Corporate debt securities
11,010

 

 
(1
)
 
11,009

Total cash equivalents
$
104,905

 
$

 
$
(1
)
 
$
104,904

 
 
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
U.S. treasury securities
$
55,768

 
$

 
$
(17
)
 
$
55,751

U.S. government agency securities
17,953

 

 
(19
)
 
17,934

Corporate debt securities
89,362

 
1

 
(88
)
 
89,275

Total short-term investments
$
163,083

 
$
1

 
$
(124
)
 
$
162,960

 
 
 
 
 
 
 
 
Total cash equivalents and short-term investments
$
267,988

 
$
1

 
$
(125
)
 
$
267,864


14


The amortized cost and fair value of our short-term investments based on their stated maturities consisted of the following as of October 31, 2018:
 
Amortized
Cost
 
Fair Value
 
(in thousands)
Due within one year
$
215,368

 
$
215,169

Due between one and two years
56,203

 
56,085

Total short-term investments
$
271,571

 
$
271,254

Short-term investments that were in an unrealized loss position consisted of the following as of October 31, 2018:
 
Less than 12 Months
 
Greater than 12 Months
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
(in thousands)
U.S. treasury securities
$
135,415

 
$
(97
)
 
$

 
$

 
$
135,415

 
$
(97
)
U.S. government agency securities
39,220

 
(65
)
 

 

 
39,220

 
(65
)
Corporate debt securities
94,557

 
(155
)
 

 

 
94,557

 
(155
)
Total investments in a loss position
$
269,192

 
$
(317
)
 
$

 
$

 
$
269,192

 
$
(317
)
Short-term investments that were in an unrealized loss position consisted of the following as of July 31, 2018:
 
Less than 12 Months
 
Greater than 12 Months
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
(in thousands)
U.S. treasury securities
$
55,750

 
$
(17
)
 
$

 
$

 
$
55,750

 
$
(17
)
U.S. government agency securities
17,934

 
(19
)
 

 

 
17,934

 
(19
)
Corporate debt securities
83,332

 
(88
)
 

 

 
83,332

 
(88
)
Total investments in a loss position
$
157,016

 
$
(124
)
 
$

 
$

 
$
157,016

 
$
(124
)
We review the individual securities that have unrealized losses in our short-term investment portfolio on a regular basis to evaluate whether or not any security has experienced an other-than-temporary decline in fair value. We evaluate, among others, whether we have the intention to sell any of these investments and whether it is more likely than not that we will be required to sell any of them before recovery of the amortized cost basis. Based on this evaluation, we determined that there were no other-than-temporary impairments associated with our short-term investments as of October 31, 2018.
Note 3. Fair Value Measurements
We measure our financial assets and liabilities at fair value at each reporting period using a fair value hierarchy which requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s classification within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
Our money market funds are classified within Level I due to the highly liquid nature of these assets which also have quoted prices in active markets.

15


Certain of our investments in available-for-sale securities (i.e., U.S. treasury securities, U.S. government agency securities and corporate debt securities) are classified within Level II. The fair value of these securities is priced by using inputs based on non-binding market consensus prices that are primarily corroborated by observable market data or quoted market prices for similar instruments.
Assets that are measured at fair value on a recurring basis consisted of the following as of October 31, 2018:
 
 
 
Level I
 
Level II
 
Level III
 
Total
 
Quoted Prices
in Active
Markets for
Identical Assets
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
 
(in thousands)
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
23,418

 
$
23,418

 
$

 
$

U.S. treasury securities
3,997

 

 
3,997

 

Total cash equivalents
$
27,415

 
$
23,418

 
$
3,997

 
$

 
 
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
U.S. treasury securities
$
135,415

 
$

 
$
135,415

 
$

U.S. government agency securities
39,220

 

 
39,220

 

Corporate debt securities
96,619

 

 
96,619

 

Total short-term investments
$
271,254

 
$

 
$
271,254

 
$

Assets that are measured at fair value on a recurring basis consisted of the following as of July 31, 2018:
 
 
 
Level I
 
Level II
 
Level III
 
Total
 
Quoted Prices
in Active
Markets for
Identical Assets
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
 
(in thousands)
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
74,408

 
$
74,408

 
$

 
$

U.S. treasury securities
17,488

 

 
17,488

 

U.S. government agency securities
1,999

 

 
1,999

 

Corporate debt securities
11,009

 

 
11,009

 

Total cash equivalents
$
104,904

 
$
74,408

 
$
30,496

 
$

 
 
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
U.S. treasury securities
$
55,751

 
$

 
$
55,751

 
$

U.S. government agency securities
17,934

 

 
17,934

 

Corporate debt securities
89,275

 

 
89,275

 

Total short-term investments
$
162,960

 
$

 
$
162,960

 
$

We did not have transfers between levels of the fair value hierarchy of assets measured at fair value during the periods presented.


16


Note 4. Property and Equipment
Property and equipment consisted of the following:
 
October 31, 2018
 
July 31, 2018
 
(in thousands)
Hosting equipment
$
36,830

 
$
30,743

Computers and equipment
2,398

 
2,335

Purchased software
1,321

 
1,324

Capitalized internal-use software
6,519

 
6,163

Furniture and fixtures
1,477

 
1,478

Leasehold improvements
2,123

 
2,123

Property and equipment, gross
50,668

 
44,166

Less: Accumulated depreciation and amortization
(26,536
)
 
(24,401
)
Total property and equipment, net
$
24,132

 
$
19,765

Depreciation and amortization expense on property and equipment was $2.2 million and $1.9 million for the three months ended October 31, 2018 and 2017, respectively.
Note 5. Acquired Intangible Assets, Net
Acquired intangible assets consist of developed technology. As of October 31, 2018, acquired intangible assets have a weighted-average remaining useful life of 2.8 years and are amortized on a straight-line basis. Amortization expense of intangible assets was $0.1 million for the three months ended October 31, 2018. We did not have acquired intangible assets as of July 31, 2018.
The gross carrying amount and accumulated amortization of acquired intangible assets consisted of the following as of October 31, 2018:
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Book Value
 
(in thousands)
Developed technology
$
1,716

 
$
(95
)
 
$
1,621

Future amortization expense of acquired intangible assets consisted of the following as of October 31, 2018:
 
Amortization
Year ending July 31,
(in thousands)
2019 (remaining nine months)
$
430

2020
572

2021
572

2022
47

Total
$
1,621


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Note 6. Commitments and Contingencies
Operating Leases
We lease our office space under various operating lease agreements expiring at various dates through August 2021.
Future minimum payments under our non-cancelable operating leases consisted of the following as of October 31, 2018:
 
Operating
Leases
 
(in thousands)
Year ending July 31,
 
2019 (remaining nine months)
$
2,296

2020
2,466

2021
1,581

2022
18

Total
$
6,361

Rent expense was $0.7 million and $0.5 million for the three months ended October 31, 2018 and 2017, respectively.
Data Center Contract Commitments
We enter into long-term non-cancelable agreements with providers in various countries to purchase data center capacity, such as bandwidth and colocation space, for our cloud platform. Bandwidth and colocation costs were $2.9 million and $2.1 million for the three months ended October 31, 2018 and 2017, respectively.
Future minimum payments under our non-cancelable data center contracts consisted of the following as of October 31, 2018:
 
Data Center
Contracts 
 
(in thousands)
Year ending July 31,
 
2019 (remaining nine months)
$
5,435

2020
4,860

2021
2,672

2022
483

Total
$
13,450

Non-cancelable Purchase Obligations
In the normal course of business, we enter into non-cancelable purchase commitments with various parties to purchase products and services such as technology equipment, office renovations, corporate events and consulting services. As of October 31, 2018 and July 31, 2018, we had outstanding non-cancelable purchase obligations with a term of 12 months or longer of $3.9 million and $3.1 million, respectively.

18


Legal Matters
Symantec Litigation
We are currently involved in legal proceedings with Symantec. On December 12, 2016, Symantec filed a complaint, which we refer to as Symantec Case 1, in the U.S. District Court for the District of Delaware alleging that "Zscaler’s cloud security platform" infringes U.S. Patent Nos. 6,279,113, 7,203,959 ("’959 patent"), 7,246,227 ("’227 patent"), 7,392,543, 7,735,116, 8,181,036 and 8,661,498. The complaint seeks compensatory damages, an injunction, enhanced damages and attorney fees. On August 2, 2017, the court granted our motion to transfer Symantec Case 1 from the District of Delaware to the Northern District of California. On March 23, 2018, the Northern District of California court granted our motion to dismiss the asserted claims of the ’959 and ’227 patents as invalid based on unpatentable subject matter.
On April 18, 2017, Symantec filed a second complaint, which we refer to as Symantec Case 2, in the U.S. District Court for the District of Delaware alleging that "Zscaler’s cloud security platform" infringes U.S. Patent Nos. 6,285,658, 7,360,249, 7,587,488, 8,316,429 ("’429 patent"), 8,316,446 ("’446 patent"), 8,402,540 and 9,525,696. The complaint seeks compensatory damages, an injunction, enhanced damages and attorney fees.
On June 22, 2017, Symantec filed a notice of voluntary dismissal of its complaint in Symantec Case 2 along with a new complaint alleging infringement of the same patents and adding Symantec Limited as a plaintiff and alleging willful infringement of the ’429 and ’446 patents. On July 31, 2017, the court granted our motion to transfer Symantec Case 2 from the District of Delaware to the Northern District of California. On May 21, 2018, Symantec filed an amended complaint adding allegations of willful infringement of all of the asserted patents in Symantec Case 2. 
We have also received letters from Symantec alleging that our "cloud security platform" infringes U.S. Patent Nos. 7,031,327, 7,496,661, 7,543,036 and 7,624,110.
We believe that our technology does not infringe Symantec’s asserted patents and that these patents are invalid.
Should Symantec prevail with its infringement allegations, we could be required to pay substantial damages for past and future sales and/or licensing of our services, enjoined from making, using, selling or otherwise disposing of our services if a license or other right to continue selling our services is not made available to us, and required to pay substantial ongoing royalties and comply with unfavorable terms if such a license is made available to us. Any of these outcomes could result in a material adverse effect on our business. Even if we were to prevail, this litigation could be costly and time-consuming, divert the attention of our management and key personnel from our business operations, deter distributors from selling or licensing our services, and dissuade potential customers from purchasing our services, which would also materially harm our business. The expense of litigation and the timing of this expense from period to period are difficult to estimate, subject to change and could adversely affect our results of operations. In addition, any public announcements of the results of any proceedings in Symantec Case 1 or Case 2 could be negatively perceived by industry or financial analysts and investors, and could cause our stock price to experience volatility or decline.
We have not recorded a liability with respect to Symantec Case 1 or Case 2 based on our determination that a loss in either case is not probable under the applicable accounting standards.
We are vigorously defending Symantec Case 1 and Case 2. We are unable to predict the likelihood of success of Symantec’s infringement claims.
Finjan Litigation
We are currently involved in legal proceedings with Finjan. On December 5, 2017, Finjan filed a complaint, in the U.S. District Court for the Northern District of California alleging that Zscaler’s "Internet Access Bundles," "Private Access Bundle," "Zscaler Enforcement Node," "Secure Web Gateway," "Cloud Firewall," "Cloud Sandbox" and "Cloud Architecture products

19


and services" infringe U.S. Patent Nos. 6,804,780, 7,647,633, 8,677,494 and 7,975,305. The complaint seeks compensatory damages, an injunction, enhanced damages and attorney fees.
We believe our technology does not infringe Finjan’s asserted patents and that Finjan’s patents are invalid.
Should Finjan prevail with its infringement allegations, we could be required to pay substantial damages for past and future sales and/or licensing of our services, enjoined from making, using, selling or otherwise disposing of our services if a license or other right to continue selling our services is not made available to us, and required to pay substantial ongoing royalties and comply with unfavorable terms if such a license is made available to us. Any of these outcomes could result in a material adverse effect on our business. Even if we were to prevail, this litigation could be costly and time-consuming, divert the attention of our management and key personnel from our business operations, deter distributors from selling or licensing our services, and dissuade potential customers from purchasing our services, which would also materially harm our business. The expense of litigation and the timing of this expense from period to period are difficult to estimate, subject to change and could adversely affect our results of operations. In addition, any public announcements of the results of any proceedings in this matter could be negatively perceived by industry or financial analysts and investors, and could cause our stock price to experience volatility or decline.
While the range of potential loss resulting from the lawsuit cannot be reasonably estimated, we have accrued a total liability of $3.2 million as of October 31, 2018 related to past negotiations with Finjan of which we recognized $0.7 million in fiscal 2018 and $2.5 million in fiscal 2017.
We are vigorously defending this lawsuit. Given the early stage in the litigation, we are unable to predict the likelihood of success of Finjan’s infringement claims.
Other Litigation and Claims
In addition, from time to time we are a party to various litigation matters and subject to claims that arise in the ordinary course of business, including patent, commercial, product liability, employment, class action, whistleblower and other litigation and claims, as well as governmental and other regulatory investigations and proceedings. In addition, third parties may from time to time assert claims against us in the form of letters and other communications. Except as otherwise described above, there is no pending or threatened legal proceeding to which we are a party that, in our opinion, is likely to have a material adverse effect on our future financial results or operations; however, the results of litigation and claims are inherently unpredictable. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors. The expense of litigation and the timing of this expense from period to period are difficult to estimate, subject to change and could adversely affect our results of operations.
Note 7. Preferred Stock
Upon completion of our IPO, as further described in Note 1, all shares of convertible preferred stock then outstanding, totaling 72,500,750 shares, were automatically converted into an equivalent number of shares of common stock on a one-to-one basis and their carrying value, totaling $207.3 million, inclusive of accretion of Series C and D redeemable convertible preferred stock of $24.7 million, was reclassified to stockholders' equity (deficit).
Prior to the IPO, we recognized accretion to the redemption price of Series C and D redeemable convertible preferred stock. Accretion was recognized as a reduction of additional paid-in capital with a corresponding increase to the carrying value of Series C and D redeemable convertible preferred stock. Upon completion of the IPO, the accretion rights of Series C and D redeemable convertible preferred stock were terminated. For the three months ended October 31, 2017, we recognized accretion of $2.5 million.

20


Note 8. Common Stock
Holders of our common stock are entitled to one vote for each share of common stock held and are not entitled to receive dividends unless declared by our board of directors.
As of October 31, 2018, shares of common stock reserved for future issuance consisted of the following:
 
October 31, 2018
 
(in thousands)
Equity awards outstanding:
 
Stock options
13,417

Unvested restricted stock units
2,636

Unvested performance stock units, based on the target number of shares granted (*)
1,175

Purchase rights committed under the employee stock purchase plan
1,973

Equity awards available for future grants:
 
Equity incentive plans
17,010

Employee stock purchase plan
1,425

Total reserved shares of common stock for future issuance
37,636

(*) Holders of performance stock units corresponding to fiscal 2019, as further described in Note 9, have the ability to receive up to 150% of the target number of shares granted if maximum achievement of target performance metrics is attained.
Note 9. Stock-Based Compensation
Equity Incentive Plans
We adopted the Fiscal Year 2018 Equity Incentive Plan (the "2018 Plan") in fiscal 2018 and the 2007 Stock Plan (the "2007 Plan") in fiscal 2008, collectively referred to as the "Plans." Equity incentive awards granted under the Plans may be either incentive RSUs, restricted stock, stock options, nonstatutory stock options, stock appreciation rights, performance units and performance shares to our employees, directors, officers and consultants. In March 2018, in connection with our IPO, the 2007 Plan was terminated along with its remaining balance of shares of common stock available for grant. With the establishment of the 2018 Plan, we no longer grant stock-based awards under the 2007 Plan and any shares underlying stock options that expire or terminate or are forfeited or repurchased by us under the 2007 Plan will be automatically transferred to the 2018 Plan. As of October 31, 2018, a total of 18,688,216 shares of common stock have been reserved for issuance under the 2018 Plan.
Stock Options
Under the Plans, the exercise price of a stock option grant must not be less than 100% of the fair market value of the common stock on the date of grant. Generally, stock options vest over four years with 25% of the option shares vesting one year from the date of grant and monthly thereafter over the remaining vesting term. Stock options granted under the 2018 Plan and 2007 Plan are exercisable over a maximum term of ten years and seven years, respectively, from the date of grant. Stock options that are forfeited or canceled shall become available for future grant or sale under the 2018 Plan.



The activity of stock options consisted of the following:
 
Outstanding
Stock
Options
 
Weighted-Average
Exercise
Price 
 
Weighted-Average
Remaining
Contractual Term
(in years)
 
Aggregate
Intrinsic
Value
 
(in thousands, except per share data)
Balance as of July 31, 2018
16,175

 
$6.20
 
5.1
 
$
470,860

Stock options exercised
(2,350
)
 
$4.17
 
 
 
$
87,739

Stock options canceled, forfeited, expired
(408
)
 
$6.26
 
 
 
 
Balance as of October 31, 2018
13,417

 
$6.56
 
5.1
 
$
398,958

Exercisable and expected to vest as of July 31, 2018
5,499

 
$3.97
 
4.0
 
$
172,317

Exercisable and expected to vest as of October 31, 2018
4,027

 
$4.20
 
4.0
 
$
129,225

The aggregate intrinsic value of the stock options exercised represents the difference between the fair value of our common stock on the date of exercise and their exercise price. The total intrinsic value of options exercised was $87.7 million and $2.0 million for three months ended October 31, 2018 and 2017, respectively. The weighted-average grant-date fair value per share of awards granted was $2.03 for the three months ended October 31, 2017. Since our IPO, we have not granted additional stock options.
We estimated the fair value of employee stock option using the Black-Scholes option pricing model with the following assumptions.
 
Three Months Ended
October 31, 2017
Expected term (in years)
4.6
Expected stock price volatility
41.5%
Risk-free interest rate
1.7%
Dividend yield
0.0%
Restricted Stock Units
The 2018 Plan allows for the grant of restricted stock units ("RSUs"). Generally, RSUs are subject to a four-year vesting period, with 25% of the shares vesting one year from the date of grant and quarterly thereafter over the remaining vesting term. We began granting RSUs in our fourth quarter of fiscal 2018.

22


The RSU activity for the three months ended October 31, 2018 consisted of the following:
 
Number of Shares
 
Weighted-Average Grant Date Fair Value per Share
 
Aggregate Intrinsic Value
 
(in thousands, except per share data)
Balance as of July 31, 2018
209

 
$26.26
 
$
7,394

Granted
2,449

 
$41.15
 
 
Vested

 
 
 
Canceled, forfeited
(22
)
 
$41.34
 
 
Balance as of October 31, 2018
2,636

 
$39.97
 
$
95,674

Performance Stock Units
The 2018 Plan allows for the grant of performance stock units ("PSUs"). In the quarter ended October 31, 2018, the compensation committee of our board of directors approved the grant of PSUs to certain members of our executive team corresponding to the performance periods of fiscal 2019, 2020, 2021 and 2022. In addition, the compensation committee determined and approved the corporate performance metrics for fiscal 2019. The corporate performance metrics corresponding to future fiscal years will be determined and approved in the future for each corresponding fiscal year. Holders of PSUs corresponding to the performance period of fiscal 2019 have the ability to receive up to 150% the target number of shares granted if maximum achievement of target performance metrics is achieved. The right to receive such awards is subject to achievement of the defined corporate performance metrics corresponding for each fiscal year and continuous service by the employee. Any earned awards are subject to additional time-based vesting in accordance with the respective award agreement. Since the performance conditions of future fiscal years have not been established as of October 31, 2018, these awards are not considered granted for accounting purposes. Therefore, we have not recognized stock-based compensation expense for PSUs corresponding to fiscal years beyond 2019.
As of October 31, 2018, the number of unvested PSUs outstanding based on the target number of shares granted consisted of the following:
 
Shares
Performance periods:
(in thousands)
Fiscal 2019
438

Fiscal 2020
437

Fiscal 2021
150

Fiscal 2022
150

Total
1,175


23


The following table presents the activity of PSUs for which performance conditions have been established and are expected to be earned:
 
Three Months Ended October 31, 2018
 
Number of Shares
 
Weighted-Average Grant Date Fair Value per Share
 
Aggregate Intrinsic Value
 
(in thousands, except per share data)
Balance as of July 31, 2018

 
 
$

Granted
438

 
$37.04
 
 
Vested

 
 
$

Canceled, forfeited

 
 
 
Balance as of October 31, 2018
438

 
$37.04
 
$
15,877

Employee Stock Purchase Plan
We adopted the Fiscal Year 2018 Employee Stock Purchase Plan (the "ESPP") in the third quarter of fiscal 2018. As of October 31, 2018, a total of 3,397,643 shares of common stock were reserved for issuance under the ESPP. The ESPP provides eligible employees with an opportunity to purchase shares of our common stock through payroll deductions of up to 15% of their eligible compensation. A participant may purchase a maximum of 3,000 shares of common stock during a purchase period. The purchase price of the shares shall be 85% of the lower of the fair market value of our common stock on (i) the first trading day of the applicable offering period and (ii) the last trading day of each purchase period in the related offering period. The ESPP provides for consecutive offering periods that will typically have a duration of approximately 24 months in length and is comprised of four purchase periods of approximately six months in length. The offering periods are scheduled to start on the first trading day on or after June 15 and December 15 of each year. Our first and second ESPP offering periods commenced on March 16, 2018 and June 15, 2018. The first ESPP purchase date is scheduled in December 2018.
ESPP employee payroll contributions accrued at October 31, 2018 and July 31, 2018, totaled $7.8 million and $4.6 million, respectively, and are included within accrued compensation in the condensed consolidated balance sheets. Employee payroll contributions ultimately used to purchase shares under the ESPP will be reclassified to stockholders' equity at the end of the purchase period.
Early Exercise of Employee Options
The 2007 Plan allowed for the early exercise of stock options for certain individuals as determined by the board of directors. The consideration received for an early exercise of an option is considered to be a deposit of the exercise price and is reflected as liability in the condensed consolidated balance sheets and reclassified to additional paid-in capital as the awards vest. Upon an employee’s termination, we have the option to repurchase unvested shares at a price per share equal to the lesser of the fair market value of the shares at the time of the repurchase or the original purchase price. During the three months ended October 31, 2018 and 2017, we reclassified to additional paid-in capital $0.3 million and 0.5 million, respectively, related to awards vested during these periods. As of October 31, 2018 and July 31, 2018, the number of shares of common stock subject to repurchase was 323,653 shares and 422,528 shares with an aggregate purchase price of $1.2 million and $1.6 million, respectively.
Notes Receivable from Stockholders
Prior to fiscal 2017, we entered into notes receivable agreements with certain of our current and former executives and employees in connection with the exercise of their stock options. The outstanding principal amount and related accrued interest on the notes are presented as contra-equity in the condensed consolidated balance sheets until the notes are fully

24


settled. As of July 31, 2018, the carrying amount of the outstanding notes receivable, inclusive of accrued interest of $0.1 million, was $2.1 million. During the three months ended October 31, 2018, the principal amount and accrued interest of the remaining outstanding notes were fully repaid, resulting in cash proceeds of $2.1 million.
Stock-based Compensation Expense
The components of stock-based compensation expense recognized in the condensed consolidated statements of operations consisted of the following:
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)
Cost of revenue
$
503

 
$
109

Sales and marketing
2,801

 
785

Research and development
2,795

 
398

General and administrative
1,487

 
441

Total stock-based compensation expense
$
7,586

 
$
1,733

As of October 31, 2018, the unrecognized stock-based compensation cost was $148.6 million, which we expect to amortize over a weighted-average period of 3.7 years.
Note 10. Income Taxes
Our tax provision for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, we update our estimate of the annual effective tax rate, and if the estimated annual effective tax rate changes, we make a cumulative adjustment in such period.
Our quarterly tax provision, and estimate of our annual effective tax rate, is subject to variation due to several factors, including variability in pre-tax income (or loss), the mix of jurisdictions to which such income relates, changes in how we do business, and tax law developments. Our estimated effective tax rate for the year differs from the U.S. statutory rate of 21% primarily due to the earnings of our foreign subsidiaries being taxed at rates higher than the U.S. statutory rate.
We recorded a provision for income taxes of $0.3 million for the three months ended October 31, 2018. We are subject to income tax in the U.S. as well as other tax jurisdictions in which we conduct business. Earnings from our non-U.S. operations are subject to income taxes in the countries in which we operate. Our provision for income taxes consists primarily of both income and withholding taxes in the foreign jurisdictions in which we conduct business.
The realization of deferred tax assets is dependent upon the generation of sufficient taxable income of the appropriate character in future periods. We assess our ability to realize the deferred tax assets on a quarterly basis and we establish a valuation allowance if it is more-likely-than-not that some portion of the deferred tax assets will not be realized. We weigh all available positive and negative evidence, including our earnings history and results of recent operations, scheduled reversals of deferred tax liabilities, projected future taxable income and tax planning strategies. Due to the weight of objectively verifiable negative evidence, including our history of losses in certain jurisdictions, we believe that it is more likely than not that our U.S. federal and state deferred tax assets will not be realized. Accordingly, we have maintained a valuation allowance on our U.S. federal and state deferred tax assets. During the three months ended October 31, 2018, we determined that due to the weight of objectively verifiable negative evidence our UK deferred tax assets are no longer more likely than not to be realized in future and a full valuation allowance was recorded during this period.
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 or the Tax Act was enacted. The Tax Act contains several key tax provisions that affect us, including, but not limited to, reducing the U.S. federal corporate tax rate from 34% to 21% imposing a one-time mandatory transition tax on previously untaxed foreign earnings, and changing rules related to the use of net operating

25


loss carryforwards created in tax years beginning after December 31, 2017. In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”), which allows us to record provisional amounts during a measurement period not to extend beyond one year past the enactment date.
We currently maintain a full valuation allowance recorded against our U.S. federal deferred tax assets. As such, the provision estimate associated with the remeasurement of our deferred tax assets was offset by the change in our valuation allowance which resulted in no income tax expense or benefit. Because of our full valuation allowance and current year losses, there is no tax expense associated with the one-time mandatory transition tax. We are still in the process of analyzing the impacts of the policy decision regarding whether to record deferred taxes associated with GILTI.
We will complete our assessment of the impacts of the Tax Act, including the remeasurement of our deferred taxes, the one-time mandatory transition tax, and the policy decision regarding whether to record deferred taxes associated with GILTI during the second quarter of this fiscal year in accordance with SAB 118. Our final assessment of the Tax Act may differ from our provisional estimates during the measurement period due to, among other things, further refinement in our calculations, changes in interpretations and assumptions we have made, or guidance that may be issued. However, due to our full valuation allowance, any changes to our provisional estimates will have no impact to our tax expense.
Note 11. Net Loss Per Share Attributable to Common Stockholders
The following table sets forth the computation of basic and diluted net loss per share attributable to common stockholders:
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)
Net loss
$
(7,588
)
 
$
(11,398
)
Accretion of Series C and D redeemable convertible preferred stock

 
(2,530
)
Net loss attributable to common stockholders
$
(7,588
)
 
$
(13,928
)
Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted
120,587

 
30,793

Net loss per share attributable to common stockholders, basic and diluted
$
(0.06
)
 
$
(0.45
)

26


Since we have reported net losses for all periods presented, we have excluded all potentially dilutive securities from the calculation of the diluted net loss per share attributable to common stockholders as their effect is antidilutive and accordingly, basic and diluted net loss per share attributable to common stockholders is the same for all periods presented.
The following table summarizes the unweighted outstanding potentially dilutive securities that were excluded from the computation of the diluted net loss per share attributable to common stockholders because the impact of including them would have been antidilutive:
 
October 31,
2018
 
October 31,
2017
 
(in thousands)
Convertible preferred stock

 
72,501

Outstanding stock options
13,418

 
14,654

Shares subject to repurchase from early exercised stock options
324

 
1,146

Purchase rights committed under the ESPP
1,973

 

Unvested RSUs
2,636

 

Unvested PSUs (*)
438

 

Total
18,789

 
88,301

(*) This table excludes unvested PSUs for which performance conditions have not been established as of October 31, 2018, as they are not considered outstanding for accounting purposes. Refer to Note 9 for further information.
Note 12. Significant Customers and Geographic Information
No single customer accounted for 10% or more of our revenue for the three months ended October 31, 2018 and 2017. Refer to Note 1 to our condensed consolidated financial statements for revenue by geography.
The following table summarizes 10% or more of the total balance of accounts receivable, net:
 
October 31, 2018
 
July 31, 2018
Channel partner A
12%
 
13%
Channel partner B
11%
 
*
Channel partner C
10%
 
*
Channel partner D
*
 
13%
(*) Represents less than 10%.
Our long-lived assets are composed of property and equipment, net and acquired intangible assets, net and are summarized by geographic area as follows:
 
October 31, 2018
 
July 31, 2018
 
(in thousands)
United States
$
19,000

 
$
14,742

Rest of the world
6,753

 
5,023

Total long-lived assets
$
25,753

 
$
19,765


27


Note 13. Related Party Transactions
We previously entered into notes receivable agreements with certain of our current and former executives and employees in connection with the exercise of their stock options. Outstanding notes receivable were fully repaid during the quarter ended October 31, 2018. Refer to Note 9 to our condensed consolidated financial statements for further information.






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 included elsewhere in this Quarterly Report on Form 10-Q and with our Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K filed with the SEC on September13, 2018. As discussed in the section titled "Special Note Regarding Forward-Looking Statements," the following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such difference include, but are not limited to, those identified below and those discussed in the section titled "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q. Our fiscal year end is July 31, and our fiscal quarters end on October 31, January 31, April 30 and July 31. Our fiscal year ended July 31, 2018 is referred to as fiscal 2018 and our fiscal year ending July 31, 2019 is referred to as fiscal 2019.
Overview
Zscaler was incorporated in 2007, during the early stages of cloud adoption and mobility, based on a vision that the internet would become the new corporate network as the cloud becomes the new data center. We predicted that with rapid cloud adoption and increasing workforce mobility, traditional perimeter security approaches would provide inadequate protection for users and data and an increasingly poor user experience. We pioneered a security cloud that represents a fundamental shift in the architectural design and approach to network security.
We generate revenue primarily from sales of subscriptions to access our cloud platform, together with related support services. We also generate an immaterial amount of revenue from professional and other services, which consist primarily of fees associated with mapping, implementation, network design and training. Our subscription pricing is calculated on a per-user basis. We recognize subscription and support revenue ratably over the life of the contract, which is generally one to three years. As of July 31, 2018, we had expanded our operations to over 3,250 customers across every major industry, with users in 185 countries. Government agencies and some of the largest enterprises in the world rely on us to help them transform to the cloud, including more than 300 of the Forbes Global 2000.
We operate our business as one reportable segment. Our revenue has experienced significant growth, with revenue increasing from $39.9 million in the three months ended October 31, 2017 to $63.3 million in the three months ended October 31, 2018, representing year-over-year revenue growth of 59%. However, we have incurred net losses in all periods since our inception. Our net loss decreased from $11.4 million for the three months ended October 31, 2017 to $7.6 million for the three months ended October 31, 2018. We expect we will continue to incur net losses for the foreseeable future, as we continue investing in our sales and marketing organization to take advantage of our market opportunity, continue to invest in research and development efforts to enhance the functionality of our cloud platform, continue to incur additional compliance and other related costs as we operate as a public company, and deal with ongoing legal matters and related accruals, certain of which are described in further detail Note 6 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
Initial Public Offering
In March 2018, we completed our IPO of common stock, in which we sold 13,800,000 shares. The shares were priced at an IPO price of $16.00 per share for net proceeds of $205.3 million, after deducting underwriters’ discounts and commissions of $15.5 million. In connection with the IPO, we incurred deducting offering costs of $6.5 million which were recorded in stockholders’ equity (deficit) as a reduction of the net proceeds received from the IPO. Immediately prior to the closing of the IPO, all our outstanding shares of preferred stock were automatically converted into 72,500,750 shares of common stock on a one-to-one basis.

29


Certain Factors Affecting Our Performance
Increased Internet Traffic and Adoption of Cloud-Based Software and Security
The adoption of cloud applications and infrastructure, explosion of internet traffic volumes and shift to mobile-first computing generally, and the pace at which enterprises adopt the internet as their corporate network in particular, impact our ability to drive market adoption of our cloud platform. We believe that most enterprises are in the early stages of a broad transformation to the cloud. Organizations are increasingly relying on the internet to operate their businesses, deploying new SaaS applications and migrating internally managed line-of-business applications to the cloud. However, the growing dependence on the internet has increased exposure to malicious or compromised websites, and sophisticated hackers are exploiting the gaps left by legacy network security appliances. To securely access the internet and transform their networks, organizations must also make fundamental changes in their network and security architectures. We believe that most organizations have yet to fully make these investments. Since we enable organizations to securely transform to the cloud, we believe that the imperative for organizations to securely move to the cloud will increase demand for our cloud platform and broaden our customer base.
New Customer Acquisition
We believe that our ability to increase the number of customers on our cloud platform is an indicator of our market penetration and our future business opportunities. As of July 31, 2018 and 2017, we had over 3,250 customers and over 2,800 customers, respectively, across all major geographies. As of July 31, 2018, we had over 300 of the Forbes Global 2000 as customers. Our ability to continue to grow this number will increase our future opportunities for renewals and follow-on sales. We believe that we have significant room to capture additional market share and intend to continue to invest significantly in sales and marketing to engage our prospective customers, increase brand awareness, further leverage our channel partnerships and drive adoption of our solution.
Follow-On Sales
We typically expand our relationship with our customers over time. While most of our new customers route all of their internet-bound web traffic through our cloud platform, some of our customers initially use our services for specific users or specific security functionality. We leverage our land-and-expand model with the goal of generating incremental revenue, often within the term of the initial subscription, by increasing sales to our existing customers in one of three ways:
expanding deployment of our cloud platform to cover additional users;
upgrading to a more advanced Business, Transformation or Secure Transformation suite; and
selling a ZPA subscription to a ZIA customer, a ZIA subscription to a ZPA customer, or other features on an a la carte basis.
Investing in Business Growth
Since our founding, we have invested significantly in growing our business. We intend to continue to invest in our research and development organization, our development efforts to offer new solutions on our platform and to continue dedicating resources to update and upgrade our existing solutions. We also intend to continue to invest significantly in sales and marketing to grow and train our sales force. Although we have a channel sales model, we use a joint sales approach in which our sales force develops relationships directly with our customers. We also are investing in programs to increase recognition of our brand and solutions, including joint marketing activities with our channel partners and strategic partners. In addition, we expect our general and administrative expenses to increase in absolute dollars for the foreseeable future to support our growth, as a result of additional costs associated with ongoing legal matters and related accruals, and in connection with accounting, compliance and investor relations as a public company.

30


Key Business Metrics and Other Financial Measures
We review a number of operating and financial metrics, including the following key metrics, to measure our performance, identify trends, formulate business plans and make strategic decisions.
Dollar-Based Net Retention Rate
We believe that dollar-based net retention rate is a key metric to measure the long-term value of our customer relationships because it is driven by our ability to retain and expand the recurring revenue generated from our existing customers. Our dollar-based net retention rate compares the recurring revenue from a set of customers against the same metric for the prior 12-month period on a trailing basis. Because our customers have repeat buying patterns and the average term of our contracts is more than 12 months, we measure this metric over a set of customers who were with us as of the last day of the same reporting period in the prior fiscal year. Our dollar-based net retention rate includes customer attrition. We have not experienced a material increase in customer attrition rates in recent periods.
We calculate our dollar-based net retention rate as follows:
Denominator: To calculate our dollar-based net retention rate as of the end of a reporting period, we first establish the annual recurring revenue, or ARR, from all active subscriptions as of the last day of the same reporting period in the prior fiscal year. This effectively represents recurring dollars that we expect in the next 12-month period from the cohort of customers that existed on the last day of the same reporting period in the prior fiscal year.
Numerator: We measure the ARR for that same cohort of customers representing all subscriptions based on confirmed customer orders booked by us as of the end of the reporting period.
Dollar-based net retention rate is obtained by dividing the numerator by the denominator. Our dollar-based net retention rate may fluctuate due to a number of factors, including the performance of our cloud platform, the rate of ARR expansion of our existing customers, potential changes in our rate of renewals and other risk factors described in this Quarterly Report on Form 10-Q.
 
Trailing 12 Months Ended October 31, 2018
 
Trailing 12 Months Ended October 31, 2017
Dollar-based net retention rate
118%
 
116%
Non-GAAP Financial Measures
In addition to our results determined in accordance with U.S. GAAP, we believe the following non-GAAP measures are useful in evaluating our operating performance. We use the following non-GAAP financial information to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with U.S. GAAP. In particular, free cash flow is not a substitute for cash used in operating activities. Additionally, the utility of free cash flow as a measure of our liquidity is further limited as it does not represent the total increase or decrease in our cash balance for a given period. In addition, other companies, including companies in our industry, may calculate similarly-titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with U.S. GAAP. Investors are encouraged to review

31


the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures, and not to rely on any single financial measure to evaluate our business.
Non-GAAP Gross Profit and Non-GAAP Gross Margin
We define non-GAAP gross profit as GAAP gross profit excluding stock-based compensation expense. We define non-GAAP gross margin as non-GAAP gross profit as a percentage of revenue.
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)
Gross profit
$
51,199

 
$
31,590

Add: Stock-based compensation expense included in cost of revenue
503

 
109

Non-GAAP gross profit
$
51,702

 
$
31,699

Gross margin
81
%
 
79
%
Non-GAAP gross margin
82
%
 
80
%
Non-GAAP Income (Loss) from Operations and Non-GAAP Operating Margin
We define non-GAAP income (loss) from operations as GAAP loss from operations excluding stock-based compensation expense, certain litigation-related expenses and amortization expense of acquired intangible assets. We define non-GAAP operating margin as non-GAAP income (loss) from operations as a percentage of revenue. These excluded litigation-related expenses are professional fees and related costs incurred by us in defending against significant claims that we deem not to be in the ordinary course of our business and, if applicable, accruals related to estimated losses in connection with these claims. There are many uncertainties and potential outcomes associated with any litigation, including the expense of litigation, timing of such expenses, court rulings, unforeseen developments, complications and delays, each of which may affect our results of operations from period to period, as well as the unknown magnitude of the potential loss relating to any lawsuit, all of which are inherently subject to change, difficult to estimate and could adversely affect our results of operations.
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)
Loss from operations
$
(8,663
)
 
$
(11,277
)
Add: Stock-based compensation expense
7,586

 
1,733

Add: Litigation-related expenses
2,174

 
2,146

Add: Amortization expense of acquired intangible assets
95

 

Non-GAAP income (loss) from operations
$
1,192

 
$
(7,398
)
Operating margin
(14
)%
 
(28
)%
Non-GAAP operating margin
2
 %
 
(19
)%
Free Cash Flow and Free Cash Flow Margin
Free cash flow is a non-GAAP financial measure that we calculate as net cash used in operating activities less purchases of property and equipment and capitalized internal-use software. Free cash flow margin is calculated as free cash flow divided by revenue. We believe that free cash flow and free cash flow margin are useful indicators of liquidity that provide information to management and investors about the amount of cash generated from our operations that, after the investments in property and equipment and capitalized internal-use software, can be used for strategic initiatives, including investing in our business, and strengthening our financial position.

32


Free cash flow includes the cyclical impact of inflows and outflows resulting from contributions to our employee stock purchase plan for which the purchase period of approximately six months ends in each of our second and fourth fiscal quarter. As of October 31, 2018, the employee contributions to our employee stock purchase plan was $7.8 million, which will be reclassified to stockholders' equity upon issuance of the shares during our second quarter of fiscal 2019.
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)
Net cash provided by (used in) operating activities
$
11,014

 
$
(4,352
)
Less: Purchases of property and equipment
(5,414
)
 
(4,010
)
Less: Capitalized internal-use software
(356
)
 
(534
)
Free cash flow
$
5,244

 
(8,896
)
As a percentage of revenue:
 
 
 
Net cash provided by (used in) operating activities
17
 %
 
(11
)%
Less: Purchases of property and equipment
(8
)%
 
(10
)%
Less: Capitalized internal-use software
(1
)%
 
(1
)%
Free cash flow margin
8
 %
 
(22
)%
Calculated Billings
We believe that calculated billings is a key metric to measure our periodic performance. Calculated billings represents our revenue plus the change in deferred revenue in a period. Calculated billings in any particular period aims to reflect amounts invoiced for subscriptions to access our cloud platform, together with related support services related to our new and existing customers. We typically invoice our customers annually in advance, and to a lesser extent quarterly in advance, monthly in advance or multi-year in advance.
Calculated billings increased $23.0 million, or 56%, for the three months ended October 31, 2018 over the three months ended October 31, 2017. As calculated billings continues to grow in absolute terms, we expect our calculated billings growth rate to trend down over time. We also expect that calculated billings will be affected by seasonality in terms of when we enter into agreements with customers; and the mix of billings in each reporting period as we typically invoice customers annually in advance, and to a lesser extent quarterly in advance, monthly in advance or multi-year in advance.
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)
Revenue
$
63,298

 
$
39,861

Add: Total deferred revenue, end of period
165,279

 
98,266

Less: Total deferred revenue, beginning of period
(164,023
)
 
(96,619
)
Calculated billings
$
64,554

 
$
41,508


Components of Results of Operations
Revenue
We generate revenue primarily from sales of subscriptions to access our cloud platform, together with related support services. These subscription and related support services accounted for approximately 99% of our revenue for the three months ended October 31, 2018 and 2017. Our contracts with our customers do not at any time provide the customer with the right to

33


take possession of the software that runs our cloud platform. Our customers may also purchase professional services, such as mapping, implementation, network design and training. Professional services account for an immaterial portion of our revenue.
We generate revenue from contracts with typical durations ranging from one to three years. We typically invoice our customers annually in advance, and to a lesser extent quarterly in advance, monthly in advance or multi-year in advance. We recognize revenue ratably over the life of the contract. Amounts that have been invoiced are recorded in deferred revenue, or they are recorded in revenue if the revenue recognition criteria have been met. Subscriptions that are invoiced annually in advance or multi-year in advance represent a significant portion of our short-term and long-term deferred revenue in comparison to invoices issued quarterly in advance or monthly in advance. Accordingly, we cannot predict the mix of invoicing schedules in any given period.
We generally experience seasonality in terms of when we enter into agreements with our customers. We typically enter into a higher percentage of agreements with new customers, as well as renewal agreements with existing customers, in our second and fourth fiscal quarters. However, because we recognize revenue ratably over the terms of our subscription contracts, a substantial portion of the revenue that we report in each period is attributable to the recognition of deferred revenue relating to agreements that we entered into during previous periods. Consequently, increases or decreases in new sales or renewals in any one period may not be immediately reflected as revenue for that period. Any downturn in sales, however, may negatively affect our revenue in future periods. Accordingly, the effect of downturns in sales and market acceptance of our platform, and potential changes in our rate of renewals, may not be fully reflected in our results of operations until future periods.
Cost of Revenue
Cost of revenue includes expenses related to operating our cloud platform in data centers, depreciation of our data center equipment and the amortization of our capitalized internal-use software. Cost of revenue also includes employee-related costs, including salaries, bonuses, stock-based compensation expense and employee benefit costs associated with our customer support and cloud operations organizations. Cost of revenue also includes overhead costs for facilities, IT, and amortization and depreciation expense.
As our customers expand and increase the use of our cloud platform driven by additional applications and connected devices, our cost of revenue will increase due to higher bandwidth and data center expenses. However, we expect to continue to benefit from economies of scale as our customers increase the use of our cloud platform. We intend to continue to invest additional resources in our cloud platform and our customer support organizations as we grow our business. The level and timing of investment in these areas could affect our cost of revenue in the future.
Gross Profit and Gross Margin
Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, have been and will continue to be affected by various factors, including the timing of our acquisition of new customers and our renewals of and follow-on sales to existing customers, the average sales price of our services, mix of services offered in our solutions, the data center and bandwidth costs associated with operating our cloud platform, the extent to which we expand our customer support and cloud operations organizations and the extent to which we can increase the efficiency of our technology, infrastructure and data centers through technological improvements. We expect our gross profit to increase in absolute dollars and gross margin to remain relatively unchanged over the long-term, although our gross margin could fluctuate from period to period depending on the interplay of all of the above factors.

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Operating Expenses
Our operating expenses consist of sales and marketing, research and development and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, stock-based compensation expense and, with respect to sales and marketing expenses, sales commissions that are recognized as expenses. Operating expenses also include overhead costs for facilities, IT and depreciation expense.
Sales and Marketing
Sales and marketing expenses consist primarily of employee compensation and related expenses, including salaries, bonuses and benefits for our sales and marketing employees, sales commissions that are recognized as expenses over the period of benefit, stock-based compensation expense, marketing programs, travel and entertainment expenses, expenses for conferences and events and allocated overhead costs. We capitalize our sales commissions and associated payroll taxes and recognize them as expenses over the estimated period of benefit. The amount recognized in our sales and marketing expenses reflects the amortization of cost previously deferred as attributable to each period presented in this Quarterly Report on Form 10-Q, as described below under "Critical Accounting Policies and Estimates."
We intend to continue to make significant investments in our sales and marketing organization to drive additional revenue, further penetrate the market and expand our global customer base. As a result, we expect our sales and marketing expenses to continue to increase in absolute dollars and to be our largest operating expense category for the foreseeable future. In particular, we will continue to invest in growing and training our sales force, broadening our brand awareness and expanding and deepening our channel partner relationships. However, we expect our sales and marketing expenses to decrease as a percentage of our revenue over the long term, although our sales and marketing expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses.
Research and Development
Our research and development expenses support our efforts to add new features to our existing offerings and to ensure the reliability, availability and scalability of our solutions. Our cloud platform is software-driven, and our research and development teams employ software engineers in the design, and the related development, testing, certification and support, of these solutions. Accordingly, a majority of our research and development expenses result from employee-related costs, including salaries, bonuses and benefits, stock-based compensation expense and costs associated with technology tools used by our engineers. We expect our research and development expenses to continue to increase in absolute dollars for the foreseeable future, as we continue to invest in research and development efforts to enhance the functionality of our cloud platform, improve the reliability, availability and scalability of our platform and access new customer markets. However, we expect our research and development expenses to decrease as a percentage of our revenue over the long term, although our research and development expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses.
General and Administrative
General and administrative expenses consist primarily of employee-related costs, including salaries and bonuses, stock-based compensation expense and employee benefit costs for our finance, legal, human resources and administrative personnel, as well as professional fees for external legal services (including certain litigation-related expenses), audit, accounting and other related consulting services. These litigation-related expenses include professional fees and related costs incurred by us in defending significant claims that we deem not to be in the ordinary course of our business and, if applicable, accruals related to estimated losses in connection with these claims. We expect our general and administrative expenses to continue to increase in absolute dollars for the foreseeable future, due to additional costs associated with audit, accounting, compliance, insurance and investor relations as we operate as a public company, and due to ongoing legal matters and related accruals, certain of which are described in further detail in Note 6 to our condensed consolidated financial statements included elsewhere in this Quarterly

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Report on Form 10-Q. However, we expect our general and administrative expenses to decrease as a percentage of our revenue over the long term, although our general and administrative expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. In particular, litigation-related expenses related to significant litigation claims may result in significant fluctuations from period to period as they are inherently subject to change and difficult to estimate.
Interest Income, net
Interest income consist primarily of income earned on our cash equivalents and short-term investments and interest earned on outstanding notes receivable extended to certain current and former employees who early exercised their stock options. For more information on these notes receivable, refer to Note 9 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
Other Expense, net
Other expense, net consists primarily of foreign currency transaction gains and losses.
Provision for Income Taxes
Our provision for income taxes consists primarily of income and withholding taxes in the foreign jurisdictions in which we conduct business, offset by the tax benefit for excess stock-based compensation deductions. We have not recorded any U.S. federal income tax expense. We have recorded deferred tax assets for which we provide a full valuation allowance, which includes net operating loss carryforwards and tax credits. We expect to maintain this full valuation allowance for the foreseeable future as it is more likely than not that some or all of those deferred tax assets may not be realized based on our history of losses. During the period ended October 31, 2018, we determined that due to the weight of objectively verifiable negative evidence, our UK deferred tax assets are no longer more likely than not to be realized in future and a full valuation allowance was recorded during the period.

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Results of Operations
The following table set forth our results of operations for the periods presented in dollars:
 
Three Months Ended October 31,
 
2018
 
2017
 
(in thousands)