Item 1. Business.
Business Overview
ReachLocal’s mission is to provide more customers to local businesses. We began in 2004 with the goal of helping local businesses move their advertising spend from traditional media and yellow pages to online search. While we have sold to a variety of local businesses and will continue to do so, our present focus is on small to medium-sized businesses (SMBs) and in particular, what we refer to as Premium SMBs. A Premium SMB generally has 10 to 30 employees, $1 to $10 million in annual revenue and spends approximately $40,000 annually on marketing. Premium SMBs have become increasingly sophisticated in their understanding of online marketing. However, we believe that Premium SMBs have not changed their desire for a single, unified solution to their marketing needs. Our goal is to provide a total digital marketing solution that will address Premium SMBs’ online marketing needs. Our total digital marketing solution consists of products and solutions in three categories: digital advertising (including ReachSearch™, ReachDisplay™, ReachDisplay InAppTM and ReachRetargeting™), web presence (including ReachSite+ReachEdge™, ReachSEO™, ReachCast™, ReachListings™, and TotalLiveChat™), and software (ReachEdge™ and Kickserv™).
We began by offering online advertising solutions with the rollout of ReachSearch in 2005, when we pioneered the provisioning of search engine marketing services (SEM) on a mass scale for local businesses through the use of our technology platform. ReachSearch combines search engine marketing optimized across multiple publishers, call tracking and call recording services, and industry leading campaign performance transparency. ReachSearch remains a leading SEM offering for local businesses and has won numerous awards since its rollout, including most recently winning Google’s Quality Score Champion Award in North America and Latin America. However, ReachSearch does not solve all of the online advertising challenges of our clients. We have therefore added additional elements to our platform including our display products, such as ReachDisplay and ReachDisplay InApp, our behavioral targeting product, ReachRetargeting, and other products that are primarily focused on leveraging third-party media to drive leads to our clients.
To complement our online advertising solutions, we have also launched a number of web presence solutions. These solutions include websites, search engine optimization (SEO), social, chat, listings and other products and solutions, all focused on expanding and leveraging our clients’ web presence. Often these products are designed to work in concert with our digital advertising products with a goal of enhancing the return to our clients. These products are generally available in North America and selectively available in our international markets.
We also recognize that even successfully driving leads to our clients does not represent a complete solution to local businesses’ online marketing needs. In 2013 we expanded into lead conversion software with the introduction of ReachEdge in order to move beyond being a media-driven lead generation business to offering integrated solutions for our clients. ReachEdge is marketing automation and lead conversion software and includes tools for capturing web traffic information and converting leads into new customers. Initially, ReachEdge only came bundled with a responsive website. However, beginning in the first quarter of 2015, clients have been able to license ReachEdge’s lead conversion software without having to also purchase a website, allowing us to sell ReachEdge to local businesses who do not need a new website or who purchase their website from another provider.
Over time, we plan to add additional dynamic optimization functionality to ReachEdge, as well as features that create a more seamless relationship between our clients and their customers. For example, in the fourth quarter of 2014, we acquired Kickserv, a provider of cloud-based business management software for service businesses. With this addition, we have the ability to provide an end-to-end solution to our clients that starts with lead generation (ReachSearch, ReachDisplay and ReachSEO), includes lead conversion software (ReachEdge), and then closes and manages the business relationship (Kickserv). Local businesses already spend marketing dollars in these categories with a significant number of providers in a highly fragmented and confusing marketplace. Our integrated total marketing solution seeks to address this broad array of business needs with a simple integrated solution.
In North America, we sell our products and solutions directly, principally through our outside sales force and in certain situations, an inside sales force, in what we refer to as our Direct Local channel. Our sales personnel (primarily referred to as Digital Marketing Consultants or DMCs) both generate the sale and manage the client relationship. Each DMC is paired with a Marketing Expert (or ME) who provides day-to-day campaign management. We believe that this approach enables the DMC to focus primarily on selling and managing client relationships, while the client benefits from the support and expertise of dedicated MEs. We also have certain veteran salespeople that we refer to as IMCs who have more discretion to manage their client relationships and campaigns. Our international markets generally operate under a modified version of the North American model, suited for local market and product availability differences.
We refer to our separate sales channel targeting national brands, franchises and strategic accounts with operations in multiple local markets, and select third-party agencies and resellers, as our NBAR channel. The sales process for the NBAR channel typically has substantially longer lead times than in our Direct Local channel. In addition, national brand clients often involve complex operational and marketing requirements that are not typically required by our Direct Local clients. Our third-party agencies and reseller partners use our technology platform in customer segments where they have sales forces with established relationships with their client bases. We currently have over 350 agencies and resellers actively selling on our technology platform. We have a team that is responsible for identifying potential agencies and resellers, training their sales forces to sell our products and services and supporting the relationships on an ongoing basis.
During the third quarter of 2015 we introduced our Web Partner Program, under which we distribute ReachEdge through third-party web developers. We are focusing on potential partners that typically have client bases ranging from 200 to 2,000 clients. By distributing ReachEdge with their platforms, Web Partners can deliver value to their clients while also earning an additional revenue stream. We believe that our Web Partner Program can increase our sales force’s productivity by giving our sales people easier access to potential new clients.
In addition to the United States and Canada, we have sales operations in Australia, New Zealand, Japan, Germany, the Netherlands, Austria, Brazil and Mexico. We exited direct sales in the United Kingdom market in the fourth quarter of 2015 when our local subsidiary ReachLocal UK Ltd. entered administration. We continue to review our operations in order to rationalize those that are underperforming and to optimize operations in our other markets.
Industry Overview
Over the past decade, the market for online marketing services for SMBs and other local businesses has undergone rapid and fundamental changes. The delivery and consumption of local online marketing services, like all media, has become fragmented and digitized. Consumers are searching on Google and Bing, checking reviews on Yelp and Citysearch, asking friends for their opinions on Facebook and Twitter, and doing it increasingly on mobile. Accordingly, for SMBs to prosper in this evolving world, they need to possess a tool kit that enables them to reach and interact with consumers in the same manner that consumers are seeking their services. This consumer-led digital transformation has profoundly disrupted the ways that businesses of all sizes need to acquire, transact with, maintain and retain their customers. As the Internet continues to grow and evolve, we believe that these trends will accelerate. To keep pace with this transformation, we believe that local businesses need to follow their customers and move an increasing portion of their marketing efforts and spend online. Accordingly, we believe that the market opportunity is huge and as we expand our product suite we will further differentiate our company from competitors.
The ReachLocal Solution
We provide local businesses with a suite of products that are optimized for their needs. Our products are designed to work the way that local businesses-and in particular, SMBs-work. They are easy to use, value-added, “do-it-for-me” solutions that leverage our technology and service platforms to enable our clients to acquire, transact with and retain customers. While we have sold to a wide variety of local businesses and will continue to do so, we target what we refer to as the Premium SMB. A Premium SMB generally has 10 to 30 employees, $1 to $10 million in annual revenue and spends approximately $40,000 annually on marketing. In addition, we focus on certain core verticals, which include Home Services (such as plumbers), Professional Services (such as lawyers and accountants), Specialty Services (such as travel agents) and Healthcare (such as doctors and dentists). We also provide solutions to multi-location advertisers, such as franchises and other businesses that have multiple locations across a number of cities and states.
Our Products
We offer a comprehensive suite of online marketing and reporting solutions designed to deliver efficacy and insight to our clients.
Our products are organized into three categories: digital advertising, web presence and software:
Digital Advertising. Our digital advertising products are designed to drive customers to our clients in an efficient and cost-effective manner.
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ReachSearch. Our award-winning ReachSearch is focused on ensuring that our clients’ advertisements appear prominently among the search results when local consumers enter certain keywords on leading local search sites such as Google, Yahoo! and Bing. ReachSearch is optimized for local markets in each of our territories. ReachSearch accounted for 88%, 86% and 87% of our revenue during 2015, 2014 and 2013, respectively. As over one-third of searches are now being conducted through mobile devices (smartphones and tablets) we also provide mobile optimized websites to all of our clients that purchase ReachSearch. ReachSearch is available in all of our markets.
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ReachDisplay. Our ReachDisplay products are primarily focused on maximizing the exposure for local businesses by displaying their ads on websites that, in the aggregate, reach an estimated 90% of the U.S. online audience. We offer a number of display advertising products across a wide variety of publishing partners, including multiple display networks and demand-side platforms. Our ReachDisplay product was introduced in 2009 and we continue to add new publishers and options as display advertising on the Internet evolves. In May 2015 we launched ReachDisplay InApp, which shows compelling, interactive ads to consumers using popular mobile apps when they are near our client’s business. ReachDisplay is available in most of our markets.
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ReachRetargeting. Our ReachRetargeting products allow us to target consumers who have previously visited a specific client’s website, either through a ReachSearch campaign or a ReachDisplay campaign, or who have previously searched for a client’s keywords. When the potential customer visits any other site within our retargeting network, we can market to the target customer on behalf of that client. ReachRetargeting is available in most of our markets.
Web Presence. Our suite of web presence products are designed to enhance the profile of our clients on the Internet.
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ReachSite + ReachEdge. Our ReachSite + ReachEdge solution provides a professionally designed, mobile-responsive web site optimized to enhance lead generation, paired with our ReachEdge lead conversion software. ReachSite +ReachEdge is available in North America, Australia, New Zealand and our European markets.
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ReachCast. Our ReachCast solution was introduced in 2010 and combines a proprietary technology platform with an expert service team to help local businesses build and optimize their Web presence for the purpose of driving online search discovery, powering reputation management, and managing social media marketing. We substantially revamped this solution in 2014. ReachCast is available in North America.
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ReachSEO. Our ReachSEO solution has historically been designed to boost the visibility of our ReachSite + ReachEdge clients on the top search engines, but beginning in 2016 will be available to clients in North America and certain of our international markets who do not use our website solution. ReachSEO is available in North America, Australia and New Zealand.
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TotalLiveChat. Our TotalLiveChat widget gives our clients the ability to interact with new website visitors and collect their contact information so they can follow up with them later. TotalLiveChat is available in North America, Australia, New Zealand and our European markets.
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ReachListings. Our ReachListings solution provides a managed local listings service that broadens our client’s online exposure in search engines and directories to help drive more traffic from local search. ReachListings is available in our US Market.
Software. Our software products are designed to enable our clients to both easily assess the efficacy of their marketing efforts and to facilitate their interactions with their customers.
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ReachEdge. In 2013, we introduced ReachEdge, our most important new product introduction to date. ReachEdge is a marketing automation platform that includes tools for capturing web traffic information and converting leads into new customers for our clients. With ReachEdge, we are working to solve the critical problem of lead capture and conversion, while also providing business insights such as marketing ROI. While we have generated tens of millions of leads for our clients during our history, with ReachEdge, we provide our clients with tools designed to significantly improve their conversion of leads to customers. ReachEdge manages the leads generated by our other products. For example, ReachEdge notifies our client of new leads in real time via text message, email or the ReachLocal mobile app, so that the client is able to follow up within minutes. ReachEdge also helps the client stay top-of-mind during the prospect’s decision-making process by using integrated marketing automation to send new prospects targeted emails and alerts to the client’s staff reminding them to follow up on each lead. ReachEdge also provides reports to show clients how many leads they are getting from each marketing source and other important business insights. ReachSite +ReachEdge is available in most of our markets.
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Kickserv. Kickserv is cloud-based business management software for service businesses. Kickserv allows us to provide an end-to-end solution to our clients that starts with lead generation (ReachSearch, ReachDisplay and ReachSEO), includes lead conversion (ReachEdge), and then closes and manages the business relationship (Kickserv). Kickserv is available in North America.
Our Distribution Approach
Sales Organization
In 2006, we executed on a strategy to build the first pure-play online advertising sales force. Our approach to the market has gone through many iterations. Today, our sales personnel (primarily referred to as Digital Marketing Consultants or DMCs) both generate the sale and manage the client relationship. Each DMC is paired with a Marketing Expert (or ME), who provides day-to-day campaign management. We believe this approach enables the DMC to focus on selling and maintaining client relationships, while the client benefits from the support and expertise of dedicated MEs. We also have certain veteran salespeople that we refer to as IMCs who have more discretion to manage their client relationships and campaigns. In addition, we have a small inside sales force that we leverage in certain situations.
We employ a separate sales channel targeting national brands, franchises and strategic accounts with operations in multiple local markets and select third-party agencies and resellers. We refer to this as our NBAR channel. The sales process for the NBAR channel typically has substantially longer lead times than in our Direct Local channel. In addition, national brand clients often involve complex operational and marketing requirements that are not typically required by our Direct Local clients. Our third-party agencies and reseller partners use our technology platform in customer segments where they have sales forces with established relationships with their client bases. We currently have over 350 agencies and resellers actively selling on our technology platform. We have a team that is responsible for identifying potential agencies and resellers, training their sales forces to sell our products and services and supporting the relationships on an ongoing basis.
During the third quarter of 2015 we introduced our Web Partner Program, under which we distribute ReachEdge through third-party web developers. We are focusing on potential partners that typically have client bases ranging from 200 to 2,000 clients. By distributing ReachEdge with their platforms, Web Partners can deliver value to their clients while also earning an additional revenue stream. We believe that our Web Partner Program can increase our sales force’s productivity by giving our sales people easier access to potential new clients.
Historically we focused on international expansion. Our first expansion was in Australia in 2006. We subsequently entered Europe (the United Kingdom, Germany, the Netherlands and Austria), Japan, Brazil, Mexico and New Zealand. During the fourth quarter of 2015 we exited the United Kingdom and continue to review our operations in order to rationalize our underperforming markets and optimize operations in our primary markets. We are transitioning to localized versions of our DMC sales models in our international markets.
Customer Service
Our customer service organization is responsible for providing ongoing support to our sales forces, clients and resellers, including technical assistance with the use of our platform, as well as providing product- and campaign-specific technical assistance and recommendations to our local business clients. Our Marketing Experts (or MEs) provide primary client support. We also field an advanced campaign management team that is responsible for supporting and optimizing the overall performance of the products on a category-by-category level. With a combination of employees in each of our regional markets and India, we have a dedicated team focused on the provisioning and review of campaigns before they are deployed.
Our Strategy
We believe that the market for online marketing solutions for local businesses is still in its early stages and the market is still highly fragmented, providing us with significant opportunities for growth. Our strategy for pursuing this opportunity includes the following key components:
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Great Products. We plan to offer our clients a total digital marketing system with lead conversion software at its core that shows them how their marketing is working and helps them more effectively turn leads into customers. Our software will be supported and enhanced by our core digital advertising solutions (search, display, retargeting, social media, in-app display) and our web presence solutions (websites, SEO, chat, listings). During 2016 we plan to continue to deliver new offerings and will focus on driving licenses of our software solutions to increase penetration, client engagement and client retention.
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Great Client Experience. We believe that our sales model enables us to build strong relationships with our clients. We continue to focus on taking a more proactive approach to client support in order to both increase client retention and improve our reputation. We also intend to leverage our DMCs to produce more client referrals.
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Great Reputation. If we build great products and provide great client experience, a great reputation will follow. Our reputation will be built on the way we sell and service our clients, and the strength of our products. It comes from doing the right thing for the client every time. We’re building a culture that thinks client-first in everything we do.
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Great Go-To-Market. We believe that optimizing our go-to-market model across products and markets is critical to our success. Our Direct Local Channel utilizes a consultative sales approach with local execution, but we believe that our Web Partner Program can increase our sales force’s productivity by giving our sales people easier access to potential new clients. We are also focused on strengthening our NBAR channel, which gives us access to different types of clients than our Direct Local Channel.
Product and Technology Development and Technology Operations
We devote a substantial portion of our resources to developing new solutions and enhancing existing solutions, conducting product and quality assurance testing, and improving our core technology. We have approximately 160 product and engineering professionals located in various locations primarily in the United States and India.
Our technology platform has been built to scale globally. We have a large number of customer facing services that reside in seven data centers spanning five countries, and we keep more than a 99.9% service availability. Our primary data center hardware is co-located in El Segundo, California. We also maintain smaller regional data centers, including redundant facilities at various locations to support our domestic and international operations. We continuously monitor the performance and availability of our products and have well documented procedures to respond to incidents. In addition, we utilize cloud computing providers for certain of our products and services.
We architect our applications to enable us to scale our operations quickly while reducing deployment costs. We have a highly-available, scalable infrastructure that employs hardware load-balancers, redundant interconnected network switches and firewalls, replicated databases and fault-tolerant storage devices. Research and development expenses are included in product and technology expenses in the accompanying consolidated statements of operations. Our research and development expenses were $6.9 million, $15.5 million, and $9.5 million, during 2015, 2014 and 2013, respectively, and our capitalized software development costs were $10.1 million, $13.5 million, and $11.5 million during 2015, 2014 and 2013, respectively. We have also completed several acquisitions to accelerate our product paths, increase our core competencies and otherwise expand or accelerate various technology initiatives.
Intellectual Property
Our success and ability to compete is dependent in part on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing upon the proprietary rights of others. We have patents in certain foreign jurisdictions and patent applications pending on some of our technology, but rely primarily on a combination of copyright, trade secret and trademark laws, confidentiality procedures, contractual provisions and other similar measures to protect our proprietary technology and information. Among other practices, we enter into confidentiality agreements with our employees, consultants and business partners, and we control access to and distribution of our proprietary information.
We consider trademark registration for some of our product names, slogans and logos in the United States and in some foreign countries. ReachLocal and TotalTrack are registered U.S. trademarks on an ongoing basis. We have also registered ReachLocal, ReachCast and TotalTrack as trademarks in a number of international territories. Other trademarks we use are ReachSearch, ReachDisplay, ReachRetargeting, ReachEdge and Kickserv.
We are the registrant of the Internet domain name for our websites as well as for our proxy services, in addition to the international extensions of those domains. The information on, or accessible through, our websites does not constitute part of, and is not incorporated into, this Annual Report.
We also participate actively in free and open-source software (FOSS) programs, which afford us opportunities to lead technology discussions in the industry and across leading technology conferences.
Clients
We currently primarily sell to SMB clients, national brands, agencies and resellers. No single client, national brand, agency or reseller represents more than 10% of our total consolidated revenue.
Competition
The market for local online advertising solutions is intensely competitive and rapidly changing, and with the introduction of new technologies and market entrants, we expect competition to intensify in the future. Many of our current and potential competitors enjoy substantial competitive advantages, such as greater name recognition, longer operating histories and larger marketing budgets, as well as substantially greater financial, technical and other resources. In addition, many of our current and potential competitors have established marketing relationships and access to larger customer bases.
Our competitors include:
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Online Publishers. We compete with large Internet marketing providers such as Google, Yahoo! and Microsoft. These providers typically offer their products and services through disparate, online-only, self-service platforms.
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Traditional, Offline Media Companies. We compete with traditional yellow page, newspaper, television and radio companies that, in many cases, have large, direct sales forces and digital publishing properties.
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Local SMB Marketing Providers. The market for internet marketing services is highly fragmented and there are a number of smaller companies which provide internet marketing services and may be able to offer such services at highly competitive prices.
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Vertical-Specific SMB Marketing Providers. Increasingly we compete with vertical-specific SMB marketing providers such as Dealer.com, Haystak Digital Marketing or Healthgrades, who offer solutions tailored for specific verticals that often include vertical-specific features that our products do not.
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SMB Marketing Technology Providers. We also compete with technology companies providing online marketing platforms focused on the SMB market such as Angie’s List, Groupon, Intuit, Web.com, Wix, GoDaddy and Yelp, and, in some cases, with significant direct sales forces.
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New Competitors in New Markets. With the expansion of our product suite that came with the introduction of our ReachEdge and ReachSite + ReachEdge solutions, and the acquisition of Kickserv, we will encounter new competitors. While we believe that there are no competitors that offer an integrated solution similar to ours, there are a number of companies that offer various related services, such as Hubspot, Web.com, Wix and Constant Contact, as well as smaller start-ups.
Government Regulation
We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, broadband residential Internet access and the characteristics and quality of services. It is not clear how existing laws governing issues such as property ownership, sales and other taxes, libel and personal privacy apply to the Internet. Unfavorable resolution of these issues may substantially harm our business and operating results. For more information about laws and regulations that affect us and our business, including privacy and data protection laws and regulations, see Item 1A.
Item 1A. Risk Factors.
You should carefully consider the risks described below and the other information in this Annual Report on Form 10-K.
Risks Related to Our Business
Our operations and financial results are subject to various risks and uncertainties, including declining revenue, that could adversely affect our business, financial condition, results of operations, and the trading price of our common stock.
Our current business and future prospects are difficult to evaluate. We commenced operations in late 2004 in North America, and developed a strategy for taking advantage of what we believe is a shift of local marketing budgets from traditional media formats to digital media formats. Our strategy allowed us to grow rapidly. However, our growth rate slowed over a number of years and in 2015 and 2014 our revenue declined 19.4% and 7.6%, respectively, as compared to the respective prior year. In addition, in the fourth quarter of 2015 we exited direct sales in the U.K. market, which represented 6.6% of 2015 revenue and we continue to review our international operations in order to rationalize our operations in underperforming markets. We are introducing products internationally, continuing to refine the structure of our sales force and introducing new go-to-market strategies, and developing new products to attempt to grow our business, but we cannot assure you that our strategy will be successful and that our revenue will not decline further. In particular, although our international salespeople historically were more productive than our North American salespeople, as those markets have matured, our international salespeople’s productivity has declined and may decline further, putting further pressure on our results of operations. As our revenues have declined we have reduced costs to maintain economic viability, but if revenues continue to decline, we may not be able to implement enough additional cost savings to sustain the business.
You must also consider our business and prospects in light of the risks and difficulties we encounter as a company in the rapidly evolving online marketing industry. These risks and difficulties include:
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our limited number of product offerings and the difficulties and risks associated with developing and selling new products and solutions, including, in particular, new subscription and software-as-a-service (SaaS) products;
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successfully executing new sales and go-to-market strategies and approaches, including the realignment of our North American sales force;
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successfully entering new markets, domestically and internationally;
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maintaining the effectiveness of our technology platform, and adapting our technology to new market opportunities and challenges;
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competition from existing and new competitors, technologies, and products;
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reaching and maintaining profitability;
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maintaining compliance with debt covenants;
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acquiring additional capital, if necessary;
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continuing to attract new clients, many of which have not previously advertised online and may not understand the value to their businesses of our products and services; and
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effectively managing our sales force, personnel and operations.
Failing to successfully address these challenges or others could significantly harm our business, financial condition, results of operations and the trading price of our common stock.
We have incurred significant operating losses in the past and may incur significant operating losses in the future.
At December 31, 2015, we had an accumulated deficit of approximately $136.1 million, and we may incur significant net operating losses in the future. Our cash and cash equivalents decreased from $43.7 million as of December 31, 2014 to $18.8 million as of December 31, 2015, which includes the amounts borrowed under our Loan and Security Agreement with Hercules Technology Growth Capital (the “Hercules Loan Agreement”) ($10 million of unrestricted cash) and pursuant to the 4.0% Convertible Second Lien Subordinated Notes issued to certain affiliates of VantagePoint Capital Partners (the “VantagePoint Notes”) ($5 million). Although we have significantly reduced, and are attempting to further reduce, our operating expenses, we may not be successful or our operating expenses may increase in the future as we expand our operations. In addition, our business strategy contemplates making substantial investments in new and existing products, which will require significant expenditures. If our expenses don’t decrease according to our plan or revenues are less than expected, we will not be profitable and our liquidity and financial condition will be adversely affected. We also expect that a variety of factors, including increased competition and the maturation of our business, may continue to put pressure on our revenue, and we cannot assure you that our revenue will not continue to decline. As a result, you should not consider our historical revenue performance as indicative of our future performance.
Our Hercules Loan Agreement and VantagePoint Notes contain operating and financial covenants that may restrict our business and financing activities.
Borrowings under the Hercules Loan Agreement are secured by substantially all of our assets. The Hercules Loan Agreement includes certain affirmative and negative covenants applicable to us and our subsidiaries which are co-borrowers under the loan, and in certain cases, to all of our subsidiaries. The affirmative covenants include, among others, covenants requiring us to maintain our legal existence and governmental approvals, deliver certain financial reports and maintain insurance coverage. The negative covenants include, among others, restrictions on investments in and cash held at foreign subsidiaries, transferring collateral, incurring additional indebtedness, engaging in mergers or acquisitions, paying dividends or making other distributions, making investments, creating liens, selling assets, and undergoing a change in control, in each case subject to certain exceptions. We are also required to maintain minimum cash and cash equivalents in accounts subject to a control agreement with Hercules, as administrative agent, in an amount equal to $15.0 million (which decreases to $12.5 million under certain circumstances) at all times. The term loan is secured by substantially all of our personal property, including our intellectual property.
In addition, the Hercules Loan Agreement requires performance within certain trailing-three-month revenue and adjusted EBITDA targets, computed on a monthly basis. The operating and financial restrictions and covenants in the Loan Agreement, as well as any future financing agreements that we may enter into, may restrict our ability to finance our operations, engage in business activities or expand or fully pursue our business strategies. Our ability to comply with these covenants may be affected by events beyond our control, and we may not be able to meet those covenants. During 2015 we entered into several amendments to the Hercules Loan Agreement that allowed us to maintain compliance with the term loan’s covenants, including an amendment on August 3, 2015 to reduce the term loan’s covenant thresholds for revenue for the months ending September 30, 2015 through December 31, 2015, and an amendment on November 9, 2015, to waive compliance with the term loan’s revenue and earnings covenant thresholds for November and December 2015. In connection with the November amendment, we paid Hercules a one-time fee of $0.2 million, reset the schedule of prepayment fees, and agreed to amend the Hercules warrant to lower the exercise price and increase the number of shares subject to it. A breach of any of the Hercules Loan Agreement covenants could result in a default under the Hercules Loan Agreement, which could cause all of the outstanding indebtedness under the term loan to become immediately due and payable and Hercules could exercise remedies against the collateral securing the term loan, including our cash, or could result in the interest-only extension period being unavailable to us.
The VantagePoint Notes also include events of default, including any event of default under the Hercules Loan Agreement.
If we are unable to generate sufficient cash available to repay our debt obligations when they become due and payable, either when they mature or in the event of a default, we may not be able to obtain additional debt or equity financing on favorable terms, if at all, which may negatively impact our ability to continue as a going concern.
We cannot be certain that the significant steps that we have taken to strengthen our North American market will work.
Commencing in the fourth quarter of 2013, we realigned our sales infrastructure in North America, which we believe significantly contributed to our 2014 and 2015 revenue declines. In 2015, we further refined the structure of our sales force to combine the best elements of our original sales model and our more recent sales model. We believe the current North American sales model is superior to the prior model, but we cannot be certain that this continued evolution will slow the declines and ultimately return our North American operations to growth.
We depend on key personnel to operate our business, and our workforce has undergone significant disruption which may adversely affect performance and tenure.
We believe that our future success is highly dependent on the contributions of our executive officers, as well as our ability to attract and retain highly skilled managerial, sales, technical and finance personnel. Qualified individuals are in high demand, and we may incur significant costs to attract them. All of our U.S. officers and other U.S. employees are at-will employees, which means they may terminate their employment relationship with us at any time, and their knowledge of our business and industry would be extremely difficult to replace. If we are unable to attract and retain our executive officers and key employees, our business, operating results and financial condition will be harmed.
2014 and 2015 were very difficult years for our business. Our operating and stock price performance have resulted in a drop in morale within our work force. While we have taken reasonable steps to ensure that our key people are adequately incented to stay with the company, we cannot be certain that such incentives will be sufficient to keep our top performers.
Volatility or lack of performance in our stock price and limitations imposed by the size of our equity plan may also affect our ability to attract and retain our key employees. In addition, as some of our executive officers become vested in a substantial amount of stock or stock options, if our stock price appreciates significantly they may be more likely to leave us as their equity holdings become valuable.
Our product roadmap relies on developing a total marketing solution, which is a somewhat untested product concept that may not gain market acceptance or may not perform as we intend.
ReachEdge, our lead conversion software, is our initial step towards our goal of offering a total marketing solution. In addition, during the fourth quarter of 2014 we acquired Kickserv, a business management platform for service businesses that we are beginning to integrate with ReachEdge. The success of this new product strategy is subject to numerous risks and uncertainties, such as uncertain customer acceptance, the difficulties of designing a complex software product, integrating our software products with our existing technology and third-party service providers, training our salespeople to sell software products, and gaining market acceptance. We are also still developing our go-to market strategy for our software business, which has different requirements than our traditional media business. Because our software products are complex and incorporate a variety of proprietary and third-party software, they may have errors or defects that could result in unanticipated downtime for our customers and harm to our reputation and our business. Internet-based services frequently contain undetected errors when first introduced or when new versions or enhancements are released. In addition, our customers may use our software products in unanticipated ways that may cause a disruption in service for other customers attempting to access their data. Since our customers may use this product for important aspects of their business, such as lead generation, lead management, scheduling, and other services, any errors, defects, disruptions in service or other performance problems, could damage our customers’ businesses and result in financial losses, which would hurt our reputation. As a result, customers could elect to not renew, or delay or withhold payment to us, we could lose future sales or customers may make warranty or other claims against us. In addition, our total marketing solution is a relatively new solution for the marketplace and, therefore, wide market acceptance cannot be assured. Substantial components of our software products may be outsourced to third parties. While we believe that our relationships with these third parties are sound, if one of those relationships were to deteriorate, our ability to sell and maintain our software products could be substantially degraded.
We purchase most of our media from Google, and our business could be adversely affected if Google takes actions that are adverse to our interests or if we fail to meet advertiser or spend targets necessary for receiving rebates from Google. Similar actions from Yahoo!, Microsoft and other media providers could adversely affect our business, though to a lesser degree.
Most of our cost of revenue is for the purchase of media, and a substantial majority of the media we purchase is from Google. Google accounts for a large majority of all U.S. searches, and Google’s share in foreign markets is often even greater. As a result, we expect that our business will depend upon media purchases from Google for the foreseeable future. This dependence makes us vulnerable to actions that Google may take to change the manner in which it sells AdWords, as described below, or conducts its business on a number of levels:
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Google Can Choose to Change the Terms and Conditions Upon Which it Does Business with Us and our Clients. Google can act unilaterally to change the terms and conditions for our purchase of media or the purchase of Google products, and Google has done so in the past. Future changes by Google to the terms and conditions upon which we purchase media could materially and adversely affect our business.
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Competitive Risk. Google offers its products directly to local businesses through an online self-service option. In addition, Google has continued to expand its partner program, which we believe has attracted additional competitors to enter our market. Google enjoys substantial competitive advantages over us, such as substantially greater financial, technical and other resources. In addition, Google continues to launch products that are targeted directly at SMBs, which Google does not always make available to third parties. While we cannot assess at this time the effect of Google’s offering such products directly to SMBs, the prices charged by Google for direct service are lower than the prices we charge for the same media.
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Technology Risk. Our technology platform interacts with Google through publicly available application programming interfaces, or APIs. If Google were to discontinue the availability of all or a portion of these APIs to us, we may have to change our technology, incur additional costs or discontinue certain products or services that we currently offer our clients. Any of these changes could adversely affect our ability to provide effective online marketing and reporting solutions to our clients. In addition, Google may decide to alter the amount it charges us for the right to use its APIs, which would decrease our gross margin absent any change in our pricing to our customers.
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Editorial Control. Google closely monitors the experience of end-users, and from time-to-time, its editorial personnel request that companies alter their services based on Google’s determination that aspects of such services could adversely affect the end-user experience and/or avoid providing Google-dependent services to certain types of clients. For example, each of our media products includes TotalTrack, a tracking service powered by our proprietary reverse proxy technology and tracking code. If Google were to determine that the tracking URLs utilized by our TotalTrack service adversely affects the end-user’s experience, Google could require us to alter or suspend the way we implement our tracking solutions. Such a change would significantly decrease our ability to optimize our clients’ advertising campaigns and limit our ability to provide the level of campaign performance reporting that we currently provide to our clients.
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Rebate/Incentive Risk. Google retains broad authority with respect to its rebate programs and has, from time to time, canceled rebate programs. During 2014, we entered into a new global agreement with Google that provides rebates based on overall global growth of our spending with Google. We amended the terms of our Google agreement in December 2015, and during the fourth quarter of 2015 we earned a rebate well in excess of the amount we have received in recent quarters. The December 2015 amendment only applies through the end of 2016 and we can provide no assurance that we will qualify for rebates under the current Google agreement or otherwise in the future. Even if we earn rebates from Google in the future, the agreement is subject to broad mutual termination rights and there is no assurance of renewal. Termination or nonrenewal of the Google agreement would negatively affect our cost of revenue materially.
In addition, any new developments or rumors of developments regarding Google’s business practices that affect the local online advertising industry may adversely affect our products or create perceptions with our customers or investors that our ability to compete has been impaired. For instance, beginning in February 2016, Google began changing where and how ads are shown next to search results, potentially significantly reducing the number of ad impressions available to advertisers, including our clients.
The above risks also apply to other publishers from whom we purchase media, including Yahoo! and Microsoft.
We purchase a significant majority of our media from Google, Microsoft and Yahoo! in an auction marketplace. If we are unable to purchase media from any one of these companies, if prices for media significantly increase or if the manner in which the media is sold changes, our business could be adversely affected.
Our success depends on our ability to purchase media from Google, Microsoft and Yahoo! at reasonable prices so that we can provide our clients with a reasonable return on the advertising expenditures they make through us. We generally purchase this media in an auction marketplace. Increased competition or other factors may cause the cost of the media that we purchase from Google, Yahoo! and Microsoft to rise. In particular, if our expectation that local SMB advertising will increasingly migrate to the Internet is correct, the marketing budget available to bid in these auctions will increase and the price of media may increase substantially. An increase in the cost of media in these marketplaces without a corresponding increase in our media buying efficiency could result in an increase in our cost of revenue as a percentage of revenue even if our business expands. In addition, such an increase could result in an increase in the prices we must charge our clients or a decrease in our ability to fulfill our clients’ service expectations. Furthermore, the Internet search companies that operate these media marketplaces may change the operating rules or bidding procedures in ways that decrease the effectiveness of the technology that we use to optimize our purchases or otherwise prevent us from purchasing media at reasonable prices or at all. Any change in our ability to provide effective online marketing campaigns to our clients may adversely affect our ability to attract and retain clients.
The market in which we participate is intensely competitive, which may adversely impact our margins and if we do not compete effectively, our operating results could be harmed.
The market for online marketing solutions is intensely competitive and rapidly changing, and with the emergence of new technologies and market entrants, we expect competition to intensify in the future. In particular, some of our competitors offer products similar to ours at a lower price, putting pressure on us to lower our prices or lose clients.
Our competitors include:
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Internet Online Publishers. We compete with large Internet marketing providers such as Google, Yahoo! and Microsoft. These providers typically offer their products and services through disparate, online-only, self-service platforms.
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Traditional, Offline Media Companies. We compete with traditional yellow page, newspaper, television and radio companies that, in many cases, have large, direct sales forces and digital publishing properties.
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Local SMB Marketing Providers. The market for internet marketing services is highly fragmented and there are a number of smaller companies which provide internet marketing services and offer such services at highly competitive prices. Many of these partners also participate in publisher partner programs, which allows them to compete with us more effectively.
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SMB Marketing Technology Providers. We also compete with technology companies providing online marketing platforms focused on the SMB market such as Angie’s List, Groupon, Intuit, Web.com, Wix, and Yelp, and, in some cases, building significant direct sales forces.
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New Competitors in New Markets. In late 2013 we launched ReachEdge, our lead conversion software-as-a-service, or SaaS, product, and in late 2014, we acquired Kickserv, business management software for service businesses. We are also developing other new subscription and SaaS products designed to provide SMBs additional tools to convert leads to customers, retain customers, and transact with customers. In each case, as we enter new markets we will encounter new competitors.
Many of our current and potential competitors enjoy substantial competitive advantages, such as greater name recognition, longer operating histories, substantially greater financial, technical and other resources and, in some cases, the ability to combine their online marketing products with traditional offline media such as newspapers or yellow pages. These companies may use these advantages to offer products similar to ours at a lower price, develop different products to compete with our current solutions and respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or client requirements. In particular, if major Internet search companies such as Google, Yahoo! and Microsoft decide to devote greater resources to develop and market online advertising offerings directly to SMBs, greater numbers of our clients and potential clients may choose to purchase online advertising services directly from these competitors, particularly if and as the ease of their self-service models increases. In addition, many of our current and potential competitors have established marketing relationships with and access to larger client bases and are heavily investing in recruiting sales personnel, which might affect our ability to achieve our salespeople hiring targets.
As the market for local online advertising increases, we expect new competitors, business models and solutions to emerge, some of which may be superior to ours. We also believe that the marketplace for online media is more transparent than other media marketplaces. Our competitors may use information available to them to price their products at a discount to the prices that we currently offer. Clients and potential clients might adopt competitive products and services in lieu of purchasing our solutions, even if our online marketing and reporting solutions are more effective than those offered by our competitors, if we are not able to differentiate our products and convince clients that our products are more effective than our competitors’ offerings. For all of these reasons, we may not be able to compete successfully against our current and potential competitors.
Our future success depends in part on our ability to effectively develop and sell additional products and solutions.
We invest in the development of new products and solutions with the expectation that we will be able to effectively offer them to our clients. We are developing, and may in the future develop or acquire, other products and solutions that address new segments of local companies’ marketing activities. We are also developing subscription and SaaS products, such as ReachEdge and Kickserv, which present different challenges from those we have faced in the past. Our future revenue depends in part on our ability to stay competitive with our product and service offerings, including providing integrated solutions to our clients. Our ability to develop and launch new products on our expected timelines, or at all, is subject to numerous risks and uncertainties, such as our decreased product and technology spending, the difficulties of designing complex software products, achieving desired functionality and integrating the new products with our existing technology.
The sale of new or additional features, products and services, the value or utility of which may be different from our current products and services or less easily understood by our clients, may require increasingly sophisticated and costly sales efforts and increased operating expenses, as well as additional training of our salespeople and education for our SMB clients. New product launches require the investment of resources in advance of any revenue generation. If new products fail to achieve market acceptance, we may never realize a return on this investment. If these efforts are not successful, our business may suffer. Many SMBs have modest advertising budgets. Accordingly, we cannot assure you that our SMB clients will increase their aggregate spending as a result of the introduction of new products and services or that the successful introduction of new products or services will not adversely affect sales of our current products and services through cannibalization of our current products or disharmony created by consumer offerings that could be perceived as in competition with our current customers. Any such adverse impact on our current media products could also adversely affect our publisher rebates.
We may require additional capital to respond to business opportunities, challenges, acquisitions or unforeseen circumstances. If capital is not available to us, our business, operating results and financial condition may be harmed.
We may require additional capital to operate or expand our business. In addition, some of our product development initiatives may require substantial additional capital resources before they begin to generate material revenue. Additional funds may not be available when we need them, on terms that are acceptable to us, or at all. Any debt financing secured by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. The Hercules Loan Agreement restricts our ability to obtain additional capital without Hercules’ consent or payment in full. If we do not have funds available to enhance our solutions, maintain the competitiveness of our technology or pursue business opportunities, we may not be able to service our existing clients or acquire new clients, which would have an adverse effect on our business, operating results and financial condition.
Client dissatisfaction with our products, complaints, negative publicity or litigation related to our sales tactics, customer service or other business practices could adversely affect our reputation and brand.
Client dissatisfaction with our products, client complaints or negative publicity, including third-party media outlets, about our products, technology, personnel or customer service, could severely diminish confidence in and the use of our products. Our products, as well as those of our competitors, are regularly reviewed, and those reviews are regularly shared, by our clients. Negative reviews, or reviews in which our competitors’ products are rated more highly than ours, could negatively affect our brand and reputation. From time to time, our clients have expressed dissatisfaction, including dissatisfaction with our customer service, our sales and billing practices and the way our products perform. If we do not handle client complaints effectively, or otherwise adequately address clients’ concerns, our brand and reputation may suffer, we may lose our clients’ confidence and they may choose to stop working with us. For example, we experienced negative publicity in the United Kingdom, which adversely impacted our business in that region and contributed to our decision to exit the market in 2015. We have also faced legal claims regarding our business practices in both the United Kingdom and the United States and may face additional claims in the future. Complaints, negative publicity or legal claims related to our products, our sales tactics or our customer service could materially and adversely impact our reputation and brand, as well as our business, financial condition and results of operations.
We may be unsuccessful in managing or growing our international operations, which could harm our business, operating results and financial condition.
We currently have international sales operations in Australia, Canada, Germany, the Netherlands, Japan, Brazil, Austria and Mexico, and campaign support services in India. Revenue from international operations outside North America accounted for 34.9%, 38.3% and 33.5% of total revenue for the years ended December 31, 2015, 2014 and 2013, respectively. We exited the United Kingdom market in the fourth quarter of 2015 and continue to review our international operations in order to rationalize our operations in overseas markets we determine to be underperforming and to optimize operations in our primary markets. We may continue to incur losses or fail to enter new markets successfully.
Our ability to operate internationally involves various risks, including the need to invest significant resources, the possibility that returns on such investments will not be achieved in the near future and competitive environments with which we are unfamiliar. Our international operations may not prove to be successful in certain or any markets. In addition, we have incurred and expect to continue to incur significant expenses as we attempt to establish our presence in particular international markets. Our current and any future international expansion plans will require management attention and resources and may be unsuccessful. Furthermore, in many international markets, we would not be the first entrant, and greater competition may exist with stronger brand recognition than we have faced in our current markets. Different privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our business and operating results to suffer.
Our international operations may also fail to succeed due to other risks inherent in foreign operations, including:
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difficulties or delays in developing a network of clients in one or more international markets;
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legal, political or systemic restrictions on the ability of U.S. companies to market products and services or otherwise do business in foreign countries;
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different regulatory requirements, including regulation of internet services, privacy and data protection, banking and money transmitting, and selling, that may limit or prevent the offering of our products in some jurisdictions;
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international intellectual property laws that may be insufficient to protect our intellectual property or permit us to successfully defend ourselves or our intellectual property in international lawsuits;
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different employee/employer relationships and the existence of workers’ councils and labor unions, which could make it more difficult to terminate underperforming salespeople;
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difficulties in staffing and managing foreign operations;
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greater difficulty in accounts receivable collection;
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currency fluctuations or a weakening U.S. dollar, which can increase costs of international expansion;
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potential adverse tax consequences, including the difficulty of repatriating money;
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lack of infrastructure to adequately conduct electronic commerce transactions; and
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price controls or other restrictions on foreign currency.
As a result of these obstacles, we may find it impossible or prohibitively expensive to continue or expand our international operations and replicate our business model, which could harm our business, operating results and financial condition.
Failure to adequately recruit, train and retain our salespeople would impede our strategy and could harm our business, operating results and financial condition.
Our ability to maintain or grow revenue and achieve profitability will depend, in part, on the size and effectiveness of our direct sales force. During 2015, we refined the structure of our North American sales force to combine the best elements of our original sales model and our 2014 sales model. In addition, we are now standardizing our international sales models to use localized versions of our North American sales model. However, if many of our salespeople do not perform well in their new roles, or are unhappy with the new structure, we may experience greater than anticipated attrition. If our salespeople attrition is greater than anticipated, our business will be harmed. We also have certain long-tenured salespeople with significant client bases and losses of one or more of them would negatively impact our business. In addition, as more companies seek to capitalize on the shift to online media, competition for knowledgeable and qualified online media sales personnel will increase, and hiring salespeople may be more difficult than it has been historically. Moreover, employees that we hire from our competitors have in the past, and may in the future, be subject to claims of breach of noncompetition and non-solicitation obligations owed to their former employers, which could impact our ability to attract and hire high-quality candidates and potentially subject us to litigation. If we are unable to effectively recruit, train and retain salespeople, we may not be able to grow our sales force, our revenue may suffer or our costs may increase.
One of our international growth strategies has been to enter new international markets through franchise or reseller arrangements, but that strategy is subject to risks.
As we expand into other international markets, in addition to entering markets directly, we may enter through a franchisee or a reseller (as we did in New Zealand and Eastern Europe and are currently operating in Singapore). The success of this strategy will depend on a number of factors, including whether our franchisees and resellers have the experience and financial resources to be effective operators and remain aligned with us on operating, promotional and capital-intensive initiatives, and the potential impact on us if they experience operational problems or project a brand image inconsistent with our values, particularly if our contractual and other rights and remedies are limited by local law or otherwise, or are costly to exercise. Difficulties of one or more of our international franchisee or reseller arrangements could result in losses stemming from related strategic investments, delay penetration into and/or negatively affect our brand in certain international markets, and distract management and absorb product development resources. For example, in July 2012, the Company entered into a franchise agreement with OxataSMB B.V. permitting it to operate and resell our services under the ReachLocal brand in Slovakia, Czech Republic, Hungary, Poland and Russia. At the same time, we entered into a market development loan agreement with OxataSMB pursuant to which we agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) was immediately advanced and €0.92 million ($1.2 million) was advanced in August 2013. The OxataSMB operations did not perform as contemplated, and as a result, the Company recorded a $3.3 million impairment of the loan receivable and related interest from OxataSMB and a $1.6 million provision for bad debt related to the trade receivable from OxataSMB. Ultimately we terminated OxataSMB’s franchise agreement in the fourth quarter of 2014 and have not been repaid any amounts under the loan.
More consumers are using devices other than personal computers to access the Internet and accessing new platforms to make search queries. If we are unable to effectively reach consumers on the Internet on behalf of our customers, our business could be adversely affected.
The number of people who access the internet through devices other than personal computers, including mobile phones and tablets, has increased dramatically in the past few years. Mobile search advertising is growing very rapidly and may offer lower conversion rates for our customers, which if not offset by lower costs, may make search engine marketing less attractive for our customers. In addition, the lower resolution, functionality, and memory associated with some alternative devices may alter consumers’ use of the Internet, including search engines and other websites where we publish advertisements on behalf of customers. For example, search queries are increasingly being undertaken via “apps” tailored to particular devices or niches, or via social media platforms, which could affect our ability to deliver advertising results to our clients if we are unable to effectively reach consumers via those apps.
The impact of worldwide economic conditions, including the resulting effect on advertising budgets, may adversely affect our business, operating results and financial condition.
Our performance is subject to worldwide economic conditions and their impact on levels of advertising. In addition, as we increase our international footprint, we will become more sensitive to economic conditions outside of North America. We believe that the economic conditions remain challenging in North America and internationally, which have adversely affected our business.
To the extent that economic difficulties continue, or worldwide economic conditions materially deteriorate, our existing and potential clients may no longer consider investment in our online marketing solutions a necessity, or may elect to reduce advertising budgets. Historically, economic downturns have resulted in overall reductions in advertising spending. In particular, online marketing advertising solutions may be viewed by some of our existing and potential clients as a lower priority and may be among the first expenditures reduced as a result of unfavorable economic conditions. These developments could cause us to respond by temporarily reducing hiring or taking other measures and could have an adverse effect on our business, operating results and financial condition.
We are exposed to fluctuations in currency exchange rates.
Because we conduct a significant and growing portion of our business outside the United States but report our financial results in U.S. dollars, we face exposure to adverse movements in currency exchange rates. Our foreign operations are exposed to foreign exchange rate fluctuations as the financial results are translated from the local currency into U.S. dollars upon consolidation. If the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions will result in increased revenue, operating expenses and net income (or loss). If the U.S. dollar strengthens against foreign currencies, however, the translation of these foreign currency denominated transactions will result in decreased revenue, operating expenses and net income (or loss). For example, the strengthening of the U.S. dollar against the foreign currencies in which we do business resulted in a reduction in 2015 revenue of $25.9 million, principally driven by a 16% reduction in the average value of the Australian dollar relative to the prior year. As exchange rates vary, sales and other operating results, when translated, may differ materially from expectations. In addition, approximately 30% of our cash balances are denominated in currencies other than the U.S. dollar, and the value of such holdings will increase or decrease along with the weakness or strength of the U.S. dollar, respectively. We continue to review potential hedging strategies that may reduce the effect of fluctuating currency rates on our business, but there can be no assurances that we will implement such a hedging strategy or that once implemented, such a strategy would accomplish our objectives or not result in losses.
If we fail to stabilize our client base, our business, financial condition and operating results will be adversely affected.
Our ability to grow our business depends in large part on maintaining and expanding our client base. To do so, we must convince prospective clients of the benefits of our technology platform and existing clients of the continuing value of our products and services. As the online media options for SMBs have proliferated and our sales force has shrunk, our number of Active Clients has fallen from 23,900 as of December 31, 2013 to 20,800 as of December 31, 2014 and 17,500 as of December 31, 2015. We cannot assure you that we will be successful in maintaining or expanding our client base in the future.
SMB marketing and advertising campaigns are often sporadic and difficult to predict, as they may be driven by seasonal promotions or business dynamics, evolving product and service offerings, available budgets and other factors. Some SMBs advertise only periodically, such as to promote sales or special offers. Because we need to address these business considerations of our clients, we do not require clients to enter into long-term obligations to purchase our products and services. Many cancel soon after completing their initial contract terms and some cancel early. We must continually add new clients both to replace clients who choose to cancel or not to renew their advertising campaigns and to grow our business beyond our current client base. A client’s decision to cancel or not to renew may be based on a number of factors, including dissatisfaction with our products and services, inability to continue operations and spending levels or because their campaigns were event-driven or otherwise intentionally limited in scope or duration. If our clients increasingly fail to fulfill their contracts or increasingly do not renew their advertising campaigns with us, or if we are unable to attract new clients in numbers greater than the number of clients that we lose, our client base will decrease and our business, financial condition and operating results will be adversely affected.
A significant portion of our revenue is generated by our national brands, agencies and resellers. If we are not able to maintain relationships with them, our sales may suffer and it may contribute to further revenue declines.
We distribute our products and services through a separate sales force for national brands with operations in multiple local markets, as well as select third-party agencies and resellers. More generally, because national brands, agencies and resellers typically represent an aggregated group of SMB clients, if our relationship with one or more of these persons or companies were restricted or terminated, our sales would decrease and our revenue would be adversely affected, potentially materially. In addition, our strategy of distributing our products and services to our clients through our Direct Local channel and through our National Brands, Agencies and Resellers channel may result in distribution channel conflicts. Our Direct Local sales efforts may compete with our third-party agency and resellers and, to the extent different third-party agencies and resellers target the same clients, they may also come into conflict with each other. While we have certain policies in place to address these potential conflicts, there can be no assurance that these channel conflicts will not materially adversely affect our relationship with existing third-party agencies and resellers or adversely affect our ability to attract new third-party agencies and resellers. In the event that any of our relationships with existing third-party agencies and resellers are terminated or we are unable to attract new third-party agencies and resellers as a result of these distribution channel conflicts, our sales may suffer and our revenue may decline.
If SMBs increasingly opt to perform advertising tasks on their own, their demand for our products and services would decrease, negatively affecting our revenue.
Large Internet marketing providers such as Google, Yahoo! and Microsoft offer online advertising products and services through self-service platforms. As SMBs become more familiar with and experienced in interacting online, they may prefer to actively manage their own Internet presence and their demand for our products and services may decrease. We cannot predict the evolving experiences and preferences of SMBs, which may become more fully integrated into digitized modes of commerce and communication, and cannot assure you that we can develop our products and services in a manner that will suit their needs and expectations faster or more effectively than our competitors, or at all. If we are not able to do so, our results of operations would suffer.
We expect a number of factors to cause our operating results to fluctuate on a quarterly and annual basis, which may make it difficult to predict our future performance.
Our revenue and operating results could vary significantly from quarter-to-quarter and year-to-year because of a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. In addition to other risk factors discussed in this section, factors that may contribute to the variability of our quarterly and annual results include:
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unilateral actions taken by Google or other media providers;
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seasonal variations in advertising budgets and media pricing;
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seasonal variations in salespeople hiring;
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the rate at which SMBs migrate their advertising spending online;
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the timing and stage of product and technology development;
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our ability to develop, introduce and manage SaaS products;
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the impact of fluctuations in currency exchange rates, particularly the relative strength of the US Dollar to the currencies in the countries in which we do business and its impact on our consolidated revenues and results of operations;
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the impact of worldwide economic conditions on our revenue and expenses;
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the timing of and our ability to enter new markets and manage expansion in new markets;
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our ability to appropriately set the price of non-media products;
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our ability to accurately forecast revenue and appropriately plan our expenses;
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the attraction and retention of qualified employees and key personnel;
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the effectiveness of our internal controls;
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our ability to effectively manage our growth;
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our ability to successfully manage any future acquisitions of businesses, solutions or technologies;
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interruptions in service and any related impact on our reputation;
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the effects of natural or man-made catastrophic events; and
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changes in government regulation affecting our business.
As a result of these and other factors, the results of any prior quarterly or annual periods should not be relied upon as indications of our future operating performance. In addition, our operating results may not meet the expectations of investors.
Our expense reduction initiatives may place significant demands on our management and our infrastructure.
We have experienced substantial growth in the size and complexity of our business. This growth has placed significant demands on our management and our operational and financial infrastructure. However, during the past few years we have implemented a number of expense reduction initiatives, which may make it more difficult for us to continue to maintain, improve and upgrade our systems and infrastructure. Expense constraints could also strain our ability to maintain reliable service levels for our clients, develop and improve our operational, financial and management controls, enhance our reporting systems and procedures and recruit, train and retain highly skilled personnel. If we fail to maintain the necessary level of discipline and efficiency in our organization as it grows, our business, operating results and financial condition would be harmed.
Our ability to introduce new solutions and features is dependent on adequate research and development resources. If we do not adequately fund our research and development efforts, we may not be able to compete effectively and our business and operating results may be harmed.
To remain competitive, we must continue to develop new solutions, features and enhancements to our marketing system. Maintaining adequate research and development personnel and resources to meet the demands of the market is essential. If we are unable to develop our solutions internally due to certain constraints, such as high employee turnover, lack of management ability or a lack of other research and development resources, we may miss market opportunities. Further, many of our competitors expend a considerably greater amount of funds on their research and development programs, and those that do not may be acquired by larger companies that would allocate greater resources to our competitors’ research and development programs. Our failure to maintain adequate research and development resources or to compete effectively with the research and development programs of our competitors could materially adversely affect our business.
Our ability to deliver our products depends upon the quality, availability, policies and prices of certain third-party service providers.
We rely on third parties to provide technology and services that are integrated into our solutions. Examples include our call tracking and recording services, and certain aspects of our software products. In certain geographies, we rely on a single service provider for some of these services. In the event the provider were to terminate our relationship or stop providing these services, our ability to provide the affected products could be impaired. We may not be able to find an alternative provider in time to avoid a disruption of our services or at all, and we cannot be certain that such provider’s services would be compatible with our products without significant modifications or cost, if at all. Our proxy servers, which underlie key elements of our tracking services, require the use of various domains and IP address blocks. If domain registrars, website hosting companies or Internet service providers determined that our use of such domains and IP blocks were in violation of their terms of service or internet policies, such companies could elect to block our traffic. For example, several website hosting companies have blocked traffic from our reverse proxy servers for a group of our SMB clients, resulting in our inability to provide our full tracking services to those clients. Our ability to address or mitigate these risks may be limited. The failure of all or part of our tracking services could result in a loss of clients and associated revenue and could harm our results of operations.
We rely on bandwidth providers, data centers and other third parties for key aspects of the process of providing online marketing solutions to our clients, and any failure or interruption in the services provided by these third parties could harm our ability to operate our business and damage our reputation.
We rely on third-party vendors, including data center, software as a service, cloud computing Internet infrastructure and bandwidth providers. Any disruption in the services provided by these third-party providers or any failure of these third-party providers to handle current or higher volumes of use could significantly harm our business. Any financial or other difficulties our providers face may have negative effects on our business, the nature and extent of which we cannot predict. We exercise little control over these third-party vendors, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions and delays in service and availability for such elements. Any errors, failures, interruptions or delays experienced in connection with these third-party technologies and information services could negatively impact our relationship with our clients and adversely affect our brand and our business and could expose us to liabilities to third parties.
We rely on a number of financial services providers, both domestically and internationally, for banking, payment processing and other financial transaction support and any interruption in the services provided by these institutions could harm our ability to operate our business.
We rely on a number of financial services providers, both domestically and internationally, for banking, payment processing and other financial transaction support. If one or more of our financial services providers reduces some or all of the services available to us due to our financial position or otherwise, it could significantly harm our business by requiring us to change current processes to less efficient models or expend considerable resources to migrate to a different provider. For example, during the first quarter of 2016, one of our primary banking partners reduced the services available to us and one of our primary payment processors gave us notice of their intent to terminate the relationship. We have been in discussions with alternate financial service providers and believe that we will not have an interruption of service, but if no alternative financial service provider is available or we cannot migrate in time, we could have difficulty collecting payments from our clients or could fail to remain in compliance with the covenants under our Hercules Loan Agreement.
Rapid technological changes may render our lead generation and conversion solutions obsolete or decrease the attractiveness of our solutions to our clients.
To remain competitive, we must continue to enhance and improve the functionality and features of our technology platform. The Internet, access to the Internet and the online marketing and advertising industry are rapidly changing. Our competitors are constantly developing new products and services in online marketing and advertising. As a result, we must continue to invest significant resources in order to enhance our existing products and services and introduce new products and services that clients can easily and effectively use. If competitors introduce new solutions embodying new technologies, or if new industry practices emerge, our existing technology may become obsolete. Our future success will depend on our ability to:
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enhance our existing solutions;
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develop new solutions and technologies that address the increasingly sophisticated and varied needs of our prospective clients; and
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respond to technological advances and emerging industry practices on a cost-effective and timely basis.
Developing our online marketing and reporting solutions and the underlying technology entail significant technical and business risks. We may use new technologies ineffectively, or we may fail to adapt our technology platform and network infrastructure to client requirements or emerging industry practices. If we face material delays in introducing new or enhanced solutions, our clients may forego the use of our solutions in favor of those of our competitors.
Future acquisitions could disrupt our business and harm our financial condition and operating results.
Our success will depend, in part, on our ability to expand our offerings and markets and grow our business in response to changing technologies, client demands and competitive pressures. In some circumstances we may determine to do so through the acquisition of complementary businesses, solutions or technologies rather than through internal development. The identification of suitable acquisition candidates can be difficult, time-consuming and costly, and we may not be able to successfully complete identified acquisitions. Furthermore, even if we successfully complete an acquisition, we may not be able to successfully assimilate and integrate the business, technologies, solutions, personnel or operations of the company that we acquired, particularly if key personnel of an acquired company decide not to work for us. We may also inherit liability for activities of the acquired company before the acquisition, including violations of laws, rules and regulations, intellectual property disputes, commercial disputes, tax liabilities and other known and unknown liabilities. In addition, we may borrow to complete an acquisition, which would increase our costs, or issue equity securities, which would dilute our stockholders’ ownership and could adversely affect the price of our common stock. Historically, we have primarily grown organically, rather than through acquisitions. As a result, we have somewhat limited experience in identifying and executing acquisition opportunities. Acquisitions may also involve the entry into geographic or business markets in which we have little or no prior experience. Consequently, we may not achieve anticipated benefits of the acquisitions which could harm our operating results.
We make strategic investments from time to time and if they are unsuccessful, it could harm our financial condition.
We have made strategic investments in the past, such as the market development loan to OxataSMB, a franchisee, and may make additional similar or different strategic investments in the future. Such investments may not prove profitable or successful for us and may result in the partial or total loss of our invested capital. For example, the OxataSMB operations did not perform as contemplated, and as a result, at December 31, 2013, the Company recorded a $3.3 million impairment of the OxataSMB loan receivable and related interest and a $1.6 million provision for bad debt related to a trade receivable from OxataSMB. In addition, strategic investments may involve future commitments to provide further capital and we cannot assure you any such further investments will be desirable if, and when made, or will prove profitable over the long term.
Our business is subject to the risks of earthquakes, fires, floods and other natural catastrophic events and to interruption by man-made problems such as computer viruses or terrorism.
Our systems and operations are vulnerable to damage or interruption from earthquakes, fires, floods, power losses, telecommunications failures, terrorist attacks, acts of war, human errors, break-ins and similar events. For example, a significant natural disaster, such as an earthquake, fire or flood, could have a material adverse impact on our business, operating results and financial condition, and our insurance coverage will likely be insufficient to compensate us for losses that may occur. Our servers may also be vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems, which could lead to interruptions, delays, loss of critical data or the unauthorized disclosure of confidential intellectual property or client data. We may not have sufficient protection or recovery plans in certain circumstances, such as natural disasters affecting the Los Angeles area, and our business interruption insurance may be insufficient to compensate us for losses that may occur. As we rely heavily on our servers, computer and communications systems and the Internet to conduct our business and provide high quality customer service, such disruptions could negatively impact our ability to run our business, which could have an adverse effect on our operating results and financial condition.
If our security measures are breached and unauthorized access is obtained to a client’s data, our service may be perceived as not being secure and clients may curtail or stop using our service.
Our service involves the storage and transmission of clients’ proprietary information, such as credit card and bank account numbers, and security breaches could expose us to a risk of loss of this information, litigation and possible liability. Our payment services may be susceptible to credit card and other payment fraud schemes, including unauthorized use of credit cards, debit cards or bank account information, identity theft or merchant fraud.
If our security measures are breached in the future as a result of third-party action, employee error, malfeasance or otherwise, and as a result, someone obtains unauthorized access to our clients’ data, our reputation will be damaged, our business may suffer and we could incur significant liability. Because techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose sales and clients.
We provide services to clients in regulated industries (such as healthcare, financial and legal) in the United States and internationally. Clients in these regulated industries often have additional country-specific statutory and customer-specific contractual requirements. If we are not able to meet these changing requirements we could face litigation and could lose customers in those industries.
We are subject to a number of risks related to credit card payments we accept. If we fail to be in compliance with applicable credit card rules and regulations, we may incur additional fees, fines and ultimately, the revocation of the right to use the credit card company, which would have a material adverse effect on our business, financial condition or results of operations.
A majority of our clients’ campaigns were paid for using a credit card or debit card. For credit and debit card payments, we pay interchange and other fees, which may increase over time and raise our operating expenses and adversely affect our results of operations. We are also subject to payment card association operating rules, certification requirements and rules governing electronic funds transfers, which could change or be reinterpreted to make it difficult or impossible for us to comply. We believe we are compliant with the Payment Card Industry Data Security Standard, which incorporates Visa’s Cardholder Information Security Program, MasterCard’s Site Data Protection standard, and American Express’ Data Security Operating Policy and Discover Information Security & Compliance (DISC) program. However, there is no guarantee that we will maintain such compliance or that compliance will prevent illegal or improper use of our payment system. If we fail to comply with these rules or requirements, we may be subject to fines and higher transaction fees and lose our ability to accept credit and debit card payments from our clients. A failure to adequately control fraudulent credit card transactions would result in significantly higher credit card-related costs and could have a material adverse effect on our business, financial condition or results of operations.
Our revenue may be negatively affected if we are required to charge sales tax or other transaction taxes on all or a portion of our past and future sales to customers located in jurisdictions where we are currently not collecting and reporting tax.
We have not historically collected, or had imposed upon us, sales or other transaction taxes related to the products and services we sell, except for certain corporate level taxes and transaction level taxes outside of the United States. However, sales of our ReachEdge and Kickserv products are taxable in many state, local, and foreign jurisdictions, of which one or more may seek to impose additional sales or other transaction tax obligations on us in the future. A successful assertion by any state, local jurisdiction or country in which we do business that we should be collecting sales or other transaction taxes on the sale of our products or services could result in substantial tax liabilities related to past sales, create increased administrative burdens or costs, discourage clients from purchasing products or services from us, decrease our ability to compete or otherwise substantially harm our business and results of operations. The imposition of new laws requiring the collection of sales or other transaction taxes on the sale of our products or services (or the introduction of new products or services that are subject to existing transaction taxes) could create increased administrative burdens or costs, discourage clients from purchasing products or services from us, decrease our ability to compete or otherwise substantially harm our business and results of operations.
The intended tax benefits of our corporate structure and intercompany arrangements depend on the application of the tax laws of various jurisdictions and on how we operate our business.
Our corporate structure and intercompany arrangements, including the manner in which we develop and use our intellectual property and the transfer pricing of our intercompany transactions, are intended to reduce our worldwide effective tax rate. The application of the tax laws of various jurisdictions, including the United States, to our international business activities is subject to interpretation and depends on our ability to operate our business in a manner consistent with our corporate structure and intercompany arrangements. The taxing authorities of the jurisdictions in which we operate may challenge our methodologies for valuing developed technology or intercompany arrangements, including our transfer pricing, or determine that the manner in which we operate our business does not achieve the intended tax consequences, which could increase our worldwide effective tax rate and harm our financial position and results of operations.
Our corporate structure includes legal entities located in jurisdictions with income tax rates lower than the U.S. statutory tax rate. Our intercompany arrangements allocate income to such entities in accordance with arm’s-length principles and commensurate with functions performed, risks assumed and ownership of valuable corporate assets. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. statutory rate will have a beneficial impact on our worldwide effective tax rate.
Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. For example, our effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in foreign currency exchange rates or by changes in the relevant tax, accounting and other laws, regulations, principles and interpretations. As we operate in numerous taxing jurisdictions, the application of tax laws can be subject to diverging and sometimes conflicting interpretations by tax authorities of these jurisdictions. It is not uncommon for taxing authorities in different countries to have conflicting views, for instance, with respect to, among other things, the manner in which the arm’s length standard is applied for transfer pricing purposes, or with respect to the valuation of intellectual property. In addition, tax laws are dynamic and subject to change as new laws are passed and new interpretations of the law are issued or applied. In particular, there is uncertainty in relation to the U.S. tax legislation in terms of the future corporate tax rate but also in terms of the U.S. tax consequences of income derived from intellectual property related income earned overseas in low tax jurisdictions.
Our existing corporate structure and intercompany arrangements have been implemented in a manner we believe is in compliance with current prevailing tax laws. However, the tax benefits which we intend to eventually derive could be undermined if we are unable to adapt the manner in which we operate our business and due to changing tax laws.
Failure to adequately protect our intellectual property could substantially harm our business and operating results.
Because our business is heavily dependent on our intellectual property, including our proprietary technology, the protection of our intellectual property rights is crucial to the success of our business. We rely on a combination of intellectual property rights, including trade secrets, patent applications, copyrights and trademarks, as well as contractual restrictions, to safeguard our intellectual property. These afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our online marketing and reporting solutions, technology, software and functionality or obtain and use information that we consider proprietary. Moreover, policing our proprietary rights is difficult and may not always be effective. In particular, because we sell our solutions internationally, we may need to enforce our rights under the laws of countries that do not protect proprietary rights to as great an extent as do the laws of the United States.
Our proprietary technology is not currently protected by any issued patents, and policing our rights to such technology may be hindered if we are unable to obtain any patents. In addition, the type and extent of patent claims that may be issued to us in the future is uncertain, and any patents that are issued may not contain claims that permit us to stop competitors from using similar technology. In light of the costs of obtaining patent protection, at times we may choose not to protect certain innovations that later on prove to be highly important. To the extent that the various technologies underlying any patent applications are determined to be business methods, the law around these types of patents is rapidly developing, and pending changes may impact our ability to protect our technology and proprietary use thereof through patents.
We have registered ReachLocal and other trademarks as trademarks in the United States and in certain other countries. Some of our trade names are not eligible to receive trademark protection. Also, trademark protection may not be available, or sought by us, in every country in which our technology and products are available online. Competitors may adopt service names similar to ours, or purchase our trademarks and confusingly similar terms as keywords in Internet search engine advertising programs, thereby impeding our ability to build brand identity and possibly leading to client confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of the term ReachLocal or our other trademarks.
Litigation or proceedings before the U.S. Patent and Trademark Office or other governmental authorities and administrative bodies in the United States and abroad may be necessary in the future to enforce our intellectual property rights, to protect our patent rights, trade secrets and domain names and to determine the validity and scope of the proprietary rights of others. Our efforts to enforce or protect our proprietary rights may be ineffective and could result in substantial costs and diversion of resources and could substantially harm our operating results.
Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.
In order to protect our proprietary technology and processes, we rely in part on confidentiality agreements with our employees, licensees, independent contractors and other advisors. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information, and in such cases, we could not assert any trade secret rights against such parties. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.
Assertions by third parties of infringement by us of their intellectual property rights could result in significant costs and substantially harm our business and operating results.
Companies in the Internet, technology and media industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently litigate or threaten litigation based on allegations of infringement or other violations of intellectual property rights. Other parties have asserted, and may in the future assert, that we have infringed their intellectual property rights. These types of litigations may involve patent holding companies or other adverse patent owners who have no relevant product revenue, and therefore our own issued and pending patents, if any, may provide little or no deterrence. In addition, we have been and could in the future become involved in disputes over the use of keywords by our clients, to the extent such clients’ competitors allege the use of such keywords on our technology platform violates such competitors’ trademark rights. We cannot predict whether assertions of third-party intellectual property rights or claims arising from such assertions will substantially harm our business and operating results. If we are forced to defend against any infringement claims, whether they are with or without merit or are determined in our favor, we may face costly litigation and diversion of technical and management personnel. Furthermore, an adverse outcome of a dispute may require us to pay damages, potentially including treble damages and attorneys’ fees, if we are found to have willfully infringed a party’s patent or copyright rights; cease making, licensing or using solutions that are alleged to incorporate the intellectual property of others; expend additional development resources to redesign our solutions; and enter into potentially unfavorable royalty or license agreements in order to obtain the right to use necessary technologies. Royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. Over time, we expect that we will increasingly be subject to infringement claims as the number of competitors in our industry segment grows or as our presence and visibility within the industry increases.
We could lose clients if we or our media partners fail to detect click-through or other fraud on advertisements in a manner that is acceptable to our clients.
We are exposed to the risk of fraudulent clicks or actions on our third-party publishers’ websites. We may lose clients, or in the future, we may have to refund revenue that our clients have paid to us and that was later attributed to, or suspected to be caused by, click-through fraud. Click-through fraud occurs when an individual clicks on an ad displayed on a website or an automated system is used to create such clicks with little to no intent of viewing the underlying content. If fraudulent clicks are not detected, the affected clients may become dissatisfied with our campaigns, which in turn may lead to loss of clients and the related revenue.
Our business is subject to complex and evolving U.S. and foreign laws and regulations regarding privacy, data protection, and other matters. Many of these laws and regulations are subject to change and uncertain interpretation, and could result in claims, changes to our business practices, increased cost of operations, or otherwise harm our business.
We are subject to a variety of laws and regulations in the United States and abroad that involve matters central to our business, including user privacy, rights of publicity, data protection, content, intellectual property, distribution, electronic contracts and other communications, competition, protection of minors, consumer protection, taxation, and online payment services. Foreign data protection, privacy, and other laws and regulations are often more restrictive than those in the United States. These U.S. federal and state and foreign laws and regulations are constantly evolving and can be subject to significant change. In addition, the application and interpretation of these laws and regulations are often uncertain. These laws and regulations could have a significant impact on online advertising services depending on how these laws and regulations are interpreted and enforced. It is also clear that the laws and regulations are intending to regulate behavioral targeting, the availability of which could become highly limited are eliminated entirely. Our product suite does not rely heavily on the use of behavioral targeting, but we do offer a display remarketing product, which involves showing a consumer an ad for the website of a client that the consumer has previously visited.
In addition, a number of proposals are pending before federal, state, and foreign legislative and regulatory bodies that could significantly affect our business. For example, a revision to the 1995 European Union Data Protection Directive is currently being considered by European legislative bodies that may include more stringent operational requirements for data processors and significant penalties for non-compliance. Similarly, there have been a number of recent legislative proposals in the United States, at both the federal and state level, that would impose new obligations in areas such as privacy, data protection and data breach notifications. Some of the proposed changes to U.S. and European law could require that we obtain prior consent before using cookies or other tracking technologies or provide a “do not track” mechanism in certain circumstances.
We have in the past relied on adherence to the U.S. Department of Commerce’s Safe Harbor Privacy Principles and compliance with the U.S.-EU Safe Harbor Framework, which established a means for legitimating the transfer of personally identifiable information by U.S. companies doing business in Europe from the European Economic Area to the U.S. As a result of the October 6, 2015 European Union Court of Justice, or ECJ, opinion in the Schrems v. Data Protection Commissioner case, the U.S. - EU Safe Harbor Framework is no longer deemed to be a valid method of compliance with restrictions set forth in the Data Protection Directive (and member states’ implementations thereof) regarding the transfer of data outside of the EEA. We are currently relying on other methods to our customers to enable compliant data transfers from the EEA to the U.S. and are monitoring further developments in this area.
These existing and proposed laws and regulations can be costly to comply with and can delay or impede the development of new products, result in negative publicity, increase our operating costs, require significant management time and attention, and subject us to claims or other remedies, including fines or demands that we modify or cease existing business practices.
We process, store and use personal information and other data, which subjects us to governmental regulation and other legal obligations related to privacy. Our actual or perceived failure to comply with such obligations could harm our business.
We receive, store and process personal information and other user data, including credit card information for certain users. There are numerous federal, state and local laws around the world regarding privacy and the storing, sharing, use, processing, disclosure and protection of personal information and other user data, the scope of which are changing, subject to differing interpretations, and may be inconsistent between countries or conflict with other rules. It is possible that these obligations may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another and may conflict with other rules or our practices. Any failure or perceived failure by us to comply with our privacy policies, our privacy-related obligations to users or other third parties, or our privacy-related legal obligations, or any compromise of security that results in the unauthorized release or transfer of personally identifiable information or other user data, may result in governmental enforcement actions, litigation or negative publicity and could cause our clients to lose trust in us, which could have an adverse effect on our business. Additionally, if third parties with whom we work, such as our publishers or our providers of telephony services, violate applicable laws or our policies, such violations may also put our users’ information at risk and could have an adverse effect on our business.
Some of our services may utilize “open source” software, and any failure to comply with the terms of one or more of these open source licenses could negatively affect our business.
Some of our services may utilize software licensed by its authors or other third parties under so-called “open source” licenses, including, but not limited to, the GNU General Public License and the GNU Lesser General Public License. Some of those licenses may require that we make available source code for modifications or derivative works we create using the open source software, that we provide notices with our products and that we license any modifications or derivative works under an open source license or rights of further use to third parties. If we combine our proprietary software with open source software, we could be required to release the source code of our proprietary software. Although we take steps to ensure that our software engineers properly isolate our proprietary software they design from open source software components, we may not control the product development efforts of our engineers and we cannot be certain that they have not inappropriately incorporated open source software into our proprietary technologies. If an author or other third party that distributes open source software were to obtain a judgment against us based on allegations that we had not complied with the terms of any applicable open source license, we could be subject to liability for copyright infringement damages and breach of contract. In addition, we could be enjoined from selling our services that contained the open source software and required to make the source code for the open source software available, to grant third parties certain rights of further use of our software or to remove the open source software from our services, which could disrupt our distribution and sale of some of our services.
Government regulation of the Internet is evolving, and unfavorable changes could substantially harm our business and operating results.
We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet. Existing and future laws and regulations may impede the growth in use of the Internet and online services. The application of existing laws to the Internet and online services governing issues such as property ownership, sales and other taxes, libel and personal privacy has not yet been settled. Unfavorable resolution of these issues may substantially harm our business and operating results. Other laws and regulations that have been adopted, or may be adopted in the future, that may affect our business include those covering user privacy, data protection, spyware, “do not email” lists, access to high speed and broadband service, pricing, taxation, tariffs, patents, copyrights, trademarks, trade secrets, export of encryption technology, electronic contracting, click-fraud, acceptable content, search terms, lead generation, behavioral targeting, consumer protection, and quality of products and services. Any changes in regulations or laws that hinder growth of the Internet generally or that decrease the acceptance of the Internet as a communications, commercial and advertising medium could adversely affect our business. See also Part 1, Item 1A, “Risk Factors-Our business is subject to complex and evolving U.S. and foreign laws and regulations regarding privacy, data protection, and other matters. Many of these laws and regulations are subject to change and uncertain interpretation, and could result in claims, changes to our business practices, increased cost of operations, or otherwise harm our business.”
Risks Related to Owning Our Common Stock
Our stock price may be volatile, and the value of an investment in our common stock may decline.
Shares of our common stock were sold in our initial public offering in May 19, 2010 at a price of $13.00 per share, and our common stock has subsequently traded as high as $28.39 and as low as $0.55. In addition, at times during the past year, trading volumes have declined substantially as compared to earlier periods. An active, liquid and orderly market for our common stock may not be sustained, which could depress the trading price of our common stock. The trading price of our common stock may be subject to wide fluctuations in response to various factors, some of which are beyond our control, including:
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our operating performance and the operating performance of similar companies;
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our capital and liquidity position and ability to access additional capital, if necessary;
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the overall performance of the equity markets;
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the number of shares of our common stock publicly owned and available for trading;
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changes in the amounts and frequency of share repurchases;
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threatened or actual litigation;
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changes in laws or regulations relating to our solutions;
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any major change in our board of directors or management;
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publication of research reports about us or our industry or changes in recommendations or withdrawal of research coverage by securities analysts;
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large volumes of sales of our shares of common stock by existing stockholders; and
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general political and economic conditions.
In addition, the stock market in general, and the market for Internet-related companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Securities class action litigation has often been instituted against companies following periods of volatility in the overall market and in the market price of a company’s securities. This litigation, if instituted against us, could result in very substantial costs, divert our management’s attention and resources and harm our business, operating results and financial condition. In addition, the recent distress in the financial markets has also resulted in extreme volatility in security prices.
Future sales of shares of our common stock by stockholders could depress the price of our common stock.
As of March 23, 2016, approximately 55% of our common stock is held by our directors, officers and entities affiliated with our directors, including approximately 43% beneficially owned by VantagePoint Capital Partners (including approximately 450,000 shares issuable upon conversion of the VantagePoint Notes) and approximately 9% beneficially owned by Rho Ventures. Such shares have not been subject to lock-up agreements since November 2010. VantagePoint and Rho Ventures were our two primary venture capital investors and have owned their shares for a considerable length of time. If either VantagePoint or Rho Ventures decides to exit its investment in us, it could negatively impact the price of our common stock. During February and March of 2014, Rho Ventures sold an aggregate of approximately 187,000 shares of our common stock.
If there are substantial sales of our common stock in the public market, the trading price of our common stock could decline significantly. In addition, as of December 31, 2015, approximately 6.9 million shares subject to outstanding options and RSUs under our 2004 Stock Plan, our Amended and Restated 2008 Stock Incentive Plan and inducement awards, are potentially eligible for sale in the public market in the future. If these additional shares are sold, or if it is perceived that they will be sold, in the public market, the price of our common stock could decline substantially.
If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our stock price and trading volume could decline.
The trading market for our common stock depends in part on the research and reports that securities or industry analysts publish about us or our business. If one or more of the analysts who cover us downgrade our stock or publish inaccurate or unfavorable research about our business, our stock price would likely decline. The number of analysts covering our company has decreased from a maximum of nine to two currently and if one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, demand for our stock could decrease, which might cause our stock price and trading volume to decline.
If we are unable to continue to comply with the NASDAQ Global Select Market’s continued listing requirements, our common stock may be delisted from the NASDAQ Global Select Market, which could have an adverse effect on the liquidity and market price of such shares.
NASDAQ’s continued listing requirements require, among other requirements, that we maintain at least $15 million of public float and that the minimum bid price of our common stock not fall below $1.00 per share for 30 consecutive business days. Although as of March 23, 2016, we are in compliance with NASDAQ’s continued listing requirements, our public float fell below $15 million in December 2015 and our common stock has traded below $1.00 in the recent past. If we fail to meet either of these requirements, or others, for more than 30 consecutive trading days, we will have 180 days to satisfy such requirement for a period of at least 10 trading days. If we fail to regain compliance during such period, we could be subject to delisting from the NASDAQ Global Select Market.
If we fail to maintain our listing on the NASDAQ Global Select Market, the market liquidity and market price of our common stock will be harmed. If the stock were to trade it would likely trade on the OTC “pink sheets,” which provide significantly less liquidity than does NASDAQ. As a result, the liquidity of our common stock would be impaired, not only in the number of shares which could be bought and sold, but also through delays in the timing of transactions, reduction in security analysts’ and news media’s coverage, and lower prices for our common stock than might otherwise be attained. In addition, our common stock would become subject to the low-priced security or so-called “penny stock” rules that impose additional sales practice requirements on broker-dealers who sell such securities.
Investment funds managed by VantagePoint Capital Partners own a substantial amount of our stock and have significant influence over our business. In the aggregate, insiders own a majority of our outstanding stock.
As of March 23, 2016, VantagePoint Capital Partners, one of our early venture capital investors, beneficially owned approximately 43% of our outstanding common stock (including approximately 450,000 shares issuable upon conversion of the VantagePoint Notes). As a result, VantagePoint has significant influence over the outcome of matters submitted to our stockholders for approval, including the election of directors. VantagePoint’s significant ownership also could affect the market price of our common stock by, for example, delaying, deferring or preventing a change in corporate control, impeding a merger, consolidation, takeover or other business combination involving us, or discouraging a potential acquiror from making a tender offer or otherwise attempting to obtain control of us. Alan Salzman, the Chief Executive Officer of VantagePoint, serves as a member of our board of directors.
As of March 23, 2016, our current directors and executive officers as a group beneficially owned approximately 55% of our outstanding common stock.
Certain provisions in our charter documents and Delaware law could discourage takeover attempts and lead to management entrenchment.
Our certificate of incorporation and bylaws contain provisions that could have the effect of delaying or preventing changes in control or changes in our management without the consent of our board of directors, including, among other things:
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a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors;
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no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates;
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the ability of our board of directors to determine to issue shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquirer;
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the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of our board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors;
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a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders;
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the requirement that a special meeting of stockholders may be called only by the chairman of our board of directors, the Chief Executive Officer, the president (in absence of a Chief Executive Officer) or our board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors;
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the requirement for the affirmative vote of holders of at least 66 2/3% of the voting power of all of the then outstanding shares of the voting stock, voting together as a single class, to amend the provisions of our certificate of incorporation relating to the issuance of preferred stock and management of our business or our bylaws, which may inhibit the ability of an acquiror from amending our certificate of incorporation or bylaws to facilitate a hostile acquisition;
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the ability of our board of directors, by majority vote, to amend the bylaws, which may allow our board of directors to take additional actions to prevent a hostile acquisition and inhibit the ability of an acquiror from amending the bylaws to facilitate a hostile acquisition; and
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advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us.
We are also subject to certain anti-takeover provisions under Delaware law. Under Delaware law, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, our board of directors has approved the transaction.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
We do not own any real estate. We lease 38,592 square feet and 90,000 square feet for our corporate and sales offices in Woodland Hills, California, and in Plano, Texas, respectively. We also have over 65 leases for sales offices, support facilities and data centers in other locations in North America and overseas.
Item 3.
Item 3. Legal Proceedings.
From time to time, we are involved in legal proceedings arising in the ordinary course of our business.
North America
On May 2, 2014, a lawsuit, purporting to be a class action, was filed by one of our former clients in the United States District Court in Los Angeles. The complaint alleged breach of contract, breach of the implied covenant of good faith and fair dealing, and violation of California’s unfair competition law. The complaint sought monetary damages, restitution and attorneys’ fees. We filed a motion to dismiss on June 20, 2014, which was denied on December 4, 2014. On February 5, 2016, we entered into a confidential settlement agreement and release with plaintiffs to settle all of their claims. The settlement was not material to our consolidated financial position, results of operations or cash flows.
Europe
Over the past two years, our United Kingdom subsidiary (“RL UK”), has been involved in a number of disputes with former clients that allege RL UK made misrepresentations in connection with sales to those clients. We resolved a number of these disputes in 2014. On June 15, 2015, one former RL UK client filed a lawsuit in the High Court of Justice alleging fraudulent misrepresentations and breach of contract. Our insurance carrier provided a defense under a reservation of rights. On December 16, 2015, RL UK entered administration, to allow for an orderly exit from the market and as a result, any claims against RL UK are stayed, pending the outcome of the administration. Upon entering administration, we no longer held a controlling interest, and therefore deconsolidated the subsidiary.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock has been traded on The NASDAQ Global Select Market since May 20, 2010 under the symbol “RLOC.” The following table sets forth the high and low sales prices for our common stock as reported by The NASDAQ Global Select Market for the period indicated.
At March 23, 2016, we had 24 stockholders of record of our common stock. We have never declared or paid, and do not anticipate declaring or paying, any cash dividends on our common stock. Any future determination as to the declaration and payment of dividends, and share repurchases, if any, will be at the discretion of our board of directors and will depend on then existing conditions, including our financial condition, operating results, contractual restrictions, capital requirements, business prospects and other factors our board of directors may deem relevant.
Stock Price Performance Graph
This performance graph shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities under that Section, and shall not be deemed to be incorporated by reference into any filing of ReachLocal, Inc. under the Securities Act or the Exchange Act.
The following graph compares, for the period from December 31, 2010 through December 31, 2015, the total cumulative stockholder return on our common stock with the total cumulative return of the NASDAQ Composite Index and the RDG Internet Composite Index. The graph assumes a $100 investment at the beginning of the period in our common stock, the stocks represented in the NASDAQ Composite Index and the stocks represented in the RDG Internet Composite Index, and reinvestment of any dividends. Historical stock price performance should not be relied upon as an indication of future stock price performance:
*$100 invested on 12/31/10 in stock or index, including reinvestment of dividends.
Recent Sales of Unregistered Securities
On December 17, 2015, we entered into a convertible note purchase agreement with affiliates of our largest shareholder, VantagePoint Capital Partners (“VantagePoint”), for the immediate issuance of $5.0 million of Convertible Second Lien Subordinated Notes (the “VantagePoint Notes”). The note purchase agreement also provides for the issuance and sale of up to an additional $5.0 million aggregate principal amount of convertible notes, upon mutual agreement of ReachLocal and VantagePoint (and Hercules’ consent). The VantagePoint Notes bear an annual interest rate of 4%, compounded quarterly. ReachLocal is required to begin making quarterly interest and principal payments on April 15, 2017, subject to a subordination agreement with Hercules. The VantagePoint Notes mature on April 15, 2018, and all remaining principal payments and unpaid interest is due at that time. The holders of the VantagePoint Notes have the right to convert any portion of the VantagePoint Notes into shares of ReachLocal common stock, par value $0.00001 per share, at an initial conversion rate of 200 shares of common stock per $1,000 principal amount of VantagePoint Notes, which represents an initial conversion price of $5.00 per share. The conversion rate is subject to customary anti-dilution adjustments for stock dividends, splits and combinations, certain distributions on the common stock, including cash dividends, spin-offs and certain tender or exchange offers for the common stock. An event of default, as defined in the agreement, may result in the acceleration of the maturity of the notes.
On February 4, 2016, we entered into an amendment to the VantagePoint Notes. The amendment provides that, except in certain circumstances, the convertibility of the VantagePoint Notes is limited such that conversion may not result in the holders collectively acquiring beneficial ownership of more than 1.9% of our outstanding shares of common stock during any 12-month period.
VantagePoint and its affiliates beneficially own approximately 43% of ReachLocal’s common stock immediately after the issuance of $5.0 million principal amount of the Convertible Notes, and VantagePoint’s Chief Executive Officer and Managing Partner, is a member of ReachLocal’s Board of Directors.
Common Stock Repurchases
The Company’s Board of Directors previously authorized the repurchase of up to $47.0 million of our outstanding common stock. At December 31, 2013, the Company had executed repurchases of 3.4 million shares of its common stock under the program for an aggregate of $36.3 million. There were no repurchases under the program during 2014 or 2015. On April 29, 2015, the Board of Directors terminated the Company’s repurchase program.
The Company is deemed to repurchase common stock surrendered by participants to cover tax withholding obligations with respect to the vesting of restricted stock and restricted stock units.
Item 6.
Item 6. Selected Financial Data.
The data set forth below are qualified in their entirety by reference to, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements, related notes and other financial information included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2015, 2014 and 2013 and the consolidated balance sheet data as of December 31, 2015 and 2014 are derived from our audited consolidated financial statements included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2012 and 2011 and the consolidated balance sheet data as of December 31, 2013, 2012 and 2011 are derived from our audited consolidated financial statements not included in this report. In addition, as a result of the disposal of our ClubLocal business and the winding down of the operations of Bizzy, we have reclassified and presented all related historical financial information as “discontinued operations” in the accompanying Consolidated Balance Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. Historical results are not necessarily indicative of the results to be expected in the future.
______________
(1)
Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line items (in thousands):
________________
(2)
See Note 16 to our consolidated financial statements for an explanation of the method used to calculate basic and diluted net income (loss) from continuing operations per share of common stock.
_______________
(3)
We retrospectively adopted FASB Accounting Standards Update 2015-17 during the fourth quarter of 2015, which requires the presentation of all deferred income taxes as long-term assets or liabilities. Accordingly, 2014 and 2013 total assets and liabilities have been adjusted by $1.7 million and $1.1 million, respectively. The adoption did not impact 2012 or 2011.
(4)
Represents purchases of property and equipment and the amount of software development costs capitalized, in aggregate, excluding capital expenditures related to the discontinued operations of Bizzy and ClubLocal.
(5)
See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures” for our definition of Adjusted EBITDA, why we present it and for a reconciliation of our Adjusted EBITDA to loss from operations for the years ended December 31, 2015, 2014 and 2013.
(6)
Active Clients is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Clients by adjusting the number of Active Product Units to combine clients with more than one Active Product Unit as a single Active Client. Clients with more than one location are generally reflected as multiple Active Clients. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Clients includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred.
(7)
Active Product Units is a number we calculate to approximate the number of individual products, licenses, or services we are providing under contract for Active Clients. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client who also licenses ReachEdge, we consider that three Active Product Units. Similarly, if a client purchases ReachSearch campaigns for two different products or purposes, we consider that two Active Product Units. Numbers are rounded to the nearest hundred.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
You should read the following discussion together with Part II, Item 6, “Selected Financial Data” and our consolidated financial statements and the related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements about our business and operations. Our actual results may differ materially from those we currently anticipate as a result of many factors, including those we describe in Part I, Item 1A, “Risk Factors” and elsewhere in this Annual Report. See Part I, “Cautionary Notice Regarding Forward-Looking Statements.”
Overview
ReachLocal’s mission is to provide more customers to businesses. We began in 2004 with the goal of helping local businesses move their advertising spend from traditional media and yellow pages to online search. While we have sold to a variety of local businesses and will continue to do so, our present focus is on small to medium-sized businesses (SMBs) and in particular, what we refer to as Premium SMBs. A Premium SMB generally has 10 to 30 employees, $1 to $10 million in annual revenue and spends approximately $40,000 annually on marketing. Premium SMBs have become increasingly sophisticated in their understanding of online marketing. However, we believe that Premium SMBs have not changed their desire for a single, unified solution to their marketing needs. Our goal is to provide a total digital marketing solution that will address Premium SMBs’ online marketing needs. Our total digital marketing solution consists of products and solutions in three categories: digital advertising (including ReachSearch™, ReachRetargeting™, ReachDisplay™, and ReachDisplay InAppTM ), web presence (including ReachSEO™, ReachCast™, TotalLiveChat™, ReachSite+ReachEdge™) and software (ReachEdge™ and Kickserv™).
We began by offering online advertising solutions with the rollout of ReachSearch in 2005, when we pioneered the provisioning of search engine marketing services (SEM) on a mass scale for local businesses through the use of our technology platform. ReachSearch combines search engine marketing optimized across multiple publishers, call tracking and call recording services, and industry leading campaign performance transparency. ReachSearch remains a leading SEM offering for local businesses and has won numerous awards since its rollout, including most recently winning Google’s Quality Score Champion Award in North America and Latin America. However, ReachSearch does not solve all of the online advertising challenges of our clients. We have therefore added additional elements to our platform including our display product, ReachDisplay and ReachDisplay InApp, our behavioral targeting product, ReachRetargeting, and other products that are primarily focused on leveraging third-party media to drive leads to our clients.
To complement our online digital advertising solutions, we have also launched a number of presence solutions. These solutions include websites, social, search engine optimization (SEO), chat and other products and solutions, all focused on expanding and leveraging our clients’ web presence. Often these products are designed to work in concert with our digital advertising products with a goal of enhancing the return to our clients. These products are generally available in North America and selectively available in our international markets.
We also recognize that even successfully driving leads to our clients does not represent a complete solution to local businesses’ online marketing needs. In 2013, we expanded into lead conversion software with the introduction of ReachEdge in order to move beyond being a media-driven lead generation business to offering integrated solutions for our clients. ReachEdge is marketing automation and lead conversion software and includes tools for capturing web traffic information and converting leads into new customers. Initially, ReachEdge only came bundled with a responsive website. However, beginning in the first quarter of 2015, clients have been able to license ReachEdge’s lead conversion software without having to also purchase a website, allowing us to sell ReachEdge to local businesses who do not need a new website or who purchase their website from another provider.
Over time, we plan to add additional dynamic optimization functionality to ReachEdge, as well as features that create a more seamless relationship between our clients and their customers. For example, in the fourth quarter of 2014, we acquired Kickserv, a provider of cloud-based business management software for service businesses. With this addition, we now have the ability to provide an end-to-end solution to our clients that starts with lead generation (ReachSearch, ReachDisplay and ReachSEO), includes lead conversion software (ReachEdge), and then closes and manages the business relationship (Kickserv). Local businesses already spend marketing dollars in these categories with a significant number of providers in a highly fragmented and confusing marketplace. Our integrated total marketing solution seeks to address this broad array of business needs with a simple integrated solution.
In North America, we sell our products and solutions directly, principally through our outside sales force and in certain situations, an inside sales force, in what we refer to as our Direct Local channel. Our sales personnel (primarily referred to as Digital Marketing Consultants or DMCs) both generate the sale and manage the client relationship. Each DMC is paired with a Marketing Expert (or ME) who provides day-to-day campaign management. We believe that this approach enables the DMC to focus primarily on selling and managing client relationships, while the client benefits from the support and expertise of dedicated MEs. We also have certain veteran salespeople that we refer to as IMCs who have more discretion to manage their client relationships and campaigns. Our international markets generally operate under a modified version of the North American model, suited for local market and product availability differences.
We refer to our separate sales channel targeting national brands, franchises and strategic accounts with operations in multiple local markets, and select third-party agencies and resellers as our NBAR channel. The sales process for the NBAR channel typically has substantially longer lead times than in our Direct Local channel. In addition, national brand clients often involve complexity due to operational and marketing requirements that are not normally required by our Direct Local clients. Our third-party agencies and reseller partners use our technology platform in customer segments where they have sales forces with established relationships with their client bases. We currently have over 350 agencies and resellers actively selling on our technology platform. We have a team that is responsible for identifying potential agencies and resellers, training their sales forces to sell our products and services and supporting the relationships on an ongoing basis.
During the third quarter of 2015 we introduced our Web Partner Program, under which we distribute ReachEdge through third-party web developers. We are focusing on potential partners that typically have client bases ranging from 200 to 2,000 clients. By distributing ReachEdge with their platforms, Web Partners can deliver value to their clients while also earning an additional revenue stream. We believe that our Web Partner Program can increase our sales force’s productivity by giving our sales people easier access to potential new clients.
In addition to the United States and Canada, we have sales operations in Australia, New Zealand, Japan, Germany, the Netherlands, Austria Brazil and Mexico. We exited direct sales in the United Kingdom market in the fourth quarter of 2015 when our local subsidiary ReachLocal UK Ltd. (“RL UK”) entered administration and we continue to review our international operations in order to rationalize operations in overseas markets we determine to be underperforming and to optimize operations in our primary markets.
Operating Metrics
We regularly review a number of financial and operating metrics to evaluate our business, determine the allocation of resources and make decisions regarding business strategies.
The following table shows certain key operating metrics for the three years ended December 31, 2015, 2014 and 2013.
______________
(1)
(2)
See Part II, Item 6, “Selected Financial Data” for our definition of Active Clients.
See Part II, Item 6, “Selected Financial Data” for our definition of Active Product Units.
Active Clients and Active Product Units
We track the number of Active Clients and Active Product Units to evaluate the growth, scale and diversification of our business. We also use these metrics to determine the needs and capacity of our sales forces, our support organization and other personnel and resources. The decrease in the number of Active Clients and Active Product Units is primarily due to an overall decrease in salespeople in both the Direct Local and NBAR channel as we decreased the size of our sales force in an effort to focus on more productive salespeople, partially offset by the addition of Kickserv clients and increased client retention in the Direct Local channel. The productivity of our current sales force improved compared to the prior-year period, but not enough to offset the decrease in number of sales people. Our exit from direct sales in the U.K. in the fourth quarter of 2015 reduced our number of Active Clients and Active Product Units at year-end and will continue to have a negative effect on those metrics in the first quarter of 2016.
Basis of Presentation
Sources of Revenue
We derive our revenue principally from the provision and sale of online marketing products to our clients. Revenue includes (i) the sale of our ReachSearch, ReachRetargeting, ReachDisplay, and other products based on a package pricing model in which our clients commit to a fixed fee that includes the media, optimization, reporting and tracking technologies of our technology platform, and the personnel dedicated to support and manage their campaigns; (ii) the license (or sale) of ReachEdge, ReachSEO, ReachCast, TotalLiveChat, TotalTrack, ReachSite, Kickserv and other products and solutions; and (iii) set-up, management and service fees associated with these products and other solutions. We distribute our products and solutions directly through our outside and inside sales force that is focused on serving local businesses in their local markets through a consultative process, which we refer to as our Direct Local channel, as well as a separate sales force targeting our National Brands, Agencies and Resellers channel. The sales cycle for sales to our clients ranges from one day to over a month. Sales to our National Brands, Agencies and Resellers clients generally require several months.
We typically enter into multi-month agreements for the delivery of our products. Under our agreements, our Direct Local clients typically pay, in advance, a fixed fee on a monthly basis, which includes all charges for the included technology and any media services, management, third-party content and other costs and fees. We record these prepayments as deferred revenue and only recognize revenue in our statement of operations as we purchase media and perform other services on behalf of clients. Certain Direct Local clients are extended credit privileges with payment generally due in 30 days. Revenue from the licensing of our products is recognized on a straight-line basis over the applicable license or service period. There were $4.0 million and $3.2 million of accounts receivable related to our Direct Local channel at December 31, 2015 and December 31, 2014, respectively.
Our National Brands, Agencies and Resellers clients enter into agreements of various lengths or that are indefinite. Our National Brands, Agencies and Resellers clients either pay in advance or are extended credit privileges with payment generally due in 30 to 60 days. There were $3.3 million and $5.0 million of accounts receivable related to our National Brands, Agencies and Resellers at December 31, 2015 and December 31, 2014, respectively.
Cost of Revenue
Cost of revenue consists primarily of the costs of online media acquired from third-party publishers. Media cost is recorded as cost of revenue in the period in which the corresponding revenue is recognized. From time to time, publishers offer us rebates based upon various factors and operating rules, including the amount of media purchased. We record these rebates in the period in which they are earned as a reduction to cost of revenue and the corresponding payable to the applicable publisher, or as other receivable, as appropriate. Cost of revenue also includes the third-party telephone and information services costs, other third-party service provider costs, data center and third-party hosting costs, credit card processing fees, and other direct costs.
In addition, cost of revenue includes costs to manage and operate our various solutions and technology infrastructure, other than costs associated with our sales force, which are reflected as selling and marketing expenses. Cost of revenue includes salaries, benefits, bonuses and stock-based compensation for the related staff, including our MEs who manage client accounts and provide client-facing support, and allocated overhead such as depreciation expense, rent and utilities. Cost of revenue also includes the amortization and impairment charges (as applicable) on acquired technology, customer relationships and trade names.
Operating Expenses
Selling and Marketing. Selling and marketing expenses consist primarily of personnel and related expenses for our selling and marketing staff, including salaries and wages, commissions and other variable compensation, benefits, bonuses and stock-based compensation; travel and business costs; training, recruitment, marketing and promotional events; advertising; other brand building and product marketing expenses; and occupancy, technology and other direct overhead costs. A portion of the compensation for employees in the sales organization is based on commissions. In addition, the cost of agency commissions is included in selling and marketing expenses. Generally, commissions are expensed as earned. However, we pay commissions to certain sales people for the acquisition of new clients and because our client contracts are generally not cancelable without a penalty, we defer those commissions and amortize them over the initial contract term.
Product and Technology. Product and technology expenses consist primarily of personnel and related expenses for our product development and engineering professionals, including salaries, benefits, bonuses and stock-based compensation, and the cost of third-party contractors and certain third-party service providers and other expenses, including occupancy, technology and other direct overhead costs. Technology operations costs, including related personnel and third-party costs, are included in product and technology expenses. We capitalize a portion of costs as software development and, accordingly, include amortization of those costs as product and technology expenses. Our technology platform addresses all aspects of our activities, including supporting the selling and consultation process, integrating with online publishers, driving efficiency and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting financial and other back-office functions of our business.
Product and technology expenses also include the amortization of the technology obtained in acquisitions and the expensing of acquisition-related deferred payment obligations attributable to product and technology personnel. Product and technology expenses do not include the costs to deliver our solutions to clients, which are included in cost of revenue.
General and Administrative. General and administrative expenses consist primarily of personnel and related expenses for board, executive, legal, finance, human resources and corporate communications, including wages, benefits, bonuses and stock-based compensation, professional fees, insurance premiums, business taxes and other expenses, including occupancy, technology and other direct overhead, public company costs and other corporate expenses.
Restructuring Charges. Restructuring charges consist of costs associated with the realignment and reorganization of our operations. Restructuring charges include employee termination costs, facility closure and relocation costs, contract termination costs and costs associated with utilizing a third party consultant to facilitate the execution of our 2015 restructuring plan. The timing of associated cash payments is dependent upon the type of exit cost and can extend over a 12-month period or longer. We record liabilities related to restructuring charges in accrued restructuring in the consolidated balance sheets. See further discussion in Note 11 of the Notes to the Consolidated Financial Statements.
Goodwill Impairment. During the quarter ended September 30, 2015, due to a decline in internal projections for the Asia-Pacific reporting unit of both revenue and profitability as a result of recent declines its financial performance, we determined that sufficient indicators of potential impairment existed to require an interim quantitative goodwill assessment for the Asia-Pacific reporting unit as of August 31, 2015. The amount of goodwill assigned to the Asia-Pacific reporting unit at August 31, 2015 was $34.1 million. Based on our revised forecasts, the carrying value of goodwill exceeded the implied fair value of goodwill for the Asia-Pacific reporting unit. As a result, we recorded an estimated impairment charge of $27.8 million for the goodwill in the Asia-Pacific reporting unit during the third quarter of 2015, which was finalized during the fourth quarter of 2015 without further adjustment and is included in impairment of goodwill in the accompanying consolidated statements of operations. We did not identify an impairment of our finite-lived intangible assets or other long-lived assets based on our estimates included in the second step of the quantitative test.
The process of estimating the fair value of goodwill is subjective and requires us to make estimates that may significantly impact the outcome of the analyses. The estimated fair value of the Asia-Pacific reporting unit as of August 31, 2015 was determined using both an income-based valuation approach, and a market-based valuation approach, each weighted 50%. Under the income approach, fair value of the reporting unit is estimated using the discounted cash flow method. The discounted cash flow method is dependent upon a number of factors, including projections of the amounts and timing of future revenues and cash flows, assumed discount rates determined to be commensurate with the risks inherent in our business model, and other assumptions. The future cash flows for the reporting unit was projected based on our estimates, at that time, of future revenues, operating income and other factors (such as working capital and capital expenditures). We took into account expected competitive global industry and market conditions. Under the market-based valuation approach, each reporting unit’s fair value is estimated based on industry multiples of revenues and operating earnings.
The inputs of the discounted cash flow method used to determine the fair value of the Asia-Pacific reporting unit included a conservative average 3% growth rate to calculate the terminal value and a discount rate of 17%. Factors that have the potential to create variances in the estimated fair value of the Asia-Pacific reporting unit include, but are not limited to, fluctuations in (i) number of clients and active campaigns, which can be driven by multiple external factors affecting demand, including macroeconomic factors, competitive dynamics and changes in consumer preferences; (ii) marketing costs to generate new campaigns; and (iii) equity valuations of peer companies.
Discontinued Operations
As a result of the disposal of our ClubLocal business in exchange for a minority equity interest in December 2013, we have reclassified and presented all related historical financial information with respect to ClubLocal as “discontinued operations” in the Consolidated Balance Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. In addition, we have excluded all ClubLocal related activities from the following discussions, unless specifically referenced.
Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses. We continually evaluate our estimates, judgments and assumptions based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates.
We believe that the following critical accounting policies involve our more significant judgments, assumptions and estimates and, therefore, could have the greatest potential impact on our consolidated financial statements:
•
Accounts receivable
•
Software development costs
•
Loan receivables
•
Non-marketable investments
•
Variable interest entities
•
Finite-lived intangible assets and other long-lived assets
•
Goodwill
•
Revenue recognition
•
Restructuring charges
•
Stock-based compensation
•
Income taxes
Accounts Receivable
We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history, the customer’s creditworthiness and various other factors, as determined by our review of their credit information. We monitor collections and payments from our customers and maintain an allowance for estimated credit losses based on our historical experience and any customer-specific collection issues that we have identified.
Software Development Costs
Costs to develop software for internal use are capitalized when we have determined that the development efforts will result in new or additional functionality or new products. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred and included in product and technology expenses, in addition to amortization of capitalized software development costs, in the accompanying consolidated statements of operations. We monitor our existing capitalized software costs and reduce its carrying value as the result of releases that render previous features or functions obsolete. Software development costs are evaluated for impairment in accordance with our policy for finite-lived intangible assets and other long-lived assets. Costs capitalized as internal use software are amortized on a straight-line basis over an estimated useful life of three years.
Loan Receivables
We record loan receivables at carrying value, net of potential allowance for losses. Losses on receivables are recorded when probable and estimable. Interest income on loan receivables is accrued on a monthly basis over the life of the loan, and interest recognition is suspended upon impairment of loan principal.
Non-marketable Investments
We account for non-marketable investments under the cost method, which are periodically assessed for other-than-temporary impairment. The fair value of a cost method investment is not evaluated if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investment. However, if a significant adverse event were identified, we would estimate the fair value of its cost method investment considering available information at the time of the event, such as current cash position, earnings and cash flow forecasts, recent operational performance and any other readily available data. If we determine that an other-than-temporary impairment has occurred, the investment is written-down to its fair value.
Variable Interest Entities
We analyze our interests, including agreements, loans, guarantees, and equity investments, on a periodic basis to determine if such interests are variable interests. If variable interests are identified, then the related entity is assessed to determine if it is a variable interest entity (“VIE”). Our analysis includes both quantitative and qualitative reviews. We base our quantitative analysis on the forecasted cash flows of the entity, and our qualitative analysis on the design of the entity, its organizational structure including its decision-making authority, and relevant agreements. If we determine that the entity is a VIE, we then assesses if we must consolidate the VIE as our primary beneficiary. Our determination of whether we are the primary beneficiary is based upon qualitative and quantitative analyses, which assess the purpose and design of the VIE, the nature of the VIE’s risks and the risks that we absorb, the power to direct activities that most significantly impact the economic performance of the VIE, and the obligation to absorb losses or the right to receive benefits that could be significant to the VIE.
Finite-Lived Intangible Assets and Other Long-Lived Assets
Finite-lived intangible assets are attributable to the various developed technologies, trade names, and customer relationships of the businesses we have acquired. We report finite-lived, acquisition-related intangible assets at acquisition date fair value, net of accumulated amortization. Finite-lived intangible assets are amortized on a straight-line basis over their estimated useful lives, ranging from two to ten years. Straight-line amortization is used as another pattern over which the economic benefits will be consumed cannot be reliably determined. We review the carrying values of long-lived assets, including intangible assets, for possible impairment whenever events or changes in circumstances indicate that the related carrying amount may not be recoverable. In our analysis of other finite-lived amortizable intangible assets, we apply the guidance of ASC 350-20, Intangibles - Goodwill and Other, in determining whether any impairment conditions exist. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Recoverability of an intangible asset is measured by comparing its carrying amount to the expected future undiscounted cash flows that the asset is expected to generate, if it is determined that an asset is not recoverable. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Long-lived assets to be disposed of are reported at the lower of carrying amount or estimated fair value less cost to sell.
At December 31, 2015 and 2014, there were no indications of impairment of our finite-lived intangible assets or other long-lived assets.
Goodwill
Goodwill represents the excess of the purchase price of our acquired businesses over the fair value of the net tangible and intangible assets acquired. We account for goodwill in accordance with ASC 350, Intangibles-Goodwill and Other, which addresses financial accounting and reporting requirements for acquired goodwill. ASC 350 prohibits the amortization of goodwill and requires us to test goodwill at the reporting unit level for impairment at least annually.
We test the goodwill of our reporting units for impairment annually on the first day of the fourth quarter, and whenever events occur or circumstances change that would more likely than not indicate that the goodwill might be impaired. Events or circumstances which could trigger an impairment review include, but are not limited to, a significant adverse change in the legal or business climate, an adverse action or assessment by a regulator, unanticipated competition, a loss of key management or other personnel, significant changes in the manner of our use of the acquired assets or the strategy for the acquired business or our overall business, significant and sustained decline in market capitalization, significant negative industry or economic trends, or significant underperformance relative to expected historical or projected future results of operations.
Testing goodwill for impairment involves a two-step quantitative process. However, prior to performing the two-step quantitative goodwill impairment test, we have the option to first assess qualitative factors to determine whether or not it is necessary to perform the two-step quantitative goodwill impairment test for selected reporting units. If we choose the qualitative option, we are not required to perform the two-step quantitative goodwill impairment test unless we have determined, based on the qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The first step of the impairment test involves comparing the estimated fair values of a reporting unit with its respective carrying amount, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, including goodwill, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the estimated fair value of the reporting unit is less than its carrying amount, including goodwill, or if the reporting unit has a negative carrying value and we believe it is more likely than not that a goodwill impairment exists, then the second step is performed to compare the carrying amount of the goodwill with its implied fair value, which is determined by deducting the aggregate fair value of the reporting unit's identifiable assets and liabilities from the fair value of the reporting unit. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.
The process of estimating the fair value of goodwill is subjective and requires us to make estimates that may significantly impact the outcome of the analyses. The estimated fair value for each reporting unit is determined using both an income-based valuation approach, as well as a market-based valuation approach. Under the income approach, each reporting unit’s fair value is estimated using the discounted cash flow method. The discounted cash flow method is dependent upon a number of factors, including projections of the amounts and timing of future revenues and cash flows, assumed discount rates determined to be commensurate with the risks inherent in its business model, and other assumptions. Under the market-based valuation approach, each reporting unit’s fair value is estimated based on industry multiples of revenues and operating earnings. The income-based approach is weighted between 50.0% and 66.7% depending on the amount and timing of projected operating earnings attributable to each reporting unit.
We operate in one reportable segment, in accordance with ASC 280, Segment Reporting, which is the basis that financial results are regularly reviewed by our chief operating decision maker in deciding how to allocate resources and assess performance. We have identified our reporting units as North America, Asia-Pacific, Latin America, and Europe. These reporting units each constitute a business or group of businesses for which discrete financial information is available and is regularly reviewed by each reporting unit’s management. Our goodwill is comprised of balances in both the North America and Asia-Pacific reporting units.
Goodwill Impairment Assessment
During the quarter ended September 30, 2015, due to a decline in internal projections for the Asia-Pacific reporting unit of both revenue and profitability as a result of recent declines its financial performance, we determined that sufficient indicators of potential impairment existed to require an interim quantitative goodwill assessment for the Asia-Pacific reporting unit as of August 31, 2015. The amount of goodwill assigned to the Asia-Pacific reporting unit at August 31, 2015 was $34.1 million. Based on our revised forecasts, the carrying value of goodwill exceeded the implied fair value of goodwill for the Asia-Pacific reporting unit. As a result, we recorded an estimated impairment charge of $27.8 million for the goodwill in the Asia-Pacific reporting unit during the third quarter of 2015, which was finalized during the fourth quarter of 2015 without further adjustment and is included in impairment of goodwill in the accompanying consolidated statements of operations. We did not identify an impairment of our finite-lived intangible assets or other long-lived assets based on our estimates included in the second step of the quantitative test.
The process of estimating the fair value of goodwill is subjective and requires us to make estimates that may significantly impact the outcome of the analyses. The estimated fair value of the Asia-Pacific reporting unit as of August 31, 2015 was determined using both an income-based valuation approach, and a market-based valuation approach, each weighted 50%. Under the income approach, fair value of the reporting unit is estimated using the discounted cash flow method. The discounted cash flow method is dependent upon a number of factors, including projections of the amounts and timing of future revenues and cash flows, assumed discount rates determined to be commensurate with the risks inherent in our business model, and other assumptions. The future cash flows for the reporting unit was projected based on our estimates, at that time, of future revenues, operating income and other factors (such as working capital and capital expenditures). We took into account expected competitive global industry and market conditions. Under the market-based valuation approach, each reporting unit’s fair value is estimated based on industry multiples of revenues and operating earnings.
The inputs of the discounted cash flow method used to determine the fair value of the Asia-Pacific reporting unit included a conservative average 3% growth rate to calculate the terminal value and a discount rate of 17%. Factors that have the potential to create variances in the estimated fair value of the Asia-Pacific reporting unit include, but are not limited to, fluctuations in (i) number of clients and active campaigns, which can be driven by multiple external factors affecting demand, including macroeconomic factors, competitive dynamics and changes in consumer preferences; (ii) marketing costs to generate new campaigns; and (iii) equity valuations of peer companies.
As of October 1, 2015, the date of our annual goodwill impairment assessment, we considered our recent interim quantitative goodwill impairment assessment, which included a reconciliation of our total market capitalization based on the estimated fair value of our individual reporting units as of August 31, 2015. We qualitatively determined that then existing facts and circumstances were considered in our quantitative interim impairment test, such that it was not necessary to perform the two-step quantitative goodwill impairment test for our North America and Asia Pacific reporting units as of the annual testing date.
As of November 30, 2015, due to the then recent significant declines in our market capitalization and other changes in the business, including consideration of exiting the U.K. market, and the entrance of RL UK into administration, we determined that sufficient indicators existed to perform an interim quantitative goodwill impairment assessment of our North America and Asia Pacific reporting units.
The first step of the November 30, 2015 quantitative goodwill impairment test resulted in the determination that the estimated fair value of both our North American reporting unit and our Asia Pacific reporting unit each substantially exceeded its respective carrying amount, including goodwill. Accordingly, the second step was not required. The inputs for the fair value calculations of the North America reporting unit included a conservative 2% growth rate to calculate the terminal value and a discount rate of 18%. The inputs for the fair value calculations of the Asia Pacific reporting unit included a conservative 2% growth rate to calculate the terminal value and a discount rate of 20.5%. In addition, we assumed revenue growth and applied margin and other cost assumptions consistent with each reporting unit's historical trends. Factors that have the potential to create variances in the estimated fair value of the reporting units include, but are not limited to, fluctuations in (i) number of clients and active campaigns, which can be driven by multiple external factors affecting demand, including macroeconomic factors, competitive dynamics and changes in consumer preferences; (ii) marketing costs to generate new campaigns; and (iii) equity valuations of peer companies.
Revenue Recognition
We recognize revenue for our products and solutions when persuasive evidence of an arrangement exists, services have been performed, the selling price is fixed or determinable, and collectability is reasonably assured. We recognize revenue for search engine marketing as clicks are recorded on sponsored links on the various search engines and for our display advertising and retargeting when the display advertisements record impressions or as otherwise provided in our agreement with the applicable publisher. We recognize revenue for lead conversion software, web presence and other products with a defined license or service period on a straight line basis over the applicable license or service period. We recognize revenue when we charge set-up, management service or other fees on a straight line basis over the term of the related contract or the completion of any obligation for services, if shorter. We account for sales and similar taxes imposed on our services on a net basis in the consolidated statements of operations.
When we receive advance payments from clients, we record these amounts as deferred revenue until the revenue is recognized. From time to time, we offer incentives to clients in exchange for minimum commitments. In these circumstances, we estimate the amount of the incentives that will be earned by clients and adjust the recognition of revenue to reflect such incentives. Estimates are either based upon a statistical analysis of previous campaigns for which such incentives were offered, or calculated on a straight-line basis over the life of the campaign.
When we sell through agencies, we either receive payment in advance of the delivery of our products or solutions or in some cases extend credit. We pay each agency an agreed-upon commission based on the revenue we earn or cash we receive. Some agency clients that have been extended credit may offset the amount otherwise due to us by any commissions they have earned. We evaluate whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions. As we are generally the primary party obligated in the arrangement, subject to the credit risk, with discretion over both price and media, we typically recognize the gross amount of such sales as revenue and any commissions are recognized as a selling and marketing expense.
We also have a small number of resellers. Resellers integrate our products and solutions, including branded search engine marketing, display advertising and online marketing analytics, into their product offerings. In most cases, the resellers integrate with our technology platform through a custom Application Programming Interface (API). Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay us in arrears, net of commissions and other adjustments. We recognize revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as we believe that the reseller has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.
Restructuring Charges
We record costs associated with exit activities related to restructuring plans in accordance with the ASC Topic 420, Exit or Disposal Obligations. Liabilities for costs associated with an exit or disposal activity are recognized in the period in which the liability is incurred. Restructuring charges consist of costs associated with the realignment and reorganization of our operations. Restructuring charges include employee termination costs, facility closure and relocation costs, and contract termination costs. The timing of associated cash payments is dependent upon the type of exit cost and can extend over a 12-month period. We record restructuring charge liabilities in accrued restructuring in the consolidated balance sheet.
Stock-Based Compensation
We account for stock-based compensation based on the fair market value of the equity award on the date of grant. We follow the attribution method, which reduces current stock-based compensation expenses recorded by the effect of anticipated forfeitures. We estimate forfeitures based upon our historical experience.
The fair value of each award is estimated on the date of the grant and amortized over the requisite service period, which is the vesting period. We use the Black-Scholes option pricing model to estimate the fair value of stock option awards on the date of grant. Determining the fair value of stock option awards at the grant date under this model requires judgment, including estimating volatility, expected term and the risk-free interest rate. The fair value of restricted stock and restricted stock unit awards is based on the closing market price of our common stock on the date of grant. In addition, we use a Monte Carlo simulation model to estimate the fair value of market-based performance-vesting restricted stock and restricted stock units. Determining the fair value of these awards at the grant date under this model requires judgment, including estimating volatility, risk-free rate and expected future stock price. We determine the probability of achievement of performance milestones for non-market based performance vesting restricted stock and restricted stock units, and recognize expense based on the fair value of the award if it is probable that the performance milestone will be achieved. The assumptions described above rely on management estimates based on judgment and subjective future expectations, which may result in stock-based compensation for future awards that differs significantly from the awards granted previously.
The fair value of modifications to stock-based awards is generally estimated using the Black-Scholes option pricing model. If a stock-based compensation award is modified after the grant date, incremental compensation expense is recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. Incremental compensation expense for fully vested awards is recognized immediately. For unvested awards, the sum of the incremental compensation expense and the remaining unrecognized compensation expense for the original award on the modification date is recognized over the modified service period.
Income Taxes
We use the asset and liability method of accounting for income taxes. Significant judgment is required in determining the consolidated provision for income taxes and evaluating our tax positions. In the ordinary course of business, there are many transactions and calculations for which the ultimate tax settlement is uncertain. As a result, we recognize tax liabilities based on estimates of whether additional taxes and interest will be due. These tax liabilities are recognized when, despite our belief that our tax return positions are supportable, we believe that it is more likely than not that those positions may not be fully sustained upon review by tax authorities.
For the periods presented, income tax expense represents income taxes imposed by federal, state, foreign and local tax jurisdictions applicable to our activities. We are also generating net operating losses in the various tax jurisdictions in which we operate. We believe that it is likely that taxes imposed by state, local and foreign jurisdictions will increase in magnitude, particularly to the extent we become profitable in certain jurisdictions before the time we obtain profitability on a consolidated basis.
We evaluate deferred tax assets on a quarterly basis to determine if a valuation allowance against deferred tax assets is required. Realization of our deferred tax assets is dependent primarily on the generation of future taxable income. Due to our recent history of cumulative losses, we recorded a full valuation allowance against our net deferred tax assets, excluding indefinite lived assets in U.S. jurisdictions. We continue to monitor the valuation allowance at each reporting period, and at this time, it is uncertain when such a release will occur.
The value of our investments in foreign subsidiaries exceeds our tax basis in those subsidiaries by $1.0 million. However, we have not recognized deferred income taxes on the associated gain because the gain only becomes taxable upon a repatriation of assets from the subsidiary or a sale or liquidation of the subsidiary and these amounts are expected to be reinvested indefinitely outside of the U.S.
We are required to file income tax returns in the United States and various foreign jurisdictions, which requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions. Such returns are, and from time to time, have been subject to audit by the various federal, state and foreign taxing authorities, which may disagree with our tax positions. We believe that our accruals for tax liabilities are adequate for all open audit years based on our assessment of many factors, including past experience and interpretations of tax law. We review and update our estimates in light of changing facts and circumstances, such as the closing of a tax audit, the lapse of a statute of limitations or a material change in estimate. To the extent that the final tax outcome of these matters differs from our expectations, such differences will impact income tax expense in the period in which such determination is made.
Results of Operations
Comparison of the Years Ended December 31, 2015, 2014 and 2013
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(1)
Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line-items (in thousands):
Revenue
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(1)
North America includes the United States and Canada. International includes all other countries.
(2)
Active Clients is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Clients by adjusting the number of Active Product Units to combine clients with more than one Active Product Unit as a single Active Client. Clients with more than one location are generally reflected as multiple Active Clients. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Clients includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred.
(3)
Active Product Units is a number we calculate to approximate the number of individual products, licenses, or services we are providing under contract for Active Clients. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client that also licenses ReachEdge, we consider that three Active Product Units. Similarly, if a client purchases ReachSearch campaigns for two different products or purposes, we consider that two Active Product Units. Numbers are rounded to the nearest hundred.
North American revenue decreased by $43.9 million in 2015 compared to 2014. North America Direct Local revenue declined $27.4 million in 2015 compared to 2014 due to smaller client bases entering the period and fewer new client acquisitions during the period due to a more difficult selling environment and fewer salespeople as we decreased the size of our salesforce in an effort to focus on more productive salespeople, partially offset by improvements in client retention. The average productivity of our current sales force improved compared to the prior-year period, but did not improve enough to offset client cancellations and fewer salespeople. North America National Brands, Agencies and Resellers revenue decreased by $16.4 million in 2015 compared to 2014 primarily due to a decrease in client acquisitions and a decrease in client budgets in both the National Brands and Agencies and Resellers channels due to losses of key partners in both channels.
International revenue decreased by $48.5 million in 2015 compared to 2014. International revenue was negatively impacted by foreign currency translations of $24.1 million due to the substantial strengthening of the U.S. dollar compared to certain foreign currencies, particularly the euro and Australian dollar. International Direct Local decreased by $24.8 million, on a constant currency basis compared to the prior-year period, due to smaller client bases entering the periods and fewer new client acquisitions during the periods due to a more difficult selling environment and fewer salespeople as we contracted our salesforce during the ongoing transition to our new sales model, partially offset by an improvement in client retention. The decrease in 2015, was partially offset by an increase of $1.6 million of revenue from former SureFire clients being reported in the Direct Local channel rather than the National Brands, Agencies and Resellers channel as in the prior-year period. Excluding the impact of the SureFire revenue, the International National Brands, Agencies and Resellers revenue remained relatively flat on a constant currency basis compared to 2014. International revenue related to our U.K. market, which we exited in 2015, was $25.2 million and $36.4 million in 2015 and 2014, respectively.
Direct Local revenue decreased by $37.5 million in 2014 compared to 2013. The decrease was primarily due to a 19.3% decline of North American Direct Local revenue compared to the prior year period as a result of decreased new customer acquisitions due to lower sales productivity, lower customer retention and fewer salespeople selling our products during 2014, each of which we believe are primarily attributable to the realignment of our North American Direct Local sales force. Since the realignment of our North American sales force in late 2013, we experienced high attrition in our North American sales force, which negatively impacted client acquisition and retention. The decline in our North American Direct Local revenue was partially offset by growth in our international markets. We experienced this growth notwithstanding negative impact from the substantial strengthening of the U.S. dollar compared to certain foreign currencies, particularly the Australian dollar.
Direct Local and National Brands, Agencies and Resellers revenue were both impacted as SureFire-related revenue that was reported as part of our National Brands, Agencies and Resellers channel prior to our acquisition of SureFire is now reported as part of our Direct Local channel. As a result, $6.4 million of SureFire revenue is included in Direct Local for 2014 instead of National Brands, Agencies and Resellers.
The decrease in National Brands, Agencies and Resellers revenue of $1.7 million in 2014 compared to 2013 was primarily due to reporting revenue from Surefire clients in the Direct Local channel rather than in National Brands, Agencies and Resellers. Revenue from SureFire included in National Brands, Agencies and Resellers for 2014 was $1.3 million as compared to $5.0 million in the prior-year period.
Cost of Revenue
The increase in our cost of revenue as a percentage of revenue in 2015 compared to 2014 was primarily due to transfers of certain personnel to service and support functions (MEs) costing approximately $5.0 million that were previously included in sales and marketing, and an increase in service costs primarily related to our non-media products.
Publisher rebates as a percentage of revenue decreased to 1.7% of revenue in 2015 from 2.5% in 2014. In addition, 2015 publisher rebates included 0.5% better than normal benefits attributable to the impact of regional and product mix, foreign exchange and program structure, which we do not expect to reoccur. On June 27, 2014, we entered into a new global agreement with Google Inc. and certain of its affiliates (the “2014 Google Agreement”) that replaced our expiring Google agreement. The 2014 Google agreement provided rebates based on overall global growth of our spending with Google, as opposed to commitments to enter new markets and market-specific growth targets. On December 8, 2015, we amended the terms of the 2014 Google Agreement to replace the growth of spending targets with tiered aggregate global spending targets.
The increase in cost of revenue as a percentage of revenue in 2014 compared to 2013 was primarily due to a decrease in publisher rebates from 4.2% in 2013 to 2.5% in 2014, an increase in service, support, and third party costs primarily related to the launch of our ReachEdge and ReachSEO products, and increased costs to improve the performance of certain of our products.
Our gross margins will be affected in the future by the availability and amount of publisher rebates, the costs of support and delivery, the mix and relative amount of media we purchase to fulfill service requirements, and the cost of third-party service providers that we use as part of our solutions. We expect publisher rebates as a percentage of revenue to be between 0.5% and 1.0% during 2016.
Operating Expenses
Selling and Marketing
The decreases in selling and marketing salaries, benefits and other costs in absolute dollars in 2015 compared to 2014 was primarily due to fewer salespeople and non-sales personnel, and related cost reductions, including transfers of certain personnel to service and support functions (MEs) and reported in cost of revenue as a result of our transition to our DMC sales model. The decreases as a percentage of revenue were also due to increased revenue per-salesperson as we decreased the number of salespeople to focus on higher performing salespeople and consolidate client accounts.
The increases in commission expense as a percentage of revenue in 2015 compared to 2014 was primarily driven by a shift in the revenue mix as a higher percentage of revenue was derived from channels which pay a higher commission rate and a lower percentage of revenue derived from channels which pay a lower commission rate.
The increase in selling and marketing salaries, benefits and other costs as a percentage of revenue in 2014 compared to 2013 was primarily due to the decrease in revenue and increases in salaries and fixed costs as a result of partially replacing residual commissions with base compensation for most of our North American sales personnel under the 2013 realignment of that sales force. The increase in selling and marketing salaries, benefits and other costs in absolute dollars was primarily a result of the shift to base compensation from residual commissions.
The decrease in commission expense in absolute dollars and as a percentage of revenue in 2014 compared to 2013 was due to a decrease in sales activity and a change in compensation structure in North America in connection with the North American sales force realignment. Commission expense also decreased due to a higher percentage of revenue from our international Direct Local channel, for which we have historically paid lower commission rates.
Product and Technology
Product and technology expenses increased in absolute dollars in 2015 compared to 2014, while total product and technology expenses and capitalized costs decreased during the period. Employee and professional services costs decreased by $5.7 million during 2015 due to our cost savings initiatives, but were more than offset by increased amortization of software development costs of $2.1 million and a decrease in the amount of total product and technology costs expensed and capitalized during the period of $3.4 million due to the timing of achieving certain project development milestones. The increase in total product and technology costs expensed and capitalized as a percentage of revenue were primarily driven by the decrease in revenue.
The increases in product and technology expenses in absolute dollars and as a percentage of revenue in 2014 compared to 2013 were primarily attributable to increased third-party development costs of $4.0 million and increased salaries and compensation expense of $2.2 million, each as part of the ongoing development of our technology platform and new product initiatives, and increased expense related to the commencement of amortization of previously capitalized software development costs and acquired intangibles of $0.9 million. The increases were partially offset by $2.0 million of increased capitalization due to an increase in capitalizable projects, including those relating to our new product initiatives. The increases in product and technology expenses as a percentage of revenue were also a result of decreased revenue.
General and Administrative
The decreases in general and administrative expenses in absolute dollars and as a percentage of revenue in 2015 compared to 2014 were primarily due to decreases of $5.1 million for employee costs and $3.2 million for stock based compensation, each due to workforce reductions as a result of our cost management activities, and a decrease of $0.7 million in professional services costs. In addition, 2014 included $1.5 million for bad debt expense related to our United Kingdom market, which did not occur in 2015.
The increases in general and administrative expenses in absolute dollars and as a percentage of revenue in 2014 compared to 2013 were primarily due to a $3.5 million increase in employee-related costs largely as a result of increased salaries and payroll costs, $3.6 million of professional fees, which consist of tax, consulting, audit and legal fees, primarily as a result of increased legal fees and contingencies in the U.K., and a $1.9 million increase in stock-based compensation expense as a result of extending, on March 27, 2014, the time to exercise from seven to ten years for certain options granted during 2008 and 2009 with a strike price of $10.91. The increases were partially offset by a decrease in bad debt expense as compared to 2013 when we impaired $3.9 million due from OxataSMB. The increase in general and administrative expenses as a percentage of revenue was also a result of decreased revenue.
Restructuring Charges
In January 2015, we commenced our 2015 Restructuring Plan as part of our ongoing efforts to reduce expenses and improve the operating performance of our business. The initiative is focused on enhancing earnings through an analysis of opportunities to both improve revenue performance and reduce costs. Restructuring charges in 2015 totaled $7.5 million, consisting of $3.6 million in costs associated with utilizing a third party consultant to facilitate the execution of the plan, $2.3 million in contract termination costs, $1.1 million of lease termination costs as a result of down-sizing a North American facility, and $0.5 million in other associated costs. We expect to have continued restructuring activity under this plan for at least the next 12 months.
During the first and second quarters of 2014, we also implemented restructuring plans to streamline operations and increase profitability. There has been no additional restructuring activity recognized within these 2014 plans in 2015, other than settlement of associated liabilities.
Impairment of Goodwill
During the quarter ended September 30, 2015, due to a decline in internal projections for the Asia-Pacific reporting unit of both revenue and profitability as a result of recent declines its financial performance, we determined that sufficient indicators of potential impairment existed to require an interim quantitative goodwill assessment for the Asia-Pacific reporting unit as of August 31, 2015. The amount of goodwill assigned to the Asia-Pacific reporting unit at August 31, 2015 was $34.1 million. Based on our revised forecasts, the carrying value of goodwill exceeded the implied fair value of goodwill for the Asia-Pacific reporting unit. As a result, we recorded an estimated impairment charge of $27.8 million for the goodwill in the Asia-Pacific reporting unit during the third quarter of 2015, which was finalized during the fourth quarter of 2015 without further adjustment and is included in impairment of goodwill in the accompanying consolidated statements of operations.
Gain on Deconsolidation of Subsidiary, Net
During the fourth quarter of 2015, we recorded a gain of $2.9 million related to the deconsolidation of RL U.K. upon its entrance into administration in connection with our plan to exit from the U.K. market. The gain is principally due to relief of accrued liabilities and reversal of the previously recorded cumulative translation adjustments that were previously reflected in operating income and loss. See further discussion in Note 12 of the Notes to the Consolidated Financial Statements.
Interest Expense
Interest expense increased $2.7 million in 2015 compared to 2014 as we began paying interest under a Loan and Security Agreement (the “Hercules Loan Agreement”) entered into on April 30, 2015.
Interest expense remained relatively flat in 2014 compared to 2013.
Other Income (Expense), Net
Other expense, net of $0.3 million in 2015 primarily consisted of foreign currency fluctuations affecting our cash balances, offset by interest income resulting from invested balances.
Other income, net of $1.0 million in 2014 primarily consisted of interest income from invested balances of $0.6 million, the revaluation of the contingent consideration for SureFire of $0.3 million.
Provision for Income Taxes
Our effective tax rate for 2015, 2014 and 2013 was (0.6) %, (1.0) % and 54.8%, respectively. We recorded a provision for income taxes of $0.4 million in 2015, compared to $0.5 million in 2014 and $3.7 million in 2013.
The income tax provisions for 2015, 2014 and 2013 relate primarily to U.S. Federal and State taxes as well as certain foreign income taxes. The overall decrease in tax expense in 2014 compared to the same period in 2013 was primarily due to the tax benefits associated with current period losses in U.S. jurisdictions, offset by the recording of a full valuation allowance against our net deferred tax assets, excluding indefinite-lived assets in the U.S.
Gain (Loss) from Discontinued Operations
In the fourth quarter of 2013, our Board of Directors approved a plan to dispose of our ClubLocal business, and on February 18, 2014, we completed the contribution of our ClubLocal business to a new entity in exchange for a minority interest in the entity. This business has been accounted for as discontinued operations for all periods presented.
Non-GAAP Financial Measures
In addition to our GAAP results discussed above, we believe Adjusted EBITDA is useful to investors in evaluating our operating performance. For the years ended December 31, 2015, 2014 and 2013, our Adjusted EBITDA was as follows:
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(1)
Adjusted EBITDA. We define Adjusted EBITDA as net income (loss) from continuing operations before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, stock-based compensation, the effects of accounting for business combinations (including any impairment of acquired intangibles and, in the case of the acquisition of SMB:LIVE, the deferred cash consideration), restructuring charges, and other non-operating income or expense. Adjusted EBITDA reflects the reclassification of discontinued operations.
Our management uses Adjusted EBITDA because (i) it is a key basis upon which our management assesses our operating performance; (ii) it may be a factor in the evaluation of the performance of our management in determining compensation; (iii) we use it, in conjunction with GAAP measures such as revenue and income (loss) from operations, for operational decision-making purposes; and (iv) we believe it is one of the primary metrics investors use in evaluating Internet marketing companies.
We believe that Adjusted EBITDA permits an assessment of our operating performance, in addition to our performance based on our GAAP results that is useful in assessing the progress of the business. By excluding (i) the effects of accounting for business combinations and associated acquisition and integration costs, which obscure the measurable performance of the business operations; (ii) restructuring charges, which we do not consider reflective of our ongoing operating performance; (iii) depreciation and amortization and other non-operating income and expense, each of which may vary from period to period without any correlation to underlying operating performance; and (iv) stock-based compensation, which is a non-cash expense, we believe that we are able to gain a fuller view of the operating performance of the business. We provide information relating to our Adjusted EBITDA so that investors have the same data that we employ in assessing our overall operations. We believe that trends in our Adjusted EBITDA are a valuable indicator of operating performance on a consolidated basis and of our ability to produce operating cash flow to fund working capital needs, capital expenditures and investments in our sales force.
In addition, we believe that Adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:
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Adjusted EBITDA does not reflect our cash expenditures for capital equipment or other contractual commitments;
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Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect capital expenditure requirements for such replacements;
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Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;
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Adjusted EBITDA does not consider the potentially dilutive impact of issuing equity-based compensation to our management team and employees;
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Adjusted EBITDA does not reflect the potentially significant interest expense or the cash requirements necessary to service interest or principal payments on indebtedness we may incur in the future;
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Adjusted EBITDA does not reflect income and expense items that relate to our financing and investing activities, any of which could significantly affect our results of operations or be a significant use of cash;
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Adjusted EBITDA does not reflect certain tax payments that may represent a reduction in cash available to us; and
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Other companies, including companies in our industry, calculate Adjusted EBITDA measures differently, which reduces its usefulness as a comparative measure.
Adjusted EBITDA is not intended to replace operating income (loss), net income (loss) and other measures of financial performance reported in accordance with GAAP. Rather, Adjusted EBITDA is a measure of operating performance that you may consider in addition to those measures. Because of these limitations, Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results, including cash flows provided by operating activities, and using total Adjusted EBITDA as a supplemental financial measure.
Liquidity and Capital Resources
Operating Activities
During 2015, we used $20.0 million of net cash in operating activities from continuing operations, primarily due to a loss of $61.5 million from continuing operations and a change in operating assets and liabilities of $20.5 million, partially offset by non-cash expenses of $62.0 million. The change in operating assets and liabilities included a decrease in accounts payable of $9.2 million due to the timing of payments, a decrease in deferred revenue of $4.5 million due to a decrease in sales, and a decrease in accrued restructuring of $6.5 million. Non-cash expenses included $27.8 million of goodwill impairment, $19.7 million of depreciation and amortization, $8.7 million of stock-based compensation expense, and $7.5 million of restructuring charges, offset in part by a gain of $2.9 million on deconsolidation of our U.K subsidiary due to exiting the market.
Net cash used in operating activities related to continuing operations increased by $18.6 million in 2015 compared to 2014, primarily as a result of lower operating performance, offset by a reduction in expenses. Cash flow from operating activities was unfavorably impacted by a decrease in accounts payable of $18.3 million compared to 2014 due to the timing of payments and a decrease in accrued restructuring of $3.9 million. These unfavorable impacts to cash flow were partially offset by a decrease of income from continuing operations adjusted for non-cash items of $7.4 million primarily due to reduction in operating expenses and a gain of $2.9 million on deconsolidation of our U.K subsidiary due to exiting the market.
Net cash used in operating activities related to continuing operations increased by $32.1 million in 2014 compared to 2013, primarily as a result of lower operating performance. Income from continuing operations adjusted for non-cash items decreased by $37.5 million. In addition, cash flow from operating activities was unfavorably impacted by a decrease in accrued compensation and benefits of $3.8 million compared to 2013 due to lower accruals for commissions and severance, a decrease in deferred revenue of $3.1 million compared to 2013 due to decreased sales, and restructuring payments of $2.6 million that did not occur in 2013. These unfavorable impacts to cash flow were partially offset by an increase in accounts payable of $6.2 million due to a change in timing of payment to vendors, a decrease in accounts receivable of $5.9 million compared to 2013 due to decreased sales, and an increase in deferred rent and other liabilities of $1.9 million compared to 2013 due to increased rent on operating leases and increased sales tax payables related to our international markets.
Investing Activities
Our primary investing activities have consisted of capitalized software development costs, purchases of property and equipment, business acquisitions, investments in a partnership, and short-term investments. Each of these activities varies from period to period due to the timing of the expansion of our operations and our software development efforts.
We invested $13.8 million during 2015, which was a decrease of $21.5 million compared to 2014. The decrease primarily relates to decreases in purchases of property and equipment of $8.6 million and software development costs of $3.2 million as we constrained investment as part of our cost savings initiatives. In addition, in 2014 we made investments that were not matched in 2015, including $5.3 million to acquire Kickserv, an investment of $2.0 million in a privately held partnership and an investment of $1.5 million as part of the SureFire acquisition.
We invested $35.3 million in 2014, which was an increase of $11.4 million compared to 2013. Our purchases of property and equipment increased by $3.8 million and cash outflow from capitalization of software increased by $2.1 million in 2014 compared to 2013. We made a number of strategic investments totaling $9.1 million, including $5.3 million to acquire Kickserv, $1.5 million as part of the SureFire acquisition, and made an additional $2.0 million in a privately held partnership.
At December 31, 2015, we had significant internal product and technology resources working on projects that met the criteria for capitalization as software development costs and others that did not, although none of the projects in process was a long-term project (greater than one year). The amount capitalized for such projects in future periods will be evaluated by management and will impact the portion of costs for those internal resources that are included in cash used in investing activities. At December 31, 2015, we also had significant deferred revenue arising from prepayment by the great majority of our clients and vendor trade financing, principally for media. If our revenue continues to decline, we would expect our deferred revenue to decrease.
We expect to continue to reduce our use of capital for acquisitions, purchases of property and equipment, and development of software consistent with our cost savings initiatives.
Financing Activities
Our primary financing activities have consisted of borrowing under a term loan and convertible notes, net proceeds from the exercise of stock options, and capital lease obligations.
Net cash provided by financing activities increased by $6.8 million during 2015 compared to 2014, due to $24.7 million of net proceeds from the term loan entered into during April 2015, offset by segregation of $15.0 million of the term loan proceeds as restricted cash, and $5.0 million of proceeds from convertible notes issued to a related party. The increase was offset by a decrease in net proceeds from the exercise of stock options of $6.4 million. In addition, during 2015, we made a final payment totaling $0.5 million for the earn-out and indemnity holdback related to the acquisition of SureFire.
Net cash provided by financing activities increased by $17.2 million in 2014 compared to 2013, primarily due to the absence of share repurchases in 2014.
Hercules Loan Agreement
On April 30, 2015, we entered into the Hercules Loan Agreement with our direct and indirect domestic subsidiaries, as co-borrowers, Hercules Technology Growth Capital, Inc. (“Hercules”), as administrative agent, and the lenders party thereto from time to time (the “Lenders”), including Hercules, pursuant to which the Lenders agreed to make a term loan available to us for working capital and general business purposes, in a principal amount of $25.0 million. The term loan has an annual interest rate equal to the greater of (i) 11.75% and (ii) the sum of (a) the prime rate, plus (b) 8.50%. During December 2015, the annual interest rate increased from 11.75% to 12.00%. The annual interest rate on the Hercules Loan was 12.00% at December 31, 2015. On the closing date we paid a fee of $0.3 million, which is to be credited against the final payment, and debt issuance costs of $0.2 million.
We are required to make interest-only payments on the term loan through May 1, 2016, though such payments may be extended through August 1, 2016 and November 1, 2016 if we remain in continuous compliance with the financial covenants under the Hercules Loan Agreement through April 1, 2016 and July 1, 2016, respectively, and no default or event of default has occurred and is continuing on such dates. The term loan will begin amortizing at the end of the applicable interest-only period, with monthly payments of principal and interest to the Lenders in consecutive monthly installments following the end of such interest-only period. The term loan matures on April 1, 2018 or, if the interest-only payments are extended through November 1, 2016, the term loan will mature October 1, 2018. Upon repayment of the term loan, we are also required to make an end-of-term payment to the Lenders equal to $1.5 million, which is accrued as interest based on the effective interest method over the 3-year term of the Hercules Loan Agreement. The term loan is secured by substantially all of our personal property, including our intellectual property.
At our option, the outstanding principal balance of the term loan may be prepaid in whole, or in part in a minimum amount of $2.5 million, subject to a prepayment fee of 3% of any amount prepaid if the prepayment occurs on or prior to April 30, 2016, or 2% of the amount prepaid if the prepayment occurs after April 30, 2016 but on or prior to April 30, 2017. If the prepayment occurs after April 30, 2017, there is no prepayment fee.
The Hercules Loan Agreement includes covenants applicable to us, which include restrictions on transferring collateral, incurring additional indebtedness, engaging in mergers or acquisitions, paying dividends or making other distributions, making investments, creating liens, selling assets, and undergoing a change in control, in each case subject to certain exceptions. These restrictions also include a maximum net new investment in our foreign subsidiaries, subject to certain exclusions of $8.0 million during 2015, $5.5 million during 2016, $4.0 million annually thereafter, and $18.0 million in the aggregate during the term of the agreement. Additionally, the Hercules Loan Agreement includes financial covenant requirements to maintain certain minimum levels of revenue and earnings during each three-month period, tested monthly, during the term, as amended on August 3, 2015 from September 30, 2015 through December 31, 2015. These minimum levels of revenue and earnings were waived for compliance for November and December 2015 as amended on November 9, 2015. Under the Hercules Loan Agreement, we are required to maintain minimum cash in North America in an amount equal to $15.0 million at all times, as amended on December 17, 2015, unless we achieve positive “Adjusted EBITDA” as defined, for three consecutive quarters, in which case the minimum cash and cash equivalent balance decreases to $12.5 million. We achieved positive “Adjusted EBITDA” as defined, during the quarters ended September 30, 2015 and December 31, 2015, which qualifies as two quarters of the required three consecutive quarters. The Hercules Loan Agreement also includes events of default, the occurrence and continuation of which provide Hercules, as administrative agent, with the right to exercise remedies against us and the collateral securing the term loan, including potential foreclosure against our assets securing the Hercules Loan Agreement, including our cash. The Hercules Loan Agreement also contains a subjective acceleration clause that can be triggered if we experience a Material Adverse Effect, as defined in the Hercules Loan Agreement, which would be considered an event of default.
On August 3, 2015, we entered into an amendment to the Hercules Loan Agreement, which reduced the term loan’s covenant thresholds for revenue for the months ending September 30, 2015 through December 31, 2015. On November 9, 2015, we entered into a second amendment to the Hercules Loan Agreement with Hercules, which waives compliance with the term loan’s revenue and earnings covenant thresholds for November and December 2015. In connection with the amendment, we (i) paid Hercules a one-time fee of $0.2 million, (ii) reset the schedule of prepayment fees to begin from November 9, 2015, instead of April 30, 2016, and (iii) agreed to amend the Hercules warrant as described below. On December 17, 2015, we entered into the third amendment to the Hercules Loan Agreement, which reduces the amount of restricted cash we are required to maintain in North America from $17.5 million to $15.0 million and which amount will further be reduced to $12.5 million if we achieve positive “Adjusted EBITDA” as defined in the loan agreement. We are in compliance with all of the Hercules Loan Agreement’s covenants as of December 31, 2015.
Concurrently with entrance into the Hercules Loan Agreement, we issued to Hercules, as the sole lender on the closing date, a warrant to purchase up to 177,304 shares of our common stock, at an exercise price of $2.82 per share. In connection with the November 9, 2015 Hercules Loan Agreement amendment, we agreed to amend the warrant to increase the number of shares to 300,000 and reduce the exercise price to $0.85. The warrant is exercisable in full and not in part. In addition, if upon the sale of all shares issued upon exercise of the warrant, or in the case of a merger or sale transaction involving other securities in whole or in part, upon the sale of such securities, the absolute return on the warrant exceeds $2.55 per share underlying the warrant, the warrant holder will pay us the excess in cash. The warrant may be exercised either for cash or on a cashless basis. The warrant expires April 30, 2022. We estimated the fair value of the warrant to be $0.3 million based on its relative fair value to the term loan using a Black-Sholes pricing model and accounted for the warrant as a discount on the carrying amount of the term loan and a component of additional paid-in capital. The fair value of the warrant will be amortized in the statement of operations as a component of interest expense.
VantagePoint Convertible Notes (Related Party)
On December 17, 2015, we entered into a convertible note purchase agreement with affiliates of our largest shareholder, VantagePoint Capital Partners (“VantagePoint”), for the immediate issuance of $5.0 million of Convertible Second Lien Subordinated Notes (the “VantagePoint Notes”). The note purchase agreement also provides for the issuance and sale of up to an additional $5.0 million aggregate principal amount of convertible notes, upon mutual agreement of ReachLocal and VantagePoint (and Hercules’ consent). The notes bear an annual interest rate of 4%, compounded quarterly. We are required to begin making quarterly interest and principal payments on April 15, 2017, subject to a subordination agreement with Hercules. The VantagePoint Notes mature on April 15, 2018, and remaining principal payments and unpaid interest is due at that time. The holders of the VantagePoint Notes have the right to convert any portion of the VantagePoint Notes into shares of ReachLocal common stock, par value $0.00001 per share, at an initial conversion rate of 200 shares of common stock per $1,000 principal amount of VantagePoint Notes, which represents an initial conversion price of $5.00 per share. The conversion rate is subject to customary anti-dilution adjustments for stock dividends, splits and combinations, certain distributions on the common stock, including cash dividends, spin-offs and certain tender or exchange offers for the common stock. An event of default, as defined in the agreement, may result in the acceleration of the maturity of the notes. The VantagePoint Notes are included in convertible notes - related party in our accompanying consolidated balance sheet.
On February 4, 2016, we entered into an amendment to the VantagePoint Notes. The amendment provides that, except in certain circumstances, the convertibility of the VantagePoint Notes is limited such that conversion may not result in the holders collectively acquiring beneficial ownership of more than 1.9% of our outstanding shares of common stock during any 12-month period.
VantagePoint and its affiliates beneficially own approximately 43% of our common stock and VantagePoint’s Chief Executive Officer and Managing Partner, is a member of our Board of Directors.
The agreement governing the notes and the term loan contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other borrowings. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under the term loan to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable.
Liquidity
During 2015, we experienced declining revenues as a result of challenging market conditions and worse than expected performance in our international markets. These conditions, combined with our initiatives to transform the business and focus on profitable revenue, have had a significant negative impact on our operating results and cash flows. As a result, we have taken a number of steps to reduce expenses and improve our results of operations through, for example, our 2015 Restructuring Plan, including cost-saving measures, such as workforce reductions, downsizing certain facilities in North America, as well as reductions of general corporate expenses and capital expenditures.
In order to provide additional liquidity to meet working capital and capital resource requirements, on April 30, 2015, we entered into the Hercules Loan Agreement for a $25.0 million term loan. We received $24.7 million of net proceeds from the term loan, $15.0 million of which is considered restricted cash required under the terms of the Hercules Loan Agreement. In addition, on December 17, 2015, we entered into a convertible note purchase agreement with affiliates of its largest shareholder for the immediate issuance of $5.0 million of the VantagePoint Notes. The note purchase agreement also provides for the issuance and sale of up to an additional $5.0 million aggregate principal amount of convertible notes, upon mutual agreement of ReachLocal and VantagePoint (and Hercules’ consent). We are required to make interest-only payments on the Hercules term loan through May 1, 2016, though such payments may be extended through August 1, 2016 and November 1, 2016 if we remain in continuous compliance with the financial covenants under the Hercules Loan Agreement through April 1, 2016 and July 1, 2016, respectively, and no default or event of default has occurred and is continuing on such dates. Upon repayment of the term loan, we are also required to make an end-of-term payment to the Lenders equal to $1.5 million, which is accrued as interest based on the effective interest method over the 3-year term of the Hercules Loan Agreement. The term loan is secured by substantially all of our personal property, including our intellectual property. We are required to begin making quarterly interest and principal payments on the VantagePoint Notes on April 15, 2017, subject to a subordination agreement with Hercules.
The Hercules Loan Agreement includes covenants applicable to the Company and its subsidiaries, which include restrictions on transferring collateral, incurring additional indebtedness, creating liens, selling assets, and undergoing a change in control, in each case subject to certain exceptions, as well as financial covenant requirements to maintain certain minimum levels of revenue and earnings during each three-month period, tested monthly, during the term. These restrictions also include a maximum net new investment in our foreign subsidiaries, subject to certain exclusions of $8.0 million during 2015, $5.5 million during 2016, $4.0 million annually thereafter, and $18.0 million in the aggregate during the term of the agreement. The Hercules Loan Agreement also contains a subjective acceleration clause that can be triggered if we experience a Material Adverse Effect, as defined in the Hercules Loan Agreement, which would be considered an event of default. On August 3, 2015, we entered into an amendment to the Hercules Loan Agreement, which reduced the Hercules Loan Agreement’s covenant thresholds for revenue for the months ending September 30, 2015 through December 31, 2015. On November 9, 2015, we entered into an amendment to the Hercules Loan Agreement, which waived compliance with the revenue and earnings covenant thresholds for November and December 2015. In connection with the amendment, we (i) paid Hercules a one-time fee of $0.2 million, (ii) reset the schedule of prepayment fees to begin from November 9, 2015, instead of April 30, 2016, and (iii) agreed to amend the Hercules Warrant. As of December 31, 2015, we were in compliance with all financial covenants of the Hercules Loan Agreement.
Our operating losses and capital expenditures more than offset the $15.0 million of net unrestricted cash from the Hercules Loan Agreement and VantagePoint Notes, resulting in cash and cash equivalents of $18.8 million and short-term investments of $0.4 million at December 31, 2015. Cash and cash equivalents consist of cash, money market accounts and certificates of deposit. Short term investments consist of certificates of deposit with original maturities in excess of three months but less than 12 months. To date, we have experienced no loss of our invested cash, cash equivalents or short-term investments, although some of those balances are subject to foreign currency exchange risk (see Item 3, “Foreign Currency Exchange Risk,” for more information). We cannot, however, provide any assurances that access to our invested cash, cash equivalents and short-term investments will not be impacted by adverse conditions in the financial markets. At December 31, 2015, we had restricted cash in North America related to the minimum cash balance required to be maintained under the terms of the Hercules Loan Agreement of $15.0 million. If we achieve positive “Adjusted EBITDA” as defined in the Loan Agreement, for three consecutive quarters, the minimum cash balance decreases to $12.5 million. We achieved positive “Adjusted EBITDA” as defined during the quarters ended September 30, 2015 and December 31, 2015, which qualifies as two quarters of the required three consecutive quarters. Also, at December 31, 2015, we had restricted cash related to certificates of deposits held at financial institutions that are pledged as collateral for letters of credit related to lease commitments, collateral for merchant accounts, and cash deposits funded to a restricted account determined on a monthly basis in accordance with our employee health care self-insurance plan in the amount of $3.5 million, of which, $0.2 million relate to the employee health care self-insurance plan. Our current liabilities exceeded our current assets by $60.6 million at December 31, 2015, and we incurred an operating loss of $61.5 million for the year then ended.
We believe that we will be able to maintain compliance with the minimum cash balance in North America in excess of $15.0 million through March 31, 2016, and subsequently maintain a minimum cash balance in North America of $12.5 million in accordance with achievement of positive “Adjusted EBITDA” as defined above. We also believe that we will extend our interest-only payments through November 1, 2016 by maintaining continuous compliance and not experiencing a default or event of default through July 1, 2016. In addition, we believe that we will be able to maintain compliance with the other financial covenants contained in the Hercules Loan Agreement through 2016 as a result of our cost and capital expenditure control measures. We believe that we will be able to achieve the revenue and earnings targets for 2016 under the Hercules Loan Agreement, which equal 90% of the revenue estimated in our 2016 operating plan and 70% and 80% of the earnings estimated for the first and second six months, respectively, in our 2016 operating plan as approved by our board of directors.
To meet our liquidity needs, we expect to minimize increases in personnel until our business performance has improved and supports additional costs. However, we may need to implement further cost reductions in our operating expenses to maintain a sufficient cash balance to fund its operations and maintain compliance with the minimum cash balance requirement under the Hercules Loan Agreement. Should it become necessary, we would implement additional cost reductions primarily through forgoing certain discretionary compensation increases, and further constraining identified non-critical product investments, and marketing and other costs, including reductions in personnel related to those activities. These identified potential actions, commencing as soon as May 2016, comprise a developed plan to reduce such costs by $4.6 million, net of implementation costs. In addition, we would consider borrowing up to an additional $5.0 million under the current VantagePoint notes purchase agreement, however such borrowings would be subject to VantagePoint’s willingness to lend and Hercules’ consent. We will continue to evaluate the extent and effectiveness of our cost-saving measures and monitor expenses compared to revenue and intend to implement additional cost reductions in future periods if and as circumstances warrant. However, there can be no assurance that these actions will be successful or that further adverse events outside of our control may arise that would result in our inability to comply with the Hercules Loan Agreement’s covenants. If an event of default were to occur, we may be required to obtain a further amendment or a waiver to the Hercules Loan Agreement, refinance the term loan, divest non-core assets or operations and/or obtain additional equity or debt financing. If we were unable to obtain such a waiver or amendment, or consummate such a transaction, the administrative agent could exercise remedies against us and the collateral securing the term loan, including potential foreclosure against our assets securing the Hercules Loan Agreement, including our cash. Further, the VantagePoint Notes and Hercules Loan Agreement contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other borrowings. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under the term loan to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable.
In consideration of these conditions, we currently anticipate that funds expected to be generated from operations, including cost-saving measures we have taken and intend to take will be sufficient to meet our anticipated cash requirements through at least the next twelve months. However, there is no assurance that the results of operations and cash flows expected during that period of time will be achieved
Off-Balance Sheet Arrangements
At December 31, 2015, we did not have any off-balance sheet arrangements.
Contractual Obligations
The following table presents certain payments due under contractual obligations with minimum firm commitments as of December 31, 2015:
__________
(1) Represents principal payments due on debt, including the credit against the final payment.
(2) The VantagePoint Notes are subject to a subordination agreement with Hercules such that the VantagePoint Notes are subordinated in right of repayment to all of our obligations under the Hercules Loan Agreement. In accordance with the subordination agreement, payment of the VantagePoint Notes would commence in the second quarter of 2018.
(3) Represents estimated aggregate interest obligations for our outstanding debt obligations that are payable in cash, including the end of term charge under the Hercules Loan agreement, and excluding capital lease obligations and, the non-cash amortization of debt issuance costs.
(4) Includes principal and imputed interest.
Operating Leases
We lease our primary office space in Woodland Hills, California; Plano, Texas; and other locations under various cancelable and non-cancelable operating leases that will expire between 2015 and 2024. All of our property and equipment have been purchased for cash or leased pursuant to capital leases.
During 2015, we recorded facilities restructuring charges related to lease termination costs as a result of closing facilities as part of our restructuring plan. Operating lease payments in the table above include approximately $2.4 million of lease payments related to terminated or restructured leases, net of actual sublease income of $0.4 million, from operating lease commitments for those facilities. Amounts related to the lease terminations will be paid over the respective lease terms, the longest of which extends through 2024.
Hercules Loan Agreement
We have entered into the Loan Agreement with a principal amount of $25.0 million. The term loan has an annual interest rate equal to the greater of (i) 11.75% and (ii) the sum of (a) the prime rate, plus (b) 8.50%. The annual interest rate as of December 31, 2015 was 12.00%. We are required to make interest-only payments on the Hercules term loan through May 1, 2016, though such payments may be extended through August 1, 2016 and November 1, 2016 if we remain in continuous compliance with the financial covenants under the Hercules Loan Agreement through April 1, 2016 and July 1, 2016, respectively, and no default or event of default has occurred and is continuing on such dates. The term loan matures on April 1, 2018 or, if the interest-only payments are extended through November 1, 2016, the term loan will mature October 1, 2018. For more information see the Financing Activities section above.
VantagePoint Convertible Notes (Related Party)
We have entered into a convertible note agreement for the immediate issuance of $5.0 million of Convertible Second Lien Subordinated Notes. The notes bear an annual interest rate of 4%, compounded quarterly, and mature on April 15, 2018. Quarterly principle and interest payments are due starting April 15, 2017, subject to a subordination agreement with Hercules. For more information see the Financing Activities section above.
Purchase Obligations
We have long-term purchase obligations outstanding with partners and third-party service providers for enhanced marketing functionality for our clients and for internal business software.
Capital Leases
We have entered into non-cancelable capital leases for computer equipment. We recorded $1.2 million of capital leases, net of accumulated amortization of $0.8 million. The interest rates on these leases range from 4.8% to 5.2%. Interest payable on the lease obligations was $0.1 million as of December 31, 2015.
Recent Accounting Pronouncements Adopted in 2015
In November 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-17, Balance Sheet Classification of Deferred Taxes. The amendments in this update require that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. The amendments in this update are effective for annual reporting periods beginning after December 15, 2016. Early application is permitted for all entities as of the beginning of an interim or annual reporting period. We early adopted this standard retrospectively and reclassified all of our current deferred tax assets to noncurrent deferred tax assets on our consolidated balance sheets for all periods presented. Adoption resulted in a $1.8 million decrease in prepaid expenses and other current assets, a $0.1 million increase in other assets, and a $1.7 million increase in deferred rent and other liabilities in our Consolidated Balance Sheet as of December 31, 2014.
In April 2015, the FASB issued ASU No. 2015-03, Interest- Imputation of Interest. The amendments in this update require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the corresponding debt liability, consistent with debt discounts. The amendments in this update are effective for us as of January 1, 2016. We early adopted this update in the second quarter of 2015.
In April 2014, the FASB issued ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this update changes the criteria for determining which disposals can be presented as discontinued operations and modifies related disclosure requirements. The guidance applies prospectively to new disposals and new classifications of disposal groups as held for sale after the effective date, and was effective for us as of January 1, 2015. We have applied this guidance to our consolidated financial statements in 2015.
Recent Accounting Pronouncements Not Yet Adopted
In February 2016, the FASB issued ASU No. 2016-02, Leases. The amendments in this update supersedes the guidance in former Accounting Standards Codification (“ASC”) 840, Leases with ASC 842, Leases, to increase transparency and comparability among organizations by requiring recognition of lease assets and lease liabilities on the balance sheet and disclosure of key information about leasing arrangements. The amendments in this update are effective for us as of January 1, 2019. Early application of this update is permitted. The guidance is required to be adopted at the earliest period presented using a modified retrospective approach. We are currently assessing the impact of this update on our consolidated financial statements.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments- Overall. The amendments in this update address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments in this update are effective for us as of January 1, 2018. Early application of certain aspects of the amendment is permitted by public entities, otherwise early adoption is not permitted. We are currently assessing the impact of this update on our consolidated financial statements.
In September 2015, the FASB issued ASU No. 2015-16, Business Combinations. The amendments in this update require that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. The amendments in this update require an acquirer to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The amendments in this update are effective for us as of January 1, 2016. The amendments in this update should be applied prospectively to adjustments to provisional amounts that occur after the effective date of this update. We are currently assessing the impact of this update, and believes that its adoption on January 1, 2016 will not have a material impact on our consolidated financial statements.
In April 2015, the FASB issued ASU No. 2015-05, Intangibles-Goodwill and Other-Internal-Use Software. The amendments in this update provide guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The amendments in this update are effective for us as of January 1, 2016. We are currently assessing the impact of this update on our consolidated financial statements.
In February 2015, the FASB issued ASU No. 2015-02, Consolidation. The amendments in this update require management to reevaluate whether certain legal entities should be consolidated. Specifically, the amendments (1) modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIEs) or voting interest entities, (2) eliminate the presumption that a general partner should consolidate a limited partnership, (3) affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships, and (4) provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. The amendments in this update are effective for us as of January 1, 2016. We are currently assessing the impact of this update, and believe that its adoption on January 1, 2016 will not have a material impact on our consolidated financial statements.
In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements - Going Concern. The amendments in this update require management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. Specifically, the amendments (1) provide a definition of the term substantial doubt, (2) require an evaluation every reporting period including interim periods, (3) provide principles for considering the mitigating effect of management’s plans, (4) require certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans, (5) require an express statement and other disclosures when substantial doubt is not alleviated, and (6) require an assessment for a period of one year after the date that the financial statements are issued (or available to be issued). The amendments in this update are effective for us as of January 1, 2017. Early application is permitted. The adoption of this standard is not expected to have an impact on our consolidated financial statements.
In June 2014, the FASB issued ASU No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. The amendments in this update require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Accounting Standards Codification (“ASC”) 718, Compensation - Stock Compensation, as it relates to awards with performance conditions that affect vesting to account for such awards. The amendments in this update will be effective for us as of January 1, 2016. Earlier adoption is permitted. Entities may apply the amendments in this update either: (a) prospectively to all awards granted or modified after the effective date; or (b) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. If retrospective transition is adopted, the cumulative effect of applying this update as of the beginning of the earliest annual period presented in the financial statements should be recognized as an adjustment to the opening retained earnings balance at that date. In addition, if retrospective transition is adopted, an entity may use hindsight in measuring and recognizing the compensation cost. We are currently assessing the impact of this update, and believe that its adoption on January 1, 2016 will not have a material impact on our consolidated financial statements.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. The guidance in this update supersedes the revenue recognition requirements in ASC 605, Revenue Recognition, and most industry-specific guidance throughout the Codification. Additionally, this update supersedes some cost guidance included in ASC 605-35, Revenue Recognition - Construction-Type and Production-Type Contracts. In addition, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer (for example, assets within the scope of ASC 360, Property, Plant, and Equipment, and intangible assets, within the scope of ASC 350, Intangibles - Goodwill and Other) are amended to be consistent with the guidance on recognition and measurement in this update. The standard was to be effective for us as of January 1, 2017, but in August 2015, the FASB delayed the effective date of the new revenue accounting standard to January 1, 2019, and will permit early adoption as of the original effective date. Earlier adoption is not otherwise permitted for public entities. An entity can apply the revenue standard retrospectively to each prior reporting period presented (full retrospective method) or retrospectively with the cumulative effect of initially applying the standard recognized at the date of initial application in retained earnings (simplified transition method). We are currently assessing the impact of this update on our consolidated financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We are exposed to market risk in the ordinary course of our business. These risks primarily include interest rate, foreign exchange and inflation risks.
Interest Rate Fluctuation Risk
Our investments include cash, cash equivalents and short-term investments. Cash and cash equivalents and short-term investments consist of cash, money market accounts and certificates of deposit. The primary objective of our investment activities is to preserve principal while maximizing income without significantly increasing risk. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to a fluctuation in interest rates, which may affect our interest income and the fair market value of our investments. Due to the short-term nature of our investment portfolio, we do not believe an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio, and therefore we do not expect our operating results or cash flows to be materially affected to any degree by a sudden change in market interest rates.
On April 30, 2015, we entered into the Hercules Loan Agreement for a $25.0 million term loan. The term loan bears interest at the prime rate plus 8.5% (with a prime rate floor of 3.25%), which increases our risk exposure to increases in interest rates. During December 2015, the annual interest rate increased from 11.75% to 12.00%. Accordingly, a one percentage point increase in the prime rate above the floor would result in net additional annual interest expense on our outstanding borrowings as of December 31, 2015 of $0.2 million.
Foreign Currency Exchange Risk
We have foreign currency risks related to our investments, revenue and operating expenses denominated in currencies other than the U.S. dollar, including the Australian dollar, the British pound sterling, the Canadian dollar, the euro, the Japanese yen, the Indian rupee, and the Brazilian real. For the year ended December 31, 2015, a 10% strengthening of the U.S. dollar relative to those foreign currencies would have resulted in a decrease in revenue of $14.0 million, but an increase in operating income of $0.9 million. A 10% weakening of the U.S. dollar relative to those foreign currencies, however, would have resulted in an increase in revenue of $14.0 million, but a decrease in operating income of $0.9 million. As exchange rates vary, sales and other operating results, when translated, may differ materially from expectations. In addition, approximately 30% of our cash balances are denominated in currencies other than the U.S. dollar, and the value of such holdings will increase or decrease along with the weakness or strength of the U.S. dollar, respectively. We continue to review potential hedging strategies that may reduce the effect of fluctuating currency rates on our business, but there can be no assurances that we will implement such a hedging strategy or that once implemented, such a strategy would accomplish our objectives or not result in losses.
Inflation Risk
We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Please refer to Item 15 - Exhibits and Financial Statement Schedules.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
(a)
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e) as of December 31, 2015. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
(b)
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on criteria established in the framework in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2015.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. A control system no matter how well designed and operated, can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
(c)
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
Amendment to Hercules Loan Agreement
On March 25. 2016, the Company and certain of its affiliates entered into a Fourth Amendment to Loan and Security Agreement with Hercules Capital, Inc. (formerly Hercules Technology Capital, Inc.), as administrative agent and lender. The loan amendment amends the Hercules Loan Agreement to increase the maximum net new investment in the Company’s foreign subsidiaries during 2016 from $4.0 million to $5.5 million.
Amended and Restated Employment Letter with Ross G. Landsbaum
On March 28, 2016, the Company entered into an amended and restated employment letter with Ross G. Landsbaum, the Company’s Chief Financial Officer.
The employment letter provides Mr. Landsbaum an annual base salary of $400,000 per year (effective July 1, 2016) and an annual bonus opportunity of up to 100% of his base salary. The employment letter also provides that Mr. Landsbaum’s 2016 annual bonus will not be less than 100% of his base salary. During his employment, Mr. Landsbaum will continue to be eligible to participate in the Company’s health and welfare, retirement and other plans and programs that the company makes available to senior executives from time to time. On March 28, 2016, in connection with entering into the employment letter, Mr. Landsbaum was granted 40,000 restricted stock units pursuant to the Company’s Amended and Restated 2008 Stock Incentive Plan, which will vest 25% on the one-year anniversary of the date on which we entered into the employment letter, and quarterly thereafter for the subsequent three years, subject to Mr. Landsbaum’s continued employment through the applicable vesting date.
Under the employment letter, upon the occurrence of a “change in control” (as defined in the Company’s Change in Control and Severance Policy (the “Severance Policy”)) of the Company, then Mr. Landsbaum will be entitled to receive his 2016 annual bonus and each of Mr. Landsbaum’s equity awards will, immediately prior to the occurrence of the change in control, vest with respect to 100% of the then-remaining outstanding unvested shares. Mr. Landsbaum’s employment letter also provides that he will be eligible to participate in the Severance Policy as a Group A participant. In the event Mr. Landsbaum gives the Company at least three months’ notice, he may resign effective December 31, 2016 and receive certain severance benefits available to him as a Group A Participant under the Severance Policy.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2016 Annual Meeting of Stockholders.
We have adopted a code of business conduct and ethics applicable to our directors, officers (including our principal executive officer and principal financial officer) and employees. The Code of Business Conduct and Ethics is available on the investor relations section of our website at www.reachlocal.com under “Corporate Governance.”
We intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of our Code of Business Conduct and Ethics by posting such information on our website, at the address and location specified above and, to the extent required by the listing standards of The NASDAQ Stock Market, by filing a Current Report on Form 8-K with the SEC, disclosing such information.
Item 11.
Item 11. Executive Compensation.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2016 Annual Meeting of Stockholders.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2016 Annual Meeting of Stockholders.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2016 Annual Meeting of Stockholders.
Item 14.
Item 14. Principal Accountant Fees and Services.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2016 Annual Meeting of Stockholders.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
We have filed the following documents as part of this Annual Report on Form 10-K:
Page
ReachLocal, Inc. Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Comprehensive Loss
Consolidated Statements of Stockholders’ Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to the Consolidated Financial Statements
The exhibits listed in the accompanying Exhibit Index are filed as part of, or incorporated by reference into, this Annual Report on Form 10-K.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
ReachLocal, Inc.
We have audited the accompanying consolidated balance sheets of ReachLocal, Inc. (the “Company”) as of December 31, 2015 and 2014, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ReachLocal, Inc. as of December 31, 2015 and 2014, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2015 in conformity with accounting principles generally accepted in the United States of America.
/s/ GRANT THORNTON LLP
Irvine, California
March 30, 2016
REACHLOCAL, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
See notes to consolidated financial statements.
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
See notes to consolidated financial statements.
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
See notes to consolidated financial statements.
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
(in thousands)
See notes to consolidated financial statements.
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See notes to consolidated financial statements.
REACHLOCAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Description of Business
ReachLocal, Inc.’s (the “Company”) operations are located in the United States, Canada, Australia, New Zealand, Japan, Germany, the Netherlands, Austria, Brazil, Mexico, and India. The Company’s mission is to provide more customers to local businesses around the world. The Company offers online marketing products and solutions in three categories: digital advertising (including ReachSearch™, ReachRetargeting™, ReachDisplay™, and ReachDisplay InAppTM), software (ReachEdge™ and Kickserv™), and web presence (including ReachSEO™, ReachCast™, ReachSite + ReachEdge™, and TotalLiveChat™). The Company delivers its suite of products and solutions to local businesses through a combination of its proprietary technology platform, its direct inside and outside sales force, and select third-party agencies and resellers.
Liquidity and Capital Resources
During 2015, the Company experienced declining revenues as a result of challenging market conditions and worse than expected performance in the Company’s international markets. These conditions, combined with the Company’s initiatives to transform the business and focus on profitable revenue, have had a significant negative impact on its operating results and cash flows. As a result, the Company has taken a number of steps to reduce expenses and improve its results of operations through, for example, its 2015 Restructuring Plan, including cost-saving measures such as workforce reductions, downsizing certain facilities in North America, as well as reductions of general corporate expenses and capital expenditures.
In order to provide additional liquidity to meet working capital and capital resource requirements, on April 30, 2015, the Company entered into a Loan and Security Agreement (the “Hercules Loan Agreement”) for a $25.0 million term loan. The Company received $24.7 million of net proceeds from the term loan, $15.0 million of which is considered restricted cash required under the terms of the Hercules Loan Agreement. In addition, on December 17, 2015, the Company entered into a convertible note purchase agreement with affiliates of its largest shareholder for the immediate issuance of $5.0 million of Convertible Second Lien Subordinated Notes (the “VantagePoint Notes”). The note purchase agreement also provides for the issuance and sale of up to an additional $5.0 million aggregate principal amount of convertible notes, upon mutual agreement of ReachLocal and VantagePoint (and Hercules’ consent). The Company is required to make interest-only payments on the Hercules term loan through May 1, 2016, though such payments may be extended through August 1, 2016 and November 1, 2016 if the Company remains in continuous compliance with the financial covenants under the Hercules Loan Agreement through April 1, 2016 and July 1, 2016, respectively, and no default or event of default has occurred and is continuing on such dates. Upon repayment of the term loan, the Company is also required to make an end-of-term payment to the Lenders equal to $1.5 million, which is accrued as interest based on the effective interest method over the 3-year term of the Hercules Loan Agreement. The term loan is secured by substantially all of the Company’s personal property, including the Company’s intellectual property. The Company is required to begin making quarterly interest and principal payments on the VantagePoint Notes on April 15, 2017, subject to a subordination agreement with Hercules.
The Hercules Loan Agreement includes covenants applicable to the Company, which include restrictions on transferring collateral, incurring additional indebtedness, engaging in mergers or acquisitions, paying dividends or making other distributions, making investments, creating liens, selling assets, and undergoing a change in control, in each case subject to certain exceptions, as well as financial covenant requirements to maintain certain minimum levels of revenue and earnings during each three-month period, tested monthly, during the term. These restrictions also include a maximum net new investment in the Company’s foreign subsidiaries, subject to certain exclusions of $8.0 million during 2015, $5.5 million during 2016, $4.0 million annually thereafter, and $18.0 million in the aggregate during the term of the agreement. The Hercules Loan Agreement also contains a subjective acceleration clause that can be triggered if the Company experiences a Material Adverse Effect, as defined in the Hercules Loan Agreement, which would be considered an event of default. On August 3, 2015, the Company entered into an amendment to the Hercules Loan Agreement, which reduced the Hercules Loan Agreement’s covenant thresholds for revenue for the months ending September 30, 2015 through December 31, 2015. On November 9, 2015, the Company entered into an amendment to the Hercules Loan Agreement, which waived compliance with the revenue and earnings covenant thresholds for November and December 2015. In connection with the amendment, the Company (i) paid Hercules a one-time fee of $0.2 million, (ii) reset the schedule of prepayment fees to begin from November 9, 2015, instead of April 30, 2016, and (iii) agreed to amend the Hercules Warrant as described in Note 13, Debt and Other Obligations. The Company is in compliance with all of the Hercules Loan Agreement’s covenants as of December 31, 2015.
The Company’s operating losses and capital expenditures more than offset the $15.0 million of net unrestricted cash from the Hercules Loan Agreement and VantagePoint Notes, resulting in cash and cash equivalents of $18.8 million and short-term investments of $0.4 million at December 31, 2015. To date, the Company has experienced no loss of its invested cash, cash equivalents or short-term investments, although some of those balances are subject to foreign currency exchange risk. The Company cannot, however, provide any assurances that access to its invested cash, cash equivalents and short-term investments will not be impacted by adverse conditions in the financial markets. At December 31, 2015, the Company had restricted cash in North America related to the minimum cash balance required to be maintained under the terms of the Hercules Loan Agreement of $15.0 million. If the Company achieves positive “Adjusted EBITDA” as defined in the Hercules Loan Agreement, for three consecutive quarters, the minimum cash balance decreases to $12.5 million. The Company achieved positive “Adjusted EBITDA” as defined, during the quarters ended September 30, 2015 and December 31, 2015, which qualifies as two quarters of the required three consecutive quarters. Also, at December 31, 2015, the Company had restricted cash related to certificates of deposits held at financial institutions that are pledged as collateral for letters of credit related to lease commitments, collateral for merchant accounts, and cash deposits funded to a restricted account determined on a monthly basis in accordance with its employee health care self-insurance plan in the amount of $3.5 million, of which, $0.2 million relate to the employee health care self-insurance plan. The Company’s current liabilities exceeded its current assets by $60.6 million at December 31, 2015, and it incurred an operating loss of $61.5 million for the year then ended.
The Company believes that it will be able to maintain compliance with the minimum cash balance in North America in excess of $15.0 million through March 31, 2016, and subsequently maintain a minimum cash balance in North America of $12.5 million in accordance with achievement of positive “Adjusted EBITDA” as defined above. The Company also believes that it will extend its interest-only payments through November 1, 2016 by maintaining continuous compliance and not experiencing a default or event of default through July 1, 2016. In addition, the Company believes that it will be able to maintain compliance with the other financial covenants contained in the Hercules Loan Agreement through 2016 as a result of its implemented cost and capital expenditure control measures. The Company believes that it will be able to achieve the revenue and earnings targets for 2016 under the Hercules Loan Agreement, which equal 90% of the revenue estimated in the Company’s 2016 operating plan and 70% and 80% of the earnings estimated for the first and second six months, respectively, in the Company’s 2016 operating plan as approved by the Company’s board of directors.
To meet the Company’s liquidity needs, management expects to minimize increases in personnel until the Company’s business performance has improved and supports additional costs. However, the Company may need to implement further cost reductions in its operating expenses to maintain a sufficient cash balance to fund its operations and maintain compliance with the minimum cash balance requirement under the Hercules Loan Agreement. Should it become necessary, the Company would implement additional cost reductions primarily through forgoing certain discretionary compensation increases, and further constraining identified non-critical product investments, and marketing and other costs, including reductions in personnel related to those activities. These identified potential actions, commencing as soon as May 2016, comprise a developed plan to reduce such costs by $4.6 million, net of implementation costs. In addition, the Company would consider borrowing up to an additional $5.0 million under the current VantagePoint notes purchase agreement, however such borrowings would be subject to VantagePoint’s willingness to lend and Hercules’ consent. The Company will continue to evaluate the extent and effectiveness of its cost-saving measures and monitor expenses compared to revenue and intends to implement additional cost reductions in future periods if and as circumstances warrant. However, there can be no assurance that these actions will be successful or that further adverse events outside of the Company’s control may arise that would result in the Company’s inability to comply with the Hercules Loan Agreement’s covenants. If an event of default were to occur, the Company may be required to obtain a further amendment or a waiver to the Hercules Loan Agreement, refinance the term loan, divest non-core assets or operations and/or obtain additional equity or debt financing. If the Company was unable to obtain such a waiver or amendment, or consummate such a transaction, the administrative agent could exercise remedies against the Company and the collateral securing the term loan, including potential foreclosure against the Company’s assets securing the Hercules Loan Agreement, including the Company’s cash. Further, the VantagePoint Notes and Hercules Loan Agreement contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other borrowings. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under the term loan to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable.
In consideration of these conditions, the Company currently anticipates that funds expected to be generated from operations, including cost-saving measures the Company has taken and intends to take, will be sufficient to meet the Company’s anticipated cash requirements through at least the next twelve months. However, there is no assurance that the results of operations and cash flows expected during that period of time will be achieved.
2. Summary of Significant Accounting Policies
Principles of Consolidation and Basis of Presentation
The consolidated financial statements include the accounts of ReachLocal, Inc. and its wholly owned subsidiaries. The Company's consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results may differ from those estimates.
Reclassifications and Adjustments
Certain prior period amounts have been reclassified to conform to the current period presentation. See further discussion below under recent accounting pronouncements and in Note 14, Income Taxes.
Foreign Currency Translation
The Company’s operations are conducted in several countries around the world, and the financial statements of its foreign subsidiaries are reported in the applicable foreign currencies (functional currencies). Financial information is translated from the applicable functional currency to the U.S. dollar, the reporting currency, for inclusion in the Company’s consolidated financial statements. Revenue and expenses are translated at average exchange rates prevailing during the period, and assets and liabilities are translated at exchange rates in effect at the balance sheet date. Resulting translation adjustments are included as a component of accumulated other comprehensive income (loss), net in stockholders’ equity. Foreign currency translation adjustments are generally not adjusted for income taxes as they are primarily related to indefinite investments in foreign subsidiaries. Foreign exchange transaction gains and losses are included in other income (expense), net in the accompanying consolidated statements of operations. Exchange gains and losses on intercompany balances that are considered permanently invested are also included as a component of accumulated other comprehensive loss in stockholders’ equity.
Cash and Cash Equivalents
The Company reports all highly liquid short-term investments with original maturities of three months or less at the time of purchase as cash equivalents. As of December 31, 2015 and 2014, cash equivalents consist of demand deposits and money market accounts. Cash equivalents are stated at cost, which approximates fair value.
Short-Term Investments
The Company classifies investments as short-term when the original maturity is less than one year, or when the Company intends to sell the investment within one year. As of December 31, 2015 and 2014, short-term investments consisted of certificates of deposit. All of the short-term investments are classified as available-for-sale. Short-term investments are stated at cost, which approximates fair value.
Accounts Receivable
The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history, the customer’s creditworthiness and various other factors, as determined by its review of their credit information. The Company monitors collections and payments from its customers and maintains an allowance for estimated credit losses based upon its historical experience and any customer-specific collection issues that it has identified.
Concentrations of Credit Risk
Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of cash and cash equivalents, restricted cash, short-term investments and accounts receivable. Cash and cash equivalents and certificates of deposit are deposited with a limited number of financial institutions in the United States, Canada, Australia, United Kingdom, India, the Netherlands, Germany, Japan and Brazil. The balances held at any one financial institution are generally in excess of Federal Deposit Insurance Corporation insurance limits or, in foreign territories, local insurance limits, and as a result, access to the Company’s cash and cash equivalents may be impacted by adverse conditions in the global financial markets, including fluctuations in currency exchange rates. As of December 31, 2015, domestic bank balances in excess of insured limits were $23.3 million and foreign bank balances in excess of insured limits were $12.5 million.
During March 2016, the Company commenced a process to transition its two primary financial service providers of commercial banking services and merchant services for its credit and debit card processing in North America. The Company does not expect a significant impact to its financial position, results of operations or cash flows in North America as a result of the transition, which is expected to be completed by May 2016.
The Company’s customers are primarily local businesses, dispersed both geographically and across a broad range of industries. Management performs ongoing evaluation of trade receivables for collectability and provides an allowance for potentially uncollectible accounts. The following table summarizes the change in the Company’s allowance for doubtful accounts for each of the three years ended December 31, 2015, 2014 and 2013 (in thousands):
For the years ended December 31, 2015, 2014, and 2013, the Company did not have any individual clients that comprised more than 10% of consolidated revenues.
During 2015, 2014, and 2013, the Company’s cost of revenue was primarily for the purchase of media from two of the Company’s vendors. Other receivables and prepaid expenses included $3.6 million and $0.6 million of non-trade receivables from media vendors at December 31, 2015 and 2014, respectively. Accounts payable included $17.3 million and $17.1 million of accrued media expenses from media vendors at December 31, 2015 and 2014, respectively.
Property and Equipment
Property and equipment are stated at historical cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which is generally three years for computer hardware and software, five years for office equipment, and seven years for furniture and fixtures. Leasehold improvements are amortized using the straight-line method over the lesser of the useful life or the lease term. Upon retirement or sale, the cost of assets disposed of and the related accumulated depreciation are eliminated from the accounts and any resulting gain or loss is credited or charged to operations. Repairs and maintenance costs are expensed as incurred.
Software Development Costs
Costs to develop software for internal use are capitalized when the Company has determined that the development efforts will result in new or additional functionality or new products. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred and included in product and technology expenses, in addition to amortization of capitalized software development costs, in the accompanying consolidated statements of operations. The Company monitors its existing capitalized software costs and reduces its carrying value as the result of releases that render previous features or functions obsolete. Software development costs are evaluated for impairment in accordance with the Company’s policy for finite-lived intangible assets and other long-lived assets. Costs capitalized as internal use software are amortized on a straight-line basis over an estimated useful life of three years.
Restricted Cash-Term Loan
Under the terms of the Hercules Loan Agreement, as amended, the Company is required to maintain, at all times, cash in North America of at least $15.0 million, unless the Company achieves positive “Adjusted EBITDA” as defined in the Loan Agreement for three consecutive quarters, in which case the minimum cash balance decreases to $12.5 million. Restricted cash-term loan represents the required minimum compensating balance to secure the term loan. See Note 13, Debt and Other Obligations, for more information.
Restricted Cash
Restricted cash represents certificates of deposit held at financial institutions that are pledged as collateral for letters of credit related to lease commitments, collateral for the Company’s merchant accounts, and cash deposits in a restricted account in accordance with the Company’s employee health care self-insurance plan. The letters of credit will lapse at the end of the respective lease terms through 2024 and the certificates of deposit automatically renew for successive one-year periods over the duration of the lease term. The restrictions related to merchant accounts and the Company’s self-insurance plan will lapse upon termination of the respective underlying arrangements. At December 31, 2015 and December 31, 2014, the Company had restricted cash in the amount of $3.5 million and $3.6 million, respectively, of which, $0.2 million, related to the employee health care self-insurance plan.
Loan Receivables
The Company records loan receivables at carrying value, net of potential allowance for losses. Losses on receivables are recorded when probable and estimable. Interest income on loan receivables is accrued on a monthly basis over the life of the loan, and interest recognition is suspended upon impairment of loan principal.
Non-marketable Investments
The Company accounts for non-marketable investments under the cost method, which are periodically assessed for other-than-temporary impairment. The fair value of a cost method investment is not evaluated if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investment. However, if a significant adverse event were identified, the Company would estimate the fair value of its cost method investment considering available information at the time of the event, such as current cash position, earnings and cash flow forecasts, recent operational performance and any other readily available data. If the Company determines that an other-than-temporary impairment has occurred, the investment is written-down to its fair value.
Variable Interest Entities
The Company analyzes its interests, including agreements, loans, guarantees, and equity investments, on a periodic basis to determine if such interests are variable interests. If variable interests are identified, then the related entity is assessed to determine if it is a variable interest entity (“VIE”). The Company’s analysis includes both quantitative and qualitative reviews. The Company bases its quantitative analysis on the forecasted cash flows of the entity, and its qualitative analysis on the design of the entity, its organizational structure including its decision-making authority, and relevant agreements. If the Company determines that the entity is a VIE, the Company then assesses if it must consolidate the VIE as its primary beneficiary. The Company’s determination of whether it is the primary beneficiary is based upon qualitative and quantitative analyses, which assess the purpose and design of the VIE, the nature of the VIE’s risks and the risks that the Company absorbs, the power to direct activities that most significantly impact the economic performance of the VIE, and the obligation to absorb losses or the right to receive benefits that could be significant to the VIE.
Finite-Lived Intangible Assets and Other Long-Lived Assets
Finite-lived intangible assets are attributable to the various developed technologies, trade names, and customer relationships of the businesses the Company has acquired. The Company reports finite-lived, acquisition-related intangible assets at acquisition date fair value, net of accumulated amortization. Finite-lived intangible assets are amortized on a straight-line basis over their estimated useful lives, ranging from two to ten years. Straight-line amortization is used as another pattern over which the economic benefits will be consumed cannot be reliably determined. The Company reviews the carrying values of long-lived assets, including intangible assets, for possible impairment whenever events or changes in circumstances indicate that the related carrying amount may not be recoverable. In its analysis of other finite lived amortizable intangible assets, the Company applies the guidance of ASC 350-20, Intangibles - Goodwill and Other, in determining whether any impairment conditions exist. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Recoverability of an intangible asset is measured by comparing its carrying amount to the expected future undiscounted cash flows that the asset is expected to generate, if it is determined that an asset is not recoverable. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Long-lived assets to be disposed of are reported at the lower of carrying amount or estimated fair value less cost to sell.
At December 31, 2015 and 2014, there were no indications of impairment of the Company’s finite-lived intangible assets or other long-lived assets.
Goodwill
Goodwill represents the excess of the purchase price of the Company’s acquired businesses over the fair value of the net tangible and intangible assets acquired. The Company accounts for goodwill in accordance with ASC 350, Intangibles-Goodwill and Other, which addresses financial accounting and reporting requirements for goodwill and requires testing of goodwill at the reporting unit level for impairment at least annually.
The Company tests the goodwill of its reporting units for impairment annually on the first day of the fourth quarter, and whenever events occur or circumstances change that would more likely than not indicate that the goodwill might be impaired. Events or circumstances which could trigger an impairment review include, but are not limited to, a significant adverse change in the legal or business climate, an adverse action or assessment by a regulator, unanticipated competition, a loss of key management or other personnel, significant changes in the manner of the Company’s use of the acquired assets or the strategy for the acquired business or the Company’s overall business, significant and sustained decline in market capitalization, significant negative industry or economic trends, or significant underperformance relative to expected historical or projected future results of operations.
Testing goodwill for impairment involves a two-step quantitative process. However, prior to performing the two-step quantitative goodwill impairment test, the Company has the option to first assess qualitative factors to determine whether or not it is necessary to perform the two-step quantitative goodwill impairment test for selected reporting units. If the Company chooses the qualitative option, the Company is not required to perform the two-step quantitative goodwill impairment test unless the Company has determined, based on the qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The first step of the impairment test involves comparing the estimated fair values of a reporting unit with its respective carrying amount, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, including goodwill, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the estimated fair value of the reporting unit is less than its carrying amount, including goodwill, or if the reporting unit has a negative carrying value and the Company believes it is more likely than not that a goodwill impairment exists, then the second step is performed to compare the carrying amount of the goodwill with its implied fair value, which is determined by deducting the aggregate fair value of the reporting unit's identifiable assets and liabilities from the fair value of the reporting unit. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.
The process of estimating the fair value of goodwill is subjective and requires the Company to make estimates that may significantly impact the outcome of the analyses. The estimated fair value for each reporting unit is determined using both an income-based valuation approach, as well as a market-based valuation approach. Under the income-based approach, each reporting unit’s fair value is estimated using the discounted cash flow method. The discounted cash flow method is dependent upon a number of factors, including projections of the amounts and timing of future revenues and cash flows, assumed discount rates determined to be commensurate with the risks inherent in its business model, and other assumptions. Under the market-based valuation approach, each reporting unit’s fair value is estimated based on industry multiples of revenues and operating earnings. The income-based approach is weighted between 50.0% and 66.7% depending on the amount and timing of projected operating earnings attributable to each reporting unit.
The Company operates in one reportable segment, in accordance with ASC 280, Segment Reporting, which is the basis that financial results are regularly reviewed by the Company's chief operating decision maker in deciding how to allocate resources and assess performance. The Company has identified its reporting units as North America, Asia Pacific, Latin America, and Europe. These reporting units each constitute a business or group of businesses for which discrete financial information is available and is regularly reviewed by each reporting unit’s management. The Company’s goodwill is comprised of balances in both the North America and Asia Pacific reporting units.
Self-Insurance
Beginning July 2, 2014, the Company implemented a self-insurance plan to provide for potential liabilities for employee health care claims in the United States. Liabilities associated with the risks are estimated, in part, by considering historical claims experience, demographic factors, severity factors, and other actuarial assumptions. The Company had insurance liabilities totaling approximately $1.3 million and $0.5 million at December 31, 2015 and December 31, 2014, respectively, which are included in accrued compensation and benefits in the accompanying consolidated balance sheets.
Leases
The Company leases various facilities under agreements accounted for as operating leases. For leases that contain escalation or rent concessions provisions, management recognizes rent expense during the lease term on a straight-line basis over the term of the lease. The difference between rent paid and straight-line rent expense is recorded as a deferred rent liability in the accompanying consolidated balance sheets.
Assets held under capital leases are recorded at the lower of the net present value of the minimum lease payments or at the fair value of the leased asset at the inception of the lease. Amortization expense is computed using the straight-line method over the shorter of the estimated useful life of the asset or the period of the related lease. Principal payments on capital lease obligations are recorded as reduction of capital lease liability in the accompanying consolidated balance sheets, and interest payments are recorded as interest expense which is included in other income, net in the accompanying consolidated statements of operations.
Revenue Recognition
The Company recognizes revenue for its products and solutions when persuasive evidence of an arrangement exists, services have been performed, the selling price is fixed or determinable, and collectibility is reasonably assured. The Company recognizes revenue for search engine marketing as clicks are recorded on sponsored links on the various search engines and for its display advertising and retargeting when the display advertisements record impressions or as otherwise provided in its agreement with the applicable publisher. The Company recognizes revenue for lead conversion software, web presence and other products with a defined license or service period on a straight-line basis over the applicable license or service period. The Company recognizes revenue when it charges set-up, management service or other fees on a straight-line basis over the term of the related contract or the completion of any obligation for services, if shorter. The Company accounts for sales and similar taxes imposed on its services on a net basis in the consolidated statements of operations.
When the Company receives advance payments from clients, it records these amounts as deferred revenue until the revenue is recognized. From time to time, the Company offers incentives to clients in exchange for minimum commitments. In these circumstances, management estimates the amount of the incentives that will be earned by clients and adjusts the recognition of revenue to reflect such incentives. Estimates are either based upon a statistical analysis of previous campaigns for which such incentives were offered, or calculated on a straight-line basis over the life of the campaign.
When the Company sells through agencies, it either receives payment in advance of delivery of its products or solutions or in some cases extends credit. The Company pays each agency an agreed-upon commission based on the revenue it earns or cash it receives. Some agency clients who have been extended credit may offset the amount otherwise due to the Company by any commissions they have earned. Management evaluates whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions. As the Company is generally the primary party obligated in the arrangement, subject to the credit risk, with discretion over both price and media, management typically recognizes the gross amount of such sales as revenue and any commissions are recognized as a selling and marketing expense.
The Company also has a small number of resellers. Resellers integrate the Company’s products and solutions, including the Company’s branded search engine marketing, display advertising and online marketing analytics, into their product offerings. In most cases, the resellers integrate with the Company’s technology platform through a custom Application Programming Interface (API). Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay the Company in arrears, net of commissions and other adjustments. Management recognizes revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as management believes that the reseller has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.
The Company distributes its products and solutions directly through its outside and inside sales force that is focused on serving local businesses in their local markets through a consultative process, which the Company refers to as its Direct Local channel. The Direct Local channel also includes revenue from licensing of the Company’s Kickserv software solution, which is marketed directly to local businesses over the Internet. In addition, the Company employs a separate sales channel targeting national brands, franchises and strategic accounts with operations in multiple local markets and select third-party agencies and resellers. The Company refers to this as its National Brands, Agencies and Resellers channel.
Cost of Revenue
Cost of revenue consists primarily of the costs of online media acquired from third-party publishers. Media cost is classified as cost of revenue in the period in which the corresponding revenue is recognized. From time to time, publishers offer the Company rebates based upon various factors and operating rules, including the amount of media purchased. Rebates are recorded in the period in which they are earned as a reduction to cost of revenue and the corresponding payable to the applicable publisher, or as an other receivable, as appropriate. Cost of revenue also includes the third-party telephone and information services costs, other third-party service provider costs, data center and third-party hosting costs, credit card processing fees, and other direct costs.
In addition, cost of revenue includes costs to manage and operate the Company’s various solutions and technology infrastructure, other than costs associated with the Company’s sales force, which are reflected as selling and marketing expenses. Cost of revenue includes salaries, benefits, bonuses and stock-based compensation for the related staff, and allocated overhead such as depreciation expense, rent and utilities. Cost of revenue also includes the amortization and impairment charges on certain acquired intangible assets.
Selling and Marketing Expenses
Selling and marketing expenses consist primarily of personnel and related expenses for selling and marketing staff, including salaries and wages, commissions and other variable compensation, benefits, bonuses and stock-based compensation; travel and business costs; training, recruitment, marketing and promotional events; advertising; other brand building and product marketing expenses; and occupancy, technology and other direct overhead costs. A portion of the compensation for employees in the sales organization is based on commissions. In addition, the cost of agency commissions is included in selling and marketing expenses. Generally, commissions are expensed as earned. However, commencing in 2014, the Company began paying commissions to certain sales people for the acquisition of new clients. Client contracts are generally not cancelable without a penalty, and the Company defers those commissions and amortizes them over the term of the initial customer campaign. Unamortized commission expense of $0.2 million and $0.6 million at December 31, 2015 and December 31, 2014, respectively, is included in prepaid expenses and other current assets in the accompanying consolidated balance sheets.
Product and Technology Expenses
Product and technology expenses consist primarily of personnel and related expenses for product development and engineering professionals, including salaries, benefits, bonuses and stock-based compensation, and the cost of third-party contractors and certain other third-party service providers and other expenses, including occupancy, technology and other direct overhead costs. Technology operations costs, including related personnel and third-party costs, are included in product and technology expenses. Research and development expenses are included in product and technology costs and were $6.9 million, $15.5 million, and $9.5 million during 2015, 2014, and 2013, respectively. The Company capitalizes a portion of its software development costs and, accordingly, includes amortization of those costs as costs of product and technology, as the Company’s technology platform and the Company’s other systems address all aspects of the Company’s activities, including supporting the selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back-office functions of the business. Product and technology expenses also include the amortization of the technology obtained in acquisitions and the expenses of deferred payment obligations related to product and technology personnel. Product and technology costs do not include the costs to operate and deliver the Company’s solutions to clients, which are included in cost of revenue in the consolidated statements of operations.
General and Administrative Expenses
General and administrative expenses consist primarily of personnel and related expenses for board, executive, legal, finance, human resources and corporate communications, including wages, benefits, bonuses and stock-based compensation, professional fees, insurance premiums, business taxes and other expenses, including occupancy, technology and other direct overhead, public company costs and other corporate expenses.
Restructuring Charges
The Company records costs associated with exit activities related to restructuring plans in accordance with the ASC Topic 420, Exit or Disposal Obligations. Liabilities for costs associated with an exit or disposal activity are recognized in the period in which the liability is incurred. Restructuring charges consist of costs associated with the realignment and reorganization of the Company’s operations. Restructuring charges include employee termination costs, facility closure and relocation costs, and contract termination costs. The timing of associated cash payments is dependent upon the type of exit cost and can extend over a 12-month period. The Company records restructuring charge liabilities in accrued restructuring in the consolidated balance sheets.
Advertising Expenses
The Company expenses advertising as incurred. Advertising expense was $2.1 million, $2.9 million and $1.7 million for the years ended December 31, 2015, 2014 and 2013, respectively, and was recorded in sales and marketing expense in the consolidated statements of operations.
Stock-Based Compensation
The Company accounts for stock-based compensation based on the fair market value of the equity award on the date of grant. The Company follows the attribution method, which reduces current stock-based compensation expenses recorded by the effect of anticipated forfeitures. Management estimates forfeitures based upon its historical experience.
The fair value of each award is estimated on the date of the grant and amortized over the requisite service period, which is the vesting period. The Company uses the Black-Scholes option pricing model to estimate the fair value of stock option awards on the date of grant. Determining the fair value of stock option awards at the grant date under this model requires judgment, including estimating volatility, expected term and the risk-free interest rate. The fair value of restricted stock and restricted stock unit awards is based on the closing market price of the Company's common stock on the date of grant. In addition, the Company uses a Monte Carlo simulation model to estimate the fair value of market-based performance-vesting restricted stock and restricted stock units. Determining the fair value of these awards at the grant date under this model requires judgment, including estimating volatility, risk-free rate and expected future stock price. The Company determines the probability of achievement of performance milestones for non-market based performance vesting restricted stock and restricted stock units, and recognize expense based on the fair value of the award if it is probable that the performance milestone will be achieved. The assumptions described above rely on management estimates based on judgment and subjective future expectations, which may result in stock-based compensation for future awards that differs significantly from the awards granted previously.
The fair value of modifications to stock-based awards is generally estimated using the Black-Scholes option pricing model. If a stock-based compensation award is modified after the grant date, incremental compensation expense is recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. Incremental compensation expense for fully vested awards is recognized immediately. For unvested awards, the sum of the incremental compensation expense and the remaining unrecognized compensation expense for the original award on the modification date is recognized over the modified service period.
Income Taxes
The Company records income taxes using the asset and liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in its financial statements or tax returns. In estimating future tax consequences, all expected future events other than enactments or changes in the tax law or rates are considered. Valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized.
The Company records tax benefits for income tax positions only if it is “more-likely-than-not” to be sustained based solely on its technical merits as of the reporting date. Management considers many factors when evaluating and estimating tax positions and tax benefits, which may require periodic adjustments and which may differ from actual outcomes. The Company follows a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. The Company’s policy is to recognize interest and penalties related to tax in income tax expense.
Recent Accounting Pronouncements Adopted in 2015
In November 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-17, Balance Sheet Classification of Deferred Taxes. The amendments in this update require that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. Early application is permitted for all entities as of the beginning of an interim or annual reporting period. The Company early adopted this standard retrospectively and reclassified all of the current deferred tax assets to noncurrent deferred tax assets on the consolidated balance sheets for all periods presented. Adoption resulted in a $1.8 million decrease in prepaid expenses and other current assets, a $0.1 million increase in other assets, and a $1.7 million increase in deferred rent and other liabilities in the Company’s consolidated balance sheet as of December 31, 2014.
In April 2015, the FASB issued ASU No. 2015-03, Interest- Imputation of Interest. The amendments in this update require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the corresponding debt liability, consistent with debt discounts. The Company early adopted this update in the second quarter of 2015.
In April 2014, the FASB issued ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this update changes the criteria for determining which disposals can be presented as discontinued operations and modifies related disclosure requirements. The guidance applies prospectively to new disposals and new classifications of disposal groups as held for sale after the effective date, and was effective for the Company as of January 1, 2015. The Company has applied this guidance to the Company’s consolidated financial statements in 2015.
Recent Accounting Pronouncements Not Yet Adopted
In February 2016, the FASB issued ASU No. 2016-02, Leases. The amendments in this update supersedes the guidance in former Accounting Standards Codification (“ASC”) 840, Leases with ASC 842, Leases, to increase transparency and comparability among organizations by requiring recognition of lease assets and lease liabilities on the balance sheet and disclosure of key information about leasing arrangements. The amendments in this update are effective for the Company as of January 1, 2019. Early application of this update is permitted. The guidance is required to be adopted at the earliest period presented using a modified retrospective approach. The Company is currently assessing the impact of this update on its consolidated financial statements.
In January 2016, the FASB ASU No. 2016-01, Financial Instruments- Overall. The amendments in this update address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments in this update are effective for the Company as of January 1, 2018. Early application of certain aspects of the amendment is permitted by public entities, otherwise early adoption is not permitted. The Company is currently assessing the impact of this update on its consolidated financial statements.
In September 2015, the FASB issued ASU No. 2015-16, Business Combinations. The amendments in this update require that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments require that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. The amendments in this update require an acquirer to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The amendments in this update are effective for the Company as of January 1, 2016. The amendments in this update should be applied prospectively to adjustments to provisional amounts that occur after the effective date of this update. The Company is currently assessing the impact of this update, and believes that its adoption on January 1, 2016 will not have a material impact on the consolidated financial statements.
In April 2015, the FASB issued ASU No. 2015-05, Intangibles-Goodwill and Other-Internal-Use Software. The amendments in this update provide guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The Company is currently assessing the impact of this update on its consolidated financial statements.
In February 2015, the FASB issued ASU No. 2015-02, Consolidation. The amendments in this update require management to reevaluate whether certain legal entities should be consolidated. Specifically, the amendments (1) modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIEs) or voting interest entities, (2) eliminate the presumption that a general partner should consolidate a limited partnership, (3) affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships, and (4) provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. The amendments in this update are effective for the Company as of January 1, 2016. Early adoption is permitted. The Company is currently assessing the impact of this update, and believes that its adoption on January 1, 2016 will not have a material impact on its consolidated financial statements.
In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements - Going Concern. The amendments in this update require management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. Specifically, the amendments (1) provide a definition of the term substantial doubt, (2) require an evaluation every reporting period including interim periods, (3) provide principles for considering the mitigating effect of management’s plans, (4) require certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans, (5) require an express statement and other disclosures when substantial doubt is not alleviated, and (6) require an assessment for a period of one year after the date that the financial statements are issued (or available to be issued). The amendments in this update are effective for the Company as of January 1, 2017. The adoption of this standard is not expected to have an impact on the Company’s consolidated financial statements.
In June 2014, the FASB issued ASU No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. The amendments in this update require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Accounting Standards Codification (“ASC”) 718, Compensation - Stock Compensation, as it relates to awards with performance conditions that affect vesting to account for such awards. The amendments in this update will be effective for the Company as of January 1, 2016. Earlier adoption is permitted. Entities may apply the amendments in this update either: (a) prospectively to all awards granted or modified after the effective date; or (b) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. If retrospective transition is adopted, the cumulative effect of applying this update as of the beginning of the earliest annual period presented in the financial statements should be recognized as an adjustment to the opening retained earnings balance at that date. In addition, if retrospective transition is adopted, an entity may use hindsight in measuring and recognizing the compensation cost. The Company is currently assessing the impact of this update, and believes that its adoption on January 1, 2016 will not have a material impact on its consolidated financial statements.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. The guidance in this update supersedes the revenue recognition requirements in ASC 605, Revenue Recognition, and most industry-specific guidance throughout the Codification. Additionally, this update supersedes some cost guidance included in ASC 605-35, Revenue Recognition - Construction-Type and Production-Type Contracts. In addition, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer (for example, assets within the scope of ASC 360, Property, Plant, and Equipment, and intangible assets, within the scope of ASC 350, Intangibles - Goodwill and Other) are amended to be consistent with the guidance on recognition and measurement in this update. The standard was to be effective for the Company as of January 1, 2017, but in August 2015, the FASB delayed the effective date of the new revenue accounting standard to January 1, 2019, and would permit early adoption as of the original effective date. Earlier adoption is not otherwise permitted for public entities. An entity can apply the revenue standard retrospectively to each prior reporting period presented (full retrospective method) or retrospectively with the cumulative effect of initially applying the standard recognized at the date of initial application in retained earnings (simplified transition method). The Company is currently assessing the impact of this update on its consolidated financial statements.
3. Fair Value of Financial Instruments
The Company applies the fair value hierarchy for its financial assets and liabilities. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs, of which the first two are considered observable and the last is considered unobservable, that are used to measure fair value:
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Level 1-Quoted prices in active markets for identical assets or liabilities.
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Level 2-Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
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Level 3-Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
The following table summarizes the basis used to measure certain of the Company’s financial assets and liabilities that are carried at fair value (in thousands):
The Company’s restricted cash is valued using pricing sources and models utilizing market observable inputs, as provided to the Company by its broker.
On April 10, 2015, ReachLocal New Zealand Limited (“RL NZ”) paid NZ$0.4 million ($0.3 million) of earn-out consideration due, offset by NZ$0.2 million ($0.1 million) pursuant to a net working capital adjustment in the Company’s favor. On September 18, 2015, RL NZ made the final payment of $0.1 million for the indemnity holdback.
The Company also has an investment in a privately held partnership that is one of its service providers. During March 2013, the Company invested $2.5 million for a 4% equity interest in the service provider, and in March 2014, the Company invested $2.0 million for an additional 3.2% equity interest. The Company does not have significant influence over the entity. In addition, the Company has an equity interest of 14.2% in SERVIZ, Inc., the entity that acquired its former ClubLocal business and does not have significant influence over the entity. The carrying amounts of the Company’s cost method investments were each $4.5 million at December 31, 2015 and December 31, 2014, and are included in non-marketable investments in the accompanying consolidated balance sheet. The Company’s maximum exposure to loss is limited to its cost based investments.
Financial Instruments Not Recorded at Fair Value on a Recurring Basis
The Company carries its financial instruments at fair value with the exception of its debt. Financial instruments that are not recorded at fair value are measured at fair value on a quarterly basis for disclosure purposes. The carrying amounts and estimated fair values of financial instruments not recorded at fair value are as follows:
The Company’s debt relates to its Hercules Loan Agreement and VantagePoint Notes. The term loan and notes are considered Level 3 under ASC 820 because there is no known or accessible market or market indices for these debt instruments to be traded or exchanged. The fair value of the Hercules Loan Agreement and the VantagePoint Notes was determined by discounting their respective cash flows expected to be paid using a discount rate commensurate with the risk, including market participant assumptions about current interest rates and the creditworthiness of the Company. The fair value of the Hercules Loan Agreement includes the discounts attributable to issuance costs as well as the end-of-term payment. The fair value of the VantagePoint Notes includes an estimated value for the embedded conversion feature determined based on its contractual terms as well as the trading information of the Company's common stock into which the notes are convertible.
During 2015, the Company recognized a $27.8 million goodwill impairment charge related to the Company’s Asia Pacific reporting unit. The Company recognized an impairment charge to write-down the goodwill to its fair value. The Company utilized unobservable inputs in determining the magnitude of the non-recurring impairment representing level 3 inputs in the fair value hierarchy.
The Company did not have any financial instruments not recorded at fair value on a recurring basis as of December 31, 2014.
4. Acquisitions
Acquisition of Kickserv
On November 21, 2014, the Company acquired Kickserv, Inc. (“Kickserv”) as part of the Company’s continued effort to expand its product offerings. Kickserv is a provider of cloud-based business management software for service businesses.
The purchase price consisted of $6.75 million of initial consideration, subject to a holdback and certain adjustments, and up to $4.0 million of earn-out consideration. At closing, the Company paid $5.3 million in cash with the remaining balance of the initial purchase price payable after the 18-month anniversary of the closing date, subject to certain conditions. The Company also issued 250,000 restricted stock units to the hired employees, which are accounted for as stock-based compensation over the period in which they are earned. A liability was not recorded for the earn-out consideration as the financial targets, as defined in the purchase agreement, are not expected to be achieved. Any changes in the fair value of the earn-out consideration will be recorded as other income or expense. There has been no change in the fair value since the date of acquisition.
The acquisition was accounted for using the acquisition method of accounting. The Company completed and finalized the purchase price allocation in the fourth quarter of 2014. The Company recorded assets acquired and liabilities assumed at their respective fair values. The following table summarizes the final fair value of assets acquired and liabilities assumed (in thousands):
Intangible assets acquired from Kickserv included software technology of $3.0 million, trade names of $0.6 million and customer relationships of $0.7 million, amortized over eight, ten, and four years, their respective estimated useful lives, using the straight-line method. The estimated useful life of the technology was determined based on assumptions of its remaining economic life. The estimated useful life of trade names was determined based on assumptions of revenue attributable to the trade name, and the estimated useful life of the customer relationships was determined based on assumptions of customer attrition rates. The fair value of the intangible assets were determined by applying the income approach and based on significant inputs that are not observable in the market. Key assumptions include estimated future revenues from acquired customers and a discount rate of 15%, comprised of an estimated internal rate of return for this transaction and a weighted average cost of capital for comparable companies. The goodwill arising from the acquisition consists largely of the synergies expected from combining the operations of Kickserv and the Company. The acquired goodwill is not expected to be deductible for tax purposes.
Acquisition costs in connection with the Kickserv acquisition were immaterial. The revenues and results of operations of the acquired businesses for the post-acquisition period were included in the consolidated statements of operations and were immaterial for the periods ended December 31, 2015 and December 31, 2014. The pro forma results are not shown as the impact is not material.
Acquisition of SureFire
On March 21, 2014, RL NZ acquired certain assets and hired certain employees of SureFire Search Limited (“SureFire”) as part of the Company’s international expansion plan. From 2010 until the acquisition, SureFire was the Company’s exclusive reseller in New Zealand.
At closing, RL NZ paid NZ$1.7 million ($1.5 million) in cash of the estimated NZ$2.8 million ($2.4 million) purchase price. The remaining balance of the estimated purchase price was deferred subject to meeting revenue targets and an indemnity holdback, payable, if at all, after the 12-month anniversary of the closing date, and the 12- and 18-month anniversaries of the closing date, respectively. The maximum amount of contingent consideration payable was NZ$2.0 million and the fair value of the contingent consideration was recorded as an accrued expense. The fair value of the earn-out consideration under the income approach was determined at the time of acquisition by using the Black-Scholes option pricing model. This approach is based on significant inputs that are not observable in the market, which are considered Level 3 inputs. Key assumptions include forecasted first year revenue, volatility of 30% based on volatilities of selected comparable companies, and a risk-free rate of 0.14% based on a one-year U.S, treasury yield rate. The liability for the indemnity holdback was recorded based on the assumption that there would be no claims made against the holdback and that 65% ($0.2 million) of the indemnity holdback would be paid April 2015, and the remaining 35% ($0.1 million) would be paid October 2015. The fair value of the indemnity holdback at the date of acquisition was NZ$0.4 million ($0.3 million). On April 10, 2015, RL NZ paid NZ$0.6 million ($0.4 million), which included NZ$0.4 million ($0.3 million) of earn-out consideration and NZ$0.3 million ($0.2 million) for the 12-month indemnity holdback release, offset by NZ$0.2 million ($0.1 million) to a net working capital adjustment in the Company’s favor. On September 18, 2015, RL NZ made the final payment of $0.1 million for the indemnity holdback.
The acquisition was accounted for using the acquisition method of accounting. The Company completed a preliminary purchase price allocation in the first quarter of 2014 and finalized the allocation in the third quarter of 2014 with respect to the timing of certain valuation adjustments. The Company recorded acquired assets and liabilities assumed at their respective fair values. The following table summarizes the final fair value of acquired assets and liabilities assumed (in thousands):
Intangible assets acquired from SureFire included customer relationships of $1.3 million which are amortized over three years, their estimated useful life, using the straight line method. The estimated useful life was determined based on assumptions of customer attrition rates. The fair value of the intangible assets was determined by applying the income approach and based on Level 3 inputs. Key assumptions include estimated future revenues from acquired customers and a discount rate of 25%, comprised of an estimated internal rate of return for this transaction and a weighted average cost of capital for comparable companies. The goodwill arising from the acquisition consists largely of the synergies expected from combining the operations of SureFire. The Company expects to increase its presence in the Asia-Pacific region as a result of this acquisition. The acquired goodwill is not expected to be deductible for tax purposes.
Acquisition costs in connection with the SureFire acquisition were immaterial. The revenues and results of operations of the acquired businesses for the periods post-acquisition were included in the consolidated statements of operations and were immaterial for the periods ended December 31, 2015 and December 31, 2014. The pro forma results are not shown as the impact is not material.
5. Goodwill and Finite-Lived Intangible Assets
Goodwill represents the excess of the purchase price of the Company’s acquired businesses over the fair value of the net tangible and intangible assets acquired. The Company accounts for goodwill in accordance with ASC 350, Intangibles-Goodwill and Other, which addresses financial accounting and reporting requirements for goodwill and requires testing of goodwill at the reporting unit level for impairment at least annually. The Company’s goodwill is comprised of balances in both the North America and Asia-Pacific reporting units. The Company tests the goodwill of its reporting units for impairment annually on the first day of the fourth quarter, and whenever events occur or circumstances change that would more likely than not indicate that the goodwill might be impaired.
The goodwill impairment test involves a two-step process. However, for the annual goodwill assessment prior to performing the two-step quantitative test, the Company has the option to first assess qualitative factors. In the first step, the Company compares the fair value of each reporting unit to its carrying value. If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired and no further testing is required. If the fair value of the reporting unit is less than the carrying value or if the carrying value of the reporting unit is negative, the Company must perform the second step of the impairment test to measure the amount of impairment loss. In the second step, the reporting unit's fair value is allocated to the assets and liabilities of the reporting unit, including any unrecognized intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the reporting unit was being acquired in a business combination. If the implied fair value of the reporting unit's goodwill is less than the carrying value, the difference is recorded as an impairment loss.
Impairment of Goodwill
During the quarter ended September 30, 2015, due to a decline in internal projections for the Asia-Pacific reporting unit of both revenue and profitability as a result of recent declines in its financial performance, the Company determined that sufficient indicators of potential impairment existed to require an interim quantitative goodwill impairment test for the Asia-Pacific reporting unit as of August 31, 2015. The amount of goodwill assigned to the Asia-Pacific reporting unit at August 31, 2015 was $34.1 million. Based on the Company’s revised forecasts, the carrying value of goodwill exceeded the implied fair value of goodwill for the Asia-Pacific reporting unit. As a result, the Company recorded an estimated impairment charge of $27.8 million for the goodwill in the Asia-Pacific reporting unit during the third quarter of 2015, which was finalized during the fourth quarter of 2015 without further adjustment and is included in impairment of goodwill in the accompanying consolidated statements of operations. The Company did not identify an impairment of its finite-lived intangible assets or other long-lived assets based on its estimates included in the second step of the quantitative test.
The process of estimating the fair value of goodwill is subjective and requires the Company to make estimates that may significantly impact the outcome of the analyses. The estimated fair value of the Asia-Pacific reporting unit as of August 31, 2015 was determined using both an income-based valuation approach, and a market-based valuation approach, each weighted 50%. Under the income approach, fair value of the reporting unit is estimated using the discounted cash flow method. The discounted cash flow method is dependent upon a number of factors, including projections of the amounts and timing of future revenues and cash flows, assumed discount rates determined to be commensurate with the risks inherent in its business model, and other assumptions. The future cash flows for the reporting unit were projected based on the Company’s estimates, at that time, of future revenues, operating income and other factors (such as working capital and capital expenditures). The Company considered expected competitive global industry and market conditions. Under the market-based valuation approach, each reporting unit’s fair value is estimated based on industry multiples of revenues and operating earnings.
The inputs of the discounted cash flow method used to determine the fair value of the Asia-Pacific reporting unit included a conservative average 3% growth rate to calculate the terminal value and a discount rate of 17%. Factors that have the potential to create variances in the estimated fair value of the Asia-Pacific reporting unit include, but are not limited to, fluctuations in (i) number of clients and active campaigns, which can be driven by multiple external factors affecting demand, including macroeconomic factors, competitive dynamics and changes in consumer preferences; (ii) marketing costs to generate new campaigns; and (iii) equity valuations of peer companies.
As of October 1, 2015, the date of the Company’s annual goodwill impairment assessment, the Company considered the recent interim quantitative goodwill impairment assessment, which included a reconciliation of the Company’s total market capitalization based on the estimated fair value of the Company’s individual reporting units as of August 31, 2015. The Company qualitatively determined that the existing facts and circumstances were considered in the quantitative interim impairment test, such that it was not necessary to perform the two-step quantitative goodwill impairment test for the North America and the Asia-Pacific reporting units as of the annual testing date.
As of November 30, 2015, due to the then recent significant declines in the Company’s market capitalization and other changes in the business, including consideration of exiting the U.K. market, and the entrance of ReachLocal UK Limited (“RL UK”), into administration, the Company determined that sufficient indicators existed to perform an interim quantitative goodwill impairment assessment of the North America and the Asia-Pacific reporting units.
The first step of the November 30, 2015 quantitative goodwill impairment test resulted in the determination that the estimated fair value of both the North America reporting unit and the Asia-Pacific reporting unit each substantially exceeded its respective carrying amount, including goodwill. Accordingly, the second step was not required. The inputs for the fair value calculations of the North America reporting unit included a conservative 2% growth rate to calculate the terminal value and a discount rate of 18%. The inputs for the fair value calculations of the Asia-Pacific reporting unit included a conservative 2% growth rate to calculate the terminal value and a discount rate of 20.5%. In addition, the Company assumed revenue growth and applied margin and other cost assumptions consistent with each reporting unit's historical trends. Factors that have the potential to create variances in the estimated fair value of the reporting units include, but are not limited to, fluctuations in (i) number of clients and active campaigns, which can be driven by multiple external factors affecting demand, including macroeconomic factors, competitive dynamics and changes in consumer preferences; (ii) marketing costs to generate new campaigns; and (iii) equity valuations of peer companies.
The changes in the carrying amount of goodwill for the year ended December 31, 2015 were as follows (in thousands):
Finite-Lived Intangible Assets
At December 31, 2015 and 2014, finite-lived intangible assets consisted of the following (in thousands):
Based on the current amount of intangibles subject to amortization, the estimated amortization expense over the remaining lives is as follows (in thousands):
For the year ended December 31, 2015, 2014 and 2013 amortization expense related to acquired intangible assets was $1.4 million, $1.2 million, and $1.2 million, respectively.
6. Property and Equipment
Property and equipment consisted of the following (in thousands):
For the years ended December 31, 2015, 2014 and 2013 depreciation expense for property and equipment was $6.4 million, $6.4 million and $5.8 million, respectively.
7. Software Development Costs
Capitalized software development costs consisted of the following (in thousands):
For the years ended December 31, 2015, 2014 and 2013, the Company recorded amortization expense of $11.4 million, $9.7 million and $8.1 million, respectively. At December 31, 2015 and 2014, $2.9 million and $5.0 million, respectively, of capitalized software development costs were related to projects still in process of development.
8. Commitments and Contingencies
Operating Leases
The Company leases office facilities under operating lease agreements that expire at various dates through 2024. The terms of the majority of the Company’s lease agreements provide for rental payments on a graduated basis. The Company recognizes rent expense on a straight-line basis over the lease term.
Rental expense, principally for leased office space under operating lease commitments, was $9.1 million, $13.0 million and $11.9 million for the years ended December 31, 2015, 2014 and 2013, respectively.
As of December 31, 2015, future minimum payments under cancelable and non-cancelable operating leases are as follows (in thousands):
During 2015 and 2014, the Company recorded facilities restructuring charges related to lease termination costs as a result of closing facilities as part of a restructuring plan. Operating lease payments in the table above, include approximately $2.4 million of lease payments related to terminated or restructured leases, net of actual sublease income of $0.4 million, from operating lease commitments for those facilities. Amounts related to the lease terminations will be paid over the respective lease terms, the longest of which extends through 2024.
As part of the Company’s 2015 Restructuring Plan, during March, 2016, the Company entered into an agreement to sublease 21,000 square feet of its Plano, Texas office.
Purchase Obligations
The Company has long-term purchase obligations outstanding with partners and third-party service providers for enhanced marketing functionality for its clients and for internal business software. As of December 31, 2015, future minimum payments under purchase obligations are as follows (in thousands):
Letters of Credit and Restricted Certificates of Deposit
At December 31, 2015 and 2014, the Company has certificates of deposit held at financial institutions, which are pledged as collateral for letters of credit related to lease commitments or collateral for the Company’s merchant accounts. The letters of credit will lapse at the end of the respective lease terms through 2024 and the certificates of deposit automatically renew for successive one-year periods over the duration of the lease term. The restrictions related to merchant accounts will lapse upon termination of the merchant accounts. At December 31, 2015 and 2014, the Company had restricted certificates of deposit in the amounts of $3.3 million and $3.4 million, respectively. At December 31, 2015, restricted cash also included $0.2 million of cash reserved to provide for potential liabilities for employee health care claims.
Litigation
From time to time, the Company is involved in legal proceedings arising in the ordinary course of its business. The Company believes that there is no litigation or claims pending or threatened that are likely to have a material adverse effect on its consolidated financial position, results of operations or cash flows.
North America
On May 2, 2014, a lawsuit, purporting to be a class action, was filed by one of the Company’s former clients in the United States District Court in Los Angeles. The complaint alleged breach of contract, breach of the implied covenant of good faith and fair dealing, and violation of California’s unfair competition law. The complaint sought monetary damages, restitution and attorneys’ fees. The Company filed a motion to dismiss on June 20, 2014, which was denied on December 4, 2014. On February 5, 2016, the Company entered into a confidential settlement agreement and release with plaintiffs to settle all of their claims. The settlement was not material to the Company’s consolidated financial position, results of operations or cash flows.
Europe
Over the past two years, the Company’s United Kingdom subsidiary (“RL UK”), has been involved in a number of disputes with former clients that allege RL UK made misrepresentations in connection with sales to those clients. The Company resolved a number of these disputes. On June 15, 2015, one former RL UK client filed a lawsuit in the High Court of Justice alleging fraudulent misrepresentations and breach of contract. The Company’s insurance carrier provided a defense under a reservation of rights. On December 16, 2015, RL UK entered administration, to allow for an orderly exit from the market and as a result, any claims against RL UK are stayed, pending the outcome of the administration. Upon entering administration, the Company no longer held a controlling interest, and therefore deconsolidated the subsidiary.
Other Commitments
The Company engaged a third party facilitator to provide direct support in the execution of its 2015 Restructuring Plan. In addition to fees incurred during 2015, the Company will continue to make payments for the final committed fees based on the future projected value of results achieved by the facilitator-led program. The final payment to the facilitator was made in January 2016. See Note 11, Restructuring Charges, for more information.
9. Stockholder’s Equity
Common Stock Repurchases
The Company’s Board of Directors previously authorized the repurchase of up to $47.0 million of the Company’s outstanding common stock. At December 31, 2013, the Company had executed repurchases of 3.4 million shares of its common stock under the program for an aggregate of $36.3 million. There were no repurchases under the program during 2014 or 2015. On April 29, 2015, the Board of Directors terminated the Company’s repurchase program.
The Company is deemed to repurchase common stock surrendered by participants to cover tax withholding obligations with respect to the vesting of restricted stock and restricted stock units.
Shares Reserved For Future Issuance
The following table shows the number of shares of common stock reserved for future issuance as of December 31, 2015 (in thousands):
10. Stock-Based Compensation
Stock Option Plans
On April 21, 2004, the Company adopted the 2004 Stock Plan (the “2004 Plan”), as amended. Grants under the 2004 Plan may be incentive stock options or nonqualified stock options or awards. The 2004 Plan is administered by the Company’s board of directors, which has the authority to designate participants and determine the number and type of awards to be granted, the time at which awards are exercisable, the method of payment and any other terms or conditions of the awards. The vesting of these awards varies subject to the participant’s period of future service, or otherwise at the discretion of the Company’s board of directors. The majority of awards vest over four years and have a term of 10 years. There were no shares available for grant under the 2004 Plan as of December 31, 2015 and 2014.
On July 1, 2008, the Company adopted the 2008 Stock Incentive Plan (the “2008 Plan”) and retired the 2004 Plan. Options outstanding under the 2004 Plan are unaffected by the retirement of the 2004 Plan. The aggregate number of shares of the Company’s common stock available for issuance pursuant to awards granted under the 2008 Plan is equal to the sum of (x) 5,471,350 plus (y) any shares of the Company’s common stock subject to awards under the 2004 Plan that terminate, expire or lapse for any reason or are settled in cash after the date the 2008 Plan originally became effective, and (z) an annual increase in shares on the first day of each year beginning in 2011 and ending in 2018. The annual increase will be equal to the lesser of (A) 2,500,000 shares (as adjusted for stock splits, stock combinations, stock dividends and similar matters), (B) 4.5% of the Company’s common stock outstanding on the last day of the prior year or (C) such smaller number of shares as may be determined by the Board. The 2008 Plan is administered by the Company’s Compensation Committee, which has the authority to designate participants and determine the number and type of awards to be granted, the time at which awards are exercisable, the method of payment and any other terms or conditions of the awards. The vesting of these awards vary subject to the participant’s period of future service, or otherwise at the discretion of the Compensation Committee. The majority of awards issued under the 2008 Plan vest over four years and have a term of seven years. There were 2,682,047 shares available for grant under the 2008 Plan as of December 31, 2015. On January 1, 2016, an additional 1,334,000 shares were added to the pool under the evergreen provision.
During the second quarter of 2014, the Company granted stock options to certain new employees as “employment inducement” awards pursuant to NASDAQ rules. The inducement awards were not issued under the 2008 Plan and did not decrease the number of shares available thereunder, but 160,000 inducement awards are included in the table of stock options below.
On February 29, 2016, the Company granted stock options covering 1,397,000 shares, primarily related to its annual compensation program.
Stock Options
The following table summarizes stock option activity (in thousands, except years and per share amounts):
The assumptions utilized for purposes of the Black-Scholes pricing model are summarized as follows:
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Volatility-As the Company has limited trading history for its common stock, the expected stock price volatility was estimated by taking a combination of 1) the median historic price volatility for industry peers based on daily price observations over a period equivalent to the expected term of the stock option grants and 2) the Company’s own historic price volatility based on daily price observations since May 2010. Industry peers consist of several public companies in the technology industry similar in size, stage of life cycle and financial leverage. Management did not rely on implied volatilities of traded options in its industry peers’ common stock because the volume of activity was relatively low.
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Expected term-The expected term was estimated using the simplified method allowed under Securities and Exchange Commission Staff Accounting Bulletin No. 107, Share-Based Payment. Management uses this method because it has limited historical data to estimate future terms and it is unable to obtain objective, measurable and comparative historical data of comparable companies.
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Risk free rate-The risk free interest rate is based on the yields of U.S. Treasury securities with maturities similar to the expected term of the options for each option group.
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Dividend yield-The Company has never declared or paid any cash dividends and does not presently plan to pay cash dividends in the foreseeable future. Consequently, management used an expected dividend yield of zero.
In addition, management estimates the forfeiture rate based on its historical experience with forfeitures and reviews estimated forfeiture rates each period-end, and makes changes as factors affecting the forfeiture rate calculations and assumptions change.
The following table summarizes the weighted average assumptions used to estimate the fair value of stock options granted during the years ended December 31, 2015, 2014 and 2013.
The aggregate intrinsic value of stock options exercised during the years ended December 31, 2015, 2014 and 2013 were $0.1 million, $2.7 million and $5.3 million, respectively. The total grant-date fair value of stock options exercised and restricted stock and restricted stock units vested during the years ended December 31, 2015, 2014 and 2013 were $3.7 million, $9.0 million and $4.2 million, respectively.
Restricted Stock and Restricted Stock Units
The Company issues restricted stock and restricted stock units in conjunction with acquisitions and long-term employee incentive programs from time to time. These shares of restricted stock and restricted stock units generally have vesting periods of 4 years. Stock-based compensation expense related to restricted stock and restricted stock units was $3.3 million, $5.6 million and $3.0 million for the years ended December 31, 2015, 2014, and 2013, respectively.
The following table summarizes restricted stock and restricted stock unit awards (in thousands, except per share amounts):
Stock-Based Compensation Expense
The Company records stock-based compensation expense, net of amounts capitalized as software development costs. The following table summarizes stock-based compensation (in thousands):
Stock-based compensation, net of capitalization, is included in the accompanying consolidated statements of operations, within the following captions (in thousands):
At December 31, 2015, there was $11.1 million of unrecognized stock-based compensation related to restricted stock, restricted stock units and outstanding stock options, net of estimated forfeitures. This amount is expected to be recognized over a weighted average period of 1.44 years. Future stock-based compensation expense for these awards may differ to the extent actual forfeitures vary from management estimates.
Stock-based compensation for the year ended December 31, 2014 includes $1.9 million of expense related to the modification of grants to 73 participants in March 2014, which extended the time to exercise from seven years to ten years for certain options granted during 2008 and 2009 with a strike price of $10.91.
Commencing in 2015, 50% of the Company’s annual corporate bonus plan for certain executives and senior level employees will be settled with fully vested restricted stock units, and is payable in the first quarter of the following fiscal year. The plan does not limit the number of shares that can be issued to settle the obligation. During 2015, the Company has recognized stock-based compensation expense related to this plan of $1.0 million. As of December 31, 2015, 603,000 shares would be required to satisfy the obligation relating to the 2015 annual corporate bonus plan. On February 26, 2016, 414,239 shares (net of 258,255 shares withheld to satisfy tax withholding obligations) were issued to satisfy the 2015 annual corporate bonus plan obligation.
Stock Option Exchange
On December 2, 2014, the Company commenced an option exchange to permit employee option holders to surrender certain outstanding stock options for cancellation in exchange for the grant of new replacement options to purchase an equal number of shares having an exercise price equal to the greater of $6.00 and the fair market value of the Company’s common stock on the replacement grant date. The option exchange was completed on January 9, 2015. Exchanged options were cancelled at that time and immediately thereafter, the Company granted replacement options under the Amended and Restated ReachLocal 2008 Stock Incentive Plan with exercise prices of $6.00 per share. A total of 2.8 million options were exchanged. The Company is amortizing the incremental expense of $1.5 million in addition to the remaining expense attributable to the exchanged awards over the vesting period of the new awards.
11. Restructuring Charges
The Company has implemented various restructuring plans to reduce its cost structure, align resources with its product strategy, improve operating efficiency and implement cost savings, which have resulted in workforce reductions and the consolidation of certain real estate facilities and data centers.
2015 Restructuring Plan
In accordance with the Company’s ongoing efforts to reduce expenses and improve the operating performance of its business, the Company commenced its 2015 Restructuring Plan. The initiative is focused on enhancing earnings through an analysis of opportunities to both improve revenue performance and reduce costs. Operational efficiency improvements under the 2015 Restructuring Plan are identified and implemented through strategic realignment and targeted cost reductions, including workforce costs, facility-related expenditures and other operating expenses. The charges incurred during the year ended December 31, 2015 primarily involved down-sizing certain facilities in North America, costs to utilize a third party facilitator to aid execution of the plan, and a reduction of the Company’s North American and international workforces. The Company expects to have continued restructuring activity under this plan, including estimated additional expenses relating to facilitation and execution of the plan of $0.7 million, estimated to be incurred through the third quarter of 2016.
A summary of the accrued restructuring liability related to this plan, which is recorded in “Accrued restructuring” on the consolidated balance sheet is as follows (in thousands):
The Company expects the facility closures and equipment write-downs to be paid through the third quarter of 2024 and the workforce reduction costs to be paid through the fourth quarter of 2016.
2014 Restructuring Plans
As a result of declining performance in the Company’s North American operations during the first quarter of 2014, the Company implemented a restructuring plan that primarily involved a reduction of the Company’s North American and international workforces, as well as the closure of facilities in North America and certain international markets. The Company does not expect to have continued restructuring activity under this plan, other than settlement of associated liabilities.
A summary of the accrued restructuring liability related to this plan, which is recorded in “Accrued restructuring” on the consolidated balance sheet is as follows (in thousands):
The Company expects the facility closures and equipment write-downs to be paid through the third quarter of 2024.
During the second quarter of 2014, the Company implemented a business restructuring plan which involved the elimination of certain senior management positions, a reduction of international workforce, as well as the closure of facilities in certain international markets. The Company does not expect to have continued restructuring activity under this plan, other than settlement of associated liabilities.
A summary of the accrued restructuring liability related to this plan, which is recorded in “Accrued restructuring” on the consolidated balance sheet is as follows (in thousands):
The Company does not expect to have continued restructuring activity under this plan.
12. Gain on Deconsolidation of Subsidiary
On December 16, 2015, RL UK entered administration to allow for an orderly exit from the market. Upon entering administration, the Company no longer held a controlling interest, and therefore deconsolidated the subsidiary. As a result, the Company recorded a gain of $2.9 million, which is included in Gain on deconsolidation of subsidiary, net in the Company’s consolidated statement of operations for the year ended December 31, 2015.
The gain is primarily comprised of the net reduction in carrying value of the assets and liabilities of RL UK from the consolidated balance sheet and the resulting reduction of the net amounts due from RL UK to the Company and its subsidiaries, including the effects of cumulative translation adjustments of $1.1 million, which was reclassified from accumulated other comprehensive income to Gain on deconsolidation of subsidiary, net in the consolidated statement of operations.
13. Debt and Other Obligations
Long-term debt consisted of the following (in thousands):
(1) Debt issuance costs are related to the Hercules term loan and are amortized to interest expense over the life of the term loan.
Hercules Term Loan
On April 30, 2015, the Company entered into the Hercules Loan Agreement with its direct and indirect domestic subsidiaries, as co-borrowers, Hercules Technology Growth Capital, Inc. (“Hercules”), as administrative agent, and the lenders party thereto from time to time (the “Lenders”), including Hercules, pursuant to which the Lenders agreed to make a term loan available to the Company for working capital and general business purposes, in a principal amount of $25.0 million. The term loan has an annual interest rate equal to the greater of (i) 11.75% and (ii) the sum of (a) the prime rate, plus (b) 8.50%. During December 2015, the annual interest rate increased from 11.75% to 12.00%. The annual interest rate on the Hercules Loan was 12.00% at December 31, 2015. On the closing date the Company paid a fee of $0.3 million, which is to be credited against the final payment, and debt issuance costs of $0.2 million. Debt issuance costs will be amortized over the life of the loan of 3 years and calculated using the effective interest method.
The Company is required to make interest-only payments on the term loan through May 1, 2016, though such payments may be extended through August 1, 2016 and November 1, 2016 if the Company remains in continuous compliance with the financial covenants under the Hercules Loan Agreement through April 1, 2016 and July 1, 2016, respectively, and no default or event of default has occurred and is continuing on such dates. The term loan will begin amortizing at the end of the applicable interest-only period, with monthly payments of principal and interest to the Lenders in consecutive monthly installments following the end of such interest-only period. The term loan matures on April 1, 2018 or, if the interest-only payments are extended through November 1, 2016, the term loan will mature October 1, 2018. Upon repayment of the term loan, the Company is also required to make an end-of-term payment to the Lenders equal to $1.5 million, which is accrued as interest based on the effective interest method over the 3-year term of the Hercules Loan Agreement. The term loan is secured by substantially all of the Company’s personal property, including its intellectual property.
At the Company’s option, the outstanding principal balance of the term loan may be prepaid in whole, or in part in a minimum amount of $2.5 million, subject to a prepayment fee of 3% of any amount prepaid if the prepayment occurs on or prior to April 30, 2016, or 2% of the amount prepaid if the prepayment occurs after April 30, 2016 but on or prior to April 30, 2017. If the prepayment occurs after April 30, 2017, there is no prepayment fee.
The Hercules Loan Agreement includes covenants applicable to the Company and its subsidiaries, which include restrictions on transferring collateral, incurring additional indebtedness, engaging in mergers or acquisitions, paying dividends or making other distributions, making investments, creating liens, selling assets, and undergoing a change in control, in each case subject to certain exceptions. These restrictions also include a maximum net new investment in the Company’s foreign subsidiaries, subject to certain exclusions of $8.0 million during 2015, $5.5 million during 2016, $4.0 million annually thereafter, and $18.0 million in the aggregate during the term of the agreement. Additionally, the Hercules Loan Agreement includes financial covenant requirements to maintain certain minimum levels of revenue and earnings during each three-month period, tested monthly, during the term, as amended on August 3, 2015 from September 30, 2015 through December 31, 2015. These minimum levels of revenue and earnings were waived for compliance for November and December 2015 as amended on November 9, 2015. Under the Hercules Loan Agreement, the Company is also required to maintain minimum cash in North America in an amount equal to $15.0 million at all times, unless the Company achieves positive “Adjusted EBITDA” as defined in the Hercules Loan Agreement for three consecutive quarters, in which case the minimum cash balance decreases to $12.5 million. The Company achieved positive “Adjusted EBITDA” as defined, during the quarters ended September 30, 2015 and December 31, 2015, which qualifies as two quarters of the required three consecutive quarters. The Hercules Loan Agreement also includes events of default, the occurrence and continuation of which provide Hercules, as administrative agent, with the right to exercise remedies against the Company and the collateral securing the term loan, including potential foreclosure against the Company’s assets securing the Hercules Loan Agreement, including the Company’s cash. The Hercules Loan Agreement contains a subjective acceleration clause that can be triggered if the Company experiences a Material Adverse Effect, as defined in the Hercules Loan Agreement, which would be considered an event of default.
On August 3, 2015, the Company entered into an amendment to the Hercules Loan Agreement, which reduced the term loan’s covenant thresholds for revenue for the months ending September 30, 2015 through December 31, 2015. On November 9, 2015, the Company entered into a second amendment to the Hercules Loan Agreement, which waives compliance with the term loan’s revenue and earnings covenant thresholds for November and December 2015. In connection with the amendment, the Company (i) paid Hercules a one-time fee of $0.2 million, (ii) reset the schedule of prepayment fees to begin from the November 9, 2015, instead of April 30, 2016, and (iii) agreed to amend the Hercules warrant as described below. On December 17, 2015 the Company entered into the third amendment to the Hercules Loan Agreement, which reduces the amount of restricted cash the Company is required to maintain in North America from $17.5 million to $15.0 million and which amount will further be reduced to $12.5 million if the Company achieves positive “Adjusted EBITDA” as defined in the loan agreement. The Company is in compliance with all of the Hercules Loan Agreement’s covenants as of December 31, 2015.
Hercules Warrant
Concurrently with entrance into the Hercules Loan Agreement, the Company issued to Hercules, as the sole lender on the closing date, a warrant to purchase up to 177,304 shares of the Company’s common stock at an exercise price of $2.82 per share. In connection with the November 9, 2015 Hercules Loan Agreement amendment, the Company agreed to amend the warrant to increase the number of shares to 300,000 and reduce the exercise price to $0.85. The warrant is exercisable in full and not in part. In addition, if upon the sale of all shares issued upon exercise of the warrant, or in the case of a merger or sale transaction involving other securities in whole or in part, upon the sale of such securities, the absolute return on the warrant exceeds $2.55 per share underlying the warrant, the warrant holder will pay the Company the excess in cash. The warrant may be exercised either for cash or on a cashless basis. The warrant expires April 30, 2022. The Company estimated the fair value of the warrant to be $0.3 million based on its relative fair value to the term loan using a Black-Sholes pricing model and accounted for the warrant as a discount on the carrying amount of the term loan and a component of additional paid-in capital. The fair value of the warrant will be amortized in the statement of operations as a component of interest expense.
VantagePoint Convertible Notes (Related Party)
On December 17, 2015, the Company entered into a convertible note purchase agreement with affiliates of the Company’s largest shareholder, VantagePoint, for the immediate issuance of $5.0 million of VantagePoint Notes. The note purchase agreement also provides for the issuance and sale of up to an additional $5.0 million aggregate principal amount of convertible notes, upon mutual agreement of ReachLocal and VantagePoint (and Hercules’ consent). The notes bear an annual interest rate of 4%, compounded quarterly. The Company is required to begin making quarterly interest and principal payments on April 15, 2017, subject to a subordination agreement with Hercules. The VantagePoint Notes mature on April 15, 2018, and all principal and unpaid interest is due at that time. The holders of the VantagePoint Notes have the right to convert any portion of the VantagePoint Notes into shares of ReachLocal common stock, par value $0.00001 per share, at an initial conversion rate of 200 shares of common stock per $1,000 principal amount of VantagePoint Notes, which represents an initial conversion price of $5.00 per share. The conversion rate is subject to customary anti-dilution adjustments for stock dividends, splits and combinations, certain distributions on the common stock, including cash dividends, spin-offs and certain tender or exchange offers for the common stock. An event of default, as defined in the agreement, may result in the acceleration of the maturity of the notes. The VantagePoint Notes are included in convertible notes - related party in the accompanying consolidated balance sheet.
On February 4, 2016, the Company entered into an amendment to the VantagePoint Notes. The amendment provides that, except in certain circumstances, the convertibility of the VantagePoint Notes is limited such that conversion may not result in the holders collectively acquiring beneficial ownership of more than 1.9% of the Company’s outstanding shares of common stock during any 12-month period.
VantagePoint and its affiliates beneficially own approximately 43% of the Company’s common stock and VantagePoint’s Chief Executive Officer and Managing Partner, is a member of the Company’s Board of Directors.
The VantagePoint Notes and Hercules Loan Agreement contain cross-default provisions whereby a default under one agreement would likely result in cross defaults under agreements covering other borrowings. The occurrence of a default under any of these borrowing arrangements would permit the applicable note holders or the lenders under the term loan to declare all amounts outstanding under those borrowing arrangements to be immediately due and payable.
Future Debt Maturities
Aggregate principal payments, exclusive of any unamortized debt issuance costs or discounts, due on debt as of December 31, 2015 are as follows (in thousands):
Capital Leases
The Company has entered into non-cancelable capital leases for computer equipment. At December 31, 2015, the Company had $1.2 million of capital leases, net of accumulated amortization of $0.8 million, of which $0.7 million is recorded in short-term liabilities and $0.5 million is recorded in long-term liabilities. Amortization of assets recorded under capital leases is included in depreciation expense. The interest rates on these leases range from 4.8% to 5.2%. As of December 31, 2015, future minimum payments under these leases are as follows (in thousands):
14. Income Taxes
The components of income (loss) from continuing operations before income taxes were (in thousands):
The provision for income taxes for the years ended December 31, 2015, 2014 and 2013, consists primarily of federal, state and foreign income taxes payable in the various jurisdictions in which the Company operates.
Significant components of the provision for income taxes are as follows (in thousands):
Income taxes payable as of December 31, 2015 amounted to $0.1 million and was classified within “Other current liabilities” in the accompanying consolidated balance sheet. Income taxes receivable as of December 31, 2014 amounted to $2.0 million and was classified within prepaid expenses and other current assets in the accompanying consolidated balance sheet.
The provision for income taxes differs from the amount computed by applying the federal statutory income tax rate to income before income taxes as follows (in thousands):
The components of deferred income tax assets and liabilities are as follows (in thousands):
(a)
For the years ended December 31, 2014 and 2013, the presentation of foreign income tax expense, net operating loss carryforward deferred tax asset, and corresponding valuation allowance have been revised in the above tables due to a prior overstatement of foreign net operating losses in both respective years. As a result of the valuation allowance recorded against the foreign net deferred tax assets, there is no impact to the accompanying consolidated balance sheets or statement of operations.
In the accompanying consolidated balance sheets, the non-current portion of deferred tax assets of $0.2 million and $0.1 million as of December 31, 2015 and 2014, respectively, is included in other assets. The non-current portion of net deferred tax liabilities of $0.9 million and $0.7 million as of December 31, 2015 and 2014, is included in deferred rent and other liabilities.
The following table summarizes the Company’s net operating loss carryforwards as of December 31, 2015:
The federal net operating loss and research and development credit carryforwards per the income tax returns filed included unrecognized tax benefits taken in prior years, and are larger than the net operating losses and credits for which a deferred tax asset is recognized for financial statement purposes.
As of December 31, 2015, the Company had gross federal and state research and development credit carryforwards of approximately $5.3 million and $3.9 million, respectively. The federal carryovers begin to expire in 2024, while the state carryovers have an indefinite carryover period. At December, 31, 2015, the Company had $0.1 million of foreign tax credits carryovers which begin to expire in 2023. As of December 31, 2015, the Company had gross California Enterprise Zone Credits of $1.4 million which begin to expire in 2024.
Certain deferred tax assets are not presented that arose directly from tax deductions related to equity compensation greater than the amount of compensation recognized for financial reporting. Equity will be increased by $2.2 million if and when such deferred tax assets are ultimately realized.
As of December 31, 2015 and 2014, the Company recorded valuation allowances of $36.5 million and $28.1 million, respectively, as the Company has determined that it is more likely than not that the deferred tax assets will not be realized. Due to the Company’s cumulative losses in U.S. and certain foreign jurisdictions, management has concluded that a full valuation allowance continues to be warranted with respect to the net deferred tax assets in these jurisdictions, excluding indefinite lived assets.
In 2015, the net increase in valuation allowance of $8.5 million was primarily due to net operating losses in domestic and foreign jurisdictions and the deconsolidation of RL U.K. In 2014, the net increase in valuation allowance of $12.8 million was primarily due to net operating losses in foreign jurisdictions and the recording of a full valuation allowance against its net domestic deferred tax assets, excluding indefinite lived assets.
The book value of the Company’s investments in foreign subsidiaries exceeds its tax basis in those subsidiaries by $1.0 million. However, the deferred income taxes on the associated gain have not been recognized, as gains become taxable upon a repatriation of assets from the subsidiary or a sale or liquidation of the subsidiary, and these amounts are expected to be reinvested indefinitely outside of the U.S. Determination of the amount of any unrecognized deferred income tax liability on this temporary difference is not practicable because of the complexities of the hypothetical calculation.
At December 31, 2015, the Company had gross unrecognized tax benefits of approximately $1.6 million. Of this total, approximately $1.5 million would affect the Company’s effective tax rate if recognized. The liabilities for unrecognized tax benefits are primarily recorded as a reduction of gross deferred taxes which are included in deferred rent and other liabilities in the accompanying balance sheets.
A reconciliation of the beginning and ending amounts of gross unrecognized tax benefits is as follows (in thousands):
The Company expects a decrease of $0.8 million of unrecognized tax benefits in the next 12 months due to expiration of the applicable statute of limitations. These unrecognized tax benefits relate to the formation of a foreign joint venture.
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. Related to the unrecognized tax benefits noted above, the Company accrued no interest or penalties during 2015 and in total, as of December 31, 2015, has not recognized a liability for interest and penalties.
The Company and its subsidiaries file income tax returns in the U.S. federal, various state and foreign jurisdictions. Certain statutes begin to expire as early as 2016.
In May of 2015, the Internal Revenue Service initiated an examination of the Company’s U.S. consolidated 2013 and 2014 income tax returns that was finalized in December 2015 with no proposed adjustments.
15. Retirement Contribution Plans
The Company provides a defined contribution savings plan under Section 401(k) of the Internal Revenue Code and certain other plans in other countries. The 401(k) plan is available to all full-time U.S. employees and allows participants to defer a portion of their annual compensation on a pre-tax basis. The Company may contribute to the 401(k) plan at the discretion of its board of directors. No contributions have been made to the plan during the years ended December 31, 2015, 2014 and 2013.
16. Net Income (Loss) Per Share
Basic net income (loss) from continuing operations per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period. Shares of unvested restricted stock are excluded from the calculation of basic weighted average shares outstanding, but their dilutive impact is added back in the calculation of diluted weighted average shares outstanding. Diluted net income (loss) from continuing operations per share is computed by dividing the net income (loss) for the period by the weighted average number of common and potential dilutive shares outstanding during the period, to the extent such shares are dilutive. Potential dilutive shares are composed of incremental common shares issuable upon the exercise of stock options, warrants and unvested restricted shares using the treasury stock method and shares issuable upon the conversion of convertible debt using the if-converted method. The Company had a loss from continuing operations for the year ended December 31, 2015 and therefore the number of diluted shares was equal to the number of basic shares for the period.
The following potentially dilutive securities have been excluded from the calculation of diluted net loss per common share as they would be anti-dilutive for the periods below (in thousands):
The following table sets forth the computation of basic and diluted income (loss) from continuing operations per share (in thousands, except per share amounts):
17. Variable Interest Entities
In July 2012, the Company entered into a franchise agreement with OxataSMB B.V. permitting it to operate and resell the Company’s services under the ReachLocal brand in Slovakia, Czech Republic, Hungary, Poland and Russia. At the same time, the Company entered into a market development loan agreement with OxataSMB pursuant to which we agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) was immediately advanced and €0.92 million ($1.2 million) was advanced in August 2013. The OxataSMB operations did not perform as contemplated, and as a result, the Company recorded a $3.3 million impairment of the loan receivable and related interest from OxataSMB and a $1.6 million provision for bad debt related to the trade receivable from OxataSMB. Ultimately we terminated OxataSMB’s franchise agreement in the fourth quarter of 2014 and have not been repaid any amounts under the loan.
18. Segment Information
Revenue by geographic region with respect to the Direct Local channel and National Brands, Agencies and Resellers, is based on the physical location of the sales office, and with respect to Agencies and Resellers, is based on the physical location of the agency or reseller. The following summarizes revenue by geographic region (in thousands):
The results of the Australia geographic region have been included in the Company’s consolidated financial statements and include revenues of $52.5 million, $80.3 million, and $85.0 million in 2015, 2014 and 2013, respectively. Long-lived assets of the Australia geographic region were $1.7 million at December 31, 2015 and 2014.
The Company operates in one operating segment. The Company’s chief operating decision maker manages the Company’s operations on a consolidated basis for purposes of evaluating financial performance and allocating resources.
19. Supplemental Cash Flow Information
The following table sets forth supplemental cash flow disclosures (in thousands):
20. Discontinued Operations
ClubLocal
In the fourth quarter of 2013, the Company’s Board of Directors approved a plan to dispose of the Company’s ClubLocal business, and on February 18, 2014, the Company closed a transaction in which it transferred its ClubLocal business to SERVIZ, Inc. in exchange for a minority equity interest. The Company has an equity interest in the new entity of 14.2%, with a recorded fair value of $4.5 million. As a result of the disposition, in the first quarter of 2014 the Company recorded a gain on disposal of $0.8 million, net of income tax of $0.4 million. This business has been accounted for as discontinued operations.
21. Quarterly Information (Unaudited)
The following table sets forth unaudited and quarterly financial data for the four quarters of each of 2015 and 2014.
22. Subsequent Events
Amendment to Hercules Loan Agreement
On March 25. 2016, the Company and certain of its affiliates entered into a Fourth Amendment to Loan and Security Agreement with Hercules Capital, Inc. (formerly Hercules Technology Capital, Inc.), as administrative agent and lender. The loan amendment amends the Hercules Loan Agreement to increase the maximum net new investment in the Company’s foreign subsidiaries during 2016 from $4.0 million to $5.5 million.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, as of March 30, 2016.
POWER OF ATTORNEY
Each person whose individual signature appears below hereby authorizes and appoints Sharon Rowlands and Ross Landsbaum, and each of them, with full power of substitution and resubstitution and full power to act without the other, as his or her true and lawful attorney-in-fact and agent to act in his or her name, place and stead and to execute in the name and on behalf of each person, individually and in each capacity stated below, solely for the purposes of filing any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing, ratifying and confirming all that said attorneys-in-fact and agents or any of them or their or his substitute or substitutes may lawfully do or cause to be done by virtue thereof solely for the purposes stated therein.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the date indicated.
Signature
Title
Date
/s/ Sharon T. Rowlands
Chief Executive Officer, Director
March 30, 2016
Sharon T. Rowlands
(Principal Executive Officer)
/s/ Ross G. Landsbaum
Chief Financial Officer
March 30, 2016
Ross G. Landsbaum
(Principal Financial Officer and Principal Accounting Officer)
/s/ James Geiger
Director
March 30, 2016
James Geiger
/s/ Thomas Hale
Director
March 30, 2016
Thomas Hale
/s/ Habib Kairouz
Director
March 30, 2016
Habib Kairouz
/s/ Lawrence Kutscher
Director
March 30, 2016
Lawrence Kutscher
/s/ Alan Salzman
Director
March 30, 2016
Alan Salzman
/s/ Edward Thompson
Director
March 30, 2016
Edward Thompson
10.6*
Offer Letter between ReachLocal, Inc. and Kris Barton, dated January 30, 2012 (incorporated by reference to Exhibit 10.01 of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014 (File No. 001-34749) filed with the SEC on May 8, 2014)
10.7*
Employment Letter between ReachLocal, Inc. and Adam Wergeles, dated November 15, 2007, as amended (incorporated by reference to Exhibit 10.3 of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015 (File No. 001-34749) filed with the SEC on May 6, 2015)
10.8*
Transition Agreement between ReachLocal, Inc. and Adam Wergeles, dated March 9, 2015 (incorporated by reference to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015 (File No. 001-34749) filed with the SEC on May 6, 2015)
10.9*
Form of Amended and Restated Restricted Stock Purchase Agreement (incorporated by reference to Exhibit 10.15 of the Company’s Amendment No. 1 to the Registration Statement on Form S-1 (File No. 333-163905) filed with the SEC on February 2, 2010)
10.21*
Form of Performance-Vesting Restricted Stock Award Agreement (incorporated by reference to Exhibit 99.1 of the Company’s Form 8-K (File No. 001-34749) filed with the SEC on February 15, 2013)
10.22*
Form of Stock Option Agreement (Regulation D Early Exercise) (incorporated by reference to Exhibit 10.06 of the Company’s Amendment No. 1 to the Registration Statement on Form S-1 (File No. 333-163905) filed with the SEC on February 2, 2010)
10.23*
Form of Stock Option Agreement (Rule 701) (incorporated by reference to Exhibit 10.07 to the Company’s Amendment No. 1 to the Registration Statement on Form S-1 (File No. 333-163905) filed with the SEC on February 2, 2010)
10.24*
Form of Non-Employee Director Stock Option Agreement (incorporated by reference to Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2011 (File No. 001-34749) filed with the SEC on August 4, 2011)
10.25*
Form of Interim-Employee Director Restricted Stock Award Agreement (incorporated by reference to Exhibit 10.33 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 (File No. 001-34749) filed with the SEC on March 4, 2014)
10.26*
Form of Inducement Stock Option Agreement (incorporated by reference to Exhibit 10.02 of the Company’s Current Report on Form 8-K (File No. 001-34749) filed with the SEC on April 2, 2014)
10.27
Loan and Security Agreement, dated as of April 30, 2015, by and among ReachLocal, Inc., direct and indirect domestic subsidiaries of ReachLocal, Inc., as co-borrowers, Hercules Technology Growth Capital, Inc., as administrative agent, and the lenders party thereto from time to time, including Hercules Technology Growth Capital, Inc. (incorporated by reference to Exhibit 10.2 of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015 (File No. 001-34749) filed with the SEC on May 7, 2015)
10.28
First Amendment to Loan and Security Agreement, dated as of August 3, 2015, by and between ReachLocal, Inc., direct and indirect domestic subsidiaries of ReachLocal, Inc., as co-borrowers, Hercules Technology Growth Capital, Inc., as administrative agent, and the lenders party thereto from time to time, including Hercules Technology Growth Capital, Inc. (incorporated by reference to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2015 (File No. 001-34749) filed with the SEC on August 6, 2015)
10.29
Second Amendment to Loan and Security Agreement, dated as of November 9, 2015, by and among ReachLocal, Inc., direct and indirect domestic subsidiaries of ReachLocal, Inc., as co-borrowers, Hercules Technology Growth Capital, Inc., as administrative agent, and the lenders party thereto from time to time, including Hercules Technology Growth Capital, Inc. (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K (File No. 001-34749) filed with the SEC on November 12, 2015)
10.30
Third Amendment to Loan and Security Agreement, dated as of December 17, 2015, by and among ReachLocal, Inc., direct and indirect domestic subsidiaries of ReachLocal, Inc., as co-borrowers, Hercules Technology Growth Capital, Inc., as administrative agent, and the lenders party thereto from time to time, including Hercules Technology Growth Capital, Inc.
10.31
Fourth Amendment to Loan and Security Agreement, dated as of March 28, 2016, by and among ReachLocal, Inc., direct and indirect domestic subsidiaries of ReachLocal, Inc., as co-borrowers, Hercules Capital, Inc., as administrative agent, and the lenders party thereto from time to time, including Hercules Capital, Inc.
10.32
Note Purchase Agreement, dated as of December 17, 2015, by and among ReachLocal, Inc., and the purchasers thereof
10.33
Security Agreement, dated as of December 17, 2015, by and among ReachLocal, Inc., and the holders of the Company’s 4.0% Convertible Second Lien Subordinated Notes from time to time
10.34
Office Lease, dated as of August 30, 2006, by and between ReachLocal, Inc. and Douglas Emmett 2000, LLC, as amended (incorporated by reference to Exhibit 10.03 of the Company’s Amendment No. 3 to the Registration Statement on Form S-1 (File No. 333-163905) filed with the SEC on April 27, 2010)
10.35
Second Amendment to Office Lease, dated as of September 1, 2010, between Douglas Emmett 2000, LLC, as Landlord and ReachLocal, Inc., as Tenant (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2010 (File No. 001-34749) filed with the Securities and Exchange Commission on November 4, 2010)
10.36
Third Amendment to Office Lease, dated as of July 22, 2011, between Douglas Emmett 2000, LLC, as Landlord and ReachLocal, Inc., as Tenant (incorporated by reference to Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2011 (File No. 001-34749) filed with the SEC on November 7, 2011)
10.37
Lease Agreement, dated June 17, 2013, between EPC-IBP 16, LLC and ReachLocal (incorporated by reference to Exhibit 10.01 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013 (File No. 001-34749) filed with the SEC on August 7, 2013)
10.38
Side Letter, dated June 17, 2013, between EPC-IBP 16, LLC and ReachLocal, Inc. (incorporated by reference to Exhibit 10.03 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013 (File No. 001-34749) filed with the SEC on August 7, 2013)
10.39†
Google Adwords PSP Addendum, dated June 27, 2014, among ReachLocal, Inc. and certain of its affiliates, and Google Inc. and certain of its affiliates (incorporated by reference to Exhibit 10.02 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014 (File No. 001-34749) filed with the SEC on August 7, 2014)
10.40
Sales Promotion Addendum to Google Adwords PSP Addendum, dated February 2, 2015, among ReachLocal Europe B.V. and Google Ireland Limited (incorporated by reference to Exhibit 10.33 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 (File No. 001-34749) filed with the SEC on March 12, 2015)
10.41†
Addendum to Google AdWords PSP Addendum, dated May 4, 2015, among ReachLocal, Inc. and certain of its affiliates, and Google Inc. and certain of its affiliates (incorporated by reference to Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015 (File No. 001-34749) filed with the SEC on May 7, 2015)
10.42†
Amendment to Google AdWords PSP Addendum, effective June 1, 2015, among ReachLocal, Inc. and certain of its affiliates, and Google Inc. and certain of its affiliates (incorporated by reference to Exhibit 10.2 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2015 (File No. 001-34749) filed with the SEC on August 6, 2015)
10.43†
Amendment to Google AdWords PSP Addendum, effective October 1, 2015, among ReachLocal, Inc. and certain of its affiliates, and Google Inc. and certain of its affiliates
21.1
List of subsidiaries of ReachLocal, Inc.
23.1
Consent of Independent Registered Public Accounting Firm
24.1
Power of Attorney (included on signature page to this Annual Report on Form 10-K)
31.1
Certification of the Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of the Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INSXBRL
Instance Document
101.SCHXBRL
Taxonomy Extension Schema Document
101.CALXBRL
Taxonomy Extension Calculation Linkbase Document
101.DEFXBRL
Taxonomy Extension Definition Linkbase Document
101.LABXBRL
Taxonomy Extension Label Linkbase Document
101.PREXBRL
Taxonomy Extension Presentation Linkbase Document
_________________
*
Indicates management contract or compensatory plan, contract or arrangement.
†
Certain provisions of this exhibit have been omitted pursuant to a request for confidential treatment.