Item 1. Business
Corporate Information
Data Domain, Inc. was incorporated in Delaware in October 2001. Our executive offices are located at 2421 Mission College Blvd, Santa Clara, CA 95054, and our telephone number is (408) 980-4800. Our website address is www.datadomain.com. Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments to these reports, are available through our website as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission, or SEC . Information contained or referenced on our website is not incorporated by reference and does not form a part of this Annual Report on Form 10-K.
Overview
Data Domain is a leading provider of deduplication storage appliances for disk-based backup, archiving and network-based disaster recovery. Our appliances reduce the storage of redundant copies of data and associated storage costs within enterprises and are an alternative to tape-based protection storage systems. Our storage solutions address protection storage requirements with low operating costs, ease of use, high performance, reliability and compatibility with leading enterprise backup software products.
Our disk-based appliances combine our Global Compression technology with industry standard components to enable dramatic reductions in the amount of stored backup data. Global Compression technology incorporates a process called data deduplication, which avoids storing redundant copies of data while writing data to disk. When used to deduplicate a single data set over 20 weeks of regular backup storage events, our appliances are designed to achieve a range of data compression of approximately 10x to 30x. The actual range of data compression obtained by our customers depends on the frequency of full backup events, the length of time backup data is retained and the redundancy of the backup data. Through deduplication, our appliances enable enterprises to cost-effectively utilize WAN vaulting, a process by which enterprises replicate backup data offsite using a wide area network, or WAN. Our appliances also provide advanced levels of data protection that are designed to ensure that backup data is accurate and recoverable.
Our deduplication storage appliances provide customers with the following benefits:
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Cost-Effectiveness-Our disk-based appliances enable enterprises to avoid many of the operating costs associated with tape-based systems. In addition, our appliances enable customers to deploy our appliances at an upfront cost comparable to that of tape-based systems;
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Ease of Use-Our appliances are easy to deploy and help customers avoid the inconvenience of managing the manual and logistical processes associated with tape-based systems;
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High Performance-Our appliances are designed to store and recover large amounts of data quickly. Through deduplication, our appliances also enable enterprises to utilize WAN vaulting cost-effectively;
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Reliability-Our appliances provide advanced levels of data protection by incorporating technology that performs continuous verification to help ensure that backup data is accurate and recoverable; and
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Compatibility-Our products are compatible with the leading enterprise backup software products.
Our appliances combine our software-based technologies with industry standard components and are sold in a variety of configurations that enable enterprises to optimize a backup and disaster recovery solution according to their needs. We sell our appliances through a network of channel partners and our direct sales force, and we actively partner with industry-leading companies to market our products more effectively. We have over 250 channel partners and our appliances have been purchased by approximately 1,500 customers worldwide.
Industry Background
The amount of data stored by enterprises is growing rapidly. As data is created, shared and stored, extra copies are made by multiple users across an enterprise’s network and in multiple storage systems, requiring dramatically greater storage capacity and resulting in significantly increased costs. This problem is particularly pronounced for backup and disaster recovery storage because backup systems routinely make complete, redundant copies of largely identical files even if only minimal changes have occurred since the last backup event. Even enterprises using leading backup software experience this problem. With enterprises typically performing backup events on a regular basis, redundant data is multiplied, further increasing storage requirements and associated costs.
Primary storage systems store frequently accessed data from applications and servers as users work. Protection storage systems store large amounts of infrequently accessed data for backup and disaster recovery. Disk-based systems are generally used for primary storage, despite their high upfront costs, because they read and write data quickly. On the other hand, tape-based systems have historically been used for protection storage, despite their lower performance characteristics, primarily because of their relatively low upfront costs.
Limitations of Tape-Based Systems
Tape-based systems store all data copied in a backup event and therefore contribute to the problem of increasing data redundancy. The operation of tape-based systems also suffers from the following limitations:
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High Operating Costs-Although the upfront costs of a tape-based storage system are lower than those of traditional disk-based systems, the ongoing maintenance and operating costs of tape-based systems can be more significant. Operating tape-based systems results in labor costs associated with manual processes such as moving and mounting tapes correctly in the datacenter as well as additional expenses related to the physical transport of tape cartridges. Many of these costs are not incurred when disk-based systems are used.
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Cumbersome Handling-Many of the processes related to the operation of tape-based systems are cumbersome or require substantial human involvement. The steps required in the lifecycle of saving and restoring data from tapes are many, including saving data to tapes, storing these tapes temporarily in the datacenter for pick-up, transporting them to an offsite location, identifying the correct tapes at
the offsite location, transporting them back to the datacenter, mounting the correct tapes onto a tape reader, spinning the tape to the correct position, and then reading the data. Errors can occur at any of these steps. For example, workers could mishandle or damage tapes, or tapes could be lost in transit.
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Poor Performance-Saving data to tape-based systems and restoring it properly can be slow. New generation tape drives are designed for faster data streams than those sent by many servers. If a stream of backup data sent to a tape drive is too slow, the process of saving this data to tape is slower than the rated speed of the tape drive because the tape drive must stop while it waits for data. Restoring backup data from tape-based systems can be even more time consuming. In a tape-based system, data is saved in a sequential manner as a spool of tape spins. To access particular data, the data must be located at the correct position on the tape, and then the tape must be physically spun to that position. Moreover, before the actual reading of data from tape can occur, the correct tapes must be located and, if necessary, transported to the datacenter. The overall recovery process can take hours or even days to complete for data stored offsite.
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Unreliability-Even though tape-based storage is often used by enterprises as the storage of last resort, we believe recovery attempts from tape-based systems are prone to failure for the following reasons. First, tape is inherently a fragile medium and damages easily. Second, verifying the accuracy of data written onto tape is a manual and expensive task. Therefore, IT managers often forgo this lengthy process and instead assume data has been properly stored. Errors in backed-up data are often only found when the data needs to be recovered, by which time the data may be lost forever.
Recent Developments in Storage
Disk-based protection storage systems have benefited from recent developments in disk drive technologies and other industry standard components. The development of low-cost, high-capacity disk drives with the Serial Advanced Technology Attachment, or SATA, interface enables the use of disk drives to store increasing volumes of data for existing applications as well as new kinds of data for new applications. Further, the price and performance of other industry standard components, including microprocessors and memory, continue to improve dramatically. Incorporation of these industry standard components into disk-based storage systems provides for enhanced performance relative to cost, ease of integration and time-to-market attributes that were not previously achievable.
Some storage providers have developed virtual tape library, or VTL, systems to attempt to improve the performance of tape-based systems. A VTL is a disk-based system that typically utilizes SATA disk drives and emulates the protocols of a physical tape library. With a VTL, backup data is initially stored on disks but is generally transferred to an enterprise’s existing tape-based storage infrastructure within a short period of time due to the higher price of disk-based storage relative to tape-based storage.
Although the developments above have enabled the deployment of disk-based systems for protection storage, for the following reasons we do not believe that these developments are sufficient to meet the protection storage requirements of many enterprises. SATA disk drives and improvements in industry standard components have not sufficiently reduced the upfront costs of disk-based systems. In addition, most VTLs fail to significantly address the problem of data redundancy in the enterprise and ultimately rely on tape-based systems, with all of their associated operating costs and performance limitations. A disk-based solution that significantly reduces the amount of redundant data stored in the backup process would enable disk-based systems to be cost-effective and high-performance alternatives to tape-based systems.
The Deduplication Storage Opportunity
We believe a significant opportunity exists to displace tape-based systems and other less efficient disk-based solutions with deduplication storage appliances that dramatically reduce the amount of redundant data stored in
the backup process. Traditional data compression techniques can compress backup data, but do not address the redundancy of repeated backups of the same data. Deduplication, which avoids storing redundant copies of the same data, allows enterprises to make more efficient use of their storage capacity and enables disk-based systems to become a cost-effective alternative for protection storage.
The Data Domain Deduplication Storage Solution
We provide deduplication storage appliances for disk-based backup and network-based disaster recovery. Our solution combines our Global Compression technology, which performs data deduplication, with industry standard components to significantly reduce the storage capacity required for enterprise backup data, thereby providing an alternative to tape-based protection storage systems. Approximately 1,500 customers worldwide have purchased our appliances.
Our appliances provide customers with the following benefits:
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Cost-Effectiveness-Our disk-based appliances enable enterprises to avoid many of the operating costs associated with the labor-intensive handling and transportation processes required by tape-based systems. In addition, because our Global Compression technology enables enterprises to dramatically reduce the storage capacity required for backup data, our appliances can be deployed at an upfront cost comparable to that of tape-based systems.
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Ease of Use-Our appliances are designed to integrate seamlessly with our customers’ existing storage infrastructures and are easy to install and operate. Our appliances also enable customers to avoid many of the manual collection, transportation and other physical processes associated with tape-based systems. Our common user interface allows customers to monitor the capacity and throughput of multiple appliances arranged in an array.
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High Performance-Our appliances are optimized for storing large amounts of data quickly. In addition, our appliances are designed to handle both fast and slow backup data streams effectively, unlike tape-based systems. Further, through our Global Compression technology and data replication software, data sets can be dramatically compressed, thereby enabling customers to utilize WAN vaulting cost-effectively. Because our products utilize hard disk drives and network connectivity, we provide our customers with faster access to data and more rapid recovery across their existing networks.
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Reliability-Our appliances provide advanced levels of data protection in order to serve as the storage of last resort for our customers. Unlike most tape-based systems, our appliances incorporate technology that performs continuous verification to help ensure that backup data is accurate and recoverable.
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Compatibility with Existing Backup Software-Our appliances are compatible with leading enterprise backup software products, including products offered by CommVault Systems, Inc., EMC Corporation, International Business Machines Corporation and Symantec Corporation. This compatibility enables our customers to install our appliances with minimal disruption and without significant incremental investment.
Our Strategy
Our goal is to be the leader in deduplication storage market for data protection. Key elements of our strategy include:
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Continue to focus on protection storage-We believe that backup and disaster recovery represents the greatest opportunity for the sale of our appliances. Therefore, we intend to continue to focus our sales efforts on winning new customers for these use cases. We also believe that the sale of additional appliances and other products to our existing customers as their storage needs grow represents a significant revenue opportunity for us.
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Expand direct and channel distribution-We intend to grow our network of channel partners and our direct sales organization in the United States and to continue to grow sales internationally. As of December 31, 2007, we had over 250 channel partners that generate sales leads and distribute our products worldwide. Our sales force is responsible for managing and overseeing indirect sales, and our sales personnel work closely with our channel partners. We believe that our having a relationship with substantially all of our customer accounts combined with the reach of our channel partners provides us with the ability to grow effectively.
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Innovate and improve our technology-Our Global Compression technology and our approach to maintaining the integrity of data are core elements of our solution. In addition to taking advantage of performance enhancements resulting from improvements in industry standard components, we intend to continue to innovate and improve our technology. Therefore, we intend to continue to invest in research and development to meet additional customer needs and enhance the capacity and performance of our appliances.
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Expand and deepen relationships with technology partners-We intend to broaden our relationships with existing technology partners and to establish new partnerships with the leading suppliers of storage infrastructure software and hardware. These partnerships allow us to enhance the ability of our products to interoperate with products from multiple vendors. Our technology partners also collaborate with us on co-marketing and lead generation efforts that help us extend our marketing reach. We believe our independence from backup vendors and the compatibility of our appliances with the leading enterprise backup software differentiate our solution from many of our competitors’ products.
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Apply our technology to other storage opportunities-We intend to win new customers and broaden our recently introduced product offerings for other classes of applications, such as archival storage and fixed-content data storage that manage largely static files and benefit from the fast storage and retrieval of disk-based systems but do not require the performance characteristics of primary storage. We refer to these classes of applications, which also include protection storage, as nearline storage. We believe our Global Compression technology lowers the cost of addressing nearline classes of applications with disk-based systems.
Technology
We offer high performance deduplication, data integrity and replication technologies on a modular appliance that works with other leading technologies. The core elements of our technology and system architecture include:
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Global Compression-Our Global Compression technology combines high performance deduplication with traditional data compression techniques. This approach identifies segments of data within an incoming data stream that are duplicates of segments already stored and instead of storing an additional redundant copy of these segments, stores only references to the previously stored segments. Traditional compression techniques then compress the remaining segments before the data is stored to disk. Our deduplication technology is more effective than traditional data compression techniques alone because it compares new incoming data with a much larger history of previously stored data. When used to deduplicate a single data set over 20 weeks of regular backup storage events, our appliances are designed to achieve a range of data compression of approximately 10x to 30x. The actual range of data compression obtained by our customers depends on the frequency of full backup events, the length of time backup data is retained and the redundancy of the backup data.
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High-speed, Inline Deduplication-Our Global Compression technology performs deduplication at high speed with very few disk drives. The deduplication process requires comparison of new data to a very large amount of previously stored data. Typically, this comparison requires many disk accesses to compare incoming new data to old data, a process that is relatively slow. Our appliances utilize proprietary technology to perform deduplication inline, or prior to storing to disk, at high speed. Our
approach completes a substantial portion of the deduplication process in random access memory, or
RAM, thereby minimizing the need for access to disk and increasing the speed of the backup and restore processes. Also, because our technology filters redundant segments before writing to disk, and replicates backup data shortly after writing, copies of data at remote sites can be kept up-to-date.
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Data Invulnerability Architecture-Our technology provides advanced levels of data protection that are designed to ensure that backup data is accurate and recoverable. Most disk-based storage systems have been optimized for rapid transaction processing. However, our appliances are designed to be the storage of last resort. Our appliances incorporate end-to-end data consistency, integrity verification and error correction technologies at the file system level. For example, after every backup event, our technology confirms that all data written is consistent and accurate. Additionally, our appliances can sustain multiple simultaneous disk failures without data loss, a significant benefit over many VTL products that can lose data when more than one disk in an array fails. Recently, we introduced point-in-time snapshots that can allow images which have been deleted by operator error to be recovered.
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Replication-Using our Global Compression technology, our Replicator software transfers deduplicated and compressed information over a network during the backup process. This process can be employed in a variety of common network types and requires less bandwidth, time and cost than traditional replication methods, making WAN vaulting economically and operationally feasible.
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Adaptable Design-Each of our appliances incorporates industry standard components, which simplifies the procurement, assembly and support of our appliances. Furthermore, our appliances are easy to install, are compatible with the leading backup software applications and work with both Ethernet and Fibre Channel-based networks.
Products
We offer a variety of appliances with a range of storage capacities. Our appliances are sold with varying sizes of internal storage capacity, ranging from approximately 2.25 terabytes, or TB, for our DD510 appliance to approximately 7.5 TB for our DD580 appliance. Effective storage capacity is the equivalent amount of uncompressed data that can be stored on an appliance in a compressed form. Assuming a data compression range of approximately 10x to 30x and taking into account formatting and system overhead, our base DD580 appliances provide an effective storage capacity of approximately 50 TB to 150 TB.
Customers can augment the storage capacity of our higher end systems with expansion storage. For example, the DD580 appliance can support up to three expansion shelves, each of which adds approximately 8 TB of additional internal storage capacity. Our appliances also can be combined together in an array configuration, which we refer to as a DDX, to reach higher levels of capacity and throughput. For customers that want to utilize their existing excess storage capacity, we offer what we refer to as Gateway appliances, which are versions of our appliances without internal storage.
When purchasing our appliances, customers may license one or more of the software technologies embedded in our appliances. Different technologies can be enabled or disabled based on the licenses purchased by our customers. For example, our Replicator software allows enterprises to utilize WAN vaulting for offsite disaster protection and recovery. We also offer a capacity-optimized VTL software option that emulates multiple tape libraries over a Fibre Channel interface and integrates with an enterprise’s existing backup infrastructure while supporting our standard deduplication approach. By utilizing data deduplication, our VTL offering enables more cost-effective disk-based protection storage and faster, more reliable data recovery than that provided by non-deduplication VTL offerings.
Our appliances are designed to be compatible with leading enterprise backup software, including products available from vendors such as CommVault Systems, Inc., EMC Corporation, International Business Machines Corporation and Symantec Corporation.
Customer Support
We offer tiered customer support programs through the sale of support and services contracts. Customers that purchase a support and services contract are granted rights to accelerated shipment of replacement parts, onsite hardware repair and support, and software updates and maintenance releases that become available during the support period. Our support and services contracts are typically offered for periods of one to three years. We offer product support for all of our customers, including those customers who purchase our appliances through our channel partners.
Substantially all of our support personnel are based in Santa Clara, California, and we expect to have additional support personnel located in our new facility that we will be opening in the Research Triangle Park area in Raleigh, North Carolina in 2008. Customer support personnel are available 24 hours per day, seven days per week. Our appliances include an active monitoring system that automatically notifies us of support problems we detect, enabling us to address customer problems more quickly. In addition, some of our international channel partners offer primary support for the appliances they sell to customers. We also subcontract with third parties, Anacomp, Inc. and Glasshouse, Inc., to provide onsite hardware repair and replacement services for the substantial majority of our customers that have purchased a support and services contract from us. For each such covered customer, we purchase a support contract from Anacomp or Glasshouse. Our master agreement with Anacomp has a two-year term ending in February 2009 that renews automatically absent 90 days’ prior written notice by either party. Our master agreement with Glasshouse has a three-year term ending in June 2010, except that after the initial 12 months, which ends in June 2008, either party may terminate the agreement by providing the other party with 90 days’ prior written notice.
Customers
As of December 31, 2007, our appliances had been purchased by approximately 1,500 customers worldwide in a variety of industries, including defense, education, entertainment, finance, government, healthcare, technology, legal, media and retail. During the years ended December 31, 2007, 2006 and 2005, no single customer accounted for 10% or more of our total revenue. See Note 11 of “Notes to Consolidated Financial Statements” for more information regarding the geographic distribution of our customers.
Backlog
We believe that because of industry conditions, customers are reluctant to enter into long-term contracts. Accordingly, new order volumes for our products fluctuate significantly. We typically accept and ship orders within a few days. In addition, customers may reschedule or cancel orders with little or no penalty. For these reasons, we do not believe that our order backlog as of any particular date is a reliable indicator of actual sales for any succeeding period.
Product Warranty
Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically 12 months from the date of shipment to the customer for hardware and 90 days for software.
Sales and Marketing
We sell our appliances indirectly through channel partners and through our direct sales force. Our channel partners are independent third parties that act as resellers of our appliances in the United States and internationally. We have over 250 channel partners that help market and sell our appliances, typically with the assistance of our direct sales force. Our direct sales force is responsible for managing and overseeing indirect sales within our geographic territories, including North America, Europe, Asia-Pacific and Japan. This joint sales approach combines the benefit of our having relationships with substantially all customer accounts with the reach
and relationships of our channel partners, especially internationally. We intend to expand these partner relationships in the future to further extend our distribution coverage.
We focus our marketing efforts on communicating product advantages, generating qualified leads for our direct sales force and channel partners and increasing brand awareness. We rely on a variety of marketing efforts, including tradeshows, advertising, public relations, industry research and our website. In addition, we work closely with a number of technology partners, including some of the leading suppliers of storage infrastructure products, on co-marketing and lead-generation activities in an effort to broaden our marketing reach.
Research and Development
Continued investment in research and development is critical to our business. We have assembled a team of skilled engineers with extensive experience in the fields of computing, storage, network system design, Internet routing protocols and embedded software. These individuals have extensive prior experience with many leading digital storage and computer data networking companies. We have invested significant time and financial resources in the development of our storage appliances and our Global Compression technology. Most of our research and development activities take place at our corporate headquarters in Santa Clara, California. However, we opened a research and development facility in Princeton, New Jersey in 2007 and recently announced that we will open a facility in the Research Triangle Park in Raleigh, North Carolina in fiscal 2008. We intend to dedicate significant research and development resources to continue to improve the performance and features of our deduplication storage solution and to expand our product offerings to address other segments of the enterprise storage market.
Research and development expenses were $23.5 million, $10.4 million and $6.4 million for the years ended December 31, 2007, 2006 and 2005, respectively.
Manufacturing
We outsource the manufacturing, assembly, testing, packaging and shipping of our appliances to Solectron, which was recently acquired by Flextronics. We rely on Solectron to procure a majority of the components for our appliances. We work closely with Solectron in an effort to ensure that we have a supply of components sufficient to satisfy our product delivery schedule and to oversee the manufacturing process and quality control.
We provide purchase orders for finished goods inventory to Solectron on a monthly basis. The product mix and volume of the order is adjusted each month based on anticipated demand and actual sales and shipments in prior periods. Because different configurations of our appliances use industry standard components, Solectron is more easily able to respond to changes in our product mix without significant delay or increased costs. Solectron is currently our only contract manufacturer, and our agreement with Solectron has a one-year term that is subject to automatic extensions in one-year increments absent notice of termination by either party.
This agreement is terminable at any time by either party with 90 days’ notice. We purchase our capacity expansion shelves from Xyratex Technology Limited pursuant to an agreement that has a three-year term ending in March 2010, subject to early termination by either party under certain circumstances.
Availability of Raw Materials
Our production processes require raw materials that meet exacting standards, including a few that are customized for us. We generally have a few sources of supply. Various factors could reduce the availability of raw materials such as memory, microprocessors and disk drives and shelving and other materials. Although raw material shortages have not interrupted our operations in the past, shortages may occur from time to time in the future. Also, lead times for the supply of raw materials have been extended in the past. If our supply of raw materials is interrupted, or lead times are extended, our results of operations could be harmed.
Competition
The market for our products is highly competitive and is driven by rapidly changing technology. In addition to competing with traditional providers of tape-based storage systems, such as Sun Microsystems, Inc. and Quantum Corporation, we compete with other established storage companies such as EMC Corporation and Network Appliance, Inc., and to a lesser extent Hitachi Data Systems Corporation, Hewlett-Packard Company and International Business Machines Corporation (IBM), that offer a variety of different protection storage products and products that address classes of nearline applications. Some of our competitors sell, or have announced plans to sell, deduplication storage products that compete directly with our appliances. We also compete with a number of emerging hardware and software companies that may become more significant competitors in the future. In addition, at the low-end of our product line, we may compete with WAN acceleration and backup software providers that incorporate deduplication capabilities in their products.
We believe the principal factors on which our products compete are as follows:
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product features and enhancements, including ease of use, performance, scalability, reliability, replication and multi-protocol support;
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product pricing and total cost of ownership;
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product interoperability with customer networks and backup software;
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global sales and distribution capability;
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ability to take advantage of improvements in industry standard components; and
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customer support and services.
We believe that our technologies, which enable enterprises to dramatically compress data in their protection storage environments, store data cost effectively and with high reliability, use existing networks for data recovery, and accomplish each of the foregoing with minimal disruption to existing storage infrastructures, provide us with significant competitive advantages. In addition, our appliances have been purchased by approximately 1,500 customers, which represent a significant installed base of existing customers and provide us with a significant number of reference accounts, better enabling us to market and sell additional appliances and other product offerings to new customers. However, many of our current and potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales and marketing and other resources than we have. Our competitors may offer to sell their products at more attractive prices than we offer, and potential customers may prefer to purchase from their existing vendors rather than a new vendor regardless of product performance or features. Some of our competitors have also entered into relationships with original equipment manufacturers, or OEMs, that could provide those competitors with sales, marketing, distribution and other advantages.
Intellectual Property
Our future success as a company will depend in part upon our ability to protect our core technology and intellectual property. To accomplish this, we rely on a combination of intellectual property rights, including patents, trade secrets, copyrights and trademarks, as well as customary contractual protections. Our registered trademark in the United States is Data Domain.
Our issued patents will begin to expire in 2023. We have also entered into a non-exclusive patent cross-license agreement with Quantum Corporation that provides each party and its controlled affiliates with a license to certain patents held by the other party. As a result of this patent cross-license agreement, we have a license to Quantum’s significant portfolio of current and future patents that are or may be issued or applied for (or otherwise entitled to a priority date) on or prior to January 1, 2012 and that relate to or are useful with respect to data transmission and/or data storage, excluding claims specific to tape or tape-based systems. Under the terms of the agreement, Quantum and its controlled affiliates have a license to our current and future patents that relate to
or are useful with respect to data transmission or data storage and that are or may be issued or applied for (or otherwise entitled to a priority date) on or prior to January 1, 2012.
The effect of the cross-license is that Data Domain and Quantum can implement their respective products without threat of lawsuit from the other company for patent infringement of the covered patents. The license agreement does not include a transfer of any products, software, code, know-how or trade secrets. It is not a joint development agreement or an OEM agreement. Neither party is entitled to any products implemented by the other party or any features of the other party’s products. There are no deliberately common components between Data Domain and Quantum products. Quantum and Data Domain do not collaborate on the development of any products.
United States patent filings are intended to provide the holder with a right to exclude others from making, using, selling or importing in the United States the inventions covered by the claims of granted patents. We do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims. Our issued United States patents, and any future patents that may be issued, may be contested, circumvented or invalidated, and we may not be able to prevent third parties from infringing these patents. In addition, as a result of our cross-license agreement with Quantum, we will not be able to assert our existing patent rights and many or all of our future patent rights against Quantum or its controlled affiliates for the foreseeable future, and Quantum has certain rights to assign this license to an acquirer of Quantum.
In addition to the foregoing protections, we generally control access to and use of our proprietary software and other confidential information through the use of internal and external controls, including contractual protections with employees, contractors, customers and partners, and our software is protected by United States and international copyright laws.
Although we rely on patent, copyright, trade secret, trademark and other intellectual property laws to protect our technology, we also believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements and reliable product support and services are essential to establishing and maintaining a technology leadership position. We cannot be sure that others will not develop technologies that are similar or superior to our technology.
Protecting against the unauthorized use of our patents, trademarks and other proprietary rights is expensive, difficult and, in some cases, impossible. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could be costly and divert management resources, either of which could harm our business. Furthermore, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforce their intellectual property rights than we do. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.
Employees
As of December 31, 2007, we had 435 employees in offices around the world, of which 361 were in the United States. Of the total employees, 244 are engaged in sales and marketing, 116 in research and development and 75 in general and administration, support and services and operations. None of our employees is represented by a labor union, and we consider current employee relations to be good.
Item 1A.
Item 1A. Risk Factors
Set forth below and elsewhere in this Form 10-K, and in other documents we file with the SEC, are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Form 10-K. Because of the following factors, as well as other variables affecting our operating results, past financial performance should not be considered as a reliable indicator of future performance and investors should not use historical trends to anticipate results or trends in future periods.
Risks Related to Our Business and Industry
We derive all of our revenue from sales of a single line of systems and related customer support and services, and if demand for these systems does not continue to grow, our business, results of operations and financial condition would be harmed.
We derive all of our revenue from sales of a single line of deduplication storage systems and associated customer support and services. As a result, we are vulnerable to fluctuations in demand for these systems, whether as a result of competing technologies and products, weakening economic conditions, decreases or delays in corporate spending for information technologies, product obsolescence, lack of customer acceptance, technological change, customer budgetary constraints or other factors. If demand for our systems does not continue to grow, our business, results of operations and financial condition would be harmed.
Our business could be harmed as a result of deteriorating general economic and market conditions that lead to reduced spending on information technology products.
Our business depends on the overall demand for information technology, in particular for deduplication storage appliances for backup storage and network-based disaster recovery. Information technology spending has historically declined as general economic and market conditions have worsened, and if the domestic or global economy undergoes a downturn, or if our customers believe such a downturn is imminent, our customers would likely reduce their information technology budgets. We may be particularly susceptible to reductions in information technology spending because the purchase of our appliances is often discretionary and may involve a significant commitment of capital and other resources. Many of our target customers have not purchased products similar to ours and might not have a specific budget for the purchase of our appliances. Delays in or a reduction in information technology spending, domestically or internationally, would harm our business, results of operations and financial condition in a number of ways, including by leading to longer sales cycles, lower prices for our appliances and reduced unit sales.
With the recent volatility in the capital markets, there is a risk that we could suffer a loss of principal in our cash and cash equivalents and short-term investments and suffer a reduction in our interest or return on investments.
We invest our cash and cash equivalents and short-term investments pursuant to our investment policy in cash, auction rate securities, money market funds, commercial paper, corporate bonds and government agency certificates, and we actively manage our portfolio with an objective of capital preservation. Certain of these investments are subject to general credit, liquidity, market and interest rate risks, which may be exacerbated by U.S. sub-prime mortgage defaults that have affected various sectors of the financial markets and caused credit and liquidity issues. To date, we have determined that any declines in the market value of our investments have been temporary. There could be future declines in the value of these investments, which we may determine to be other-than-temporary. These market risks associated with our investment portfolio may have a negative adverse effect on our results of operations, liquidity and financial condition.
At December 31, 2007 and January 31, 2008, we had $29.6 million and $34.5 million of principal in auction rate securities, respectively. In January 2008, these securities, which consist of AAA-rated, taxable municipal debt obligations, had auctioned successfully. On February 14, 2008, the majority of these auction rate securities failed to auction, causing access to these funds to be restricted. An auction failure means that the parties wishing to sell securities could not. If the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments. Determining whether there has been an other-than-temporary impairment of our short-term investments requires significant judgment. At this time, we believe the interest is collectable, and we do not believe that there has been an other-than-temporary impairment of these investments. With the recent volatility in the capital markets, there is a risk that we could suffer a loss of principal and suffer a reduction in our interest or return on these and other
investments, which could harm our operating results and financial condition. In addition, we may suffer a potential lack of liquidity of these investments and it could take until the final maturity of the underlying notes (up to 40 years) to realize our investments’ recorded value.
We experience quarterly fluctuations in our operating results due to a number of factors, which makes our future results difficult to predict and could cause our operating results to fall below expectations or our guidance.
Our quarterly operating results may fluctuate due to 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. You should not rely on our past results as an indication of our future performance. If our revenue or operating results fall below the expectations of investors or securities analysts, or below any guidance we may provide to the market, the price of our common stock could decline substantially.
In addition to other risk factors listed in this “Risk Factors” section, factors that may affect our quarterly operating results include:
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fluctuations in demand for our appliances;
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fluctuations in sales cycles and prices for our appliances;
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reductions in customers’ budgets for information technology purchases and delays in their purchasing cycles;
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the timing of recognizing revenue in any given quarter as a result of revenue recognition rules;
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our ability to develop, introduce and ship in a timely manner new products and product enhancements that meet customer requirements;
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the timing of product releases or upgrades by us or by our competitors;
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our ability to hire additional sales personnel and the length of time required for any such additional personnel to generate significant revenue;
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any significant changes in the competitive dynamics of our market, including new entrants or substantial discounting of products;
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our ability to control costs, including our operating expenses and the costs of the components we purchase; and
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general economic conditions in our domestic and international markets.
In addition, we may experience seasonality in the sales of our appliances. We believe our rapid growth and limited operating history may have masked the nature or magnitude of seasonal or cyclical factors that might have influenced our business to date. Seasonal variations in our sales may lead to significant fluctuations in our quarterly operating results.
Our international sales and operations subject us to additional risks that may harm our operating results.
In the year ended December 31, 2007, we derived approximately 28% of our revenue from international customers. We have sales personnel in numerous countries worldwide. We expect to continue to add personnel in additional countries. Our international operations subject us to a variety of risks, including:
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the difficulty of managing and staffing international offices and the increased travel, infrastructure and legal compliance costs associated with multiple international locations;
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the management of our relationships with channel partners outside the United States, whose sales and lead generation activities are very important to our international operations;
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difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets;
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tariffs and trade barriers and other regulatory limitations on our ability to sell our appliances in certain foreign markets;
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increased exposure to foreign currency exchange rate risk;
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increased exposure to possible violations of, or non-compliance with, the Foreign Corrupt Practices Act;
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reduced protection for intellectual property rights in some countries; and
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political and economic instability.
Sales to international customers may also result in greater shipping costs and additional expenses to conform our appliances to the requirements of local laws or local product specifications. As we continue to expand our business internationally, our success will depend, in large part, on our ability to anticipate and effectively manage these and other risks associated with our international operations. Our failure to manage any of these risks successfully could harm our international operations and reduce our international sales.
We have a history of losses and we may not achieve or sustain profitability in the future.
We have not yet achieved profitability for any fiscal year. We incurred a net loss of approximately $3.7 million for the year ended December 31, 2007, and as of December 31, 2007, our accumulated deficit was approximately $40.3 million. We may continue to incur losses. We expect to make significant expenditures related to the development of our business, including expenditures to hire additional personnel relating to sales and marketing and product development. In addition, we will continue to incur significant legal, accounting and other expenses that we did not incur as a private company. Our operating expenses are largely based on anticipated revenue trends, and a high percentage of our expenses are, and will continue to be, fixed in the short term. As a result, a delay in generating or recognizing revenue could cause significant variations in our operating results from quarter to quarter and annually and could result in substantial operating losses. Our revenue growth trends in prior periods are not likely to be sustainable, and we may not generate sufficient revenue to achieve or maintain profitability. We may incur significant losses in the future for a number of reasons, including those discussed in other risk factors and factors that we cannot foresee.
Our sales are difficult to predict, even in the near term, and a substantial portion of our quarterly sales typically occurs during the last several weeks of the quarter.
A substantial portion of our quarterly sales typically occurs during the last several weeks of the quarter, which we believe largely reflects customer buying patterns of products similar to ours and other products in the technology industry generally. In addition, a significant portion of our sales in any quarter is not forecast at the start of the quarter and is generated by sales activity initiated within the quarter. Similarly, we have little visibility at the start of any quarter as to which existing customers, if any, will make additional purchases and when any additional purchases may occur, if at all. As a result, our quarterly operating results are difficult to predict even in the near-term.
The market we serve is emerging and the purchase of our appliances by new customers may involve material changes to established purchasing patterns and policies. Our sales efforts involve educating potential customers about the uses and benefits of our appliances, including their technical capabilities and potential cost savings. Potential customers may undertake a significant evaluation process that has in the past resulted in a longer sales cycle. In addition, our sales cycle may be extended if potential customers decide to re-evaluate other aspects of their backup storage infrastructure at the same time they are considering a purchase of our appliances. We spend substantial time, money and other resources in our sales process without any assurance that our efforts will produce any sales. In addition, customer purchases are frequently subject to budget constraints, multiple approvals and unplanned administrative, processing and other delays. If sales expected from a specific customer for a particular quarter are not realized in that quarter, or at all, our business may suffer.
We have a limited operating history and compete in a new and rapidly evolving market, which makes our future operating results difficult to predict.
We were incorporated in October 2001 and first shipped our appliances in February 2004. We have a limited operating history in an industry characterized by rapid technological change, changing customer needs, evolving industry standards and frequent introductions of new products and services. As we encounter rapidly changing customer requirements and increasing competitive pressures, we likely will be required to reposition our product and service offerings and introduce new products and services. We may not be successful in doing so in a timely and appropriately responsive manner, or at all. Furthermore, because we compete in an early stage market, many of our target customers have not purchased products similar to ours and might not have a specific budget for the purchase of our appliances. Historically, enterprises have relied on non-deduplication, tape-based technologies for backup and recovery, and we might not succeed in generating increased demand for our products. All of these factors make it difficult to predict our future operating results, which may impair our ability to manage our business and investors’ ability to assess our prospects.
If we lose key personnel or are unable to attract and retain qualified personnel on a cost-effective basis, our business would be harmed.
Our success is substantially dependent upon the performance of our senior management and key technical and sales personnel. Our management and employees can terminate their employment at any time, and the loss of the services of one or more of our executive officers or other key employees could harm our business. Our success also is substantially dependent upon our ability to attract additional personnel for all areas of our organization, particularly in our sales and research and development departments. Our dependence on attracting and retaining qualified personnel is particularly significant as we attempt to grow our organization. Competition for qualified personnel in our industry is intense, and we may not be successful in attracting and retaining such personnel on a timely basis, on competitive terms, or at all. If we are unable to attract and retain the necessary technical, sales and other personnel on a cost-effective basis, our business would be harmed.
If we fail to manage future growth effectively, our business would be harmed.
We have expanded our operations significantly since inception and anticipate that further significant expansion of our operations and headcount will be required. For example, our headcount increased from 179 employees as of December 31, 2006 to 435 employees as of December 31, 2007, and we have announced our intent to establish a new operations center in North Carolina’s Research Triangle Park. The new facility is expected to house additional engineering, customer support and sales personnel. Our growth has placed, and will continue to place, significant demands on our management, infrastructure and other resources. To manage our growth, we will need to hire, train, integrate and retain a large number of highly skilled and motivated employees. We will also need to continue to improve our financial and management controls and reporting systems and procedures. We implemented new enterprise resource planning software for our finance and inventory management processes in October 2007, and we may in the future upgrade other finance, sales and inventory management systems. We could encounter delays or difficulties in implementing any of these systems. If we do not effectively hire, train, integrate and retain sufficient highly qualified personnel to support and continue our growth, and if we do not effectively manage our growth and the associated increase in expenses, our business, results of operations and financial condition would be harmed.
We face significant competition and expect this competition to intensify, which could prevent us from increasing our revenue, reduce our gross margins and result in the loss of market share.
The market for our products is highly competitive and we expect competition to intensify in the future. Other companies have introduced and may in the future introduce new products in the same markets we serve or intend to enter. This competition has resulted in pricing pressure, which we anticipate will increase in the future. Competition has in some instances resulted in a negative impact on the length of our sales cycle, and we may experience longer sales cycles in future periods due to increased competition. In particular, if a large number of
orders, or a large dollar value order, is delayed or cancelled, our financial results may be harmed. Competition may result in reduced gross margins for our appliances, increased sales and marketing expenses and a failure to increase, or the loss of, market share.
Competitive products may have better performance, lower prices and broader acceptance than our appliances. Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we have. Potential customers may prefer to purchase from their existing vendors rather than a new vendor regardless of product performance or features. In addition, our competitors may be able to bundle products and services that we do not offer together with products that compete with ours at a combined price that is more attractive than the price we charge for our appliances. Currently, we face competition from traditional providers of tape-based storage systems such as Sun Microsystems, Inc. and Quantum Corporation as well as a number of established storage companies that offer a variety of different disk-based storage products, including EMC Corporation and Network Appliance, Inc. and, to a lesser extent, Hitachi Data Systems Corporation, Hewlett-Packard Company and International Business Machines Corporation. Some of our competitors sell, or have announced plans to sell, deduplication storage products that compete directly with our appliances, and additional competitors may introduce deduplication storage products in the future. Pursuant to a cross-license agreement with Quantum, we have licensed our current, and certain future, patents relating to data storage or data transmission, which could assist Quantum in competing with us. We also compete with a number of emerging hardware and software companies that may become more significant competitors in the future. In addition, at the low-end of our product line, we may compete with WAN acceleration and backup software providers that incorporate deduplication capabilities in their products.
We expect increased competition from other established and emerging companies if our market continues to develop and expand. Some of our channel partners currently market products and services that compete with our appliances. If these channel partners cease to distribute our appliances for competitive reasons, our sales may decrease or not grow as quickly. In addition, some of our competitors have made acquisitions or entered into partnerships or other strategic relationships with one another to offer a more comprehensive solution than they individually are able to offer. We believe additional consolidation or partnerships are likely to occur in the future as companies attempt to strengthen or maintain their market positions in an evolving industry. The companies resulting from these consolidations or partnerships could significantly change the competitive landscape and adversely affect our ability to compete effectively. Some of our competitors have also entered into relationships with original equipment manufacturers, or OEMs, that could provide those competitors with sales, marketing, distribution and other advantages.
Our financial results would suffer if demand for deduplication storage appliances does not continue to grow.
Our products are disk-based deduplication storage appliances for backup and network-based disaster recovery. Deduplication is a new and emerging technology. Historically, enterprises have relied on non-deduplication tape-based technologies for backup and recovery. A reduction in demand for deduplication storage appliances for backup storage or network-based disaster recovery could be caused by, among other things, lack of customer acceptance, weakening economic conditions, competing technologies and products, or decreases in corporate spending. Our future financial results would suffer if the demand for deduplication storage appliances does not continue to grow.
If we fail to predict accurately our manufacturing and component requirements, we could incur additional costs or experience manufacturing delays which would harm our business.
Our agreement with our contract manufacturer, Solectron, which has recently been acquired by Flextronics, does not provide for specific quantities or inventory levels for our appliances or the components used in our appliances. Instead, we provide purchase orders to Solectron on a monthly basis. If we overestimate our manufacturing needs, Solectron may assess charges or we may have liabilities for excess or obsolete inventory.
Conversely, because lead times for required materials and components vary significantly and depend on factors such as the specific supplier, contract terms and demand for the particular component at any given time, if we underestimate our requirements, Solectron may have inadequate materials and components required to produce our appliances. In that event, the manufacturing of our appliances could be interrupted, shipments could be delayed and revenue could be deferred or lost. Solectron generally carries very little inventory of components for our appliances, and we rely on suppliers to deliver necessary components to Solectron in a timely manner based on forecasts provided to the suppliers.
Any shortages in components used in our appliances could delay shipment of our appliances or increase our product costs, which could harm our business.
We may experience shortages in components that we use in our appliances, and we may not accurately predict the availability of and demand for such components. We rely on Solectron to procure a majority of the components used in our appliances. As a result, any disruption in Solectron’s ability to procure necessary components in the quantities required or at reasonable prices could result in a delay in the shipment of our appliances. Due to technological, pricing or business reasons, some of the components used in our appliances are available only from a single or limited source of supply. For example, our capacity expansion shelves are currently supplied exclusively by a single vendor, Xyratex Technology Limited, our appliances depend on NVRAM cards that currently are only available from a single vendor, Micro Memory, LLC, which was acquired by VMETRO, and we acquire the chassis used in our appliances from a single vendor. Our agreement with Xyratex has a three-year term ending in March 2010, subject to early termination by either party under certain circumstances. Either we or Solectron order NVRAM cards under a standard purchase order arrangement with Micro Memory or its distributor, and either we or Solectron order chassis under a standard purchase order arrangement with our chassis supplier or its distributor. Significant time and effort would be required to locate new vendors for any of these components, if available at all, to qualify replacement components or to develop our appliances using an alternative technology. The unavailability of any of these or other necessary components could delay or prevent us from shipping our appliances. Component suppliers may be vulnerable to pressure from large purchasers of their products, who may be competitors of ours, to allocate available component supplies to them. In addition, increased demand generally by third parties for the components we use in our appliances may lead to decreased availability and higher prices for those components.
We are dependent on a single contract manufacturer and changes to that relationship may result in delays or disruptions that could harm our business.
We rely on a single independent contract manufacturer, Solectron, to manufacture and assemble our appliances. We currently have an agreement in place with Solectron that is subject to automatic extensions in one-year increments absent notice of termination by us or Solectron. However, either party can terminate the agreement for any reason at any time with at least 90 days’ advance written notice. We may not be able to effectively manage our relationship with Solectron, and Solectron may not meet our future requirements for timely delivery. Our orders represent only a small percentage of the overall orders received by Solectron from its customers. As a result, fulfilling our orders may not be considered a priority by Solectron in the event it is constrained in its ability to fulfill all of its customer obligations in a timely manner. Although the services required to manufacture and assemble our appliances may be readily available from a number of other established contract manufacturers, it would be time consuming and costly to qualify and implement a new contract manufacturer relationship. Although we have a contingency plan in place with Solectron in the event that its capacity at the location used to manufacture and assemble our appliances is reduced or temporarily eliminated, any event that disrupts the manufacturing and assembly process could harm our business. If Solectron suffers an interruption in its business, or experiences delays, disruptions or quality control problems in its manufacturing operations, or if we have to change or add additional contract manufacturers, our ability to manufacture and ship appliances to our customers would be delayed and our business would suffer.
If we do not successfully anticipate market needs and develop products and product enhancements that meet those needs, or if those products do not gain market acceptance, our business will suffer.
The market in which we currently operate is rapidly developing. We may not be able to anticipate future market needs or be able to develop new products or product enhancements to meet such needs, either in a timely manner or at all. We also may not be able to develop our products in a manner that enables us to successfully address the needs of other parts of the enterprise storage market. For example, we have recently introduced products for classes of applications other than backup and disaster recovery. These nearline classes of applications, such as archival storage and fixed-content data storage, manage largely static files and benefit from the fast storage and retrieval of disk-based systems, but do not require the performance characteristics of primary storage. Our failure to extend our deduplication technology into these nearline applications, particularly if our competitors are able to do so, could harm our business. In addition, any new products or product enhancements that we introduce may not achieve any significant degree of market acceptance or be accepted into our sales channel by our channel partners, which would harm our business.
If we fail to offer high quality customer support and services, our business would suffer.
Once our appliances are deployed within our customers’ networks, our customers depend on our support organization to resolve any issues relating to our appliances. A high level of customer support and services is important for the successful marketing and sale of our appliances. If we or our channel partners do not help our customers quickly resolve post-deployment issues and provide effective ongoing support, our ability to sell our appliances to existing customers would suffer and our reputation with potential customers would be harmed. Some of our international channel partners offer primary support for the appliances they sell to customers, and we rely on third parties to provide onsite hardware repair and replacement services for most of our customers. If the third parties fail to provide timely and effective services, our business could be harmed. As we expand our sales, we will be required to hire and train additional support personnel. In addition, as we expand our operations internationally, our support organization will face additional challenges including those associated with delivering support, training and documentation in languages other than English. If we fail to maintain high quality customer support or to grow our support organization to match any future sales growth, our business will suffer.
If we elect to discount our support and services pricing to attract or retain customers, we may be required to defer a portion of our revenue to future periods.
If we elect to discount our support and services pricing or otherwise introduce significant variability in our support and services arrangements, this variability may require us to defer the recognition of revenue from sales of our appliances. We recognize revenue for our appliances using the residual method as allowed by the American Institute of Certified Public Accountants, or AICPA, Statement of Position, or SOP, No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, with Respect to Certain Transactions, or SOP 98-9. Under this method, in order to recognize product revenue upon shipment, we must establish sufficient evidence, which is referred to as vendor specific objective evidence, or VSOE, of the fair value of our undelivered support and services. We have established VSOE of fair value of our support and services based on the price charged when support and services are sold separately. If we are required to change the pricing of support and services through discounting, or otherwise introduce variability in the pricing of support and services on certain transactions to attract or retain customers, we may be unable to maintain VSOE of the fair value of support and services for similar types of transactions. As a result, we could be required to defer all revenue for these transactions and recognize revenue ratably over the term of the related support and services contracts, which is typically one to three years. If this were to occur, our revenue would decline and our operating results would be negatively impacted.
Our appliances handle mission-critical data for our customers and are highly technical in nature. If customer data is lost or corrupted, or our appliances contain software errors or hardware defects, we could have product liability exposure and our reputation and business could be harmed.
Our appliances are involved in storing and replicating mission-critical data for our customers. The process of storing and replicating that data is highly technical and complex. If any data is lost or corrupted in connection with the use of our appliances, our reputation could be seriously harmed and market acceptance of our appliances could suffer. In addition, our appliances have contained and may in the future contain software errors, hardware defects or security vulnerabilities. We rely on our suppliers to deliver high quality components for use in our products and we have limited or no control over our suppliers’ product development and production processes. Some software errors or defects in the hardware components of our appliances may only be discovered after an appliance has been installed and used by customers. In April 2007, we initiated a field replacement program to replace a circuit board used in some of our appliances. To date, these circuit boards have experienced failures in less than 1% of the appliances that we believe are potentially affected. All of the circuit boards that have failed were manufactured by fabricators that are no longer supplying parts for use in our appliances. Through the replacement program, we are offering to replace the potentially affected circuit boards with circuit boards manufactured by a particular fabricator. We accrued estimated warranty costs of $1.2 million in the first quarter of 2007 for this replacement program. We accrued an additional $450,000 in the third quarter 2007 to expand this program for additional circuit boards used in some of our appliances. These estimates were based on the number of circuit boards we expect to replace under the program, the anticipated cost of replacement and refurbishment and other associated costs. As of December 31, 2007, we had incurred approximately $1.2 million of costs associated with these field replacement programs and $437,000 remained in accrued liabilities to cover future costs for the units potentially affected. Although we believe our estimates and judgments for the replacement program are reasonable, if the problem is more extensive than we currently believe or the actual costs of the program otherwise exceed our estimate, our operating results will be negatively impacted. Any such errors, defects or security vulnerabilities discovered in our appliances after commercial release could result in loss of revenue, loss of customers, increased service and warranty cost, harm to our reputation and diversion of attention of our management and technical personnel, any of which could significantly harm our business. In addition, we could face claims for product liability, tort or breach of warranty. Defending a lawsuit, regardless of its merit, is costly and may divert management’s attention and adversely affect the market’s perception of us and our appliances.
Changes in existing technologies or the emergence of new products or technologies could reduce demand for our appliances and significantly harm our business.
Changes in existing technologies could cause demand for our appliances to decline. For example, if changes in technology result in a significant reduction in the price for hard disk drives, enterprises may not need to utilize deduplication storage in order to cost-effectively backup and protect their data. One or more new technologies also could be introduced that compete favorably with our appliances or that cause our appliances to no longer be of significant benefit to our customers. In addition, because our appliances work with enterprise backup software applications to transfer and store data in the protection storage environment, we are dependent on enterprises’ use of these applications for data protection and disaster recovery purposes. If enterprises adopt products or technologies that enable them to protect and recover their data without the need for backup software, demand for our appliances would be reduced significantly.
The inability of our appliances to interoperate with backup software applications would cause our business to suffer.
We have designed our appliances to interoperate with the leading enterprise backup software applications available in the market. If our appliances are not compatible with the leading backup software applications, demand for our appliances will decline. Some backup software providers currently offer products that compete with ours and other providers may do so in the future. Backup software providers may in the future make
changes that would diminish the ability of our appliances to interoperate with their applications. If this were to occur, we may need to spend significant time and effort to ensure the continued compatibility of our appliances, which may not be possible at all. Any of these developments could significantly harm our business.
Data formats may change in a way that reduces the value of our compression technologies.
Our compression technologies have been designed to work well for data formats commonly seen in customer data centers today. The format of data stored on our appliances may change in ways that reduce the benefit of our compression technologies. Such format changes could result from changes in the applications that create or transmit the data, changes in the systems that store the data, or changes in policies concerning data encryption, compression, or encoding. For example, some potential customers in the past have employed encryption or compression technologies that they were unable or unwilling to disable and therefore did not find the benefits of our Global Compression technologies compelling. If the number of such potential customers were to increase significantly in the future, our business could suffer.
We rely on channel partners to sell our appliances, and disruptions to, or our failure to develop and manage our channel partners would harm our business.
Our future success is dependent upon establishing and maintaining successful relationships with a large number of channel partners. A substantial majority of our revenue is generated by sales through our channel partners, and we expect channel sales to continue to make up a significant portion of our total revenue in the future, particularly outside the United States. In the year ended December 31, 2007, approximately 86% of our revenue was generated by sales through our channel partners. Accordingly, our revenue depends in large part on the effective sales and lead generation activities of these channel partners.
Recruiting and retaining qualified channel partners and training them in our technology and product offerings requires significant time and resources. In order to develop and expand our distribution channel, we must continue to scale and improve our processes and procedures that support our channel, including investment in systems and training. Those processes and procedures may become increasingly complex and difficult to manage as we grow our organization. We have no minimum purchase commitments from any of our channel partners, and our contracts with these channel partners do not prohibit them from offering products or services that compete with ours. Our competitors may provide incentives to existing and potential channel partners to favor their products or to prevent or reduce sales of our appliances. Our channel partners may choose not to offer our appliances exclusively or at all. Establishing relationships with channel partners who have a history of selling our competitors’ products may also prove to be difficult. In addition, some of our channel partners are also competitors. Our failure to establish and maintain successful relationships with channel partners would seriously harm our business and operating results.
If we fail to establish and maintain proper and effective internal control over financial reporting, our operating results and our ability to operate our business could be harmed.
The Sarbanes-Oxley Act of 2002 requires, among other things, that we establish and maintain internal control over financial reporting and disclosure controls and procedures. In particular, under the current rules of the SEC, beginning with the year ending December 31, 2008, we must perform system and process evaluation and testing of our internal control over financial reporting to allow management to report on the effectiveness of our internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. Our independent registered public accounting firm will also be required to report on our internal control over financing reporting. Our and our auditor’s testing may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses and render our internal control over financial reporting ineffective. We expect to incur substantial accounting and auditing expense and expend significant management time in complying with the requirements of Section 404. If we are not able to comply with the requirements of Section 404 in a timely manner, or if we or our independent registered public accounting firm identify
deficiencies in our internal control over financial reporting that are deemed to be material weaknesses, the market price of our stock could decline and we could be subject to investigations or sanctions by the SEC, The NASDAQ Stock Market, or NASDAQ, or other regulatory authorities or subject to litigation. Our independent registered public accounting firm identified a material weakness in our financial statement close process as of December 31, 2006, and we implemented additional formal policies, procedures and processes, hired additional accounting personnel and increased management review and oversight over the financial statement close and reporting processes in order to remediate this material weakness. To the extent any material weaknesses in our internal control over financial reporting are identified in the future, we could be required to expend significant management time and financial resources to correct such material weaknesses or to respond to any resulting regulatory investigations or proceedings.
If we are unable to protect our intellectual property rights, our competitive position could be harmed, and we could be required to incur significant expenses to enforce our rights.
We depend on our ability to protect our proprietary technology. We rely on trade secret, patent, copyright and trademark laws and confidentiality agreements with employees and third parties, all of which offer only limited protection. Despite our efforts, the steps we have taken to protect our proprietary rights may not be adequate to preclude misappropriation of our proprietary information or infringement of our intellectual property rights, and our ability to police such misappropriation or infringement is uncertain, particularly in countries outside of the United States. Further, we do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims. Even issued patents may be contested, circumvented or invalidated. Moreover, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and, as with any technology, competitors may be able to develop similar or superior technologies to our own now or in the future. In addition, we have entered into a cross-license agreement with Quantum Corporation, a competitor of ours, that provides Quantum and its controlled affiliates a license to our current and future patents that relate to or are useful with respect to data transmission or data storage and that are or may be issued or applied for (or otherwise entitled to a priority date) on or prior to January 1, 2012. As a result of this agreement, we will not be able to assert our existing patent rights and many or all of our future patent rights against Quantum or its controlled affiliates for the foreseeable future, and Quantum has certain rights to assign this license to an acquirer of Quantum. It is also possible that we may find it necessary or advantageous to enter into similar cross licenses in the future with other actual or potential competitors.
Protecting against the unauthorized use of our patents, trademarks and other proprietary rights is expensive, difficult and, in some cases, impossible. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could be costly and divert management resources, either of which could harm our business. Furthermore, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforce their intellectual property rights than we do. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.
Claims by others that we infringe their proprietary technology could harm our business.
Third parties could claim that our appliances or technology infringe their proprietary rights. We expect that infringement claims may increase as the number of products and competitors in our market increases and overlaps occur. In addition, to the extent that we gain greater visibility and market exposure as a public company, we face a higher risk of being the subject of intellectual property infringement claims. Any claims of infringement by a third party, even those without merit, could cause us to incur substantial costs defending against the claim, and could distract our management from our business. Furthermore, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages. A judgment could also include an injunction or other court order that could prevent us from offering our appliances. In addition, we might be required to seek a license for the use of such intellectual property, which may not be available on
commercially reasonable terms or at all. Alternatively, we may be required to develop non-infringing technology, which could require significant effort and expense and may ultimately not be successful. Any of these events could seriously harm our business.
Third parties may also assert infringement claims relating to our appliances against our customers and channel partners. Any of these claims may require us to initiate or defend potentially protracted and costly litigation on their behalf, regardless of the merits of these claims, because we generally are obligated to indemnify our channel partners and, less frequently, our customers, from claims of infringement of proprietary rights of third parties. If any of these claims succeed, we may be forced to pay damages to, or on behalf of, our customers or channel partners, which could seriously harm our business.
Our use of open source software could impose limitations on our ability to commercialize our appliances.
We incorporate open source software into our appliances. The terms of many open source licenses have not been interpreted by United States courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our appliances. In that event, we could be required to seek licenses from third parties in order to continue offering our appliances, to re-engineer our appliances, to discontinue the sale of our appliances in the event re-engineering cannot be accomplished on a timely basis or to litigate any disputes relating to our use of open source software, any of which could harm our business.
Our business is subject to increasingly complex environmental legislation that has increased both our costs and the risk of noncompliance and may continue to do so in the future.
We face increasing complexity in the design and manufacture of our appliances as we adjust to new and upcoming requirements relating to the materials composition of many of our appliances. For example, the European Union, or EU, has adopted certain directives to facilitate the recycling of electrical and electronic equipment sold in the EU, including the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment, or RoHS, directive. The RoHS directive restricts the use of lead, mercury and certain other substances in electrical and electronic products placed on the market in the EU. A companion EU directive, the Waste Electrical and Electronic Equipment Directive imposes responsibility for the collection, recycling and recovery for certain electrical and electronic products on the manufacturers of such equipment.
We have incurred costs to comply with these regulations in the past and could incur additional costs in the future. In addition, compliance with these regulations could disrupt our operations and logistics. We will need to ensure that we can design and manufacture compliant appliances and that we can be assured a supply of compliant components from suppliers. Similar laws and regulations have been proposed or may be enacted in other regions, including the United States, Canada, China, Korea, Japan and Australia. These and other environmental regulations may require us to reengineer our appliances to utilize new components that are compatible with these regulations, which may result in additional costs to us.
We may not generate positive returns on our research and development investments.
Developing our products is expensive, and our investment in product development may involve a long investment return cycle. For the year ended December 31, 2007, our research and development expenses were $23.4 million, or approximately 19% of revenue. Our future plans include significant investments in research and development and related product opportunities. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. These investments may not generate positive returns in the near term, or at all.
We may engage in future acquisitions that could disrupt our business, cause dilution to our stockholders and harm our business, operating results and financial condition.
In the future we may acquire other businesses, products or technologies. We have not made any acquisitions to date and, as a result, our ability as an organization to make acquisitions is unproven. We may not be able to find suitable acquisition candidates and we may not be able to complete acquisitions on favorable terms, if at all. If we do complete acquisitions, we may not ultimately strengthen our competitive position or achieve our goals, and any acquisitions we complete could be viewed negatively by customers, financial markets or investors. In addition, any acquisitions that we make could lead to difficulties in integrating personnel and operations from the acquired businesses and in retaining and motivating key personnel from these businesses. Acquisitions may disrupt our ongoing operations, divert management from day-to-day responsibilities, increase our expenses and harm our business. Future acquisitions may also reduce our cash available for operations and other uses and could result in an increase in amortization expense related to identifiable assets acquired, potentially dilutive issuances of equity securities or the incurrence of debt.
We have incurred, and will continue to incur, significant costs as a result of operating as a public company, and our management is required to devote substantial time to compliance efforts.
As a public company, we incur significant legal, audit, accounting and other expenses that we did not incur as a private company. The Sarbanes-Oxley Act, as well as rules subsequently implemented by the SEC and NASDAQ, impose additional requirements on public companies, including enhanced corporate governance practices. For example, the NASDAQ listing requirements require that listed companies satisfy certain corporate governance requirements relating to independent directors, audit committees, distribution of annual and interim reports, stockholder meetings, stockholder approvals, solicitation of proxies, conflicts of interest, stockholder voting rights and codes of business conduct. Our management and other personnel are required to devote a substantial amount of time to these requirements. Moreover, these rules and regulations have increased our legal and financial compliance costs and have made some activities more time-consuming and costly. These rules and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors and board committees or as executive officers.
Our business is subject to the risks of earthquakes, fire, floods and other natural catastrophic events, and to interruption by man-made problems such as computer viruses or terrorism.
Our corporate headquarters and the operations of the contract manufacturer for our appliances are located in the San Francisco Bay Area, a region known for seismic activity. A significant natural disaster, such as an earthquake, fire or a flood, could harm our business. In addition, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems. In addition, acts of terrorism or war could cause disruptions in our or our customers’ business or the economy as a whole. To the extent that such disruptions result in delays or cancellations of customer orders, or delay the manufacture and shipment of our appliances, our business would be harmed.
Risks Related to Ownership of Our Common Stock
The trading price of our common stock has been volatile and is likely to be volatile in the future.
The trading prices of our common stock as well as the securities of other technology companies have been highly volatile. Further, our common stock has a limited trading history. Factors affecting the trading price of our common stock could include:
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variations in our operating results;
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announcements of technological innovations, new products and services, strategic alliances or significant agreements by us or by our competitors;
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recruitment or departure of key personnel;
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changes in the estimates of our operating results or changes in recommendations by any securities analysts that elect to follow our common stock;
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market conditions in our industry, the industries of our customers and the economy as a whole; and
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adoption or modification of regulations, policies, procedures or programs applicable to our business.
In addition, if the market for technology stocks or the stock market in general experiences loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. The trading price of our common stock might also decline in reaction to events that affect other companies in our industry even if these events do not directly affect us, or in reaction to reports from industry analysts about us or our competitors or others in the technology industry generally. Some companies that have had volatile market prices for their securities have had securities class actions filed against them. A suit filed against us, regardless of its merits or outcome, could cause us to incur substantial costs and could divert management’s attention.
Anti-takeover provisions in our charter documents and Delaware law could discourage, delay or prevent a change in control of our company and may affect the trading price of our common stock.
We are a Delaware corporation and the anti-takeover provisions of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting us from engaging in a business combination with an interested stockholder for a period of three years after the person becomes an interested stockholder, even if a change in control would be beneficial to our existing stockholders. In addition, our restated certificate of incorporation and amended and restated bylaws may discourage, delay or prevent a change in our management or control over us that stockholders may consider favorable. Our restated certificate of incorporation and amended and restated bylaws:
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authorize the issuance of “blank check” preferred stock that could be issued by our board of directors to thwart a takeover attempt;
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establish a classified board of directors, as a result of which the successors to the directors whose terms have expired will be elected to serve from the time of election and qualification until the third annual meeting following their election;
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require that directors only be removed from office for cause;
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provide that vacancies on the board of directors, including newly created directorships, may be filled only by a majority vote of directors then in office;
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limit who may call special meetings of stockholders;
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prohibit stockholder action by written consent, requiring all actions to be taken at a meeting of the stockholders; and
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require supermajority stockholder voting to effect certain amendments to our restated certificate of incorporation and amended and restated bylaws.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Our corporate headquarters is currently located at 2421 Mission College Blvd., Santa Clara, California 95054. We lease approximately 100,000 square feet of office space at this address pursuant to a lease that expires
in October 31, 2017. We recently signed an agreement to lease additional space next to our corporate headquarters that begins January 2009 for approximately 100,000 square feet of office space. We believe these new facilities will accommodate our needs for the foreseeable future. The lease for our former corporate headquarters in Santa Clara expires in February 2009, and we currently plan to sub-lease this space. We also maintain sales offices in multiple locations in the United States and internationally.
Item 3.
Item 3. Legal Proceedings
From time to time, we may become involved in legal proceedings arising in the ordinary course of our business. We are not presently involved in any legal proceedings, the outcome of which, if determined adversely to us, would have a material adverse affect on our business, operating results or financial condition.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth quarter of 2007.
Item 4A. Executive Officers of the Registrant
Our executive officers, and their ages and positions as of February 20, 2008, are set forth below:
Name
Age
Position
Frank Slootman
President and Chief Executive Officer
Michael P. Scarpelli
Senior Vice President and Chief Financial Officer
Daniel R. McGee
Senior Vice President of Engineering
David L. Schneider
Senior Vice President of Worldwide Sales
Frank Slootman has served as a member of our board of directors and as our President and Chief Executive Officer since July 2003. Prior to joining us, Mr. Slootman served as an executive at Borland Software Corporation from June 2000 to June 2003, most recently as Senior Vice President of Products. From March 1993 to June 2000, Mr. Slootman held management positions for two enterprise software divisions of Compuware Corporation. Mr. Slootman earned his undergraduate and graduate degrees in Economics from Erasmus University Rotterdam in the Netherlands.
Michael P. Scarpelli joined us as our Vice President and Chief Financial Officer in September 2006, and was promoted to Senior Vice President in January 2008. From January 2006 to September 2006, Mr. Scarpelli served as Executive Vice President and Chief Financial Officer for Lexar Media, Inc., a flash memory manufacturer which was acquired by Micron Technology, Inc. in 2006. From January 2002 to January 2006, Mr. Scarpelli held senior positions at HPL Technologies, Inc., a provider of yield management software and test chip solutions, most recently as Senior Vice President and Chief Financial Officer. Mr. Scarpelli began his career at PricewaterhouseCoopers LLP from May 1989 to December 2001. Mr. Scarpelli holds a B.A. in Economics from the University of Western Ontario.
Daniel R. McGee joined us as our Vice President of Engineering in February 2006, and was promoted to Senior Vice President of Engineering in January 2008. From March 2004 to February 2006, Mr. McGee was the Vice President of Engineering for Aventail Corporation, a provider of secure remote access products. From August 1999 to March 2004, Mr. McGee held various senior management positions at Pinnacle Systems, Inc., a provider of video editing solutions, TV tuners for personal computers and digital media adapters. Mr. McGee holds a M.S. in Engineering Management from Stanford University and a B.S. in Electrical Engineering & Computer Science from Oregon State University.
David L. Schneider joined us as our Vice President of Worldwide Sales in January 2004, and was promoted to Senior Vice President of Worldwide Sales in January 2008. From January 2003 to December 2003,
Mr. Schneider served as Vice President of Alliances, Channel and OEM sales for Borland Software Corporation. From May 2002 to January 2003, Mr. Schneider served as Vice President of Western United States Sales for TogetherSoft Corporation (later acquired by Borland Software Corporation). From January 1999 to May 2002, Mr. Schneider was Western Regional Manager at Iona Technologies, Inc. Mr. Schneider holds a B.A. in Political Science from the University of California, Irvine.
Part II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for Common Stock
Our common stock has been traded on The NASDAQ Global Market under the symbol “DDUP” since June 27, 2007. Prior to then, there was no public market for our common stock. The following table sets forth for the periods indicated the high and low sale prices of our common stock, as reported by The NASDAQ Global Market.
Holders of Record
As of February 20, 2008, there were 209 shareholders of record of our common stock.
Dividends
We have never declared or paid cash dividends on our common stock nor do we intend in the foreseeable future to pay cash dividends on our common stock.
Issuer Purchases of Equity Securities
We have not repurchased any of our common stock, and do not foresee purchasing our common stock in the foreseeable future.
Item 6.
Item 6. Selected Financial Data
You should read the following selected consolidated historical financial data in conjunction with the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements, related notes and other financial information included in this Annual Report. The selected financial data in this section is not intended to replace the consolidated financial statements and is qualified in its entirety by the consolidated financial statements and related notes included in this Annual Report.
We derived the selected consolidated financial data for the years ended December 31, 2007, 2006 and 2005 and as of December 31, 2007 and 2006 from our audited consolidated financial statements and related notes, which are included elsewhere in this Annual Report. We derived the selected consolidated financial data for the year ended December 31, 2004 and as of December 31, 2005 from our audited consolidated financial statements and related notes which are not included in this Annual Report. We derived the selected consolidated financial data for the year ended December 31, 2003 and as of December 31, 2004 and 2003 from our unaudited consolidated financial statements which are not included in this Annual Report. Historical results are not necessarily indicative of future results.
(2) See Note 14 of the notes to our consolidated financial statements.
Item 7.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of the financial condition and results of our operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included in Item 1A of this Form 10-K.
Overview
We were founded in October 2001 with a mission to develop breakthrough compression technology for disk-based deduplication storage. We began shipping our appliances in February 2004 to address the backup and network-based disaster recovery needs of enterprises. We sell our appliances to enterprises worldwide in a variety of industries, including defense, education, entertainment, finance, government, healthcare, technology, legal, media and retail. As of December 31, 2007, our appliances had been purchased by approximately 1,500 customers worldwide.
We are headquartered in Santa Clara, California. Our personnel are located throughout the United States and in numerous countries worldwide. We expect to continue to add personnel in the United States and internationally to provide additional geographic sales and technical support coverage.
We commenced our initial public offering, or IPO, of common stock on June 27, 2007, and the offering was completed on July 2, 2007. We sold and issued 8,108,500 shares of our common stock in our IPO, including 1,108,500 shares sold by us pursuant to the underwriters’ full exercise of their option to purchase additional shares, at an issue price of $15.00 per share. We raised approximately $109.2 million in net proceeds after deducting underwriting discounts and commissions of $8.5 million and other offering costs of $3.9 million, which were received on July 2, 2007. Upon the closing of the IPO, all shares of our mandatorily redeemable convertible preferred stock outstanding automatically converted into 34,780,625 shares of common stock.
We completed a follow-on offering of common stock on December 3, 2007. We sold and issued 3,051,114 shares of our common stock, including 251,114 shares sold by us pursuant to the underwriters’ partial exercise of their option to purchase additional shares, at an issue price of $27.00 per share. We raised approximately $77.8 million in net proceeds after deducting underwriting discounts and commissions of $3.4 million and other offering costs of $1.2 million, which were received on November 21, 2007 and December 3, 2007.
Our single product line of storage appliances is sold in different configurations depending on a customer’s requirements for storage capacity and performance. Variations in storage capacity and performance are delivered through the use of a variety of interchangeable component parts such as internal disk drives and central processing units. All of our appliances use our Global Compression technology to deduplicate data and, therefore, reduce the storage capacity required for backup and disaster recovery. When purchasing our appliances, customers may license one or more of our software technologies embedded in our appliances, including software that enables customers to utilize WAN vaulting to replicate backup data offsite.
Substantially all of our appliances have been sold in combination with support and services contracts. Our support and services contracts are typically offered for periods of one to three years.
We sell our appliances through a network of channel partners and through our direct sales force. In the year ended December 31, 2007, 2006 and 2005, approximately 86%, 85% and 85%, respectively, of our revenue was generated by sales through indirect channels. As of December 31, 2007, we had over 250 channel partners, and we expect that we will continue to sell a substantial majority of our appliances through our channel partners. We
consider the development of indirect sales channels in domestic and international markets to be important to future revenue growth and widespread acceptance of our products.
Growth of our product revenue will depend on our ability to attract new customers and on additional sales to existing customers. Our growth will also depend on our ability to introduce, and the market acceptance of, new products with higher capacity and performance and new products designed to serve other sectors of the storage market beyond protection storage that we believe will benefit from deduplication storage systems. We expect growth in international markets to be a significant factor contributing to our revenue growth in future periods. International revenue accounted for approximately 28%, 32% and 36% of our total revenue in the years ended December 31, 2007, 2006 and 2005, respectively. International revenue was 4% lower as a percentage of total revenue for fiscal 2007 compared with 2006 due to the higher growth rate of sales in North America as new sales personnel were added more rapidly and became productive more quickly in North America than elsewhere. International revenue was 4% lower as a percentage of total revenue for fiscal 2006 compared with 2005 due to the higher growth rate of sales in North America as we added new sales personnel more rapidly in North America than elsewhere. Despite these year-over-year reductions in the percentage of our international revenues, over time, we expect international revenue to increase in absolute dollars and as a percentage of our total revenue, as we add additional sales personnel internationally. Our growth in support and services revenue will depend upon increasing the number of systems under support and services contracts. Any such increases will depend on a growing customer base and renewal of existing support and services contracts. To date, no individual customer has accounted for greater than 10% of our total revenue in any year.
Our ability to achieve and sustain profitability will also be affected by the extent to which we incur additional expenses to expand our sales, marketing, product development and general and administrative capabilities. Personnel costs constitute the largest component of our operating expenses. Personnel costs consist of salaries, benefits, incentive compensation, including commissions for sales personnel, and stock-based compensation expense. As we expand internationally, we may incur additional costs to conform our products to comply with local laws or local product specifications and to ship our products to our international customers.
We believe our operations are more efficient and flexible because we outsource manufacturing of our products, and because we subcontract with third parties to provide onsite hardware repair and replacement services for our appliances, except in those instances where channel partners provide these services directly to our customers.
As a consequence of the rapidly evolving nature of our business and our limited operating history, we believe that period-to-period comparisons of revenue and operating results, including gross margin and operating expenses as a percentage of total revenue, are not necessarily meaningful and should not be relied upon as indications of future performance. Although we have experienced significant growth in our total revenue, you should not assume that our historical growth rates are indicative of future growth.
Revenue. Revenue is composed of product revenue, support and services revenue, and ratable products and related support and services revenue. Our product revenue is composed of sales of our appliances, which includes sales of expansion shelves that augment the internal storage of our appliances, and shipping charges. Our support and services revenue is derived from support and services contracts, which typically have a duration of one to three years, and installation services. Ratable product and related support and services revenue is derived from pre-2006 arrangements in which product and support are bundled and no vendor specified objective evidence of fair value exists for the undelivered support and services. For those arrangements, we recognize the entire arrangement fee over the period of the related support and services contract. As of December 31, 2007, we had $83,000 in remaining deferred revenue related to ratable product and related support and services revenue.
Cost of Revenue. Cost of revenue is composed of cost of product revenue, cost of support and services revenue, and cost of ratable products and related support and services revenue. Cost of product revenue consists primarily of the cost charged by our contract manufacturer to manufacture our appliances, the cost of expansion
shelves charged by the original equipment manufacturer, shipping charges, warranty obligations, the amortization of evaluation units, overhead allocations, personnel-related costs and provisions for excess and obsolete inventory, if any. Cost of support and services revenue consists of salaries, related costs of customer support personnel, overhead allocations and any third-party costs we incur in order to provide hardware repair and replacement services. Cost of ratable product and related support and services revenue consists of hardware and support and services costs related to transactions recognized ratably.
Gross Margin. Our gross margin has been and will continue to be affected by a variety of factors, including our appliance configuration mix, because our higher-capacity and higher-performance configurations tend to have higher gross margins; average selling prices of our appliances; the extent to which our revenue is composed of support and services revenue, which tends to have lower gross margins; new product introductions and enhancements; the cost of the components incorporated in our appliances; the cost of providing support and services; and the mix of direct sales and sales through our channel partners, which affects our average unit sales prices.
Operating Expenses. Operating expenses consist of sales and marketing, research and development, and general and administrative expenses. Personnel-related costs, which include stock-based compensation expense, are the most significant component of each of these expense categories. We grew from 179 employees as of December 31, 2006 to 435 employees as of December 31, 2007. We expect to continue to hire significant numbers of new employees in order to support our growth. In any particular period, the timing of additional hires could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue. We anticipate that our operating expenses will increase significantly in absolute dollar amounts.
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Sales and Marketing-Sales and marketing expenses represent the largest component of our operating expenses and include personnel costs, stock-based compensation, employee sales commissions and marketing programs. We intend to continue to invest heavily in sales and marketing by increasing the number of sales and channel support personnel worldwide. We expect future sales and marketing costs to continue to increase. Hiring additional sales personnel reduces operating margins until the new sales personnel generate meaningful revenue.
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Research and Development-Research and development expenses primarily include personnel costs, stock-based compensation, depreciation on lab equipment, costs of prototype equipment, quality assurance infrastructure depreciation, other related costs of quality assurance and overhead allocations. We expense research and development costs as incurred. Though we incur software development costs, the costs of software development that we incur after a product has reached technological feasibility are considered immaterial, and to date, we have not capitalized any such costs. We expect that research and development costs will increase in absolute dollar amounts.
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General and Administrative-General and administrative expenses consist primarily of compensation and related costs for personnel and facilities related to our executive, finance, human resource, information technology and legal organizations, stock-based compensation and fees for professional services. Professional services consist of outside legal, tax and audit costs. We have recently incurred, and expect to continue to incur significant additional expenses as a result of operating as a public company and as we hire additional personnel and incur costs for implementation of new information technology systems.
Other Income (Expense), Net. Other income (expense), net consists primarily of interest income on cash and cash equivalents and short-term investment balances and foreign currency remeasurement gains or losses. We historically have invested our cash in money market funds, and we have invested the funds from our IPO and follow-on offering in a combination of auction rate securities, commercial paper, corporate bonds and money market funds.
Provision for Income Taxes. In the years ended December 31, 2007 and 2006, we recorded an income tax provision for both federal and California alternative minimum taxes, or AMT, foreign taxes and state income taxes. For the year ended December, 31, 2005, we recorded an income tax provision for foreign taxes and state income taxes.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, or GAAP. These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our consolidated financial statements will be affected. The accounting policies that reflect our more significant estimates and judgments and that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition, stock-based compensation, inventory valuation, warranty reserve, allowance for doubtful accounts and short-term investments.
Revenue Recognition
Our software is integrated with industry standard components and is essential to the functionality of our appliances. We provide unspecified software updates and enhancements related to our products through support and services contracts. Accordingly, we recognize revenue in accordance with the guidance provided under AICPA Statement of Position, or SOP, No. 97-2, Software Revenue Recognition, or SOP 97-2, and SOP No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, with Respect to Certain Transactions, or SOP 98-9, for all transactions involving the sale of software. Product revenue is recognized when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer; (2) delivery has occurred, which is when the product title has transferred to the customer; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable. Our fees are considered fixed or determinable upon establishing an arrangement that contains the final terms of sale including the description, quantity and price of each product purchased. Our customer arrangements do not include rights of return or acceptance provisions. We assess our ability to collect from our customers based on a number of factors, including creditworthiness and past transaction history of the customer. If the customer is deemed not creditworthy, all revenue from the arrangement is deferred until payment is received and all other revenue recognition criteria have been met.
We recognize revenue for our appliances, which include multiple elements, using the residual method as allowed by SOP 98-9. Under this method, we allocate and defer revenue for the undelivered elements, which are generally support and services, based on relative fair value. We recognize the difference between the total arrangement fee and the amount deferred for the undelivered elements as product revenue. The determination of fair value of the undelivered elements is based on the price charged when those elements are sold separately, which is referred to as vendor specific objective evidence of fair value, or VSOE.
We have established VSOE of fair value of our support and services based on the renewal prices offered to and paid by our customers. As a result, product revenue is generally recognized upon shipment, assuming all other criteria for recognition discussed above have been met and, in the case of all indirect channel sales, persuasive evidence of the identity of the customer has been obtained. The fair value of the support and services is recognized as support and services revenue on a straight-line basis over the term of the related support period, which is typically one to three years.
Prior to January 1, 2005, we had not established VSOE of fair value of support and services, and accordingly recognized all revenue ratably over the term of the support and services contract and deferred and
recognized the direct cost of product over the corresponding period, typically one to three years. Beginning in the quarter ended March 31, 2005, we determined that we had established VSOE of fair value of support and services for products sold in certain types of transactions and continued to establish VSOE of fair value throughout 2005 for the remaining types of transactions. As of January 1, 2006, we had established VSOE of fair value for support and services for all types of transactions.
Stock-Based Compensation
Prior to January 1, 2006, we accounted for stock options granted using the fair value method in accordance with the provisions of Statement of Financial Accounting Standards, or SFAS No. 123, Accounting for Stock-Based Compensation.
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment, or SFAS 123(R), using the prospective transition method, which requires us to apply the provisions of SFAS 123(R) only to awards granted, modified, repurchased or cancelled after the adoption date. Under this transition method, our stock-based compensation expense recognized in 2006 includes the expense for stock options granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with SFAS 123(R), and the expense as determined under SFAS 123 for options granted prior to, but not vested as of January 1, 2006.
We recognize this expense on a straight-line basis over the optionees’ requisite service period, which is assumed to be the same as the vesting schedule of the options. We estimate the grant date fair value of stock option awards under the provisions of SFAS 123(R) using the Black-Scholes option valuation model, which requires, among other inputs, the deemed fair value of the underlying common stock on the date of grant and the expected volatility of the stock over the expected term of the related grants. For stock option awards granted prior to January 1, 2006, we estimated the fair value of the awards using the minimum value method under SFAS 123.
For stock options granted prior to our IPO, we determined that it was not practicable to calculate the volatility of our share price because our securities are not publicly traded and therefore there is no readily determinable market value for our stock, we have limited information on our own past volatility, and we have a limited operating history. Therefore, we estimated our expected volatility based on reported market value data for a group of publicly traded companies, which we selected from market indices that we believed were relatively comparable after consideration of their size, maturity, profitability, growth, risk and return on investment. We used the average expected volatility rates reported by the comparable group for an expected term that approximated the expected term that we estimated. Over time, once historical data and market trends become apparent, this information could change our estimates. A small change in the estimates used can result in a relatively large change in the estimated valuation.
Given the absence of an active market for our common stock prior to our IPO, our board of directors, taking into consideration the work of an independent valuation firm, determined the fair value of our common stock at each meeting at which grants were approved based on several factors, including valuation criteria and analysis, the preferential rights attributable to our then outstanding convertible preferred stock, developments in our business, the illiquid nature of our common stock and the likelihood of achieving a liquidity event, such as an initial public offering or sale of the company. Our board of directors made such determinations based on valuation criteria and analyses, the business, financial and venture capital experience of the individual directors and input from management.
If we had made different assumptions and estimates, the amount of our recognized and to be recognized stock-based compensation expense, net loss and net loss per share amounts could have been materially different. We believe that we have used reasonable methodologies, approaches and assumptions consistent with the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, in determining the fair value of our common stock prior to our IPO for financial reporting purposes.
We recorded stock-based compensation expense of $12.1 million, $1.3 million and $96,000 for the years ended December 31, 2007, 2006 and 2005, respectively. In future periods, stock-based compensation expense may increase as we issue additional equity-based awards to attract and retain employees and non-employee directors. Additionally, SFAS 123(R) requires that we recognize compensation expense only for the portion of stock options that are expected to vest. Our estimated forfeiture rate for all periods was 5%. If the actual rate of forfeitures differs from that estimated by management, we may be required to record adjustments to stock-based compensation expense in future periods.
At December 31, 2007, the total compensation expense related to stock-based awards granted but not yet recognized was approximately $41.6 million, net of estimated forfeitures. This expense will be amortized on a straight-line basis over a weighted average period of approximately 3.0 years. Our employee stock purchase plan is compensatory, and we recognized $2.8 million of expense in the year ended December 31, 2007 for the first purchase period that ended on January 31, 2008.
Inventory Valuation
Inventories consist of hardware and related component parts and are stated at the lower of cost (on a first-in, first-out basis) or market value, or cost less accumulated amortization in the case of evaluation units. We ship evaluation units to enable some of our prospective customers to test our equipment prior to purchasing. We amortize evaluation inventory on a straight-line basis over the shorter of twelve months or until sold, commencing in the month the product goes into the evaluation inventory pool. The amortization expense is included in the cost of product revenue. If a unit is purchased, we record a sale in accordance with our revenue recognition policy. We assess the valuation of our inventory on a quarterly basis and write down the value for estimated excess and obsolete inventory based upon estimates of future demand, including in-warranty and out-of-warranty service requirements. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products and technological obsolescence of our products. Inventory write-downs are reflected as cost of product. During the year ended December 31, 2007, we incurred an expense of $264,000 for inventory write-downs related to our discontinuance of our 4xx products. Amortization of evaluation units was approximately $2.6 million, $1.4 million and $588,000 for the years ended December 31, 2007, 2006 and 2005, respectively. We do not allocate indirect overhead costs to finished goods inventory as these amounts are not material. Spare parts are expensed to cost of product revenue as purchased. As of December 31, 2007 and 2006, we had approximately $2.9 million and $656,000, respectively, in historical costs of spare parts inventory on hand that had been fully expensed. The increase in the expenses related to valuation units and spare parts reflect the increase in revenue and growth of our business and our installed base.
Warranty Reserve
Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically 12 months from the date of shipment to the customer for hardware and 90 days for software. Our warranty costs consist of the estimated labor and shipping costs for the warranty repair, as the hardware costs are covered by our manufacturers’ warranties. For existing products, the warranty reserve is based on actual historical experience. For new products, the warranty reserve is based on historical experience of similar products until such time as sufficient historical data has been collected for the new product.
During the three months ended March 31, 2007, we recorded an estimated charge of $1.2 million associated with a field replacement program that was initiated in April 2007 to replace a circuit board used in some of our appliances. During the three months ended September 30, 2007, we recorded an estimated charge of $450,000 to expand this replacement program for additional circuit boards used in some of our appliances. To date, these circuit boards have experienced failures in less than 1% of the appliances that we believe are potentially affected. Through the replacement program, we are offering to replace the potentially affected circuit boards with circuit
boards manufactured by a particular fabricator. As of December 31, 2007, we had incurred approximately $1.2 million of costs associated with these field replacement programs and $437,000 remains in accrued liabilities to cover future costs for the units potentially affected. We believe our estimates and judgments for the replacement program are reasonable based upon information available at this time. Our estimated charge associated with the replacement program is based on the number of circuit boards we expect to replace under the program, the anticipated cost of replacement and refurbishment and other associated costs. To the extent there are differences between our estimates and actual results, our consolidated financial statements will be affected.
Allowance for Doubtful Accounts
We perform credit evaluations of our customers’ financial condition and generally do not require collateral from our customers. These evaluations require significant judgment and are based on a variety of factors including, but not limited to, current economic trends, payment history and financial review of the customer. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments. When we become aware that a specific customer is unable or unwilling to meet its financial obligations, we record a specific allowance to reflect the level of credit risk in the customer’s outstanding receivable balance. In addition, we record additional allowances based on certain percentages of aged receivable balances. We classify bad debt expenses as general and administrative expenses. To date, our accounts receivable write-offs have not been significant and the allowance for doubtful accounts has not been material.
Short-Term Investments
We have an investment portfolio comprised of cash, auction rate securities, money market funds, commercial paper, corporate bonds and government agency certificates, and we actively manage our portfolio with an objective of capital preservation. The value of these securities is subject to market volatility for the period we hold these investments and until their sale or maturity. We recognize realized losses when declines in the fair value of our investments, below their cost basis, are judged to be other-than-temporary. In determining whether a decline in fair value is other-than-temporary, we consider various factors including market price (when available), investment ratings, the financial condition and near-term prospects of the investee, the length of time and the extent to which the fair value has been less than our cost basis, auction success and failure rates, and our intent and ability to hold the investment until maturity or for a period of time sufficient to allow for any anticipated recovery in market value. We make significant judgments in considering these factors. If it is judged that a decline in fair value is other-than-temporary, the investment is valued at the current fair value and a realized loss equal to the decline is recorded, which could materially adversely affect our operating results.
Results of Operations
Revenue
The following table sets forth each of our sources of revenue for the specified periods and as a percentage of our total revenue for those periods.
Year ended December 31, 2007 Compared to the Year Ended December 31, 2006: Product revenue increased $72.0 million to $108.9 million in the year ended December 31, 2007 from $36.9 million in the year ended December 31, 2006. This increase was due to an increase in the number of units sold to new and existing customers, facilitated by an increase in the number of sales personnel, an increase in the number of our channel partners and the introduction of new products. As of December 31, 2007, our customer base had increased to over 1,500 customers compared to approximately 650 customers at December 31, 2006. The introduction of new products, principally our DD510, DD530, DD565 and the DD580 product lines, which have higher capacity and higher performance than our legacy products, were sold at higher average sales prices than our legacy products. We expect to continue to release new products with higher capacity, higher performance and higher average selling prices.
Support and services revenue increased $11.5 million to $14.4 million in the year ended December 31, 2007 from $2.9 million in the year ended December 31, 2006. This increase was the result of increased product sales and, to a lesser extent, the renewal of support and services contracts by existing customers. Substantially all of our customers purchase support and service contracts when they purchase our appliances. As our customer base grows, we expect the proportion of revenue generated from support and services to increase over time, from both new contracts and renewals of existing contracts.
Ratable product and related support and services decreased $6.3 million to $330,000 in the year ended December 31, 2007 from $6.7 million in the year ended December 31, 2006. This decrease was the result of establishing VSOE of fair value for all support and services agreements in fiscal 2006. At December 31, 2007, we had $83,000 in remaining deferred revenue related to ratable product and related support and services revenue.
International revenue was 28% and 32% of total revenue for the years ended December 31, 2007 and 2006, respectively. Although revenue outside North America increased in the year ended December 31, 2007 in absolute amounts, the percentage of total revenue it represented in such period declined compared with the same
period in 2006 due to the higher growth rate of sales in North America as new sales personnel were added more rapidly and became productive more quickly in North America than elsewhere. As we continue to expand into international locations and introduce our products in new markets, we expect international revenue to increase in absolute dollars and as a percentage of total revenue.
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005: Product revenue increased $33.0 million, from $3.8 million in the year ended December 31, 2005 to $36.9 million in the year ended December 31, 2006, due to an increase in the number of units sold to new and existing customers, an increase in the number of sales personnel, and an increase in the number of our channel partners. The increase in product revenue was also driven by an increase in our average sales prices resulting from the introduction of new products with higher capacity and higher performance, including our DD560 appliances which were introduced in the third quarter of 2006.
Support and services revenue increased $2.8 million, from $85,000 in the year ended December 31, 2005 to $2.9 million in the year ended December 31, 2006, due to increased sales of support and services contracts associated with increased product sales and, to a lesser extent, the renewal of support and services contracts by existing customers.
Ratable product and related support and services revenue increased $2.5 million, from $4.2 million in the year ended December 31, 2005 to $6.7 million in the year ended December 31, 2006, due to the amortization of revenue from those sales made prior to 2006 for which VSOE of fair value for support and services had not been established.
International revenue was 32% and 36% of total revenue for the years ended December 31, 2006 and 2005, respectively. Although revenue outside North America increased in the year ended December 31, 2006 in absolute amounts, the percentage of total revenue it represented in such period declined compared with the same period in 2005 due to the higher growth rate of sales in North America as we added new sales personnel more rapidly in North America than elsewhere.
Cost of Revenue, Gross Profit and Gross Margin
The following table sets forth each of our costs of revenue, gross profit and gross margin for the specified periods.
Year ended December 31, 2007 Compared to the Year Ended December 31, 2006: Cost of product revenue increased $19.6 million to $30.7 million in the year ended December 31, 2007 from $11.1 million in the year ended December 31, 2006. This increase was due to increased hardware costs associated with an increased number of shipments of appliances to our customers, as noted in the discussion of product revenue above, an increase in salaries and employee related benefits of $815,000 and an increase in stock-based compensation of $196,000. Also included in the increase for the year ended December 31, 2007 is a charge of $1.6 million for estimated warranty costs associated with a field replacement program for a circuit board used in our appliances.
To date, less than 1% of these circuit boards have experienced failures. In April 2007, we initiated this field replacement program in which we are offering to replace circuit boards that we believe are potentially affected with circuit boards manufactured by an alternative supplier, and we expanded this program in September 2007 for additional circuit boards used in some of our appliances. This warranty charge does not assume any recovery from our suppliers because any recovery is uncertain at this time.
Cost of support and services revenue increased $3.3 million to $5.2 million in the year ended December 31, 2007 from $1.9 million in the year ended December 31, 2006. This increase was due to increases in our support personnel that increased our salary expense, recruiting and employee-related benefits by $1.1 million. Also contributing to the increase was stock-based compensation, which accounted for $275,000 of the increase, increased outside service costs of $939,000 related to support of our products from increased sales, and an increase in installation costs of $599,000. We expect the cost of support and services revenue to continue to increase in 2008 as we expect our revenue and our installed base to continue to increase.
Cost of ratable product and related support and services declined in fiscal 2007 in line with the decline in ratable product and related support and services revenue.
Gross margin increased from 69% in the year ended December 31, 2006 to 71% in the year ended December 31, 2007. The increase in gross margin was due to increased product margin from cost reductions realized with respect to our products from increased sales volume and decreases in hardware costs, increased sales of higher capacity and higher performance products that have higher gross margins, and increased margins on support and services revenue resulting from increased operational efficiency due to a larger installed base. These increases were partially offset by a provision on inventories of $264,000 and estimated warranty costs associated with the field replacement program of $1.6 million. We expect our gross margins to decline slightly to a range of 68% to 70% in fiscal 2008 due to increased pricing pressures, which we expect to be partially offset by cost efficiencies from increased sales and support operations.
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005: Cost of product revenue increased $7.8 million, from $3.2 million in the year ended December 31, 2005 to $11.1 million in the year ended December 31, 2006, due to increased hardware costs associated with increased shipments of our appliances to customers. Our average cost of product per unit remained substantially the same even as average sales price increased, which resulted in higher margins. Cost of support and services revenue increased $1.0 million, from $895,000 in the year ended December 31, 2005 to $1.9 million in the year ended December 31, 2006, as we added additional customer support headcount to support increased product sales.
Gross margin increased from 36% in the year ended December 31, 2005 to 69% in the year ended December 31, 2006. The increase in gross margin was due to the introduction of higher capacity and higher performance products with higher gross margins in 2006, the allocation of fixed costs over greater total revenue, average cost of product per unit remaining substantially the same and increased margins on support and services revenue resulting from increased operational efficiency due to a larger installed customer base.
Sales and Marketing Expenses
Year ended December 31, 2007 Compared to the Year Ended December 31, 2006: Sales and marketing expenses increased $40.2 million to $60.5 million in the year ended December 31, 2007 from $20.3 million in the year ended December 31, 2006. This increase was due to an increase in the number of sales and marketing employees, which grew to 244 employees at December 31, 2007 from 90 employees at December 31, 2006,
including the addition of approximately 50 sales and marketing employees associated with our international operations. The increase in employees resulted in higher salary expense, employee-related benefits and fees for recruitment of new employees. In addition, commission expenses increased due to the substantial increase in our total revenue and the higher number of employees eligible to receive commissions, which are earned and recognized as expense on bookings. Salaries, employee-related benefits, fees for recruitment of new employees and commissions accounted for $26.9 million, stock-based compensation expense accounted for $5.8 million, and promotional, tradeshows and marketing costs accounted for $2.1 million of the fiscal 2007 increase. The remaining $5.4 million of the increase was principally the result of increased costs from travel and costs associated with international operations.
We anticipate that sales and marketing expenses will increase in absolute dollars, as we intend to expand our sales force, both domestically and internationally.
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005: Sales and marketing expenses increased $10.8 million, from $9.5 million in the year ended December 31, 2005 to $20.3 million in the year ended December 31, 2006, due to an increase in the number of sales and marketing employees, which grew from 34 employees as of December 31, 2005 to 90 employees as of December 31, 2006, including the addition of 19 sales and marketing employees associated with our international operations. The increase in employees resulted in higher salary expense, employee-related benefits and fees for recruitment of new employees. Additionally, commission expense increased in the year ended December 31, 2006 as compared to the year ended December 31, 2005 due to the substantial increase in revenue and the higher number of employees. Of the $10.8 million increase in sales and marketing expenses in the year ended December 31, 2006, salaries, employee-based benefits, fees and commissions accounted for $8.0 million. Stock-based compensation expense related to sales and marketing personnel was $28,000 in the year ended December 31, 2005 compared to $485,000 in the year ended December 31, 2006.
Research and Development Expenses
Year ended December 31, 2007 Compared to the Year Ended December 31, 2006: Research and development expenses increased $13.0 million to $23.4 million in the year ended December 31, 2007 from $10.4 million in the year ended December 31, 2006. Of the increase, salaries and employee-related benefits and recruiting costs accounted for $7.9 million, as the result of research and development headcount increasing to 116 employees at December 31, 2007 from 64 employees at December 31, 2006. Increased expenses related to cost of consultants accounted for $756,000, stock-based compensation accounted for $2.4 million and facility-related costs for equipment and depreciation on capitalized equipment accounted for $829,000 of the increase. These increases were the direct result of hiring additional personnel to drive new product introductions and broaden our product line.
We anticipate that research and development expenses as a percentage of our total revenue will remain relatively stable but expect that the absolute dollar amount will increase in fiscal 2008, as we continue to invest in research, new product development and enhancements to our existing appliances.
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005: Research and development expenses increased $4.0 million, from $6.4 million in the year ended December 31, 2005 to $10.4 million in the year ended December 31, 2006, due primarily to an increase in personnel and facility-related costs as a result of research and development headcount increasing from 33 employees as of December 31, 2005 to 64 employees as of December 31, 2006. Salaries and employee-related benefits accounted for $2.5 million of the
$4.0 million increase in research and development expenses. Stock-based compensation expense for research and development personnel was $47,000 in the year ended December 31, 2005 compared to $558,000 in the year ended December 31, 2006.
General and Administrative Expenses
Year ended December 31, 2007 Compared to the Year Ended December 31, 2006: General and administrative expenses increased $8.2 million to $11.0 million in the year ended December 31, 2007 from $2.8 million in the year ended December 31, 2006. Salaries, employee-related benefits and recruiting costs accounted for $3.4 million of the increase, professional service and consultant fees accounted for $2.2 million of the increase and stock-based compensation expense accounted for $2.0 million of the increase. The increase in salaries and employee-related benefits was due to an increase in headcount to 39 employees at December 31, 2007 from 11 employees at December 31, 2006. The additional personnel, professional service and consultant fees were the result of our ongoing efforts to build our legal, finance, human resources, recruiting and information technology functions.
We expect the absolute amount of general and administrative expenses to increase in the future as we expand our finance function to manage our growth and as we incur additional costs associated with being a public company.
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005: General and administrative expenses increased $1.8 million, from $1.0 million in the year ended December 31, 2005 to $2.8 million in the year ended December 31, 2006, due primarily to an increase in personnel costs, and an increase in professional services fees. Of the $1.8 million increase in general and administrative expenses in the year ended December 31, 2006, salaries and employee-related benefits accounted for $736,000 and professional service fees accounted for $696,000. The additional personnel and professional services fees are primarily the result of our ongoing efforts to build our legal, finance, human resources and information technology functions. Stock-based compensation expense for general and administrative personnel was $17,000 in the year ended December 31, 2005 compared to $212,000 in the year ended December 31, 2006.
Settlement Expense
In the fourth quarter of 2006, we received an inquiry from Quantum Corporation regarding our interest in licensing certain patents that Quantum believed we may have previously incorporated into our products or may incorporate in the future. As a result of our discussions with Quantum, which commenced in 2006, we entered into a patent cross-license agreement with Quantum in March 2007, with an effective date of January 1, 2007. Under the terms of the cross-license, we issued Quantum 390,000 shares of our common stock in March 2007. We engaged an independent valuation firm to assist us in our estimate of the value of the shares of our common stock as of the date of issuance. Based on consideration of this valuation, we estimated the value of the common stock issued under the agreement to be approximately $3.3 million.
The same independent valuation firm assisted us in our estimate of the value of the intangible asset associated with the cross-license agreement and to estimate its useful life. Based on consideration of this valuation, we estimated the fair value of the intangible asset to be $400,000 and have an estimated useful life of three years. This asset will be amortized to cost of product revenue beginning January 1, 2007. The $2.9 million balance of the settlement amount represents payment to Quantum for a release of all claims for any past acts or conduct, and we have recorded the amount as settlement expense in our consolidated statement of operations for the year ended December 31, 2006.
Other Income (Expense), Net
Year ended December 31, 2007 Compared to the Year Ended December 31, 2006: Total other income (expense), net increased $3.3 million to $4.0 million in the year ended December 31, 2007 from $723,000 in the year ended December 31, 2006, as a result of income earned from the investment of our IPO and follow-on offering net proceeds and other funds, net of foreign currency net gains that declined year over year.
Foreign currency net gains decreased $77,000 for the year ended December 31, 2007 from the year ended December 31, 2006. We are presently evaluating the desirability of entering into foreign currency hedging contracts, primarily Euro-based revenue contracts, to reduce our exposure to fluctuations in currency exchange rates.
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005: Total other income (expense), net increased $440,000 from $283,000 in the year ended December 31, 2005 to $723,000 in the year ended December 31, 2006, due primarily to higher interest rates on cash balances and from foreign currency gains, net of other expenses.
Provision for Income Taxes
Year ended December 31, 2007 Compared to the Year Ended December 31, 2006: Our provision for income taxes increased $282,000 to $493,000 in the year ended December 31, 2007 from $211,000 in the year ended December 31, 2006. This increase was due to our increased international activities resulting in increased foreign taxes, federal and California AMT and state income taxes.
As of December 31, 2007, we had net operating loss carryforwards for federal and state income tax purposes of $19.9 million and $19.8 million, respectively. As of December 31, 2007, the portion of the federal and state operating loss carryforwards which relates to stock option benefits is approximately $9.5 million, which will be recorded to equity when they reduce taxes payable in cash. We also had federal and state research and development tax credit carryforwards of approximately $2.2 million and $2.4 million, respectively. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, our net deferred tax assets have been fully offset by a valuation allowance. If not utilized, the federal and state net operating loss will expire between 2010 and 2025. Federal research and development tax credits begin to expire in 2022 and the California research and development credits have no expiration date. As of December 31, 2007, we had manufacturers’ investment credit carryforwards of $12,000 that will begin to expire in 2012. We have performed an analysis of our net operating loss carryforwards and credit carryforwards pursuant to Sections 382 and 383 of the Internal Revenue Code, or Code. We experienced “ownership changes” as defined in Section 382 of the Internal Revenue Code, or Code. Accordingly, the use of the net operating loss carryforwards and credit carryforwards is partially limited by the annual limitations described in Sections 382 and 383. To the extent that any single-year loss or credit is not utilized to the full amount of such limitations, such unused loss or credit is carried over to subsequent years until the earlier of its utilization or the expiration of the relevant carryforward period. Such annual limitations pursuant to Section 382 and 383 of the Code could result in the expiration of our net operating loss carryforwards and/or credit carryforwards before utilization.
Effective January 1, 2007, we adopted Financial Accounting Standards Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, or FIN 48. FIN 48
prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in a company’s income tax return, and also provides guidance on derecognition, classification, interest and penalties accounting in interim periods, disclosure, and transition. FIN 48 utilizes a two-step approach for evaluating uncertain tax positions accounted for in accordance with SFAS No. 109. Step one, Recognition, requires a company to determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. Step two, Measurement, is based on the largest amount of benefit which is more likely than not to be realized on ultimate settlement. The cumulative effect of adopting FIN 48 on January 1, 2007 was recognized as a change in accounting principle, recorded as an adjustment to the opening balance of retained earnings on the adoption date. As a result of the implementation of FIN 48, we recognized no change in the liability for unrecognized tax benefits related to tax positions taken in prior periods, and no corresponding change in retained earnings. Additionally, FIN 48 specifies that tax positions for which the timing of the ultimate resolution is uncertain should be recognized as long-term liabilities. We made no reclassifications between current taxes payable and long term taxes payable upon adoption of FIN 48. Our total amount of unrecognized tax benefits as of the January 1, 2007 adoption date and December 31, 2007 was $820,000 and $1.6 million, respectively. Of this total, $159,000 represents the amount of unrecognized tax benefits that, if recognized, would affect our effective tax rate. We expect that the amount of unrecognized benefits will change during the next 12 months; however, we do not expect the change to have a material impact on our financial position.
Upon adoption of FIN 48, our policy to include interest and penalties related to unrecognized tax benefits within our provision for income taxes did not change. For the year ended December 31, 2007, we recognized $15,000 of interest and penalties related to unrecognized tax benefits in our provision for income taxes.
The tax years 2002 through 2007 remain open to examination by the major domestic taxing jurisdictions to which we are subject, and for the international jurisdictions the tax years open to examination vary depending on the local tax laws.
Year Ended December 31, 2006 Compared to the Year Ended December 31, 2005: Our provision for income taxes increased $178,000, from $33,000 in the year ended December 31, 2005 to $211,000 in the year ended December 31, 2006 primarily due to our increased international activities resulting in increased foreign taxes, as well as increased federal and California AMT and state income taxes.
Liquidity and Capital Resources
Working Capital
Working capital consists principally of cash and cash equivalents, short-term investments, accounts receivable, inventories, prepaid expenses and other current assets, net of accounts payable, accrued compensation and related benefits, other accrued liabilities, income taxes payable and current deferred revenue. Working capital increased $190.8 million from December 31, 2006 to December 31, 2007, due primarily to the net proceeds from our IPO of $109.2 million and our follow-on offering of $77.8 million. Other changes of note are:
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The increase in cash and cash equivalents was the result of the net proceeds from our IPO and follow-on offering and improved collections from accounts receivable reflected in our decrease in day’s sales outstanding from an average of 78 days as of December 31, 2006 to an average of 71 days
as of December 31, 2007, computed based on the respective revenue from the immediately preceding quarter. We anticipate that accounts receivable will comprise a significant portion of working capital as we continue to grow revenue because a substantial portion of our sales, and therefore our shipping and billing, occurs near the end of each quarter.
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Short-term investments represent investment of the net proceeds from our IPO and follow-on offering.
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Accounts receivable increased from increased revenue.
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Inventory increased due to the net increase in the number of units held in the evaluation inventory pool, purchases of raw materials related to new product introductions and increases in finished goods levels.
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Prepaid expenses and other current assets increased for prepaid maintenance contracts, insurance, rent and other deposits.
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Accounts payable and other accrued liabilities increased from increased purchases of inventory and property, plant and equipment to support increased headcount and research and development spending, accrued payroll and vacation from the increase in employees, accrued consulting costs from increased projects and estimated warranty costs associated with our field replacement program that began in April 2007 and was expanded in September 2007.
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Current deferred revenue increased from higher product revenue and the related support that is recognized over the maintenance and support life.
Working capital increased by $3.2 million from December 31, 2005 to December 31, 2006, due to an increase in accounts receivable of $11.1 million, offset by increases in accounts payable of $2.6 million, accrued compensation and related benefits of $2.3 million, other accrued liabilities of $1.5 million and current deferred revenue of $1.5 million. Based on revenue from the immediately preceding quarter, our accounts receivable balance was outstanding for an average of 78 days as of December 31, 2006 and an average of 101 days as of December 31, 2005.
Cash and Cash Equivalents
Cash and cash equivalents consist of highly liquid investments in time deposits held at major banks, commercial paper, United States government agency discount notes, money market mutual funds and other money market securities with original maturities of 90 days or less.
Since 2005, we have expanded our operations internationally. Our sales contracts are mainly denominated in United States dollars for Asia and Japan, and denominated in Euros in Europe and Canadian dollars for Canada on certain transactions. We are presently evaluating the desirability of entering into foreign currency hedging contracts, primarily Euro-based revenue contracts, to reduce our exposure to fluctuation in currency exchange rates. We currently do not hedge the operating expenses that are primarily denominated in foreign currency in countries where we have sales or operating personnel because we believe those situations create natural hedges. We may begin to sell our products in local currency in other locations. As we fund our international operations, our cash and cash equivalents are affected by changes in exchange rates for those expenses we will not hedge. To date, the foreign currency effect on our cash and cash equivalents and working capital were gains of $123,000 and $200,000 for the years ended December 31, 2007 and 2006, respectively.
Short-term Investments
Short-term investments consist of auction rate securities, commercial paper, government agency securities and corporate bonds with original maturities of 90 to 365 days.
At December 31, 2007, we had $29.6 million of principal in auction rate securities. In January 2008, these securities, which consist of AAA-rated, taxable municipal debt obligations, auctioned successfully. On
February 14, 2008, these auction rate securities failed to auction, causing access to these funds to be restricted. At this time, we believe the interest is collectable, but we cannot determine if any impairment has occurred. With the recent volatility in the capital markets, there is a risk that we could suffer a loss of principal and suffer a reduction in our interest or return on these and other investments, which could harm our financial condition.
Cash Flows
Cash Flows from Operating Activities
Our cash flows from operating activities will continue to be affected principally by the extent to which we spend on increasing personnel, primarily in sales and marketing and research and development, in order to grow our business. The timing of hiring sales personnel in particular affects cash flows as there is a lag between the hiring of sales personnel and the generation of revenue and cash flows from such recently hired sales personnel. Our largest source of cash flows from operating activities is cash collections from our customers. Our primary uses of cash from operating activities are for personnel-related expenditures, rent payments, inventory purchases to support our revenue growth and research and development costs.
Cash provided by operating activities increased in the year ended December 31, 2007 as compared to the year ended December 31, 2006 due to increased sales activity, improved collections of accounts receivable as a result of an increased effort in our collection process, and an increase in deferred revenue resulting from payments on support and services contracts. We expect to be able to generate positive cash flows from operating activities in fiscal 2008 from increased sales and gross profit, even as we continue to add personnel, increase inventory purchases and invest in functions associated with being a public company.
Cash used in operating activities decreased in the year ended December 31, 2006 compared to the year ended December 31, 2005 due to increased sales activity offset in part by increased operating expenditures, in particular increased spending on personnel and research and development costs.
Cash Flows used in Investing Activities
Cash flows used in investing activities primarily relate to capital expenditures to support our employee headcount growth and net purchases of investment securities. Cash used in investing activities was $118.8 million in the year ended December 31, 2007 compared to $1.4 million in the year ended December 31, 2006. Included in the year ended December 31, 2007 is the investment of $104.2 million of our IPO and follow-on offering net proceeds in short-term investments, along with $14.6 million of purchases of property, plant and equipment, reflecting our increase in headcount of 256 in the period, and investments in computer equipment, lab equipment for research and development, leasehold and furniture and fixtures from our new corporate headquarters and new system infrastructure. The entire amount for the year ended December 31, 2006 related to capital purchases primarily relating to research and development, including lab equipment, and increased computer equipment for new employees and office space.
Cash used in investing activities increased $189,000 to $1.4 million in the year ended December 31, 2006 from $1.2 million in the year ended December 31, 2005.
Cash Flows from Financing Activities
Cash flow provided by financing activities in the year ended December 31, 2007 of $187.8 million resulted from the net proceeds from our IPO and follow-on offering, proceeds of $555,000 from the cash exercise of stock options to purchase 672,000 shares of our common stock by our employees, proceeds of $267,000 from the purchase of 30,000 fully vested shares by one of our directors, net of 88,000 shares repurchased by us for $64,000.
We financed our operations prior to our IPO primarily through private sales of convertible preferred stock totaling net proceeds of $41.5 million since inception. Financing activities in the year ended December 31, 2006 consisted of issuing 60,000 shares of Series C convertible preferred stock for net proceeds of $180,000 and the exercise of 1,882,000 stock options for net proceeds of $1.1 million. Cash flows provided by financing activities in the year ended December 31, 2005 consisted of selling 7,396,512 shares of our Series C convertible preferred stock in 2005 for net proceeds of $15.0 million.
We believe that our existing cash balances will be sufficient to fund our projected operating requirements for at least 12 months. However, we may need to raise additional capital or incur indebtedness to respond to competitive pressures or strategic opportunities. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of expansion into new territories, the timing of new product introductions and enhancements to existing products, and the continuing market acceptance of our products. Although we currently are not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us, or at all.
Contractual Obligations
The following is a summary of our contractual obligations as of December 31, 2007:
(1) In 2007, we entered into a new operating lease for our corporate headquarters.
(2) Represents amounts associated with agreements that are enforceable, legally binding and specify terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of payment. Obligations under contracts that we can cancel without a significant penalty are not included in the table above.
We purchase all of our appliances from our contract manufacturer, Solectron, which was recently acquired by Flextronics. We provide them with a rolling six-month forecast for planning purposes and place firm purchase orders for 30 days of expected purchases which we are contractually committed to purchase. As of December 31, 2007, we had $3.6 million in aggregate non-cancellable purchase commitments placed with Solectron, which are included in the table above. In addition, as of December 31, 2007, we had an additional $14.3 million of other non-cancellable purchase commitments with other third-party vendors, which are included in the table above.
Under the terms of the lease for our prior corporate headquarters, we are obligated to provide a letter of credit for $136,000. To date, this letter of credit is not in place and has not been required by our sub-lessor.
On July 10, 2007, we entered into a lease for office space, which has become our new corporate headquarters. The term of the lease runs from November 1, 2007 to October 31, 2017 and the approximate
aggregate rent due over the term of the lease is $23.0 million. Under the terms of the lease, we are obligated to provide a letter of credit for $209,000, which we have funded. We anticipate spending up to $12.0 million in leasehold improvements, equipment and furniture over the 10-year lease term, of which we had funded $7.6 million through December 31, 2007. The majority of our Santa Clara based employees have relocated to the new facility.
Our agreements with our channel partners and, less frequently, our customers, generally include certain provisions for indemnifying the channel partners and customers against liabilities if our products infringe a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnification provisions and have not accrued any liabilities related to such obligations in our consolidated financial statements.
Also, as discussed in Note 10 of the Notes to the Consolidated Financial Statements, effective January 1, 2007, we adopted the provisions of SFAS Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of SFAS Statement No. 109.” At December 31, 2007, we had a liability for unrecognized tax benefits on an accrual for the payment of related interest totaling $1.6 million, of which none is expected to be paid within one year. Due to uncertainties related to these tax matters, we are unable to make a reasonably reliable estimate when cash settlements with the taxing authority will occur.
Off-Balance Sheet Arrangements
At December 31, 2007 and 2006, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements. We are required to adopt SFAS No. 157 effective at the beginning of our 2008 fiscal year. We are evaluating the standard and have not yet determined the impact that SFAS No. 157 will have on our financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (SFAS 159). SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The provisions of SFAS No. 159 become effective as of the beginning of our 2008 fiscal year. We are evaluating the standard and have not yet determined the impact that SFAS No. 159 will have on our financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Foreign Currency Risk
Our European revenue is denominated in Euros. As a result, our European revenue is subject to foreign currency risk due to fluctuations in the value of the Euro compared to the U.S. dollar. We had Euro-denominated revenue of approximately $25.9 million, $12.2 million and $2.5 million for the years ended December 31, 2007, 2006 and 2005, respectively. We had $728,000 in Canadian dollar revenue for the year ended December 31, 2007, and none in any other period.
Our international sales and marketing operations incur expenses that are denominated in foreign currencies. As a result, our operating expenses and cash flows are subject to fluctuations in the value of the U.S. dollar compared to the British pound, Euro, Canadian dollar and, to a lesser extent, the Australian dollar and Singapore dollar, and Danish, Chinese, Korea and Swedish currencies. We had foreign currency denominated expenses of approximately $13.6 million, $4.2 million and $861,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
As of December 31, 2007, we had approximately $10.5 million in accounts receivable denominated in Euros, $105,000 in accounts receivable denominated in Canadian dollars and approximately $4.6 million in cash denominated in other foreign currencies.
Changes in currency exchange rates could adversely affect our revenue and profitability, and require us to reduce our prices to remain competitive in foreign markets, which could also have a material adverse effect on our results of operations. We have not entered into any foreign currency hedging contracts. We are presently evaluating the desirability of entering into foreign currency hedging contracts to offset our exposure to revenue in foreign currencies primarily Euro based contracts, primarily Euro-based revenue contracts, to reduce our exposure to fluctuations in currency exchange rates.
We estimate that a 10% decline in the value of the U.S. dollar as measured against the other currencies in which our transactions are denominated would have widened our operating loss in the year ended December 31, 2007 by approximately $1.4 million. This sensitivity analysis disregards the possibilities that rates can move in opposite directions and that losses from one geographic area may be offset by gains from another geographic area.
Interest Rate Sensitivity and Market Risk
We had cash and cash equivalents totaling $102.9 million and $11.9 million as of December 31, 2007 and 2006, respectively. These amounts were invested primarily in money market funds, and at December 31, 2007 were also invested in commercial paper. We have invested the funds from our IPO and follow-on offering according to our investment policy. The unrestricted cash and cash equivalents are held for working capital purposes. We do not enter into investments for trading or speculative purposes. We believe that we do not have any material exposure to changes in fair value as a result of changes in interest rates. Declines in interest rates, however, will reduce future investment income. If overall interest rates fell by 10% in the year ended December 31, 2007 and 2006, our interest income would have declined approximately $390,000 and $52,000, respectively, assuming consistent investment levels.
We had short-term investments of $104.2 million as of December 31, 2007. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. To achieve this objective, these amounts were invested primarily in auction rate securities, corporate bonds, government agency securities and commercial paper. These investments are classified as available for sale and held for working capital purposes. On December 31, 2007, we had $29.6 million of auction rate securities. On February 14, 2008, the majority of these auction rate securities failed to auction, causing access to these funds to be restricted. An auction failure means that the parties wishing to sell securities could not. As a result, our ability to liquidate these investments and fully recover the carrying value of our investment in the near term may be limited or not exist. All of our auction rate securities, including those subject to the failure, are currently AAA-rated taxable municipal debt obligations, the highest rating by a rating agency. If the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments. It could take until the final maturity of the underlying notes (up to 40 years) to realize our investments’ recorded value. Based on our expected operating cash flows, and our other sources of cash, we do not anticipate the potential lack of liquidity on these investments will affect our ability to execute our current business plan.
Item 8.
Item 8. Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Mandatorily Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Data Domain, Inc.
We have audited the accompanying consolidated balance sheets of Data Domain, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of operations, mandatorily redeemable convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the index at Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule 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 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, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Data Domain, Inc. at December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Notes 1 and 10 to the consolidated financial statements, Data Domain, Inc. changed its method of accounting for share-based payments as of January 1, 2006 and its method of accounting for uncertain tax positions as of January 1, 2007.
/s/ ERNST & YOUNG LLP
San Jose, California
February 28, 2008
DATA DOMAIN, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
See Notes to Consolidated Financial Statements
DATA DOMAIN, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
See Notes to Consolidated Financial Statements
DATA DOMAIN, INC.
CONSOLIDATED STATEMENTS OF MANDATORILY REDEEMABLE
CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)
For the Years ended December 31, 2007, 2006 and 2005
(in thousands)
DATA DOMAIN, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
See Notes to Consolidated Financial Statements
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization
Data Domain, Inc. was incorporated in the State of Delaware in October 2001. Our appliances provide deduplication storage for disk-based backup and network-based disaster recovery. We began selling our products and services in February 2004. Our product sales generally include a software license, hardware, post-contract customer support and, in some cases, installation services.
We commenced our initial public offering, or IPO, of common stock on June 27, 2007, and the offering was completed on July 2, 2007. We sold and issued 8,108,500 shares of our common stock in our IPO, including 1,108,500 shares sold by us pursuant to the underwriters’ full exercise of their option to purchase additional shares, at an issue price of $15.00 per share. We raised approximately $109.2 million in net proceeds after deducting underwriting discounts and commissions of $8.5 million and other offering costs of $3.9 million, which were received on July 2, 2007. Upon the closing of the IPO, all shares of our mandatorily redeemable convertible preferred stock outstanding automatically converted into 34,780,625 shares of common stock.
We completed a follow-on offering of common stock on December 3, 2007. We sold and issued 3,051,114 shares of our common stock, including 251,114 shares sold by us pursuant to the underwriters’ partial exercise of their option to purchase additional shares, at an issue price of $27.00 per share. We raised approximately $77.8 million in net proceeds after deducting underwriting discounts and commissions of $3.4 million and other offering costs of $1.2 million, which were received on November 21, 2007 and December 3, 2007.
Significant Accounting Policies
Accounting Principles
The consolidated financial statements and accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, and include our accounts and the accounts of our wholly-owned subsidiaries. Inter-company accounts and transactions have been eliminated.
Use of Estimates
Our consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. Significant estimates and assumptions made by management include the determination of the fair value of stock awards issued, the allowance for doubtful accounts, warranty reserve and inventory valuation. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our consolidated financial statements will be affected.
Revenue Recognition
We derive our revenue from sales of our products and support services through third-party value added resellers and distributors, or channel partners, and directly to customers. Product revenue primarily consists of revenue from sales of our appliances, which include expansion shelves. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Our software is integrated with industry standard appliance hardware and is essential to the functionality of the integrated system product. We provide unspecified software updates and enhancements related to our products through support and services contracts. Accordingly, we recognize revenue in accordance with the guidance provided under the American Institute of Certified Public Accountants, or AICPA, Statement of Position, or SOP, No. 97-2, Software Revenue Recognition, or SOP 97-2, and SOP No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, with Respect to Certain Transactions, or SOP 98-9. Product revenue is recognized when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer; (2) delivery has occurred, which is when the product title has transferred to the customer; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable. Our fees are considered fixed or determinable upon the establishment of an arrangement that contains the final terms of sale including the description, quantity and price of each product purchased. Our customer arrangements do not include rights of return or acceptance provisions. We assess the ability to collect from our customers based on a number of factors, including creditworthiness and past transaction history of the customer. If the customer is deemed not creditworthy, all revenue from the arrangement is deferred until payment is received and all other revenue recognition criteria have been met.
Substantially all of our products have been sold in combination with support and services, which primarily consist of hardware and software support. Hardware support includes repair or replacement in the event of breakage or failure, and telephone and internet access to technical information and support personnel during the term of the support period. Software support provides customers with rights to unspecified software updates and to maintenance releases and patches released during the term of the support period. Installation services, when provided, are also included in support and services revenue.
We have established vendor specific objective evidence, or VSOE, of fair value of our support and services as measured by the renewal prices offered to and paid by our customers. Accordingly, we use the residual method, as allowed by SOP 98-9, to determine the amount of product revenue to be recognized. Under the residual method, the fair value of the undelivered support and services, which is a specified dollar amount, is deferred and the remaining portion of the arrangement is recognized as product revenue. This product revenue is generally recognized upon shipment, based on freight terms of FOB shipping point or FCA (Incoterms 2000) shipping point, except for certain customers whose terms are FOB destination point wherein the revenue is recognized upon delivery, assuming all other criteria for revenue recognition discussed above have been met and, in the case of all indirect channel sales, persuasive evidence of the identity of the customer has been obtained. In all cases of direct or indirect channel sales, we recognize revenue once a customer is identified and shipment has occurred, assuming all other criteria for revenue recognition discussed above have been met. The fair value of the support and services is recognized as support and services revenue on a straight-line basis over the term of the related support period, which is typically one to three years.
Prior to the first quarter of 2005, we had not established VSOE of fair value of support and services contracts provided to our direct and indirect channels. As a result, prior to the first quarter of 2005, we recognized all revenue for multiple element arrangements ratably over the term of the support and services contract and deferred and recognized the direct cost of product over the corresponding period, typically one to three years. Beginning in the first quarter of 2005, we determined that we had established VSOE of fair value of support for products sold in certain types of transactions and continued to establish VSOE of fair value throughout 2005 for the remaining types of transactions. Beginning in the first quarter of 2006, we had established VSOE of fair value for support and services for all types of transactions.
Initial product sales through our direct sales channel sometimes include installation services. Installation revenue is deferred and recognized upon the earlier of customer notice that the installation is complete or sixty
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
days after shipment. We have established VSOE of fair value for our installation services based on the price separately charged to our customers. Revenue from installation, which is included in support and services revenue, was $1.6 million, $432,000 and $46,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
Deferred Cost of Product Revenue
When our products have been delivered, but the product revenue associated with the arrangement has been deferred as a result of not meeting the revenue recognition criteria in SOP 97-2, we defer the related inventory costs for the delivered items and net the amount against the applicable deferred revenue in the balance sheet presentation in accordance with Accounting Research Bulletin 43, Restatement and Revision of Accounting Research Bulletins.
Research and Development
All costs to develop our products are expensed as incurred. In accordance with Statement of Financial Accounting Standards, or SFAS, No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, software development costs are capitalized beginning when a product’s technological feasibility has been established and ending when a product is available for sale to customers. Generally, our products are released for sale soon after technological feasibility has been established. As a result, costs subsequent to achieving technological feasibility have not been significant and all software development costs have been expensed as incurred.
Accounting for Stock-Based Compensation
Stock-based compensation expense included in our Consolidated Statements of Operations for the years ended December 31, 2007, 2006 and 2005 was as follows:
Prior to January 1, 2006, we accounted for stock options granted using the fair value method in accordance with the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, or SFAS 123.
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment, or SFAS 123(R), using the prospective transition method, which requires us to apply the provisions of SFAS 123(R) only to awards granted, modified, repurchased or cancelled after the adoption date. Under this transition method, our stock-based compensation expense recognized in 2006 includes the expense for stock options granted subsequent to January 1, 2006, based on the fair value at the grant date estimated in accordance with SFAS 123(R), and the expense as determined under SFAS 123 for options granted prior to, but not vested as of, January 1, 2006. We recognize this expense on a straight-line basis over the optionees’ requisite service period, which is generally the same as the vesting schedule of the options. We estimate the grant date fair
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
value of stock option awards under the provisions of SFAS 123(R) using the Black-Scholes option valuation model, which requires, among other inputs, an estimate of the fair value of the underlying common stock on the date of grant and the expected volatility of the stock over the expected term of the related grants. For stock option awards granted prior to January 1, 2006, we determined the fair value of the award using the minimum value method under SFAS 123.
For stock options granted prior to our IPO, we determined that it was not practicable to calculate the volatility of our share price because our common stock was not publicly traded and therefore there was no readily determinable market value for our common stock, we had limited information on our own past volatility and we had a limited operating history. Therefore, we estimated our expected volatility based on reported market value data for a group of publicly traded companies, which we selected from market indices that we believed were relatively comparable after consideration of their size, maturity, profitability, growth, risk and return on investment. We used the average expected volatility rates reported by the comparable group for an expected term that approximated the expected term that we estimated. Over time, once historical data and market trends become apparent, this information could change our estimates. A small change in the estimates used could result in a relatively large change in the estimated valuation.
Given the absence of an active market for our common stock prior to our IPO, our board of directors, taking into consideration the work of an independent valuation firm, determined the fair value of our common stock at each meeting at which stock option grants were approved based on several factors, including valuation criteria and analysis, the preferential rights attributable to our then outstanding convertible preferred stock, developments in our business, the illiquid nature of our common stock and the likelihood of achieving a liquidity event, such as an initial public offering or sale of the company. Our board of directors made such determinations based on the business, financial and venture capital experience of the individual directors and input from management.
If we had made different assumptions and estimates, the amount of our recognized and to be recognized stock-based compensation expense, net loss and net loss per share amounts could have been materially different. We believe that we have used reasonable methodologies, approaches and assumptions consistent with the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, in determining the fair value of our common stock prior to our IPO for financial reporting purposes.
For stock options granted during 2005, we determined the fair value at the grant date using the minimum value method as allowed under SFAS 123. For options granted in 2007 and 2006, we determined the fair value at the date of grant using the Black-Scholes option valuation model. The following table summarizes the weighted average assumptions used in determining the fair value of stock options granted under each of these methods:
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
On June 27, 2007, we implemented our 2007 Employee Stock Purchase Plan, or ESPP, which is compensatory and results in compensation costs accounted for under SFAS 123(R). The fair value of shares purchased under the ESPP was determined using the following assumptions:
For all of our stock option grants and issuance of ESPP shares, the risk-free interest rate is based on the yield available on U.S. Treasury zero-coupon issues with an equivalent remaining expected life. We have not paid dividends in the past and do not plan to pay any dividends in the foreseeable future. We estimated our expected volatility for 2007 and 2006 based on reported market value data for a group of publicly traded companies, which we selected from market indices that we believed were relatively comparable after consideration of their size, maturity, profitability, growth, risk and return on investment. We used the average expected volatility rates reported by the comparable group for an expected term that approximated the expected term that we estimated. The expected life of options granted prior to 2006 is based on the midpoint between vesting and expiration. The expected life for options granted beginning in 2006 is based on an analysis of our historical exercise and cancellation data.
During the years ended December 31, 2007, 2006 and 2005, we awarded 30,000, 72,270 and 5,000 shares of stock, respectively. These awards granted the recipient fully vested shares of our common stock based on the deemed market value of our common stock on the date of grant. The weighted average grant date fair value of these awards was $8.90, $0.79 and $0.33 per share for the years ended December 31, 2007, 2006 and 2005, respectively. Stock-based compensation expense associated with these grants was $151,000, $28,000 and $0 for the years ended December 31, 2007, 2006 and 2005, respectively.
We account for stock compensation arrangements with non-employees in accordance Emerging Issues Task Force, or EITF, No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, using a fair value approach. For stock options granted to non-employees, the fair value of the stock options is estimated using a Black-Scholes valuation model. This model utilizes the estimated fair value of common stock and requires that, at the date of grant, we use the contractual term of the option, the expected volatility of the price of our common stock, risk free interest rates and expected dividend yield of our common stock. Non-employee stock options have a contractual term of four to ten years, expected volatility of 65-70% and no dividend yield. Stock-based compensation expense associated with grants to non-employees was $876,000, $214,000 and $21,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
On June 20, 2007, we granted 383,998 restricted stock awards, granted at fair value, 10,000 of which vested immediately on June 27, 2007 and the remainder vest over a four year period that commenced on June 27, 2007. As of December 31, 2007, 373,998 shares remained unvested.
During the years ended December 31, 2007, 2006 and 2005, the total intrinsic value of stock options exercised was approximately $9.9 million, $5.7 million and $106,000, respectively. During the years ended December 31, 2007 and 2006, the total cash received from the exercise of options was approximately $758,000 and $1.1 million, respectively.
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The weighted-average grant-date fair value of stock options granted were $7.56, $1.53 and $0.07 for the years ended December 31, 2007, 2006 and 2005, respectively. The total fair value of shares vested during the year was $55.0 million, $7.4 million and $247,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
At December 31, 2007 and 2006, the total compensation expense related to stock-based awards granted but not yet recognized was approximately $41.6 million and $7.0 million, respectively, net of estimated forfeitures of $2.2 million and $370,000, respectively. This expense will be amortized on a straight-line basis over a weighted average period of approximately 2.9 and 3.1 years, respectively.
In November 2005, the Financial Accounting Standards Board, or FASB, issued FASB Staff Position No. 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, or FASB 123R-3. We have elected to adopt the alternative transition method of calculating the tax effects of share-based compensation pursuant to FASB 123R-3. The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool related to the effects of stock-based compensation.
Cash and Cash Equivalents
We consider all highly liquid investments purchased with an original maturity of 90 days or less to be cash equivalents. Cash and cash equivalents are stated at cost, which approximates fair value.
Short-Term Investments
We carry our portfolio as available for sale. Unrealized gains or losses are recorded in other comprehensive income and amounted to $22,000 of unrealized gain at December 31, 2007.
Available for Sale Investments. Our investments comprise auction rate securities, money market funds, commercial paper, corporate bonds and government agency certificates. All investments are designated as available-for-sale and are therefore reported at fair value, with unrealized gains and losses recorded in accumulated other comprehensive income. The cost of securities sold is based on the specific identification method. Realized gains and losses on the sale of investments are recorded in interest and other income, net. Investments with original maturities greater than approximately three months and remaining maturities less than one year and investments that reset interest rates are classified as short-term investments as these investments are considered available for current operations.
Other-Than-Temporary Impairment. All of our available-for-sale investments are subject to a periodic impairment review. We recognize an impairment charge when a decline in the fair value of our investments below our cost basis is judged to be other-than-temporary. We consider various factors in determining whether to recognize an impairment charge, including the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in the market value. No impairment charges were recorded on any investments during the years ended December 31, 2007, 2006 and 2005.
Concentration of Credit Risk
Financial instruments that are potentially subject to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. Investment policies have been implemented that limit investments
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
to investment grade securities. We conduct business outside of North America in Europe, Japan and Asia, and are considering other regions. The risk with respect to accounts receivable is mitigated by credit evaluations we perform on our customers and by the diversification of our customer base. Historically, we have not hedged any of our foreign currency risk associated with accounts receivable. No individual customer has represented more than 10% of our total revenue in the years ended December 31, 2007, 2006 or 2005.
Foreign Currency Translation
The majority of our sales arrangements are denominated in United States dollars and Euros, with some of our sales arrangements also denominated in Canadian dollars. In addition, we incur operating expenses in local foreign currencies in those countries where we have sales and marketing and administrative personnel. The functional currency of our foreign operations is the local country’s currency. Consequently, expenses of operations outside the United States are translated into United States dollars using average exchange rates for the period reported while assets and liabilities of operations outside the United States are translated into United States dollars using end-of-period exchange rates. The effects of foreign currency translation of the financial statements of our foreign operations are included in stockholders’ equity (deficit) as a component of accumulated other comprehensive income in the accompanying consolidated balance sheets. The effects of foreign currency remeasurements for non-U.S. currency denominated assets and liabilities related to our domestic operations are recognized in our consolidated statement of operations, and amounted to a gain or (loss) of $122,000, $200,000 and $(34,000) for the years ended December 31, 2007, 2006 and 2005, respectively.
Allowance for Doubtful Accounts
We perform credit evaluations of our customers’ financial condition and generally do not require collateral from our customers. These evaluations require significant judgment and are based on a variety of factors including, but not limited to, current economic trends, historical payments, bad debt write-off experience, and financial review of the customer.
We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments. When we become aware that a specific customer is unable or unwilling to meet its financial obligations, we record a specific allowance to reflect the level of credit risk in the customer’s outstanding receivable balance. In addition, we record additional allowances based on certain percentages of aged receivable balances. We classify bad debt expenses as general and administrative expenses. Through December 31, 2006, we did not have write-offs of any customer receivables and our allowance had been based only on certain percentages of aged receivables. In the year ended December 30, 2007, we had one write-off of approximately $7,000 pertaining to one customer’s accounts receivable balance. To date, our accounts receivable write-offs have not been significant and the allowance for doubtful accounts has not been material.
Inventory Valuation
Inventories consist of hardware and related component parts and are stated at the lower of cost (on a first-in, first-out basis) or market value. Finished goods constitute a large portion of our inventory and include customer evaluation units which are carried at cost less accumulated amortization. We amortize the cost of these evaluation units on a straight-line basis over twelve months upon the initial transfer of a unit into the evaluation pool. The cost of the amortization of evaluation units is included in costs of product revenue. If an evaluation unit is purchased, we record a sale pursuant to our revenue recognition policy. We assess the valuation of our inventory on a quarterly basis and write down the value for estimated excess and obsolete inventory based upon
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
estimates of future demand, including warranty requirements. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products and technological obsolescence of our products.
Inventory write-downs are recorded in cost of product revenues and have not been material in any period. Spares are expensed to cost of product as purchased. We do not allocate indirect overhead costs to finished goods inventory as these amounts are not material.
We outsource the assembly of our products to a third-party manufacturing facility under an annual contract which renews automatically but may be terminated by either party with 90 days’ written notice. We also purchase some finished products from a single source supplier under a three-year agreement. At December 31, 2007 and 2006, we had $3.6 million and $2.3 million, respectively, of non-cancellable purchase commitments with a third-party supplier. In addition, at December 31, 2007 and 2006, we had an additional $14.3 million and $2.2 million, respectively, of other non-cancellable purchase commitments with other third-party vendors.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Depreciation is computed using the straight-line method over an estimated useful life of three to ten years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful lives of the assets or the term of the lease.
Impairment of Long-Lived Assets
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. We assess these assets for impairment based on estimated undiscounted future cash flows from these assets. If the carrying value of the assets exceeds the estimated future undiscounted cash flows, a loss is recorded for the excess of the asset’s carrying value over the fair value. To date, we have not recognized any impairment loss for long-lived assets.
Warranty Reserve
Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically 12 months from the date of shipment to the customer for hardware and 90 days for software. For existing products, the warranty reserve is based on actual historical experience. For new products, the warranty reserve is based on historical experience of similar products until such time as sufficient historical data has been collected for the new product.
During the three months ended March 31, 2007, we recorded an estimated charge of $1.2 million associated with a field replacement program that was initiated in April 2007 to replace a circuit board used in some of our appliances. During the three months ended September 30, 2007, we recorded an additional estimated charge of $450,000 to expand this replacement program for additional circuit boards used in some of our appliances. To date, these circuit boards have experienced failures in less than 1% of the appliances that we believe are potentially affected. Through the replacement program, we are offering to exchange the circuit boards in all of the appliances that we believe are potentially affected with circuit boards manufactured by a particular fabricator. We believe our estimates and judgments for the replacement program continue to be reasonable based upon information available at this time. Our estimated charge associated with the replacement program is based on the number of circuit boards we expect to replace under the program, the anticipated cost of replacement and refurbishment and other associated costs. As of December 31, 2007, we had incurred approximately $1.2 million
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
of costs associated with these field replacement programs and $437,000 remains in accrued liabilities to cover future costs for the units potentially affected. To the extent there are differences between our estimates and actual results, our consolidated financial statements will be affected. The following table is a summary of our warranty activity:
Advertising
All advertising costs are expensed as incurred. Advertising expenses were $351,000, $71,000 and $2,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
Accounting for Income Taxes
We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Deferred income taxes are recorded for the expected tax consequences of temporary differences between the tax bases of assets and liabilities for financial reporting purposes and amounts recognized for income tax purposes. We record a valuation allowance to reduce our deferred tax assets to the amount of future tax benefit that is more likely than not to be realized.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, short-term investments, accounts receivable, accounts payable and income taxes payable approximate their fair values due to the short-term maturity of these instruments.
Comprehensive Income
Accumulated other comprehensive income consists of other comprehensive income, unrealized gain on our short-term investment portfolio and net loss. Other comprehensive income includes foreign currency translation adjustments. Accumulated other comprehensive income has been reflected in the consolidated statement of stockholders’ equity (deficit).
Accumulated other comprehensive income was $47,000 and $3,000 at December 31, 2007 and 2006, respectively, resulting from cumulative foreign currency translation gains, and for December 31, 2007, includes an unrealized gain on our short-term investment portfolio.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
require or permit fair value measurements. We are required to adopt SFAS No. 157 effective at the beginning of our 2008 fiscal year. We are evaluating the impact this statement will have on our consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115. SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The provisions of SFAS No. 159 become effective as of the beginning of our 2008 fiscal year. We are evaluating the impact this statement will have on our consolidated financial statements.
2. NET LOSS PER SHARE
Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed by giving effect to all potential dilutive common shares, including options, common stock subject to repurchase and convertible preferred stock.
The following table sets forth the computation of loss per share:
The following weighted average outstanding options, common stock subject to repurchase and convertible preferred stock were excluded from the computation of diluted net loss per share for the periods presented because including them would have had an antidilutive effect:
3. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
We consider all highly liquid investments with an original maturity of 90 days or less to be cash equivalents. Cash and cash equivalents are stated at cost, which approximates fair value. We have restricted cash from a letter of credit on our new corporate headquarters lease for $209,000 that is part of our cash balance at December 31, 2007.
Cash and cash equivalents consist primarily of highly liquid investments in time deposits held at major banks, commercial paper, United States government agency securities and other money market securities with original maturities of 90 days or less. The carrying value of cash and cash equivalents at December 31, 2007 and 2006 was approximately $102.9 million and $11.9 million, respectively, and the weighted average interest rates were 4.8% and 4.5%, respectively.
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
We classify our portfolio of short-term investments as available for sale. Short-term investments consist of corporate bonds, government agency securities and commercial paper with original maturities of 90 to 365 days. Also included in short-term investments were approximately $29.6 million in auction rate securities with final maturities ranging from 22 to 40 years. Although some maturities may extend beyond one year, these securities are available to be used for current operations and therefore, are classified as short-term investments as all of our auction rate securities had auction dates within one year of the prior auction dates. Unrealized gains or losses are recorded in other comprehensive income (loss) and amounted to a $22,000 unrealized gain at December 31, 2007. The weighted average interest rate on our short-term investments was 5.4% for the year ended December 31, 2007.
Cash and cash equivalents at December 31, 2006 consisted of $10.9 million of money market funds, $165,000 of United States government agency securities and $809,000 of cash. Unrealized gains or losses at December 31, 2006 were nominal.
4. INVENTORIES
Inventories consisted of the following:
We recorded a provision for excess and obsolete inventory in the year ended December 31, 2007 of approximately $264,000 related to our discontinuance of our 4xx series of products. We had no excess and obsolete provision in the year ended December 31, 2006.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Amortization related to evaluation units was $2.6 million, $1.4 million and $588,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
5. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are stated at the lower of cost or net realizable value. Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets, which is three to five years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or estimated useful life of the asset. Repair and maintenance costs are expensed as incurred.
Property, plant and equipment consisted of the following:
Depreciation and amortization expense was $1.7 million, $982,000 and $606,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
6. DEFERRED REVENUE
Deferred revenue consisted of the following:
Deferred product revenue relates to arrangements where not all revenue recognition criteria have been met. Deferred support and services revenue represents customer payments made in advance for annual support and services contracts. Support and services contracts are typically billed in advance on a per annum basis and revenue is recognized ratably over the support period. Deferred ratable product and related support and services
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
revenue consists of revenue on transactions prior to fiscal 2006 where VSOE of fair value of support and services had not been established and, as a result, the entire arrangement was being recognized ratably over the related support period. All customers are known to us upon sale of our appliances.
7. GUARANTEES
Our agreements with our channel partners and, less frequently, our customers, generally include certain provisions for indemnifying the channel partners and customers against liabilities if our products infringe a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnification provisions and have not accrued any liabilities related to such obligations in our consolidated financial statements.
Under the terms of our lease for our former corporate headquarters, we are obligated to provide a letter of credit for $136,000. To date, this letter of credit is not in place, and has not been required by our sub-lessor. Under the terms of our lease for our new corporate headquarters, which commenced on November 1, 2007, we provided a letter of credit for $209,000.
As permitted or required under Delaware law and to the maximum extent allowable under that law, we have certain obligations to indemnify our officers, directors and certain key employees for certain events or occurrences while the officer, director or employee is or was serving at our request in such capacity. These indemnification obligations are valid as long as the director, officer or employee acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments we could be required to make under these indemnification obligations is unlimited; however, we have a director and officer insurance policy that mitigates our exposure and generally enables us to recover a portion of any future amounts paid.
8. LEASE COMMITMENTS
We lease our worldwide facilities and certain other equipment under non-cancelable operating lease agreements. Included in the December 31, 2007 amounts are the $23.7 million for our new corporate headquarters lease that began on November 1, 2007. This lease runs for 10 years, and we have the right to renew the lease for an additional five-year term. Future minimum commitments for these operating leases in place as of December 31, 2007 were as follows (in thousands):
The terms of certain lease agreements provide for rental payments on a graduated basis. We recognize rent expense on a straight-line basis over the lease period and have accrued for rent expense incurred but not paid. Rent expense under operating leases was $937,000, $483,000 and $351,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
9. MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK AND COMMON STOCK
Mandatorily Redeemable Convertible Preferred Stock
The following table summarizes mandatorily redeemable convertible preferred stock authorized and issued as of December 31, 2006:
All series of mandatorily redeemable preferred stock were converted on July 2, 2007, the date of the closing of our IPO, to 34,781,000 shares of common stock.
Common Stock
At December 31, 2007, we had shares of common stock reserved for future issuance as follows:
Stock Plan
In May 2002, our board of directors adopted the 2002 Stock Plan, or 2002 Plan. The 2002 Plan provided that grants of incentive stock options would be made at no less than the estimated fair value of our common stock (no less than 85% of the fair value for nonqualified stock options), as determined by our board of directors at the date of grant. Vesting and exercise provisions were determined by our board of directors at the time of grant. Options typically vest with respect to 25% of the shares one year after the options’ vesting commencement date and the remainder ratably on a monthly basis over the following three years. Options granted under the 2002 Plan have a maximum term of ten years. Recipients of stock options under the 2002 Plan generally have the right to exercise their options prior to vesting. Any unvested stock issued under the 2002 Plan is subject to repurchase by us.
In May 2007, our board of directors approved the 2007 Equity Incentive Plan, or 2007 Plan, and the 2007 Employee Stock Purchase Plan, or ESPP. The following number of shares was reserved under these plans:
As of December 31, 2007, 5,563,473 shares remained available for grant to eligible employees, directors and consultants under the 2007 Plan.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Options issued under our stock option plans are generally exercisable for periods not to exceed 10 years and are issued at the fair value of the shares of common stock on the date of grant. Following the IPO, the fair value of our common stock is determined by the trading price of such stock on the Nasdaq Global Market. Options typically vest with respect to 25% of the shares one year after the options’ vesting commencement date and the remainder ratably on a monthly basis over the following three years. For some options granted under the 2002 Plan, employees had the right to exercise their options prior to vesting. Any unvested stock issued under the 2002 Plan is subject to repurchase by us upon the employee’s termination of service. Grants made pursuant to the 2007 Plan generally do not provide for the immediate exercise of options.
On June 27, 2007, we implemented our ESPP, which is compensatory and results in compensation costs accounted for under SFAS 123(R). Under the ESPP, employees may purchase shares of common stock at a price per share that is 85% of the lesser of the fair market value of our common stock as of the beginning or the end of six-month purchase periods. Upon adoption of the ESPP plan, the initial purchase period commenced on June 27, 2007 and ended on January 31, 2008. Our ESPP is compensatory, and we have recognized $2.8 million of expense in the year ended December 31, 2007 for the first purchase period that ended in January 2008.
The following tables summarize information about the 2007 Plan:
Range of
Exercise Price
Number of Shares
Outstanding
as of
December 31,
Weighted
Average
Remaining
Contractual Life
Weighted
Average
Exercise
Price Per Share
Aggregate
Intrinsic
Value
(in years)
$0.05-$0.40
4,240,737
6.62
$0.22
$0.70-$1.00
3,516,464
8.45
$0.76
$7.26-$8.90
3,442,849
9.14
$7.95
$10.55-$35.29
2,205,050
9.51
$19.31
$0.05-$35.29
13,405,100
8.22
$5.49
$282,469,882
Vested
4,553,974
6.95
$0.65
$116,980,035
Expected to Vest
8,408,570
8.17
$5.26
$165,489,847
At December 31, 2007 and 2006, there were 1,219,000 and 1,804,000 shares, respectively, subject to repurchase under all common stock repurchase agreements upon forfeiture or early termination of employment. The cash received from the sale of these shares is initially recorded as a liability in long-term exercised unvested options and is subsequently reclassified to common stock as the shares vest. At December 31, 2007 and 2006, there was $765,000 and $1.0 million, respectively, recorded in non-current liabilities related to the issuance of these shares.
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In March 2003, in connection with services provided by our interim chief executive officer, we granted to Greylock Partners an option to purchase 217,942 shares of our common stock at an exercise price of $0.10 per share, outside of the 2002 Plan. This option was exercised in full in October 2005.
10. INCOME TAXES
Our provision for income taxes increased $282,000 to $493,000 in the year ended December 31, 2007 from $211,000 in the year ended December 31, 2006. This increase was due to our increased international activities resulting in increased foreign taxes, alternative minimum taxes and state income taxes.
As of December 31, 2007, we had net operating loss carryforwards for federal and state income tax purposes of $19.9 million and $19.8 million, respectively. As of December 31, 2007, the portion of the federal and state operating loss carryforwards which relates to stock option benefits is approximately $9.5 million, which will be recorded to equity when they reduce taxes payable in cash. We also had federal and state research and development tax credit carryforwards of approximately $2.2 million and $2.4 million, respectively. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, our net deferred tax assets have been fully offset by a valuation allowance. If not utilized, the federal and state net operating loss will expire between 2010 and 2025. Federal research and development tax credits begin to expire in 2022 and the California research and development credits have no expiration date. As of December 31, 2007, we had manufacturers’ investment credit carryforwards of $12,000, that will begin to expire in 2012. We have performed an analysis of our net operating loss carryforwards and credit carryforwards pursuant to Sections 382 and 383 of the Internal Revenue Code, or Code. We experienced “ownership changes” as defined in Section 382 of the Code. Accordingly, the use of the net operating loss carryforwards and credit carryforwards is partially limited by the annual limitations described in Sections 382 and 383. To the extent that any single-year loss or credit is not utilized to the full amount of such limitations, such unused loss or credit is carried over to subsequent years until the earlier of its utilization or the expiration of the relevant carryforward period. Such annual limitations pursuant to Section 382 and 383 of the Code could result in the expiration of our net operating loss carryforwards and/or credit carryforwards before utilization.
Effective January 1, 2007, we adopted Financial Accounting Standards Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, or FIN 48. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of uncertain tax positions taken or expected to be taken in a company’s income tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 utilizes a two-step approach for evaluating uncertain tax positions accounted for in accordance with SFAS No. 109. Step one, Recognition, requires a company to determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. Step two, Measurement, is based on the largest amount of benefit which is more likely than not to be realized on ultimate settlement. The cumulative effect of adopting FIN 48 on January 1, 2007 was recognized as a change in accounting principle, recorded as an adjustment to the opening balance of retained earnings on the adoption date. As a result of the implementation of FIN 48, we recognized no change in the liability for unrecognized tax benefits related to tax positions taken in prior periods, and no corresponding change in retained earnings. Additionally, FIN 48 specifies that tax positions for which the timing of the ultimate resolution is uncertain should be recognized as long-term liabilities. We made no reclassifications between current taxes payable and long term taxes payable upon adoption of FIN 48. Our total amount of unrecognized tax benefits as of the January 1, 2007 adoption date and December 31, 2007 was $820,000 and $1.6 million, respectively. Of this total, $159,000 represents the amount of unrecognized tax benefits that, if recognized, would affect our effective tax rate. We expect that the amount of unrecognized
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
benefits will change during the next 12 months; however, we do not expect the change to have a material impact on our financial position.
The following table summaries the activity related to our unrecognized tax benefit:
Upon adoption of FIN 48, our policy to include interest and penalties related to unrecognized tax benefits within our provision for income taxes did not change. For the year ended December 31, 2007, we recognized $15,000 of interest and penalties related to unrecognized tax benefits in our provision for income taxes.
The tax years 2002 through 2007 remain open to examination by the major domestic taxing jurisdictions to which we are subject, and for the international jurisdictions the tax years open to examination vary depending on the local tax laws.
The components of net income (loss) before provision (benefit) for income taxes consisted of the following:
Our provision (benefit) for income taxes consisted of the following:
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Income taxes differ from the amounts computed by applying the federal statutory rate of 34% to net loss as shown below:
The components of the deferred tax assets consisted of the following:
In connection with our adoption of SFAS No. 123(R), we use the “with-and-without” approach described in EITF Topic No. D-32, “Intraperiod Tax Allocation of the tax effect of pre-tax income from continuing operations,” to determine the recognition and measurement of excess tax benefits. In addition, we have elected to account for indirect effects of stock-based awards on other tax attributes, such as research and alternative minimum tax credits, through the income statement. Accordingly, we have elected to recognize excess tax benefits from the exercise of stock options in additional paid in capital only if an incremental income tax benefit would be realized after considering all other tax attributes presently available to us. At December 31, 2007, the amount of such excess tax benefits from stock option included in net operating losses was $9.5 million.
Recognition of deferred tax assets is appropriate when realization of such assets is more likely than not. Based upon the weight of the available evidence, which includes our historical operating performance and the recorded cumulative net losses in all prior fiscal periods, we have provided a full valuation allowance against our deferred tax assets. Our valuation allowance increased (decreased) by $(773,000), $1.8 million and $5.6 million in the years ended December 31, 2007, 2006 and 2005, respectively. We have performed an analysis of our net operating loss carryforwards and credit carryforwards pursuant to Sections 382 and 383 of the Code. We
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
experienced “ownership changes” as defined in Section 382 of the Code. Accordingly, the use of the net operating loss carryforwards and credit carryforwards is partially limited by the annual limitations described in Sections 382 and 383. To the extent that any single-year loss or credit is not utilized to the full amount of such limitations, such unused loss or credit is carried over to subsequent years until the earlier of its utilization or the expiration of the relevant carryforward period. Such annual limitations pursuant to Sections 382 and 383 of the Code could result in the expiration of our net operating loss carryforwards and/or credit carryforwards before utilization.
We have not provided for federal income taxes on all of our non-U.S. subsidiaries’ undistributed earnings as of December 31, 2007, because such earnings are intended to be indefinitely reinvested. The cumulative unremitted foreign earnings at December 31, 2007 were approximately $244,000. Due to net operating loss and credit carryforwards, the residual U.S. tax liability, if such amounts were remitted, would be nominal.
11. SEGMENT INFORMATION
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. Our Chief Executive Officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. We have one business activity and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, we consider ourselves to be in a single reporting segment and operating unit structure.
Revenue by geography is based on the billing address of the customer. The following table sets forth revenue and long-lived assets by geographic area:
Revenue
For the above periods presented, no one country outside the United States represented 10% or more of our total revenue.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Long-lived Assets
12. EMPLOYEE BENEFIT PLAN
We have a 401(k) plan covering all eligible employees. We are not required to contribute to the plan and had made no contributions through December 31, 2007.
13. LEGAL MATTERS
From time to time, we may be involved in various legal proceedings arising in the ordinary course of business. There were no matters at December 31, 2007 or 2006 that, in the opinion of management, might have a material adverse effect on our financial position, results of operations or cash flows.
14. QUANTUM SETTLEMENT AND OTHER LIABILITIES
In the fourth quarter of 2006, we received an inquiry from Quantum Corporation regarding our interest in licensing certain patents that Quantum believed we may have previously incorporated into our products or may incorporate in the future. As a result of our discussions with Quantum, which commenced in 2006, we entered into a patent cross-license agreement in March 2007, with an effective date of January 1, 2007. Under the terms of the cross-license, we issued Quantum 390,000 shares of our common stock in March 2007. We engaged an independent third-party valuation firm to assist us in valuing the shares of our common stock as of the date of issuance. Based on consideration of this valuation, our estimate of the value of the common stock issued under the agreement was approximately $3.3 million.
The same third-party valuation firm assisted us in estimating the value of the intangible asset associated with the cross-license agreement and to estimate its useful life. Based on consideration of this valuation, we determined the fair value of the intangible asset to be $400,000 and have an estimated useful life of three years. We began to amortize this asset to cost of product revenue beginning January 1, 2007, and we recorded $133,000 of amortization expense in fiscal 2007. The $2.9 million balance of the settlement amount represents payment to Quantum for a release of all claims for any past acts or conduct, and we have recorded the amount as settlement expense in our consolidated statements of operations for the year ended December 31, 2006.
15. SUBSEQUENT EVENT (UNAUDITED)
In January 2008, we signed an agreement to lease approximately 100,000 square feet of office space adjacent to our existing corporate facility. The new lease takes effect on January 1, 2009. Future minimum lease payments will be $24.3 million, commencing in January 2009 and continuing through June 2018. As part of signing the lease, we were required to provide a letter of credit, which has not been funded.
DATA DOMAIN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
16. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following table sets forth our unaudited quarterly consolidated statement of operations data for the years ended December 31, 2007 and 2006. In management’s opinion, the data has been prepared on the same basis as the audited consolidated financial statements, and reflects all necessary adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this data. The results of historical periods are not necessarily indicative of the results of operations for any future period.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A(T).
Item 9A(T). Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, the principal executive officer and principal financial officer concluded that those disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms and (ii) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control over Financial Reporting
Our independent registered public accounting firm reported to our audit committee a material weakness in our financial statement close process as of December 31, 2006. The identified material weakness resulted from lacking formal policies, procedures and processes relating to our financial statement close and account reconciliation processes and having inadequate resources in our finance organization to perform a high quality financial statement close and report our financial information in a timely manner consistent with the requirements for a publicly traded company. Specifically, this material weakness resulted from inadequate formal review and approval of account reconciliation and specific close processes.
In order to eliminate the material weakness in our internal controls over financial reporting, we undertook significant efforts to improve our processes and procedures, hiring additional personnel and increasing management review and oversight over the financial statement close and reporting processes. We believe the actions we took to remediate the material weakness in our financial statement close process have been successful.
This annual report does not include a report of management’s assessment regarding internal control over financial reporting or an attestation report of our independent registered public accounting firm due to a transition period established by rules of the Securities and Exchange Commission for newly public companies.
Changes in Internal Control over Financial Reporting
During the fourth quarter of fiscal 2007, we implemented a new enterprise resource software system that we use for financial, billing, inventory and consolidation processes and procedures. We believe this new system enhanced our internal control over financial reporting. Other than the implementation of this new enterprise resource software system, there were no changes in our internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Inherent Limitations of Internal Controls
Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Item 11.
Item 11. Executive Compensation
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Item 14.
Item 14. Principal Accounting Fees and Services
Certain information concerning our executive officers is included under the caption, “Executive Officers of the Registrant,” in Part I, Item 4A of this report. Other information required by Items 10, 11, 12, 13 and 14 will be contained in our definitive Proxy Statement for our 2008 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission by April 29, 2008, and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
The following documents are filed as part of this report:
1.
Financial Statement: See Index to Consolidated Financial Statements under Item 8.
2.
Certain Financial Statement Schedules have been omitted since they are either not required, not applicable or the information is otherwise included.
3.
Exhibits.
(a) Exhibits
* Denotes a management contract or compensatory plan or arrangement.
 Confidential treatment has been granted for portions of this document. The omitted portions of this document have been filed with the Securities and Exchange Commission.
(1) Filed as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File No. 333-141716), as filed with the Securities and Exchange Commission on March 30, 2007, as amended and incorporated herein by reference
(2) Filed as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 13, 2007 and incorporated herein by reference
(3) Filed as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 30, 2007 and incorporated herein by reference
(4) Filed as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File No. 333-147092), as filed with the Securities and Exchange Commission on November 1, 2007, as amended and incorporated herein by reference
(5) Filed as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on February 5, 2008 and incorporated herein by reference
(6) Filed as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on January 14, 2008 and incorporated herein by reference
(b) Financial Statement Schedules
The following schedule is filed as part of this registration statement:
Schedule II-Valuation and Qualifying Accounts
All other schedules have been omitted because the information required to be presented in them is not applicable or is shown in the consolidated financial statements or related notes.
SCHEDULE II
DATA DOMAIN, INC. VALUATION AND QUALIFYING ACCOUNTS
SIGNATURES
Pursuant to the requirements of the 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.
DATA DOMAIN, INC.
By:
/S/ FRANK SLOOTMAN
Frank Slootman,
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
INDEX TO EXHIBITS
* Denotes a management contract or compensatory plan or arrangement.
 Confidential treatment has been granted for portions of this document. The omitted portions of this document have been filed with the Securities and Exchange Commission.
(1) Filed as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File No. 333-141716), as filed with the Securities and Exchange Commission on March 30, 2007, as amended and incorporated herein by reference
(2) Filed as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 13, 2007 and incorporated herein by reference
(3) Filed as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 30, 2007 and incorporated herein by reference
(4) Filed as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File No. 333-147092), as filed with the Securities and Exchange Commission on November 1, 2007, as amended and incorporated herein by reference
(5) Filed as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commissions on February 5, 2008 and incorporated herein by reference
(6) Files as an Exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on January 14, 2008 and incorporated herein by reference