ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
The table below presents the location, size and principal function of our leased global facilities. We believe our facilities are adequate to meet business operation needs for the foreseeable future.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
The Company is subject to various legal proceedings and claims arising in the ordinary course of our business, including the cases discussed below. Although the results of litigation and claims cannot be predicted with certainty, the Company is currently not aware of any litigation or threats of litigation in which the final outcome could have a material adverse effect on our business, operating results, financial position, or cash flows. Regardless of the outcome, litigation can have an adverse impact on the Company because of defense and settlement costs, diversion of management resources and other factors. The Company records a contingent liability when it is probable that a loss has been incurred and the amount is reasonably estimable in accordance with accounting for contingencies. As of December 31, 2017, we accrued a $1.5 million reserve relating to our potential liability for currently pending disputes, presented in "Accrued Expenses" in our Consolidated Balance Sheets.
On August 23, 2016, the United States District Court for the Middle District of Tennessee granted conditional class certification in a lawsuit originally filed on September 21, 2015 by three former senior sales representatives. The lawsuit, Sarah Patton, et al v. ServiceSource Delaware, Inc., asserts a claim under the Fair Labor Standards Act alleging that certain sales account representatives and senior sales representatives in our Nashville location were not paid for all hours worked and were not properly paid for overtime hours worked. The complaint also asserts claims under Tennessee state law for breach of contract and unjust enrichment, however, the plaintiffs have not yet filed a motion to certify the state law breach of contract and unjust enrichment claims as a class action. The Company will continue to vigorously defend itself against these claims.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is traded on the NASDAQ Global Market under the symbol “SREV.” The following tables present the high and low prices of our common stock as reported on the NASDAQ Global Market during the periods presented:
Holders
As of February 23, 2018, there were 65 holders of record of our common stock. A substantially greater number of holders of our common stock are “street name” or beneficial holders, whose shares are held by banks, brokers and other financial institutions.
Dividends
We have never declared or paid cash dividends on our common stock. We currently intend to retain all available funds and any future earnings for use in the operation of our business and do not anticipate paying any dividends on our common stock in the foreseeable future. Any future determination to declare dividends will be made at the discretion of our board of directors and will depend on our financial condition, operating results, capital requirements, general business conditions and other factors that our board of directors may deem relevant.
Stock Performance Graph
The following graph shows a comparison of cumulative total stockholder return for our common stock, the Morgan Stanley Technology Index and the NASDAQ Composite Index. Such returns are based on historical results and are not intended to suggest future performance. Data for the NASDAQ Composite Index and the Morgan Stanley Technology Index assumes the reinvestment of dividends. We have never declared or paid cash dividends on our common stock nor do we anticipate paying any such cash dividends in the foreseeable future. Stockholders' returns over the indicated period are based on historical data and should not be considered indicative of future stockholder returns.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The following selected consolidated financial data should be read in conjunction with “Item 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our annual Consolidated Financial Statements and notes thereto appearing elsewhere in this annual report on Form 10-K.
Overview
ServiceSource International, Inc. is a global leader in outsourced, performance-based customer success and revenue growth solutions. Through our people, processes and technology, we grow and retain revenue on behalf of our clients-some of the world’s leading business-to-business companies - in more than 45 languages. Our solutions help our clients strengthen their customer relationships, drive improved customer adoption, expansion and retention and minimize churn. Our technology platform and best-practice business processes combined with our highly-trained, client-focused revenue delivery professionals and data from nearly 20 years of operating experience enable us to provide our clients greater value for our customer success services than attained by our clients' in-house customer success teams.
Our CEO manages and allocates resources on a company-wide basis as a single segment that is focused on service offerings which integrate data, processes and cloud technologies.
Key Business Metrics
In assessing the performance of our business, we consider a variety of business metrics in addition to the financial metrics discussed below under “Basis of Presentation.” These key metrics include Opportunity Under Management and number of engagements, both of which are operational metrics.
Opportunity Under Management. For the year ended December 31, 2017, our Opportunity Under Management in our managed services business was approximately $11.0 billion. Opportunity Under Management is an operational metric that represents our estimate of the value of all end customer service contracts that we have the opportunity to sell on behalf of our clients over a designated period of time, the value of the customer engagements we manage on behalf of our clients and the Bookings we deliver under our Inside Sales solution. Opportunity Under Management is not a measure of our expected revenue or backlog. Opportunity Under Management reflects our estimate over a designated period of time and should not be used to estimate our opportunity for any particular quarter within that period. Also, the value of end customer contracts actually delivered during a given period should not be expected to be realized in full or to occur in even quarterly increments due to seasonality and other factors impacting our clients and their end customers.
We estimate the value of our end customer contracts based on a combination of factors, including the value of end customer contracts made available to us by our clients in past periods, the minimum value of end customer contracts that our clients are required to give us the opportunity to sell pursuant to the terms of our contracts with them, periodic internal business reviews of our expectations as to the value of end customer contracts that will be made available to us by our clients, the value of end customer contracts included in the service performance analysis that we conduct with our clients during the sales process the value of the customer relationships we manage, the bookings we deliver under our Inside Sales solution, and collaborative discussions with our clients assessing their expectations as to the value of service contracts that they make available to us for sale. Although the minimum value of end customer contracts that our clients are required to give us represents a portion of our estimated Opportunity Under Management, a significant portion of the Opportunity Under Management is estimated based on the other factors described above. As our experience with our business, our clients and their contracts has grown, we have continually refined the process, improved the assumptions and expanded the data related to our calculation of Opportunity Under Management. When estimating Opportunity Under Management, we rely on our assumptions described above, which may prove incorrect. These assumptions are inherently subject to significant business and economic uncertainties and contingencies, many of which are beyond our control. Our estimates therefore may prove inaccurate, and the actual value of end customer contracts delivered to us in a given period to differ from our estimate of Opportunity Under Management. These business and economic uncertainties and contingencies include:
•
the extent to which clients deliver a greater or lesser value of end customer contracts than may be required or otherwise expected;
•changes in the pricing or terms of service contracts offered by our clients;
•increases or decreases in the end customer base of our clients;
•
the extent to which the renewal rates we achieve on behalf of a client early in an engagement affect the amount of opportunity that the client makes available to us later in the engagement;
•client cancellations of their contracts with us; and
•
changes in our clients’ businesses, sales organizations, management, sales processes or priorities; as well as other factors discussed in "Item 1.A. entitled Risk Factors" of this annual report on Form 10-K.
Our revenue also depends on our booking rates, commissions, and other fees. Our bookings represent the total amount of Opportunity Under Management that we renew on behalf of our clients or sell under our Inside Sales solution. Our commission rate is an agreed-upon percentage of the renewal value of end customer contracts or net new sales that we sell on behalf of our clients.
Our booking rate is impacted principally by our ability to successfully renew contracts on behalf of our clients or sell net new bookings. Other factors impacting our booking rate include: the manner in which our clients price their service contracts for sale to their end customers; the stage of life-cycle associated with the products and underlying technologies covered by the contracts offered to the end customer; the extent to which our clients or their competitors introduce new products or underlying technologies; the nature, size and age of the contracts; and the extent to which we have managed the renewals process or net new sales for similar products and underlying technologies in the past.
In determining commission rates for an individual engagement, various factors, including our booking rate, as described above, are evaluated. These factors include: historical, industry specific and client specific renewal rates for similar service contracts; the magnitude of the Opportunity Under Management in a particular engagement; the number of end customers associated with these opportunities; and the opportunity to receive additional performance commissions when we exceed certain renewal levels. We endeavor to set our commission rates at levels commensurate with these factors and other factors that may be relevant to a particular engagement. Accordingly, our commission rates vary, often significantly, from engagement to engagement. In addition, we sometimes agree to lower commission rates for engagements with significant Opportunity Under Management.
Number of Engagements. We track the number of engagements we have with our clients. We often have multiple engagements with a single client, particularly where we manage the sales of renewals relating to different product lines, technologies, types of contracts or geographies for the client and where we deliver multiple of our solutions. When the set of renewals we manage on behalf of a client is associated with a separate client contract or a distinct product set, type of end customer contract or geography and therefore requires us to assign a service sales team to manage the renewals, we designate the set of renewals and associated revenues and costs as a unique engagement. For example, we may have one engagement consisting of a service sales team selling maintenance contract renewals of a particular product for a client in the U.S. and another engagement consisting of a sales team selling warranty contract renewals of a different product for the same client in Europe. These would count as two engagements. When we deliver multiple solutions with separate and distinct teams, such as renewals and inside sales, we may manage these as separate engagements. We had 168, 154 and 191 engagements as of December 31, 2017, 2016 and 2015, respectively.
Factors Affecting our Performance
Sales Cycle. We sell our integrated solution through our sales organization. At the beginning of the sales process, our quota-carrying sales representatives contact prospective clients and educate them about our offerings. Educating prospective clients about the benefits of our solutions can take time, as many of these prospects have not historically relied upon integrated solutions like ours for service revenue management, nor have they typically put out a formal request for proposal or otherwise made a decision to focus on this area. As part of our sales process, our solutions design team performs a service performance analysis of our prospect’s service revenue. This includes an analysis of best practices, and benchmarks the prospect’s service revenue against industry peers. Through this process, which typically takes several weeks, we are able to assess the characteristics and size of the prospect’s service revenue, identify potential areas of performance improvement, and formulate our proposal for managing the prospect’s service revenue. The length of our sales cycle for a new client, inclusive of the service performance analysis process and measured from our first formal discussion with the client until execution of a new client contract, is typically longer than six months and has increased in recent periods.
Implementation Cycle. After entering into an engagement with a new client, and to a lesser extent after adding an engagement with an existing client, we incur sales and marketing expenses related to the commissions owed to our sales personnel. These commissions are generally based on realized revenue that the contract delivers over time with a smaller portion based on the estimated total annual contract value. Commission amounts based on realized revenue are expensed in the period the related revenue is recognized by the Company. Commission amounts based on the estimated total annual contract value are expensed and payable upfront upon executing the applicable contract. Upon adoption of ASC 606 effective as of January 1, 2018, the commissions that are paid based on realized revenue will remain as expense in the period the related revenue is recognized by
the Company, but the upfront commissions based on estimated total annual contract value will be capitalized as Contract acquisition costs and expensed ratably over the expected life of the applicable contract or five years if the contract is between the Company and one of its long-standing clients. We also make upfront investments in technology and personnel to support the engagement. These upfront commissions and investments are typically incurred one to three months before we begin generating sales and recognizing revenue. Accordingly, in a given quarter, an increase in new clients, and, to a lesser extent, an increase in engagements with existing clients, or a significant increase in the contract value associated with such new clients and engagements, will negatively impact our gross margin and operating margins until we begin to achieve anticipated sales levels associated with the new engagements, which is typically two to three quarters after we begin selling contracts on behalf of our clients.
Although we expect new client engagements to contribute to our operating profitability over time, in the initial periods of a client relationship, the near term impact on our profitability can be negatively impacted by slower-than anticipated growth in revenues for these engagements as well as the impact of the upfront costs we incur, the lower initial level of associated service sales team productivity and lack of mature data and technology integration with the client. As a result, an increase in the mix of new clients as a percentage of total clients may initially have a negative impact on our operating results. Similarly, a decline in the ratio of new clients to total clients may positively impact our near-term operating results.
Contract Terms. A significant portion of our revenue comes from our pay-for-performance model. Under our pay-for-performance model, we earn commissions based on the value of service contracts we sell on behalf of our clients. In some cases, we earn additional performance-based commissions for exceeding pre-determined service renewal targets.
Our new client contracts typically have an initial term between two and four years. Our contracts generally require our clients to deliver a minimum value of qualifying service revenue contracts for us to renew on their behalf during a specified period. To the extent that our clients do not meet their minimum contractual commitments over a specified period, they may be subject to fees for the shortfall. Our client contracts are cancelable on relatively short notice, subject in most cases to the payment of an early termination fee by the client. The amount of this fee is based on the length of the remaining term and value of the contract.
We invoice our clients on a monthly basis based on commissions we earn during the prior month, and with respect to performance-based commissions, on a quarterly basis based on our overall performance during the prior quarter. Revenue is recognized in the period in which our services are performed or, in the case of performance commissions, when the performance condition is achieved. Because the invoicing for our services generally coincides with or immediately follows the sale of service contracts on behalf of our clients, we do not generate or report a significant deferred revenue balance. However, the combination of factors including minimum contractual commitments, the performance improvement potential, our success in generating improved renewal rates for our clients, and our clients’ historical renewal rates may all affect our performance favorably or unfavorably.
Merger and Acquisition Activity. Our clients, particularly those in the technology sector, participate in an active environment for mergers and acquisitions. Large technology companies have maintained active acquisition programs to increase the breadth and depth of their product and service offerings and small and mid-sized companies have combined to better compete with large technology companies. A number of our clients have merged, purchased other companies or been acquired by other companies. We expect merger and acquisition activity to continue to occur in the future.
The impact of these transactions on our business can vary. Acquisitions of other companies by our clients can provide us with the opportunity to pursue additional business to the extent the acquired company is not already one of our clients. Similarly, when a client is acquired, we may be able to use our relationship with the acquired company to build a relationship with the acquirer. In some cases, we have been able to maintain our relationship with an acquired client even where the acquiring company handles its other service contract renewals through internal resources. In other cases, however, acquirers have elected to terminate or not renew our contract with the acquired company.
Seasonality. We experience a seasonal variance in our revenue which is typically higher in the fourth quarter when many of our clients’ products come up for renewal, and for the third quarter of the year which is typically lower as a result of lower or flat renewal volume corresponding to the timing of our customers’ product sales particularly in the international regions. The impact of this seasonal fluctuation can be amplified if the economy as a whole is experiencing disruption or uncertainty, leading to deferral of some renewal decisions.
Basis of Presentation
Net Revenue
Substantially all of our net revenue is attributable to commissions we earn from the sale of renewals of maintenance, support and subscription agreements on behalf of our clients. We generally invoice our clients for our services in arrears on a monthly basis for sales commissions, and on a quarterly basis for certain performance sales commissions; accordingly, we typically have no deferred revenue related to these services. We do not set the price, terms or scope of services in the service contracts with end customers and do not have any obligations related to the underlying service contracts between our clients and their end customers.
Historically, we earned revenue from the sale of subscriptions to our cloud based applications. To date, subscription revenue has been a small percentage of total revenue. We have terminated most of our subscription contracts and expect revenues generated from subscription revenue to be insignificant in 2018. Subscription fees are accounted for separately from commissions, and they are billed in advance over a monthly, quarterly or annual basis. Subscription revenue is recognized ratably over the related subscription term.
We have generated a significant portion of our revenue from a limited number of clients. Our top ten clients accounted for 66%, 66% and 57% of our net revenue for the years ended December 31, 2017, 2016 and 2015, respectively.
The loss of revenue from any of our top clients for any reason, including the failure to renew our contracts, termination of some or all of our services, a change of relationship with any of our key clients or their acquisition, can cause a significant decrease in our revenue.
Our business is geographically diversified. During 2017, 63% of our net revenue was earned in NALA, 26% in EMEA and 11% in APJ. Net revenue for a particular geography generally reflects commissions earned from sales of service contracts managed from our revenue delivery centers in that geography. Predominantly all of the service contracts sold and managed by our revenue delivery centers relate to end customers located in the same geography. In addition, our Kuala Lumpur location is a revenue delivery center where we have centralized, for our worldwide operations, the key contract renewal processes that do not require regional expertise, such as client data management and quoting.
Cost of Revenue and Gross Profit
Our cost of revenue expenses include employee compensation, technology costs, including those related to the delivery of our cloud-based technologies, and allocated overhead costs. Compensation expense includes salary, bonus, benefits and stock-based compensation for our dedicated service sales teams. Our allocated overhead includes costs for facilities, information technology and depreciation, including amortization of internal-use software associated with our service revenue technology platform and cloud applications. Allocated costs for facilities consist of rent, maintenance and compensation of personnel in our facilities departments. Our allocated costs for information technology include costs associated with third-party data centers where we maintain our data servers, compensation of our information technology personnel and the cost of support and maintenance contracts associated with computer hardware and software. To the extent our client base or business with existing client base expands, we may need to hire additional service sales personnel and invest in infrastructure to support such growth. Our cost of revenue may fluctuate significantly and increase or decrease on an absolute basis and as a percentage of revenue in the near term, including for the reasons discussed under, “Factors Affecting Our Performance-Implementation Cycle.” In 2017, we saw cost of revenue decrease in absolute dollars primarily related to cost reduction measures implemented in the early part of 2017. We expect cost of revenues to increase in 2018 related to higher costs incurred during the ramp of new business. Gross profit as a percent of revenue is expected to be flat for 2018.
Operating Expenses
Sales and Marketing. Sales and marketing expenses are a significant component of our operating costs and consist primarily of compensation expenses and sales commissions for our sales and marketing staff, allocated expenses and marketing programs and events. We sell our solutions through our global sales organization, which is organized across three geographic regions: NALA, EMEA and APJ. Our commission plans provide that payment of commissions to our sales representatives is contingent on their continued employment, and we recognize expense over a period that is generally between the contract signing date and twelve to fourteen months following the execution of the applicable contract. When commissions are paid upon contract signing and are not contingent on future payments and continued employment, we consider that portion of the commission to be earned and therefore expensed at contract signing. We currently expect sales and marketing expenses to increase in 2018 over 2017 due to increased headcount and related employee expenses.
Research and Development. Research and development expenses consist primarily of employee compensation expense, allocated costs and the cost of third-party service providers. We focus our research and development efforts on developing new products and applications related to our technology platform. We capitalize certain expenditures related to the development and enhancement of internal-use software related to our technology platform. We expect research and development spending to increase in 2018 compared to 2017 due to incremental costs of moving our clients to a single technology platform.
General and Administrative. General and administrative expenses consist primarily of employee compensation expense for our executive, human resources, finance and legal functions and related expenses for professional fees for accounting, tax and legal services, as well as allocated expenses, which consists of depreciation, amortization of internally developed software, facilities and technology costs. We expect our general and administrative expenses to increase in 2018 due to increases in facility costs and investment in additional information technology.
Restructuring and Other. Restructuring and other expenses consist primarily of employees’ severance payments, related employee benefits, stock compensation related to the accelerated vesting of certain equity awards, related legal fees, asset impairment charges and charges related to leases and other contract termination costs. The Company expects to incur additional restructuring charges in the first half of 2018 related to the relocation and decommissioning of our current San Francisco office space. Future cash outlays related to restructuring activities are expected to total approximately $1.8 million. These amounts are reported in “Accounts payable, Accrued compensation and benefits and Accrued expenses” in our Consolidated Balance Sheet as of December 31, 2017.
Interest Expense and Other, Net, and Impairment of Cost Basis Equity Investment
Interest expense. Interest expense consists of interest expense associated with our convertible debt, imputed interest from capital lease payments, accretion of debt discount and amortization of debt issuance costs. We recognize accretion of debt discount and amortization of interest costs using the effective interest rate method. We expect our interest expense to generally decrease in 2018 due to the maturity of our $150.0 million convertible notes in August 2018.
Other, Net. Other, net consists primarily of foreign exchange gains and losses and interest income earned on our cash, cash equivalents and marketable securities. We expect other, net to vary depending on the movement in foreign currency exchange rates and the related impact on our foreign exchange gain (loss) and the return of interest on our investments.
Provision for Income Tax Benefit (Expense)
We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries’ assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
We evaluate our ability to realize the tax benefits associated with deferred tax assets on a jurisdictional basis. This evaluation utilizes the framework contained in ASC 740, Income Taxes, wherein management analyzes all positive and negative evidence available at the balance sheet date to determine whether all or some portion of our deferred tax assets will not be realized. Under this guidance, a valuation allowance must be established for deferred tax assets when it is more likely than not (a probability level of more than 50 percent) that they will not be realized. In assessing the realization of our deferred tax assets, we consider all available evidence, both positive and negative, and place significant emphasis on guidance contained in ASC 740, which states that “a cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.”
We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. To the extent that the assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.
Results of Operations
The following table sets forth our operating results as a percentage of net revenue:
Year Ended December 31, 2017 Compared to December 31, 2016
Net Revenue, Cost of Revenue, and Gross Profit
Net revenue decreased by $13.8 million, or 5%, for the year ended December 31, 2017 compared to the same period in 2016, due to contractions and lower production with certain existing clients and the bankruptcy of one of our top 10 clients, partially offset by production related to expansion of business with our existing client base and new business in 2017.
Cost of revenue decreased $1.4 million, or 1%, for the year ended December 31, 2017 compared to the same period in 2016, primarily due to the following:
•
$2.8 million decrease in employee costs related to operational improvements in our business that resulted in a reduction in headcount and increased productivity from our revenue generating employees, and shifting headcount to lower cost locations, all of which are part of our continuous efforts to better align employee costs with revenue;
•
$2.0 million decrease in temporary labor and consulting costs;
•
$1.7 million decrease in information technology costs; and
•
$0.8 million decrease in recruitment services; partially offset by
•
$3.5 million increase in depreciation and amortization expense; and
•
$2.6 million increase in net overhead allocations from other departments.
Gross profit decreased $12.4 million, or 14%, for the year ended December 31, 2017 compared to the same period in 2016, which is in line with the decrease in revenue.
Operating Expenses
Sales and Marketing
Sales and marketing expense decreased $9.0 million, or 21%, for the year ended December 31, 2017 compared to the same period in 2016, primarily due to the following:
•
$6.2 million decrease in employee compensation costs due to lower headcount resulting from our efforts to better align our cost structure;
•
$1.7 million decrease in travel costs;
•
$0.3 million decrease in net overhead allocations from other departments;
•
$0.2 million decrease in in temporary labor and consulting costs; and
•
$0.3 million decrease in information technology costs, recruitment services and marketing costs.
Research and Development
Research and development expense decreased $2.6 million, or 31%, for the year ended December 31, 2017 compared to the same period in 2016, primarily due to our efforts to reduce research and development spend as follows:
•
$2.0 million decrease in employee related costs associated with a decrease in headcount; and
•
$0.4 million decrease in in temporary labor and consulting costs.
Internal-use software development capitalization decreased $0.5 million for the year ended December 31, 2017 compared to the same period in 2016, primarily due to the migration from our Renew OnDemand platform to PRISM. We expect to continue to invest in our technology platforms to support our services offering and thus capitalizing internal-use software costs in the future. However, the amount capitalized will depend on the future level of expenditures on our technology platforms.
General and Administrative
General and administrative expense increased $0.1 million, or 0%, for the year ended December 31, 2017 compared to the same period in 2016, primarily due to the following:
•
$3.0 million increase in depreciation and amortization expense;
•
$1.3 million increase in information technology spend;
•
$1.2 million increase in recruitment services; and
•
$1.1 million increase in employee compensation costs related to performance-based restricted stock awards issued during 2016 and 2017, offset by decreases due to shifting headcount to lower cost locations. These net increases were partially offset by
•
$2.2 million net reduction in overhead allocations to other departments;
•
$1.6 million decrease in temporary labor and consulting costs;
•
$1.5 million decrease due to a non-recurring legal reserve recorded during 2016;
•
$0.9 million decrease in travel costs; and
•
$0.5 million decrease in rent and facilities costs.
Restructuring and Other
Restructuring and other expense increased $7.3 million, or 100%, for the year ended December 31, 2017 compared to the same period in 2016 due to our effort to better align our cost structure with current revenue levels during 2017.
Interest Expense and Other, Net, Impairment Loss on Cost Basis Equity Investment, and Gain on Sale of Cost Basis Equity Investment
Interest expense increased $0.7 million, or 6%, for the year ended December 31, 2017 compared to the same period in 2016 due to the accretion of the debt discount related to our convertible notes issued in August 2013.
Other, net decreased $0.5 million, or 23%, for the year ended December 31, 2017 compared to the same period in 2016 primarily due to foreign currency fluctuations.
During the year ended December 31, 2016, we fully impaired our 2013 cost basis equity investment due to an unfavorable declining financial performance, growth trends and future liquidity needs of the investment and recorded a $4.5 million impairment. During the year ended December 31, 2017, we sold our equity investment that we fully impaired in 2016 for proceeds of $2.1 million and recorded the proceeds as a gain.
Income Tax Provision
* Not considered meaningful.
For the year ended December 31, 2017, we recorded a tax benefit of $1.6 million. This primarily represents a $2.0 million income tax benefit related to the remeasurement of our indefinite-lived intangible deferred tax liability and release of our valuation allowance for certain net operating loss provisions as enacted under the Tax Cuts and Jobs Act (H.R.1) during December 2017. Historically, we recorded a deferred income tax expense for indefinite lived deferred tax liabilities, as the Company did not have any indefinite lived deferred tax assets. H.R.1 changed the carryover period for federal net operating losses to indefinite, allowing us to utilize future indefinite lived deferred tax assets in the scheduling of valuation allowance. Our net U.S. deferred tax liability decreased from $2.2 million as of December 31, 2016 to $0.2 million as of December 31, 2017. We also recorded $0.4 million of federal, foreign and state income tax expense. No benefit was otherwise provided for losses incurred in U.S. and Singapore because these losses are offset by a valuation allowance.
For the year ended December 31, 2016, we recorded a charge to income tax expense of $3.4 million. This amount primarily represents foreign income taxes of $1.1 million and $1.8 million of valuation allowance that reflects the portion of certain state deferred tax assets that are not more-likely-than-not to be realized. No benefit was otherwise provided for losses incurred in U.S. and Singapore because these losses are offset by a full valuation allowance.
Years Ended December 31, 2016 Compared to December 31, 2015
Net Revenue, Cost of Revenue and Gross Profit
Net revenue increased $0.7 million, or 0%, for the year ended December 31, 2016 compared to the same period in 2015, primarily due to the expansion of business with our existing client base and new business with our existing clients and new clients.
Cost of revenue decreased $6.3 million, or 4%, for the year ended December 31, 2016 compared to the same period in 2015, primarily due to the following:
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$8.5 million decrease in employee costs related to operational improvements in our business that resulted in a reduction in headcount and increased productivity from our revenue generating employees, and shifting headcount to lower cost locations, all of which are part of our continuous efforts to better align employee costs with revenue; and
•
$4.1 million decrease in temporary labor and consulting costs; partially offset by
•
$3.8 million increase in net overhead allocations from other departments;
•
$1.8 million increase in depreciation and amortization expense; and
•
$0.9 million increase in information technology costs.
Gross profit increased $7.0 million, or 9%, for the year ended December 31, 2016 compared to the same period in 2015, which is in line with our moderate increase in revenue and the significant reduction in employee related costs.
Operating Expenses
Sales and Marketing
Sales and marketing expense decreased $2.1 million, or 5%, for the year ended December 31, 2016 compared to the same period in 2015, primarily due to the following:
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$1.6 million decrease in employee compensation costs due to lower headcount resulting from our efforts to better align our cost structure;
•
$0.9 million decrease in marketing programs; and
•
$0.2 million decrease in depreciation and amortization expense; partially offset by
•
$0.8 million increase in travel costs.
Research and Development
Research and development expense decreased $8.1 million, or 49%, for the year ended December 31, 2016 compared to the same period in 2015, primarily due our efforts to reduce research and development spend:
•
$4.6 million decrease in employee compensation costs;
•
$2.9 million decrease in temporary labor; and
•
$0.3 million decrease in information technology costs.
General and Administrative
General and administrative expense increased $6.7 million, or 14%, for the year ended December 31, 2016 compared to the same period in 2015, primarily due to the following:
•
$3.2 million increase in employee compensation costs related to higher headcount;
•
$2.1 million increase in facilities costs;
•
$1.0 million increase in depreciation and amortization expense;
•
$0.9 million increase in temporary labor and professional fees;
•
$0.9 million increase in technology spend; and
•
$2.2 million increase in travel costs, marketing programs and other; partially offset by
•
$3.6 million net reduction in overhead allocations to other departments.
Restructuring and Other
There were no restructuring and other costs for the year ended December 31, 2016 due to the Company completing restructuring efforts during 2015.
Interest Expense and Other, Net and Impairment Loss on Cost Basis Equity Investment
Interest expense increased $0.6 million, or 6%, for the year ended December 31, 2016 compared to the same period in 2015, due to the accretion of debt discount related to our convertible notes issued in August 2013.
Other, net decreased $1.2 million, or 116%, for the year ended December 31, 2016 compared to the same period in 2015, primarily due to lower foreign currency gains as the U.S. dollar strengthened against the Euro and other foreign currencies where we have operations.
During the year ended December 31, 2016, we fully impaired our 2013 cost basis equity investment due to an unfavorable declining financial performance, growth trends and future liquidity needs of the investment and recorded a $4.5 million impairment.
Income Tax Provision
* Not considered meaningful.
For the year ended December 31, 2016, we recorded a charge to income tax expense of approximately $3.4 million. This amount primarily represents foreign income taxes of $1.1 million and $1.8 million of valuation allowance that reflects the portion of certain state deferred tax assets that are not more-likely-than-not to be realized. No benefit was otherwise provided for losses incurred in U.S. and Singapore, because these losses are offset by a full valuation allowance.
For the year ended December 31, 2015, a charge to income tax expense of $1.6 million was recorded. This includes the impact of state income tax law changes that were recorded during the second quarter ended June 30, 2015 and affects the manner in which the Company apportions revenue to the state of Tennessee. The remaining portion of our tax expense relates to anticipated taxes in jurisdictions where we have profitable operations, including certain U.S. states, offset by benefits available from state tax credits. No benefit was otherwise provided for losses incurred in the U.S. and Singapore because these losses are offset by a full valuation allowance. In November 2015, the Philippine Economic Zone Authority granted a four-year tax holiday to the Company's Philippine affiliate, commencing with its fiscal year, beginning January 1, 2016.
Liquidity and Capital Resources
Our primary operating cash requirements include the payment of compensation and related costs and costs for our facilities and information technology infrastructure. Historically, we have financed our operations from cash provided by our operating activities, proceeds from common stock offerings and cash proceeds from the exercise of stock options and our employee stock purchase plan. We believe our existing cash and cash equivalents and short-term investments will be sufficient to meet our working capital and capital expenditure needs over the next twelve months.
As of December 31, 2017, we had cash, cash equivalents and short-term investments of $188.6 million, which primarily consisted of demand deposits, money market mutual funds, corporate bonds and U.S. government obligations held by well-capitalized financial institutions. Included in cash, cash equivalents and short-term investments was cash and cash equivalents of $7.4 million held by our foreign subsidiaries used to satisfy their operating requirements. The Company considers its undistributed earnings of ServiceSource Europe Ltd. & ServiceSource International Singapore Pte. Ltd. permanently reinvested in foreign operations and has not provided for U.S. income taxes on such earnings. As of December 31, 2017, the Company had no unremitted earnings from its foreign subsidiaries.
In August 2013, we issued $150.0 million aggregate principal amount of 1.50% convertible notes due August 1, 2018 (the "Notes") and concurrently entered into convertible notes hedges and separate warrant transactions. The Notes mature on August 1, 2018, unless converted earlier. Upon conversion, the Notes will be settled in cash, shares of our stock, or any combination thereof, at our option. The Notes were not subject to conversion or repurchase as of December 31, 2017 and are classified as a current liability on our Consolidated Balance Sheet. We believe we have sufficient cash and liquid short-term investments to repay the Notes upon maturity.
Share Repurchase Program
In August 2015, our Board of Directors authorized a stock repurchase program with a maximum authorization to repurchase up to $30.0 million of our common stock. The program expired in August 2017. During the year ended December 31, 2017, no shares were repurchased.
Letter of Credit and Restricted Cash
In connection with one of our leased facilities, the Company is required to maintain a $1.2 million letter of credit. The letter of credit is secured by $1.2 million of cash in a money market account, which is classified as an "Other assets" in our Consolidated Balance Sheets.
Cash Flows
The following table presents a summary of our cash flows:
Our total depreciation and amortization expense was comprised of the following:
Operating Activities
For the year ended December 31, 2017, net cash provided by operating activities was $19.8 million. Our net loss was $29.8 million, which was impacted by non-cash charges of $22.6 million for depreciation and amortization, $9.4 million of amortization of debt discount and issuance costs, $13.7 million of stock-based compensation, $2.1 million related to proceeds received from the sale of our cost basis equity investment and $3.1 million for restructuring and other costs. Cash provided by operations from changes in our working capital include a $9.1 million decrease in accounts receivable, net, a $2.5 million increase in accounts payable and a $1.7 million decrease in prepaid expenses and other current assets, offset by cash used in operations from a $5.5 million decrease in accrued expenses and other liabilities and a $2.9 million decrease in deferred revenue.
Net cash provided by operating activities was $4.5 million for the year ended December 31, 2016. Our net loss was $32.1 million, which was impacted by non-cash charges of $16.1 million for depreciation and amortization, $8.7 million of amortization of debt discount and issuance costs, $10.8 million of stock-based compensation and $4.5 million related to an impairment of our cost basis equity investment. Cash provided by operations from changes in our working capital include a $0.9 million increase in accounts payable, a $2.1 million increase in accrued expenses and other liabilities offset by cash used in operations from a $7.2 million increase in accounts receivable, net, a $1.6 million decrease in deferred revenue and a $0.7 million increase in prepaid expenses and other current assets.
Net cash provided by operating activities was $3.6 million for the year ended December 31, 2015. Our net loss was $40.6 million, which was impacted by non-cash charges of $13.7 million for depreciation and amortization, $8.0 million of amortization of debt discount and issuance costs, $13.4 million of stock-based compensation and $2.6 million for restructuring and other. Cash provided by operations from changes in our working capital include a $12.0 million decrease in accounts receivable, net, a $2.7 million increase in accrued compensation and benefits, offset by cash used in operations from a $1.8 million increase in prepaid expenses and other current assets, a $4.5 million decrease in accrued expenses and other liabilities, a $1.2 million decrease in deferred revenue and a $1.6 million decrease in accounts payable.
Investing Activities
Net cash used in investing activities decreased $14.1 million to $14.8 million during the year ended December 31, 2017 compared to $28.9 million during the same period in 2016, primarily due to the following activities:
•
$9.2 million decrease in cash outflows related to the acquisition of property and equipment, which includes $0.5 million of decreased internally developed software costs;
•
$45.5 million decrease in cash outflows related to the purchase of short-term investments; and
•
$2.1 million increase in cash inflows related to the proceeds from sale of our cost basis equity investment; partially offset by
•
$42.7 million decrease in cash inflows from the sale and maturity of short-term investments.
Net cash used in investing activities increased $3.7 million to $28.9 million during the year ended December 31, 2016 compared to $25.2 million during the same period in 2015, primarily due to the following activities:
•
$14.4 million increase in cash outflows related to the acquisition of property and equipment, which includes $5.9 million of increased internally developed software costs; and
•
$6.7 million increase in cash outflows related to the purchase of short-term investments; partially offset by
•
$16.1 million increase in cash inflows from the sale and maturity of short-term investments; and
•
$1.2 million increase due to a change in restricted cash in 2015 related to the San Francisco office lease.
Financing Activities
Net cash provided by financing activities decreased $0.7 million to $0.2 million during the year ended December 31, 2017 compared to $0.9 million during the same period in 2016, primarily due to the following activities:
•
$9.8 million decrease in cash inflows due to proceeds of approximately $10.9 million from the exercise of stock options and the employer purchase plan during 2016 compared to proceeds of approximately $1.1 million from the exercise of stock options and the employer purchase plan during 2017; partially offset by
•
$8.9 million increase due to the repurchase of approximately 2.3 million shares of our common stock at a weighted-average price of $3.94 per share during 2016 and no corresponding activity during 2017.
Net cash provided by financing activities decreased $2.4 million to $0.9 million during the year ended December 31, 2016 compared to $3.3 million during the same period in 2015, primarily due to the following activities:
•
$7.7 million increase in cash outflows due to the repurchase of approximately 2.3 million shares of our common stock at a weighted-average price of $3.94 per share during 2016 compared to the repurchase of approximately 0.3 million shares of our common stock at a weighted-average price of $4.11 per share during 2015; partially offset by
•
$5.2 million increase in cash inflows due to proceeds of approximately $10.9 million from the exercise of stock options and the employer purchase plan during 2016 compared to proceeds of approximately $5.7 million from the exercise of stock options and the employer purchase plan during 2015.
Off-Balance Sheet Arrangements
As of December 31, 2017 and 2016, we did not have any relationships with other entities or financial partnerships such as entities often referred to as structured finance or special-purpose entities, which have been established for facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations and Commitments
Our contractual obligations and commitments primarily consist of obligations under operating lease agreements for office space and computer equipment, convertible notes, purchase commitments and unrecognized tax benefits during our normal course of business.
As of December 31, 2017, the future minimum payments under our leases and convertible notes were as follows (in thousands):
(1) In January 2018, the Company entered into a sublease with a third-party for our San Francisco office space for the remaining term of the lease. The future minimum payments through November 30, 2022 under the original lease total approximately $9.3 million and future sublease rental income totals approximately $8.9 million over the same period.
The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding, which specify significant terms, including payment terms, related services and the approximate timing of the transaction. Obligations under contracts that we can cancel without a significant penalty are not included in the table above.
Also excluded from the table above is the income tax liability we recorded for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns (“unrecognized tax benefits”). As of December 31, 2017, our liability for unrecognized tax benefits was immaterial. Reasonably reliable estimates of the amounts and periods of related future payments cannot be made at this time.
Other Purchase Commitments
The Company had $14.1 million in non-cancelable purchase commitments with our suppliers as of December 31, 2017.
Critical Accounting Policies and Estimates
General
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. (“GAAP”) requires management to use judgment in the application of accounting policies, including making estimates and assumptions. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different or different assumptions were made, it is possible that different accounting policies would have been applied, resulting in different financial results or a different presentation of our financial statements. Our discussion and analysis of financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in accordance with GAAP. Estimates, judgments and assumptions are based on historical experiences that we believe to be reasonable under the circumstances. From time to time, we re-evaluate those estimates and assumptions.
The Company’s significant accounting policies are described in “Notes to the Consolidated Financial Statements, Note 2 - Summary of Significant Accounting Policies.” These policies were followed in preparing the Consolidated Financial Statements as of and for the year ended December 31, 2017 and are consistent with the year ended December 31, 2016.
The Company has identified the following as critical accounting policies. These accounting policies have the most significant impact on our financial condition and results of operations and require management’s most difficult, subjective and/or complex estimates.
Revenue Recognition
Our revenue is derived primarily from selling services. Other revenues include professional services and subscription services to Renew OnDemand, which was phased out in 2017.
Revenue is recognized when all of the following criteria have been met:
•
Persuasive evidence of an arrangement exists. Client contracts are generally used to determine the existence of an arrangement.
•
Delivery has occurred. The service has been or is being provided to the client.
•
Our fee is fixed or determinable. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the selling price is subject to refund or adjustment.
•
The collectability of our fee is reasonably assured. We assess collectability based primarily on the creditworthiness of the client as determined by credit checks and analysis, as well as the client’s payment history.
Selling Services
Revenue from selling services consists of fees earned from the sales of services contracts on behalf of our clients or assisting our clients in their sales process. Our contract obligations include administering and managing the sales and/or renewal process for our client’s service contracts, providing adequately trained staff, reporting and holding periodic business reviews with our clients. Under our contracts, clients are obligated to provide us with a detailed listing of sales prospects, access to their databases or management systems and sales and marketing materials. Our fees are generally calculated as a fixed percentage of the overall sales value associated with the successful renewal of service contracts sold on behalf of our clients. In addition, some of our client contracts include performance-based fees determined by the achievement of specified performance metrics. Our selling service contracts typically entitle us to additional fees and adjustments resulting from instances where our clients fail to provide us with a specified minimum value of contract renewals or they fail to provide contract renewal data within the time frames specified in our contract. We also receive termination fees in the event a client cancels a contract without cause prior to its terminations date. Our selling service contracts can also be canceled by our clients without a termination fee if we fail to achieve certain performance levels.
Our fees from selling services are recognized on a net basis since we act as an agent on behalf of our clients. We do not perform the underlying maintenance services; determine pricing, terms or scope of services to our client’s end customers. Performance incentive fees and early termination fees are recorded in the period when the performance criteria have been met.
Subscriptions and Professional Services
Subscription revenue is comprised of subscriptions fees to access our Renew OnDemand application which was phased out in 2017, and professional services is generated from implementation and project based services. Subscription revenue is recognized ratably over the contract term, commencing when our cloud applications are made available to our clients. Our subscription service arrangements are generally non-cancelable and do not contain refund-type provisions. Professional services are deemed delivered and revenue recognized upon the successful completion of implementation projects or when project milestones have been achieved and accepted by the client.
Multiple-Deliverable Arrangements
We have entered into a limited number of multiple element arrangements wherein our clients utilize a combination of selling services, subscriptions to our cloud applications and professional services. We separate deliverables at the inception of the arrangement as if each deliverable has stand-alone value to our client. Arrangement consideration is allocated based on the relative best estimate of selling prices of each deliverable. However, substantially all fees earned from our selling services are contingent in nature as the commissions we earn are based on our performance against the specific terms of each contract. Therefore, contingent fees from selling services are excluded from the allocation of relative best selling prices at inception of our multiple element arrangements.
According to the accounting guidance prescribed in Accounting Standards Codification (ASC) 605, Revenue Recognition, selling prices for each deliverable is determined based on the selling price hierarchy of vendor-specific objective evidence (VSOE), third-party evidence (TPE) and best estimated selling price (BESP). We have not been able to establish VSOE for our deliverables due to the customer-specific nature of our products and services. Also, we have not been able to reliably determine the stand-alone selling prices of competitor’s products and services, and as a result, we cannot rely on TPE for our deliverables. Therefore, we utilize estimates of BESP to determine the selling prices of our deliverables. BESP is determined through consultation with management, taking into consideration our marketing and pricing strategies. As these strategies evolve, we may modify our pricing practices in the future, which could result in changes in the estimates used to estimate BESP which could change the allocation of revenue for our multiple element arrangements.
Stock-Based Compensation
We measure and recognize compensation expense for share-based payment awards to our employees and directors, including employee stock options and restricted stock units, based on the grant-date fair values of the awards.
We estimate the fair value of stock options granted using the Black-Scholes option-pricing model which relies on estimates and assumptions we make related to the length of time an employee will retain vested stock options before exercising them, the historical volatility of our common stock price and the number of options that will be forfeited prior to vesting.
Stock-based compensation expense for our restricted stock units and performance based restricted stock awards is determined using the fair value of our common stock on the date of grant, and the expense is recognized on a straight-line basis over the vesting period. Performance based restricted stock awards compensation expense is only recorded if it is probable that the performance conditions will be met.
Valuation analysis of goodwill and intangible assets
We evaluate goodwill and indefinite-lived intangible assets for possible impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.
We use a three-step process to assess the realizability of goodwill. The first step is a qualitative assessment for each reporting unit that analyzes indicators, including, but not limited to macro-economic conditions such as deterioration in the entity's operating environment or industry or market considerations; entity-specific events such as increasing costs, declining financial performance, or loss of key personnel; or other events such as an expectation that a reporting unit will be sold or a sustained decrease in the stock price on either an absolute basis or relative to peers.
If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not (i.e. > 50% chance) the fair value of a reporting unit is less than its carrying amount, the two-step quantitative impairment test will be required. Otherwise, no further testing is required.
If the two-step quantitative assessment is required, we calculate the fair value of each reporting unit based on future cash flows. If the carrying value of each reporting unit is in excess of its fair value, we allocate the fair value to its assets and liabilities. If the carrying amount of the asset exceeds its estimated fair value, an impairment loss is recorded.
Our analysis is based on a single company-wide reporting unit, which is consistent with our single segment discussed in “Notes to Consolidated Financial Statements, Note 12 - Geographic Information.”
Significant management judgments are required in order to assess goodwill and intangible asset impairment, including the following:
•
identification of comparable companies to benchmark under the market approach giving due consideration to the following factors:
◦
financial condition and operating performance of the reporting unit being evaluated relative to companies operating in the same or similar business;
◦
economic, environmental and political factors faced by such companies;
•
impact of goodwill impairment recognized in prior years;
•
susceptibility of our reporting unit to fair value fluctuations;
•
reporting unit revenue, gross profit and operating expense growth rates;
•
financial forecasts;
•
discount rate to apply to estimated cash flows;
•
terminal values;
•
reasonable gross profit levels;
•
estimated control premium a willing buyer is likely to pay, including consideration of the following:
◦
the most similar transactions in relevant industries and determined the average premium indicated by the transactions deemed to be most similar to a hypothetical transaction involving our reporting units;
◦
weighted average and median control premiums offered in relevant industries;
◦
industry specific control premiums; and
◦
specific transaction control premiums.
•
significant events or changes in circumstances including the following:
◦
significant negative industry or economic trends;
◦
significant decline in our stock price for a sustained period;
◦
our market capitalization relative to net book value;
◦
significant changes in the manner of our use of the acquired assets;
◦
significant changes in the strategy for our overall business; and
◦
our assessment of growth and profitability in each reporting unit over the coming years.
Income Taxes
We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries’ assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
We regularly assess the need for a valuation allowance against our deferred tax assets. In making that assessment, we consider both positive and negative evidence related to the likelihood of realization of the deferred tax assets on a jurisdictional basis to determine, based on the weight of available evidence, whether it is more likely than not that some or all of the deferred tax assets will not be realized. Examples of positive and negative evidence include future growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate, historical earnings, taxable income in prior years, if carryback is permitted under the law and prudent and feasible tax planning strategies. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets valuation allowance would be charged to earnings in the period in which we make such a determination, or goodwill would be adjusted at our final determination of the valuation allowance related to an acquisition within the measurement period. If we later determine that it is more likely than not that the net deferred tax assets would be realized, we would reverse the applicable portion of the previously provided valuation allowance as an adjustment to earnings at such time.
We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. We recognize interest accrued and penalties related to unrecognized tax benefits in the income tax provision. To the extent that the assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.
Recent Accounting Pronouncements
See Notes to the Consolidated Financial Statements “Note 2. Summary of Significant Accounting Policies” in Item 8. Financial Statements and Supplementary Data for a full description of recent accounting pronouncements including the expected dates of adoption and the anticipated impact to our Consolidated Financial Statements.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Risk
Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Euro, British Pound, Singapore Dollar, Philippine Peso, Bulgarian Lev and Malaysian Ringgit. To date, we have not entered into any foreign currency hedging contracts, but may consider entering into such contracts in the future. We believe our operating activities act as a natural hedge for a substantial portion of our foreign currency exposure because we typically collect revenue and incur costs in the currency in the location in which we provide our solution from our revenue delivery centers. As our international operations grow, we will continue to reassess our approach to managing our risk relating to fluctuations in currency rates.
We performed a sensitivity analysis of our foreign currency exposure at December 31, 2017 to assess the potential impact of fluctuations in exchange rates for all foreign denominated assets and liabilities. A 10% appreciation or depreciation for all currencies against the U.S. dollar at December 31, 2017 would not have had a material impact on our results of operations or our cash flows.
Interest Rate Risk
As of December 31, 2017, we had cash and cash equivalents of $51.4 million and short-term investments of $137.2 million, which primarily consisted of corporate bonds, agency securities, asset-backed securities and U.S. treasury securities. The carrying amount of our cash equivalents reasonably approximates fair value due to the short maturities of these instruments. The primary objectives of our investment activities are the preservation of capital, the fulfillment of liquidity needs and the fiduciary control of cash and investments. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to fluctuations in interest rates, which may affect our interest income and the fair market value of our investments. Due to the short-term nature of our investment portfolio, however, we do not believe an immediate 10% increase or decrease in interest rates would have a material effect on the fair market value of our portfolio. We therefore do not expect our operating results or cash flows to be materially affected by a sudden change in market interest rates. We do not believe our cash equivalents have significant risk of default or illiquidity. While we believe our cash equivalents do not contain excessive risk, we cannot provide absolute assurance that in the future our investments will not be subject to adverse changes in market value. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. We cannot be assured that we will not experience losses on these deposits
As of December 31, 2017, we had $150.0 million aggregate principal amount of convertible senior notes outstanding and capital lease obligations of $0.1 million, all of which are fixed rate instruments. Therefore, our results of operations are not subject to fluctuations in interest rates.
Inflation Risk
We do not believe that inflation has had a material effect on our business, financial condition or results of operations. Nonetheless, if our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ServiceSource International, Inc.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE
Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors of ServiceSource International, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of ServiceSource International, Inc. (the Company) as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive loss, stockholders' equity and cash flows for each of the two years in the period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated March 2, 2018 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Ernst & Young LLP
We have served as the Company’s auditor since 2016.
Denver, Colorado
March 2, 2018
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of ServiceSource International, Inc.
In our opinion, the consolidated statements of operations, of comprehensive loss, of stockholders’ equity and of cash flows for the year ended December 31, 2015 present fairly, in all material respects, the results of operations and cash flows of ServiceSource International, Inc. and its subsidiaries for the year ended December 31, 2015, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 audit provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
San Jose, California
March 8, 2016, except for the effects of the revisions, the change in composition of reportable segment and the manner in which the Company accounts for debt issuance costs discussed in Note 2 (not presented herein) to the consolidated financial statements appearing under Item 8 of the Company’s 2016 annual report on Form 10-K, as to which the date is March 6, 2017.
ServiceSource International, Inc.
Consolidated Balance Sheets
(in thousands, except per share amounts)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ServiceSource International, Inc.
Consolidated Statements of Operations
(in thousands, except per share amounts)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ServiceSource International, Inc.
Consolidated Statements of Comprehensive Loss
(in thousands)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ServiceSource International, Inc.
Consolidated Statements of Stockholders' Equity
(in thousands)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ServiceSource International, Inc.
Consolidated Statements of Cash Flows
(in thousands)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ServiceSource International, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. The Company
ServiceSource International, Inc. is a global leader in outsourced, performance-based customer success and revenue growth solutions. Through our people, processes and technology, we grow and retain revenue on behalf of our clients-some of the world’s leading business-to-business companies - in more than 45 languages. Our solutions help our clients strengthen their customer relationships, drive improved customer adoption, expansion and retention and minimize churn. Our technology platform and best-practice business processes combined with our highly-trained, client-focused revenue delivery professionals and data from nearly 20 years of operating experience enable us to provide our clients greater value for our customer success services than attained by our clients' in-house customer success teams.
“ServiceSource,” “the Company,” “we,” “us,” or “our”, as used herein, refer to ServiceSource International, Inc. and its subsidiaries, unless the context indicates otherwise.
The Company’s pay-for-performance model allows its clients to pay for the services through either flat-rate or variable commissions based on the revenue generated by the Company on their behalf. Fixed-fee arrangements are typically used in quick deployments to address discrete target areas of our clients’ needs. The Company also earns revenue through its professional services teams, who assist clients with data optimization. The Company’s corporate headquarters is located in Denver, Colorado. The Company has additional U.S. offices in California and Tennessee, and international offices in Bulgaria, Ireland, Japan, Malaysia, Philippines, Singapore and the United Kingdom.
2. Summary of Significant Accounting Policies
Basis of Consolidation
The accompanying Consolidated Financial Statements include the accounts of ServiceSource and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amount of net revenue and expenses during the reporting period.
The Company’s significant accounting judgments and estimates include, but are not limited to: revenue recognition, the valuation and recognition of stock-based compensation, the recognition and measurement of current and deferred income tax assets and liabilities and uncertain tax positions, and the provision for bad debts.
The Company bases its estimates and judgments on historical experience and on various assumptions that it believes are reasonable under the circumstances. However, future events are subject to change and estimates and judgments routinely require adjustment. Actual results may differ from these estimates, and these differences may be material.
Significant Risks and Uncertainties
The Company is subject to certain risks and uncertainties that could have a material and adverse effect on its future financial position or results of operations. The Company’s clients are primarily high technology companies and a downturn in these industries, changes in clients’ sales strategies, or widespread shift away from end customers purchasing maintenance and support contracts could have an adverse impact on the Company’s consolidated results of operations and financial condition.
Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash, cash equivalents, short-term investments, accounts receivable and the Note Hedges. See "Note 7 - Debt" for additional information. The Company is also exposed to a variety of market risks, including the effects of changes in foreign currency exchange rates and interest rates.
Cash is maintained in demand deposit accounts at U.S., European and Asian financial institutions that management believes are credit worthy. Deposits in these institutions may exceed the amount of insurance provided on these deposits.
Accounts receivable are derived from services performed for clients located primarily in the U.S., Europe and Asia. The Company attempts to mitigate the credit risk in its trade receivables through its ongoing credit evaluation process and historical collection experience. The Company maintains an allowance for doubtful accounts based upon the expected collectability of its accounts receivable, which takes into consideration an analysis of historical bad debts and other available information.
Two customers represented 17%, and 15% of accounts receivable as of December 31, 2017. Three customers represented 15%, 14% and 12%, of accounts receivable as of December 31, 2016.
Fair Value of Financial Instruments
The Company accounts for certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value guidance establishes a hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. An asset or liability’s level is based upon the lowest level of input that is significant to the fair value measurement. The guidance requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:
Level 1: Quoted prices in active markets for identical assets or liabilities;
Level 2: Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable;
Level 3: Inputs that are generally unobservable and typically reflect management's estimates or assumptions that market participants would use in pricing the asset or liability.
The carrying amount of financial instruments including cash, restricted cash recorded in other assets, accounts receivable, accounts payable, accrued taxes, accrued expenses and other accrued liabilities approximate carrying value due to their short-term maturities. See "Note 4 - Fair value of Financial Instruments" for additional information on the convertible note.
Foreign Currency Translation and Remeasurement
Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment, where that local currency is the functional currency, are translated to U.S. dollars at exchange rates at the balance sheet date. Net revenue and expenses are translated at monthly average exchange rates. The Company accumulates net translation adjustments in equity as a component of accumulated other comprehensive income (loss). For non-U.S. subsidiaries whose functional currency is the U.S. dollar, transactions that are denominated in foreign currencies have been remeasured in U.S. dollars, and any resulting gains and losses are reported in "Interest expense and other, net" in the Consolidated Statements of Operations. For the years ended December 31, 2017, 2016, and 2015, we recorded foreign currency transaction (gains) losses of approximately $1.1 million, $0.5 million and ($0.9) million, respectively.
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are stated at their carrying values net of an allowance for doubtful accounts. The Company evaluates the ongoing collectability of its accounts receivable based on a number of factors such as the credit quality of its clients, the age of accounts receivable balances, collections experience, current economic conditions and other factors that may affect a client’s ability to pay. In circumstances where the Company is aware of a specific client’s inability to meet its financial obligations to the Company, a specific allowance for doubtful accounts is estimated and recorded, which reduces the recognized receivable to the estimated amount that management believes will ultimately be collected. Account balances are charged off against the allowance when it is probable that the receivable will not be recovered.
The following table presents changes in the allowance for doubtful accounts (in thousands):
Property and Equipment
The Company records property and equipment at cost, less accumulated depreciation and amortization. Depreciation is recorded using the straight-line method over the estimated useful lives for owned assets as follows: seven years for office furniture and equipment, three to five years for network equipment, two to three years for computer hardware and three to seven years for software. Leasehold improvements are amortized on a straight-line basis over the lesser of the related lease term or the estimated useful life of the related assets, ranging from three to fifteen years.
When assets are disposed, the cost and related accumulated depreciation and amortization are removed from their respective accounts and any gain or loss on sale or disposal is reported in "General and administrative expense" in the Consolidated Statement of Operations.
Lease Asset Retirement Obligations
The fair value of a liability for an asset retirement obligation (“ARO”) is recognized in the period in which it is incurred. The Company’s AROs associated with leasehold improvements at our international office locations, which, at the end of a lease, are contractually obligated to be removed. Our AROs were approximately $1.0 million and $1.2 million as of December 31, 2017 and 2016, respectively. Accretion expense was insignificant for the years ended December 31, 2017, 2016 and 2015.
Capitalized Internal-Use Software
Expenditures related to software developed or obtained for internal use are capitalized and amortized over a period of two to five years on a straight-line basis. The Company capitalizes direct external costs associated with developing or obtaining internal-use software. In addition, the Company also capitalizes certain payroll and payroll-related costs for employees or professional fees for consultants who are directly associated with the development of such applications. Costs associated with preliminary project stage activities, training, maintenance and all other post-implementation stage activities are expensed as incurred and are recorded in "Research and development" in the Consolidated Statements of Operations. Capitalized costs related to internal-use software under development are treated as construction-in-progress until the program, feature or functionality is ready for its intended use, at which time amortization commences.
Goodwill
We evaluate goodwill and indefinite-lived intangible assets for possible impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The Company does not have intangible assets with indefinite useful lives other than goodwill.
To assess if goodwill is impaired a qualitative assessment, referred to as the simplified method, is first performed to determine whether further quantitative impairment testing is necessary. This qualitative analysis evaluates factors including, but not limited to, macro-economic conditions such as deterioration in the entity's operating environment or industry or market considerations; entity-specific events such as increasing costs, declining financial performance, or loss of key personnel; or other events such as an expectation that a reporting unit will be sold or a sustained decrease in the stock price on either an absolute basis or relative to peers. If, as a result of the qualitative assessment, the Company considers it more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, then a two-step quantitative impairment test is performed. The first step requires comparing the fair value of the reporting unit to its net book value, including goodwill. A potential impairment exists if the fair value of the reporting unit is lower than its net book value. The second step of the process, which is performed only if a potential impairment exists, involves determining the difference between the fair value of the reporting unit's net assets other than goodwill and the fair value of the reporting unit. If this difference is less than the net book value of goodwill, an impairment is recorded.
Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments are required to estimate the fair value of reporting units which includes estimating future cash flows and determining appropriate discount rates, growth rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit which could trigger impairment.
If a two-step quantitative impairment test is required, the fair value of each reporting unit is determined based upon the income approach. Under the income approach, the Company estimates the fair value of the reporting unit based upon the present value of estimated future cash flows. Cash flow projections are determined by management to be commensurate with the risk inherent in our current business model. Key assumptions used to estimate the fair value of the reporting unit includes the discount rate, compounded annual revenue growth rates, operating expense assumptions and terminal value capitalization rate. The discount rate used is based on the weighted-average cost of capital adjusted for the relevant risk associated with business-
specific characteristics and the uncertainty related to the reporting unit's ability to execute on the projected cash flows. The discount rate and terminal value capitalization rate are derived from the use of market data which are Level 3 inputs within the fair value hierarchy.
No impairment was recorded for the years ended December 31, 2017, 2016, and 2015.
The carrying value of goodwill for the years ended December 31, 2017 and 2016 was $6.3 million.
Impairment of Long-Lived Assets Including Intangible Assets
The Company evaluates the recoverability of its long-lived assets whenever events or changes in circumstances indicate the carrying amount of the long-lived asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If the long-lived asset is impaired, an impairment is recognized for the amount by which the carrying value of the asset exceeds its fair value. No impairment was recorded for the years ended December 31, 2017, 2016, and 2015.
Acquired intangible assets are amortized over their useful lives on a straight-line basis which represents the pattern in which the Company derives benefit from the asset.
Cost Basis Equity Investment
In 2013, the Company made an equity investment in a private company for $4.5 million, which represented less than 5% of the outstanding equity of that company. Based on unfavorable growth trends and declining financial performance of this private company, the Company determined that its investment was fully impaired and recorded a $4.5 million impairment during the year ended December 31, 2016. The impairment is included in "Impairment loss on cost basis equity investment" in the Consolidated Statement of Operations. During 2017, the Company sold this investment for $2.1 million in cash and recorded the proceeds as a gain in "Gain on sale of cost basis equity investment" in our Consolidated Statements of Operations.
Operating Leases
The Company’s operating lease agreements for office facilities include provisions for certain rent holidays, tenant incentives and escalations in the base price of the rent payment. The Company records rent holidays and rent escalations on a straight-line basis over the lease term and records the difference between expense and cash payments as deferred rent. Tenant incentives are recorded as deferred rent and amortized on a straight-line basis over the lease term. Deferred rent is included in "Other current liabilities and Other long-term liabilities" in the Consolidated Balance Sheets.
Deferred Debt Issuance Costs
The Company defers debt issuance costs, which consist of the debt discount on the convertible notes and issuances costs related to the Notes. Discounts and debt issuance costs are included in the carrying value of the convertible notes and amortized to “Interest expense and other, net” in our Consolidated Statement of Operations over the remaining life of the convertible notes. See "Note 7 - Debt" for additional information.
Comprehensive Loss
We report comprehensive loss in our Consolidated Statements of Comprehensive Loss. Amounts reported in “Accumulated other comprehensive loss” consist of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency and unrealized gains and losses on available-for-sale securities.
Revenue Recognition
The Company’s revenue is derived primarily from recurring revenue management. Other revenues include subscriptions to the Company’s cloud applications and professional services.
Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured from clients and no significant obligations remain unfulfilled by the Company.
Recurring Revenue Management
Revenue from recurring revenue management consists of fees earned from the sales of services contracts on behalf of the Company’s customers, which are referred to as clients, or assisting in their sales process. The Company’s contract obligations include administering and managing the sales and/or renewal processes for client contracts; providing adequately trained staff; reporting; and holding periodic business reviews with clients. Client obligations include providing a detailed listing of sales prospects, access to their databases or systems and sales or marketing materials. Fees are generally based on a fixed percentage of the overall sales value associated with the service contracts. Some client contracts include performance-based fees determined by the achievement of specified performance metrics. Recurring revenue management contracts entitle the Company to additional fees and adjustments which are invoked in various circumstances including a client’s failure to provide the Company with a specified minimum value of sales prospects, untimely delivery of client sales prospect data or other obligations inhibiting the Company’s ability to perform its obligations. In addition, many client contracts contain early termination fees.
Recurring revenue management services are deemed delivered when clients accept purchased orders from their sales prospects (the end customer) and no significant post-delivery obligations remain for the Company. Fees from recurring revenue management services are recognized on a net basis since the Company acts as an agent on behalf of its clients. The Company does not provide the services being renewed by the end customers, nor does it determine pricing, terms or scope of services to the end customers. Performance incentive fees and early termination fees are recorded in the period when either the performance criteria have been met or a triggering event has occurred.
Subscriptions
Subscription revenue is comprised of subscriptions fees to access the Company’s cloud based applications. Subscription revenue is recognized ratably over the contract term, generally over a period of one to three years, commencing when the cloud applications are made available. The Company's subscription service arrangements are generally non-cancelable and do not contain refund-type provisions.
Professional Services
Professional services revenue is generated from implementation services. Professional services are deemed delivered upon the successful completion of implementation projects or when project milestones have been achieved and accepted by the client.
Multiple Element Arrangements
The Company enters into multiple element arrangements when clients utilize a combination of recurring revenue management services, subscriptions and professional services. Deliverables are separated at the inception of the arrangement if each deliverable has stand-alone value to the client. The Company believes that it has stand-alone value for professional services. Arrangement consideration is allocated based on the relative best selling prices of each deliverable. However, most fees earned from recurring revenue management services are contingent in nature as the fees earned by the Company are based on performance against the specific terms of each contract. Therefore, contingent fees from recurring revenue management services are excluded from the allocation of relative best selling prices at inception of multiple element arrangements.
Selling prices for each deliverable is determined based on the selling price hierarchy of vendor-specific objective evidence ("VSOE"), third-party evidence ("TPE") and best estimated selling price ("BESP"). Generally, the Company has not been able to establish VSOE for its deliverables as the items have not been sold separately. The Company has not been able to reliably determine the stand-alone selling prices of competitors’ products and services, and therefore cannot rely on TPE for its deliverables. Therefore, the Company utilizes BESP to determine the selling prices of its deliverables. The objective of BESP is to determine the price at which the Company would price a product or service if it were sold on a stand-alone basis. BESP is generally used for offerings that are not typically sold separately or for new offerings. BESP is determined by considering multiple factors including, but not limited to, pricing practices, market conditions, competitive landscape, internal costs, geographies and gross margin. The determination of BESP is made through consultation with and formal approval with management, taking into consideration the Company’s marketing strategy. As these marketing strategies evolve, the Company may modify its pricing practices in the future, which could result in changes to selling prices.
Once arrangement consideration is allocated to the various deliverables in a multiple element arrangement, revenue is recognized when all other revenue recognition criteria has been achieved.
Advertising Costs
Advertising costs are expensed as incurred and are reported in "Sales and marketing expenses" in the Consolidated Statements of Operations. Advertising expense for the years ended December 31, 2017, 2016 and 2015 was approximately $0.2 million, $0.1 million, and $0.1 million, respectively.
Income Taxes
The Company accounts for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries’ assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
The Company files U.S. federal and state and foreign income tax returns in jurisdictions with varying statutes of limitations. In the normal course of business the Company is subject to examination by taxing authorities throughout the world. These audits include questioning the timing and amount of deductions, the allocation of income among various tax jurisdictions and compliance with federal, state, local and foreign tax laws. The Company accounts for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. The Company establishes reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. The Company records an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. The Company recognizes interest accrued and penalties related to unrecognized tax benefits in the income tax provision.
Stock-Based Compensation
The Company issues share-based awards to employees and directors. Awards are measured at fair value on the grant date and amortized to compensation expense over the service period during which the awards fully vest. Such expense is included in in our Consolidated Statements of Operations, see "Note 9 - Share Repurchase Program and Stock-Based Compensation" for additional information. Forfeitures are recognized as incurred. Options issued are valued using the Black-Scholes option-pricing model, which relies on assumptions we make related to the expected term of the options, volatility, dividend yield and risk-free interest rate.
Net Income (Loss) Per Common Share
Basic net income (loss) per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased under the Company’s employee stock purchase plan and unvested restricted stock units (“RSUs”). The dilutive effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities.
Potential shares of common stock that are not included in the determination of diluted net loss per share because they are anti-dilutive consist of stock options, non-vested restricted stock and shares to be purchased under our Employee Stock Purchase Plan. The Company excluded from diluted earnings per share the weighted-average common share equivalents related to 7.1 million, 7.7 million and 9.5 million shares for the years ended December 31, 2017, 2016 and 2015, respectively, because their effect would be anti-dilutive.
New Accounting Standards Issued but not yet Adopted
Revenue Recognition
In May 2014, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update No. 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”) which amended the existing FASB Accounting Standards Codification. Under the new standard, revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. The standard also specifies that the incremental costs of obtaining a contract with a customer and the costs of fulfilling a contract with a customer (if those costs are not within the scope of another Topic or Sub-Topic) would be deferred and recognized over the appropriate period of contract performance if they are expected to be recovered. In addition, the standard requires disclosure of the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (modified retrospective method, also known as the cumulative catch-up transition method).
The Company will adopt the standard effective January 1, 2018 utilizing the modified retrospective method. The Company has completed its analysis of this standard and the adoption of this guidance will not have a material impact on our Consolidated Financial Statements or our internal controls over financial reporting.
Leases
In February 2016, the FASB issued an ASU that modifies existing accounting standards for lease accounting. The new standard requires a lessee to record a lease asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. Leases in which the Company is the lessee will generally be accounted for as operating leases and we will record a lease asset and a lease liability. The guidance is effective for fiscal years beginning after December 15, 2018, with early adoption permitted for fiscal years beginning after December 15, 2018. The standard requires a modified retrospective transition approach for all capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with an option to use certain transition relief. The Company expects to adopt this standard effective January 1, 2019, and is in the process of assessing the impact of this standard.
Restricted Cash
In November 2016, the FASB issued an ASU that requires companies to combine restricted cash and restricted cash equivalents with cash and cash equivalents when reconciling the beginning and end of period total amounts on the statement of cash flows. The guidance is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted. The Company will adopt the standard effective January 1, 2018 utilizing the retrospective transition method. The adoption of this guidance will not have a significant impact on our Consolidated Financial Statements.
Comprehensive Income
In February 2018, the FASB issued an ASU that allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. The guidance is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The guidance should be applied either in the period of adoption or retrospectively to each period in which the effect of the change in federal corporate income tax rate in the Tax Cuts and Jobs Act is recognized. We are currently evaluating this guidance.
3. Intangible Assets
Intangible assets consisted of the following (in thousands):
Amortization expense for intangibles assets was approximately $1.5 million for each of the years ended December 31, 2017, 2016 and 2015, respectively. The remaining net book value of $0.1 million will be amortized during the first quarter of 2018.
4. Fair Value of Financial Instruments
Cash, Cash Equivalents and Short-Term Investments
Cash equivalents consist of highly liquid fixed-income investments with original maturities of three months or less at the time of purchase. Short-term investments consist of readily marketable securities with a remaining maturity of more than three months from time of purchase. The Company classifies its cash equivalents and short-term investments as “available for sale,” as these investments are free of trading restrictions and are available for use in the Company's daily operations. These marketable securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as accumulated other comprehensive loss and included as a separate component of stockholders’ equity. Gains and losses are recognized when realized. When the Company determines that an other-than-temporary decline in fair value occurred, the amount of the decline that is related to a credit loss is recognized in earnings. Gains and losses are determined using the specific identification method. The Company’s realized gains and losses in the years ended December 31, 2017 and 2016 were insignificant. There were no transfers between levels during the years ended December 31, 2017 and 2016.
The following tables present the Company's cash and cash equivalents and short-term investments by significant investment category (in thousands) measured at fair value on a recurring basis:
For the Year Ended December 31, 2017:
For the Year Ended December 31, 2016:
The following table presents the amortized cost and estimated fair value of money market mutual funds and short-term fixed income securities classified as short-term investments based on stated maturities as of December 31, 2017 (in thousands):
The Company considers the declines in market value of its marketable securities investment portfolio to be temporary in nature. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates and the Company’s intent to sell, or whether it is more likely than not it will be required to sell the investment before recovery of the investment’s cost basis. As of December 31, 2017, the Company does not consider any of its investments to be other-than-temporarily impaired.
The Company had restricted cash of $1.2 million in "Other assets" in the Consolidated Balance Sheets as of December 31, 2017 and 2016. The restricted cash is classified within Level 1.
The convertible notes issued by the Company in August 2013 are included in the Consolidated Balance Sheets at their original issuance value, net of unamortized discount and issuance costs, and are not marked to market each period. The approximate fair value of the convertible notes was approximately $145.9 million and $143.8 million as of December 31, 2017 and 2016, respectively. The fair value of the convertible notes was determined using quoted market prices for similar securities and are considered Level 2 inputs due to limited trading activity.
The Company did not have any other financial instruments or debt measured at fair value as of December 31, 2017 and 2016, respectively.
5. Property and Equipment, Net
Property and equipment, net were comprised of the following (in thousands):
Depreciation and amortization expense, which includes amortization expense related to capital leases, was approximately $21.1 million, $16.1 million and $13.7 million, respectively, during the years ended December 31, 2017, 2016 and 2015.
The Company capitalized costs of approximately $12.6 million, $13.1 million and $7.2 million during the years ended December 31, 2017, 2016 and 2015, respectively, related to internal-use software. As of December 31, 2017 and 2016, the carrying value of capitalized costs related to internal-use software, net of accumulated amortization, was $16.5 million and $17.2 million, respectively. Amortization expense related to internal-use software was approximately $13.3 million, $7.6 million and $5.0 million during the years ended December 31, 2017, 2016 and 2015, respectively.
6. Other Current Liabilities
Other current liabilities were comprised of the following (in thousands):
7. Debt
Senior Convertible Notes
In August 2013, the Company issued senior convertible notes (the "Notes") in exchange for gross proceeds of $150.0 million. The Notes mature on August 1, 2018 and are recorded as a current liability in "Convertible notes" in our Consolidated Balance Sheet as of December 31, 2017.
The Notes are governed by an Indenture, dated August 13, 2013 (the "Indenture"), between the Company and Wells Fargo Bank, National Association, as trustee. The notes bear interest at a rate of 1.50% per year payable semi-annually in arrears on February 1 and August 1, beginning February 1, 2014.
The Notes are convertible at an initial conversion rate of 61.6770 shares of common stock per $1,000 principal amount of Notes, which represents an initial conversion price of approximately $16.21 per share of common stock, subject to anti-dilution adjustments upon certain specified events, as defined in the Indenture. Upon conversion, the Notes will be settled in cash, shares of the Company’s common stock, or any combination thereof, at the Company’s option. The Notes were not subject to conversion or repurchase as of December 31, 2017. However, holders of the Notes may convert their Notes at any time on or after February 1, 2018, until the close of business on the second schedule trading day immediately preceding the maturity date, regardless of the foregoing circumstances.
To account for the Notes at issuance, the Company separated the Notes into debt and equity components pursuant to the accounting standards for convertible debt instruments that may be fully or partially settled in cash upon conversion. The fair value of debt component was estimated using an interest rate for nonconvertible debt, with terms similar to the Notes, excluding the conversion feature. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The excess of the principal amount of the Notes over the fair value of the debt component was recorded as a debt discount and a corresponding increase in additional paid-in capital. The debt discount is accreted to interest expense over the term of the Notes using the interest method. The amount recorded to additional paid-in capital is not to be remeasured as long as it continues to meet the conditions of equity classification. Upon issuance of the $150.0 million of Notes, the Company recorded $111.5 million to debt and $38.5 million to additional paid-in capital.
The net carrying amount of the liability component of the Notes consists of the following (in thousands):
Estimated future amortization of deferred issuance costs is approximately $5.8 million for the year ended December 31, 2018.
The following table presents interest expense recognized related to the Notes (in thousands):
Note Hedges
Concurrent with the issuance of the Notes, the Company entered into note hedges ("Note Hedges") with certain bank counterparties, with respect to its common stock. The Company paid $31.4 million for the Note Hedges. The Note Hedges cover approximately 9.25 million shares of the Company's common stock at a strike price of $16.21 per share. The Note Hedges will expire upon the maturity of the Notes. The Note Hedges are intended to reduce the potential dilution to the Company's common stock upon conversion of the Notes and/or offset the cash payment in excess of the principal amount of the Notes the Company is required to make in the event that the market value per share of the Company's common stock at the time of exercise is greater than the conversion price of the Notes.
Warrants
Separately, the Company entered into warrant transactions, whereby it sold warrants to the same bank counterparties as the Note Hedges to acquire approximately 9.25 million shares of the Company's common stock at an initial strike price of $21.02 per share ("Warrants"), subject to anti-dilution adjustments. The Company received proceeds of approximately $21.8 million from the sale of the Warrants. If the fair value per share of the Company's common stock exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on earnings per share, unless the Company elects, subject to certain conditions, to settle the Warrants in cash.
The amounts paid and received for the Note Hedges and the Warrants have been recorded in additional paid-in capital. The fair value of the Note Hedges and the Warrants are not remeasured through earnings each reporting period.
Letter of Credit
On February 3, 2015, the Company issued a $1.2 million letter of credit in connection with a lease for a new San Francisco office facility. The letter of credit is secured by $1.2 million of cash in a money market account which is classified as restricted cash in "Other assets" in the Consolidated Balance Sheets.
8. Commitments and Contingencies
Operating Leases
The Company leases its office space and certain equipment under non-cancelable operating lease agreements with various expiration dates through December 2022. Rent expense during the years ended December 31, 2017, 2016 and 2015 was approximately $10.6 million, $11.3 million and $9.4 million, respectively. The Company recognizes rent expense on a straight-line basis over the lease period and accrues for rent expense incurred but not paid.
Future annual minimum lease payments under non-cancelable operating leases as of December 31, 2017 were as follows (in thousands):
In January 2018, the Company entered into a sublease with a third-party for the Company's San Francisco office space for the remaining term of the lease. The future minimum payments through November 30, 2022 under the original lease total approximately $9.3 million and future sublease rental income totals approximately $8.9 million over the same period.
Other Purchase Commitments
The Company had $14.1 million in non-cancelable purchase commitments with our suppliers as of December 31, 2017.
Litigation
The Company is subject to various legal proceedings and claims arising in the ordinary course of our business, including the cases discussed below. Although the results of litigation and claims cannot be predicted with certainty, the Company is currently not aware of any litigation or threats of litigation in which the final outcome could have a material adverse effect on our business, operating results, financial position, or cash flows. Regardless of the outcome, litigation can have an adverse impact on the Company because of defense and settlement costs, diversion of management resources and other factors. The Company records a contingent liability when it is probable that a loss has been incurred and the amount is reasonably estimable in accordance with accounting for contingencies. As of December 31, 2017 and 2016, the Company accrued a $1.5 million reserve relating to our potential liability for currently pending disputes, reflected in "Accrued expenses" in the Consolidated Balance Sheets.
On August 23, 2016, the United States District Court for the Middle District of Tennessee granted conditional class certification in a lawsuit originally filed on September 21, 2015 by three former senior sales representatives. The lawsuit, Sarah Patton, et al v. ServiceSource Delaware, Inc., asserts a claim under the Fair Labor Standards Act alleging that certain sales account representatives and senior sales representatives in our Nashville location were not paid for all hours worked and were not properly paid for overtime hours worked. The complaint also asserts claims under Tennessee state law for breach of contract and unjust enrichment, however, the plaintiffs have not yet filed a motion to certify the state law breach of contract and unjust enrichment claims as a class action. The Company will continue to vigorously defend itself against these claims.
9. Share Repurchase Program, Stock-Based Compensation and ESPP
Share Repurchase Program
In August 2015, our Board of Directors authorized a stock repurchase program (the "program") to repurchase up to $30.0 million of our common stock. The program expired August 2017. During the year ended December 31, 2016, the Company repurchased 2.3 million shares of common stock at a weighted-average price of $3.94 per share for an aggregate purchase price of $8.9 million. No shares were repurchased under this program during the year ended December 31, 2017.
Equity Plans
The Company maintains the 2011 Equity Incentive Plan (the “2011 Plan”) and the 2011 Employee Stock Purchase Plan. The Company’s Board of Directors, by delegation to its compensation committee, administers the 2011 Plan and has authority to determine the directors, officers, employees and consultants to whom options, restricted stock units or restricted stock awards may be granted, the option price or restricted stock purchase price, the timing of when each share is exercisable and the duration of the exercise period and the nature of any restrictions or vesting periods applicable to an option or restricted stock grant
At the end of each fiscal year, the share reserve under the 2011 Plan automatically increases, to the lessor of an amount equal to 4% of the outstanding shares as of the end of that fiscal year or 3,840,000 shares. As of December 31, 2017, there were approximately 12.4 million shares available for grant under the 2011 Plan. On January 1, 2018, 3.6 million additional shares were reserved under the 2011 Equity Incentive Plan pursuant to the automatic increase.
Stock options are recorded at fair value on the date of grant date using the Black-Scholes option-pricing model and generally vest ratably over a four-year period. Vested options may be exercised up to ten years from the grant date, as defined in the 2011 Plan. Vested but unexercised options expire 90 days after termination of employment with the Company. Compensation expense is amortized on a straight-line basis over the service period during which the right to exercise such options fully vests.
Restricted stock units are recorded at fair value on the date of grant and amortized on a straight-line basis over the service period during which the stock vests. Restricted stock units generally vest ratably over four years with vesting contingent upon employment of the Company.
2017 PSU Awards
During the second quarter of 2017, the Company granted performance-based restricted stock unit awards under the Company’s 2011 Equity Incentive Plan to certain key executives (the “2017 PSU Awards”). For each 2017 PSU Award, a number of restricted stock units became eligible to vest based on the levels of achievement of the performance-based conditions, and those restricted stock units that became eligible to vest will vest 50% on the first anniversary of the grant date and 50% on the second anniversary of the grant date, except as otherwise provided under certain termination and change-in-control provisions in each award agreement. The aggregate target number of restricted stock units subject to the 2017 PSU Awards was 1.0 million, with an aggregate grant date fair value of $3.7 million.
The performance-based conditions are based upon the Company’s revenue and adjusted EBITDA performance in fiscal year 2017 against the target goals for such metrics under the Company’s 2017 corporate incentive plan (in each case, “Performance Achievement”), which will each be determined on the date the Company files its Annual Report on Form 10-K for fiscal year 2017. The target number of restricted stock units for each 2017 PSU Award will be divided equally between the two performance metrics. For each performance metric, the number of restricted stock units that become eligible to vest will be: (i) if the applicable Performance Achievement is less than 90% of the target revenue goal or less than 69% of the target EBITDA goal, no restricted stock units for such performance metric, (ii) if the applicable Performance Achievement is equal to 90% of the target revenue goal or 69% of the target EBITDA goal, 50% of the target number of restricted stock units for such performance metric, (iii) if the applicable Performance Achievement is equal to 100% of the target revenue and EBITDA goals, 100% of the target number of restricted stock units for such performance metric, or (iv) if the applicable Performance Achievement is at least 107% of the target revenue goal or 146% of the target EBITDA goal, 150% of the target number of restricted stock units for such performance metric. For each performance metric, if the applicable Performance Achievement falls between any of the thresholds (ii), (iii), and (iv) specified in the previous sentence, the number of restricted stock units that become eligible to vest for such performance metric will be determined via linear interpolation.
Under the time-based vesting condition, 50% of the restricted stock units that have become eligible to vest will vest on the first anniversary of the grant date, and 50% of the restricted stock units that have become eligible to vest will vest on the second anniversary of the grant date, except as otherwise provided under certain termination and change-in-control provisions in each award agreement governing a 2017 PSU Award. Such provisions will determine the number of restricted stock units that
become eligible to vest and when and how many restricted stock units will actually vest in connection with the specified terminations of employment and changes in-control.
2016 PSU Awards
During the third quarter of 2016, the Company granted performance-based restricted stock unit awards under the Company’s 2011 Equity Incentive Plan to certain key executives (the “2016 PSU Awards”). The 2016 PSU Awards contain similar performance and vesting conditions as the 2017 PSU Awards. The aggregate target number of restricted stock units subject to the 2016 PSU Awards was 1.0 million with an aggregate grant date fair value of $5.1 million. Upon the filing of the Company’s 2016 form 10-K on March 6, 2017, an additional 0.2 million shares with a grant date fair value of $1.2 million became eligible to vest under the 2016 PSU Awards. The 2016 PSU Awards are expensed over the two-year vesting term using the accelerated attribution method.
Fair Value of Stock Options and Restricted Units
The estimated fair value of stock options and restricted stock units granted during the years ended December 31, 2017, 2016 and 2015, was approximately $11.5 million, $13.3 million, and $18.6 million, respectively.
The fair value of each grant of options during 2017, 2016 and 2015 was determined by the Company using the methods and assumptions discussed below. The Company stratifies its population of outstanding share options into two relatively homogeneous groups to estimate the expected term of options grants. Each of these inputs is subjective and generally requires significant judgment to determine.
Expected Term-The expected term represents the period that the Company’s share-based awards are expected to be outstanding. The Company calculated the expected term of share options using four data points: options exercised, options expired, options forfeited and options outstanding. The weighted-average of the four data points were used to calculate the expected term.
Expected Volatility-The expected volatility is based on the historical stock volatility of the Company's own common shares.
Risk-Free Interest Rate-The risk-free interest rate was based on the implied yield on U.S. Treasury zero-coupon issues for each option grant date with maturities approximately equal to the option’s contractual term.
Expected Dividend Yield-The Company has not paid dividends on its common shares nor does it expect to pay dividends in the foreseeable future.
The weighted average Black-Scholes option-pricing model assumptions were as follows:
Employee Stock Purchase Plan
The Company’s 2011 Employee Stock Purchase Plan (the “ESPP”) is intended to qualify under Section 423 of the Internal Revenue Code of 1986. Under the ESPP, employees are eligible to purchase common stock through payroll deductions of up to 10% of their eligible compensation, subject to any plan limitations. The purchase price of the shares on each purchase date is equal to 85% of the lower of the fair market value of the Company’s common stock on the first and last trading days of each six-month offering period.
The Company estimates the fair value of purchase rights under the ESPP using the Black-Scholes option-pricing model and the straight-line attribution approach. The following weighted-average assumptions were as follows:
The expected term represents the period of time from the beginning of the offering period to the purchase date. The Company uses its historical volatility for a period equivalent to the expected term of the options to estimate the expected volatility. The risk-free interest rate the Company uses in the Black-Scholes option valuation model is based on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term. The Company has never declared or paid any cash dividends and does not plan to pay cash dividends in the foreseeable future, and, therefore, used an expected dividend yield of zero in the valuation model.
The ESPP provides that additional shares are reserved annually on the first day of each fiscal year in an amount equal to the lesser of (i) 1.5 million shares, (ii) one percent of the outstanding shares of common stock on the last day of the immediately preceding fiscal year, or (iii) an amount determined by the board of directors and/or the compensation committee of the board of directors. As of December 31, 2017, 2.1 million shares had been issued under the ESPP and 3.7 million shares were available for future issuance. On January 1, 2018, 0.9 million additional shares were reserved under the 2011 ESPP.
Stock Awards Issued to Employees
The following table presents total options outstanding, granted, exercised, expired or forfeited, as well as total options exercisable (shares and aggregate intrinsic value in thousands):
The total estimated fair value of options vested during the years ended December 31, 2017, 2016, and 2015 was $2.5 million, $3.7 million and $2.7 million, respectively.
The following table summarizes additional information concerning our vested restricted stock units and performance stock units (shares in thousands):
(1)1,755 shares of common stock were issued for restricted stock units vested and the remaining 208 shares were withheld for taxes.
The total estimated fair value of restricted stock units and PSU awards vested during the years ended December 31, 2017, 2016 and 2015 was $7.3 million, $6.2 million and $8.5 million.
The following table presents stock-based compensation expense as allocated within the Company’s Consolidated Statements of Operations (in thousands):
The above table does not include approximately $0.5 million, $0.6 million and $0.4 million of capitalized stock-based compensation related to internal-use software for the years ended December 31, 2017, 2016 and 2015, respectively.
As of December 31, 2017, there was approximately $15.9 million of unrecognized compensation expense related to non-vested share-based compensation arrangements granted under the 2011 Plan, which is expected to be recognized over a weighted-average period of 1.96 years.
10. Employee Benefit Plan
The Company maintains a 401(k) defined contribution plan that covers domestic employees who have attained 21 years of age and provide at least 20 hours of service per week. This plan allows U.S. employees to contribute up to 90% of their pre-tax salary into investments at the discretion of the employee, up to maximum annual contribution limits established by the U.S. Department of Treasury. During the years ended December 31, 2017, 2016 and 2015, the Company matched up to 50% of an employee's contributions up to an annual limit of $2,000. Matching contributions by the Company are fully vested upon completion of the first year of employment. Employer matching contributions, which may be discontinued at the Company’s discretion, were approximately $1.5 million, $1.7 million and $2.1 million, during 2017, 2016 and 2015, respectively.
11. Income Taxes
Loss from continuing operations before provision for income taxes for the Company’s domestic and international operations was as follows (in thousands):
The income tax provision consisted of the following (in thousands):
The following table provides a reconciliation of income taxes provided at the federal statutory rate of 35% to the income tax provision (in thousands):
In November 2015, the Philippine Economic Zone Authority granted a four year tax holiday to the Company's Philippine affiliate, commencing with its fiscal year beginning January 1, 2016. The earnings per share benefit in 2017, 2016, and 2015 was not material.
In December 2013, Malaysia granted a ten year tax holiday to the Company’s Malaysia affiliate, commencing with its fiscal year beginning January 1, 2014. This resulted in a tax benefit in fiscal 2013 of approximately $0.2 million from the elimination of the Malaysia subsidiary’s deferred tax liabilities. The earnings per share benefit in 2017, 2016 and 2015 was not material.
The following table provides the effect of temporary differences that created deferred income taxes as of December 31, 2017 and 2016. Deferred tax assets and liabilities represent the future effects on income taxes resulting from temporary differences and carryforwards at the end of the respective periods (in thousands):
As of December 31, 2017 and 2016, management assessed the realizability of deferred tax assets and evaluated the need for a valuation allowance for deferred tax assets on a jurisdictional basis. This evaluation utilizes the framework contained in ASC 740, Income Taxes, wherein management analyzes all positive and negative evidence available at the balance sheet date to determine whether all or some portion of the Company's deferred tax assets will not be realized. Under this guidance, a valuation allowance must be established for deferred tax assets when it is more-likely-than-not (a probability level of more than 50 percent) that the asset will not be realized. In assessing the realization of the Company's deferred tax assets, management considers all available evidence, both positive and negative.
In concluding on the evaluation, management placed significant emphasis on guidance in ASC 740, which states that “a cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.” Based upon available evidence, it was concluded on a more-likely-than-not basis that all deferred tax assets were not realizable as of December 31, 2017. Accordingly, a valuation allowance of $82.9 million has been recorded to offset this deferred tax asset. The change in valuation allowance for the years ended December 31, 2017 and 2016 was a decrease of $29.0 million and an increase of $24.3 million, respectively.
Management also concluded on a more-likely-than-not basis that its Singapore deferred tax assets were not realizable, using the analysis prescribed in ASC 740. Other factors were considered but provided neither positive nor negative objectively-verifiable evidence as to the realization of our deferred tax assets. The remaining deferred tax assets as of December 31, 2017 relate to jurisdictions in which the Company has net adjusted historical pretax profits and sufficient forecast profitability to assure future realization of such deferred tax assets.
The Tax Cuts and Jobs Act (the "Act") was enacted on December 22, 2017. The Act reduces the U.S. federal corporate tax rate from 35% to 21%, requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and creates new taxes on certain foreign sourced earnings. In accordance with Staff Accounting Bulletin 118, we have not completed our accounting for the tax effects of enactment of the Act; however, in certain cases, as described below, we have made a reasonable estimate of the effects on our existing deferred tax balances and the one-time transition tax. In other cases, we have not been able to make a reasonable estimate and continue to account for those items based on our existing accounting under ASC 740, Income Taxes, and the provisions of the tax laws that were in effect immediately prior to enactment. For the items for which we were able to determine a reasonable estimate, we recognized a provisional benefit of $2.1 million, which is included as a component of income tax expense from continuing operations. In all cases, we will continue to make and refine our calculations as additional analysis is completed. In addition, our estimates may also be affected as we gain a more thorough understanding of the tax law.
We remeasured certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21%. However, we are still analyzing certain aspects of the Act and refining our calculations, which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The provisional amount recorded related to the remeasurement of our deferred tax balance was $37.0 million, which was offset by a decrease in our valuation allowance of $39.1 million. We recognized a $2.1 million tax benefit related to remeasurement of indefinite-lived deferred tax liabilities and the release of valuation allowance associated with tax reform changes in net operating loss carryforwards. Future net operating losses generated will have an indefinite carryover as opposed to a 20-year carryover. Therefore, we expect the reversal of our deferred tax assets to result in indefinite lived deferreds (future net operating losses) which can be used as an offset in our valuation allowance calculations.
The non-recurring transition tax is based on the total post-1986 earnings and profits ("E&P") previously deferred from U.S. income taxes. In aggregate, the Company has a deficit in post-1986 E&P from its foreign subsidiaries resulting in no transition tax liability. The Company considers its undistributed earnings of ServiceSource Europe, Ltd & ServiceSource International Singapore Pte. Ltd permanently reinvested in foreign operations and has not provided for U.S. income taxes on such earnings. As of December 31, 2017, the Company's had no unremitted earnings from its foreign subsidiaries.
As of December 31, 2017, the Company had net operating loss carryforwards of approximately $249.6 million for federal income tax purposes and approximately $416.5 million for state income tax purposes. These losses are available to reduce taxable income and expire at various dates beginning in 2024 for federal income tax purposes and 2021 for state income tax purposes. The Company also has foreign net operating loss carryforwards of approximately $10.4 million which are indefinitely available to reduce taxable income and do not expire.
As of December 31, 2017, the Company had $2.5 million of U.S. federal research and development credits which expire beginning in 2031, and $3.7 million of California research and development credits which do not expire. The Company also has $0.5 million of California Enterprise Zone Credits which expire beginning in 2023 if not utilized, and $1.6 million of other state tax credits which expire beginning in 2024 if not utilized.
Utilization of the Company’s net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Such an annual limitation could result in the expiration or elimination of the net operating loss and tax credit carryforwards before utilization. Management believes that the limitation will not limit utilization of the carryforwards prior to their expiration.
The Company acquired U.S. federal net operating loss carryforwards of Scout Analytics, Inc. upon the acquisition of that entity in January 2014, subject to the ownership change limitations. Acquired U.S. federal net operating losses from Scout total approximately $30.2 million net of amounts unavailable due to ownership change limitations, which is included in the total U.S. federal net operating loss above.
The Company files U.S. federal and state and foreign income tax returns in jurisdictions with varying statutes of limitations. In the normal course of business the Company is subject to examination by taxing authorities throughout the world. These audits could include examining the timing and amount of deductions, the allocation of income among various tax jurisdictions and compliance with federal, state, local and foreign tax laws. Our 2005 through 2016 tax years generally remain subject to examination by federal, state and foreign tax authorities.
The Company has implemented the provisions of ASC 740-10, Accounting for Uncertainty in Income Taxes. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands):
As of December 31, 2017, the Company had a liability for unrecognized tax benefits of $0.9 million, none of which, if recognized, would affect the Company’s effective tax rate. The Company does not expect its unrecognized tax benefits to change significantly over the next 12 months.
The Company recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense. During the year ended December 31, 2017, the interest and penalties recognized were insignificant. During the years ended December 31,
2016 and 2015, the Company recognized and accrued an insignificant amount of interest or penalties related to unrecognized tax benefits.
12. Geographical Information
The Company’s business is geographically diverse. During 2017, 63% of net revenue was earned in North America and Latin America (“NALA”), 26% in Europe, Middle East and Africa (“EMEA”) and 11% in Asia Pacific-Japan (“APJ”). Net revenue for a particular geography generally reflects commissions earned from sales of service contracts managed from revenue delivery centers in that geography and subscription sales and professional services to deploy the Company's solutions. Predominantly all of the service contracts sold and managed by the revenue delivery centers relate to end customers located in the same geography. All of NALA net revenue represents revenue generated in the U.S.
The CEO manages and allocates resources on a company-wide basis as a single segment that is focused on service offerings which integrate data, processes and cloud technologies.
Net revenue by geographic region, is summarized as follows (in thousands):
During the year ended December 31, 2017, the Company's top ten clients accounted for 66% of our net revenue. Three of our clients, Cisco, VMWare, and Dell, represented 15%, 12% and 11% of our revenue, respectively, for the year ended December 31, 2017.
The majority of the Company’s assets as of December 31, 2017 and 2016 were attributable to its U.S. operations. Property and equipment information is based on the physical location of the assets. The following table presents the long-lived assets, consisting of property and equipment, by geographic location (in thousands):
13. Restructuring and Other
In May 2017, the Company announced a restructuring effort to better align its cost structure with current business and market conditions, including a headcount reduction and the reduction of office space in four locations. The restructuring plan is accounted for in accordance with ASC 420, Exit or Disposal Cost Obligations. The Company recognized restructuring and other charges of approximately $7.3 million during the year ended December 31, 2017. Severance and other employee costs include stock compensation related to the accelerated vesting of certain equity awards, severance payments, related employee benefits and employee-related legal fees. Lease and other contract termination costs include charges related to lease consolidation and abandonment of spaces no longer utilized and the cancellation of certain contracts with outside vendors. Asset impairments include charges related to leasehold improvements and furniture in spaces vacated or no longer in use. The Company expects to incur additional restructuring charges in the first half of 2018 related to the relocation and decommissioning of our current San Francisco office space. Future cash outlays related to restructuring activities are expected to total approximately $1.8 million. These amounts are reported in “Accounts payable, Accrued compensation and benefits and Accrued expenses" in our Consolidated Balance Sheet as of December 31, 2017.
Restructuring and other reserve activities are summarized as follows (in thousands):
14. Selected Quarterly Financial Data (Unaudited)
The following table presents data derived from our unaudited quarterly Condensed Consolidated Statement of Operations data for each quarter during the years ended December 31, 2017 and 2016. Quarterly amounts may not total to annual amounts due to rounding.
15. Subsequent Events
GAAP requires an entity to disclose events that occur after the balance sheet date but before financial statements are issued or are available to be issued (“subsequent events”) as well as the date through which an entity has evaluated subsequent events. There are two types of subsequent events. The first type consists of events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements, (“recognized subsequent events”). The second type consists of events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date (“nonrecognized subsequent events”). No significant recognized or nonrecognized subsequent events were noted other than those mentioned in “Note 8 - Commitments and Contingencies.”
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this Annual Report on Form 10-K.
In designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.
Based on management’s evaluation, our chief executive officer and chief financial officer concluded that as of December 31, 2017 our disclosure controls and procedures are designed to, and are effective to, provide at a reasonable assurance level that the information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosures.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2017 based on the guidelines established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
Based on the results of our evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2017. The effectiveness of our internal control over financial reporting as of December 31, 2017 has been audited by Ernst and Young LLP, an independent registered public accounting firm, as stated in its report which is included herein.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting that occurred during the quarter ended December 31, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Inherent Limitations on Effectiveness of Controls
Our management, including our chief executive officer and chief financial officer, do not expect that our disclosure controls 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. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. 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 a 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 controls. 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 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.
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors of ServiceSource International, Inc.
Opinion on Internal Control over Financial Reporting
We have audited ServiceSource International, Inc.’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), (the COSO criteria). In our opinion, ServiceSource International, Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive loss, stockholders' equity and cash flows for each of the two years in the period ended December 31, 2017, and the related notes and our report dated March 2, 2018 expressed an unqualified opinion thereon.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Ernst & Young LLP
Denver, Colorado
March 2, 2018
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information regarding our directors is incorporated by reference from the information contained under the caption “Election of Directors” in our Proxy Statement for our 2018 Annual Meeting of Stockholders (the “2018 Proxy Statement”). Information regarding our current executive officers is incorporated by reference from information contained under the caption “Executive Officers” in our 2018 Proxy Statement. Information regarding Section 16 reporting compliance is incorporated by reference from information contained under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in our 2018 Proxy Statement. Information regarding the Audit Committee of our Board of Directors and information regarding an Audit Committee financial expert is incorporated by reference from information contained under the caption “Board Committees” in our 2018 Proxy Statement. Information regarding our code of ethics is incorporated by reference from information contained under the caption “Code of Business Conduct and Ethics” in our 2018 Proxy Statement. Information regarding our implementation of procedures for stockholder nominations to our Board of Directors is incorporated by reference from information contained under the caption “Process for Recommending Candidates to the Board of Directors” in our 2018 Proxy Statement.
We intend to disclose any amendment to our code of ethics, or waiver from, certain provisions of our code of ethics as applicable for our directors and executive officers, including our principal executive officer, principal financial and accounting officer, chief accounting officer, and controller, or persons performing similar functions, by posting such information on our website at http://www.servicesource.com.
The information required by this item is incorporated by reference from the information contained under the captions “Compensation Discussion and Analysis” and “Executive Compensation” in our 2018 Proxy Statement.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Other than information regarding securities authorized for issuance under equity compensation plans, which is set forth in the Notes to the Consolidated Financial Statements above, the information required by this item is incorporated by reference from the information contained under the caption “Security Ownership” in our 2018 Proxy Statement.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is incorporated by reference from the information contained under the captions “Related Person Transactions and Section 16(a) Beneficial Ownership Reporting Compliance” and “Director Independence” in our 2018 Proxy Statement.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated by reference from the information contained under the caption “Principal Accountant Fees and Services” in our 2018 Proxy Statement.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) Financial Statements
Consolidated Financial Statements filed as part of this report are listed under Part II, Item 8, pages [47] through [51] of this Form 10-K.
(2) Financial Statement Schedules
No schedules are required because either the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Consolidated Financial Statements or the notes thereto.
(3) Exhibits
See Item 15(b) below. Each management contract and compensatory plan or arrangement required to be filed has been identified.
(b) Exhibits
The exhibits listed on the accompanying Exhibit Index immediately following the signature page are filed as part of, or are incorporated by reference into, this Annual Report on Form 10-K.
(c) Financial Statement Schedules
Reference is made to Item 15(a)(2) above.
None.
Index to Exhibits
+
Management contract or compensatory plan or arrangement.
*
In accordance with Item 601(b)(32)(ii) of Regulation S-K, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Annual Report on Form 10-K and will not be deemed “filed” for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SERVICESOURCE INTERNATIONAL, INC.
Dated:
March 2, 2018
By:
/s/ CHRISTOPHER M. CARRINGTON
Christopher M. Carrington
Chief Executive Officer (Principal Executive Officer)
POWER OF ATTORNEY
KNOW ALL BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Robert N. Pinkerton and Patricia Elias, and each of them, his or her true and lawful attorney-in-fact and agent, with full power of substitution, each with power to act alone, to sign and execute on behalf of the undersigned any and all amendments to this Annual Report on Form 10-K, and to perform any acts necessary in order to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requested and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or their or his or her substitutes, shall do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the ServiceSource International, Inc. and in the capacities and on the dates indicated.