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QLYS-2012-9.30-10Q

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

__________________

FORM 10-Q

__________________



x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2012



o	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to

Commission file number 001-35662

__________________

QUALYS, INC.

(Exact name of registrant as specified in its charter)

__________________



Delaware		77-0534145
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification Number)

1600 Bridge Parkway, Redwood City, California 94065

(Address of principal executive offices, including zip code)

(650) 801-6100

(Registrant’s telephone number, including area code)

__________________

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ¨ No x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer	o	Accelerated filer	o	Non-accelerated filer	x	Smaller reporting company	o
				(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

The number of shares of the Registrant's common stock outstanding as of October 31, 2012 was 31,409,793.

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Qualys, Inc.

TABLE OF CONTENTS



		Page
PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2012 and December 31, 2011	3
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2012 and 2011	4
	Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2012 and 2011	5
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2011	6
	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40
Item 4.	Controls and Procedures	40
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	42
Item 1A.	Risk Factors	42
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	64
Item 3.	Defaults upon Senior Securities	64
Item 4.	Mine Safety Disclosures	65
Item 5.	Other Information	65
Item 6.	Exhibits	65
	Signatures	66

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PART I. FINANCIAL INFORMATION


Item 1.	Financial Statements

Qualys, Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share and per share data)



	September 30, 2012			December 31, 2011
				(restated)
Assets
Current assets:
Cash	$	25,804		$	24,548
Accounts receivable, net of allowance of $355 and $230 at September 30, 2012 and December 31, 2011, respectively	23,452			20,750
Prepaid expenses and other current assets	6,502			3,774
Total current assets	55,758			49,072
Restricted cash	112			112
Property and equipment, net	16,896			13,861
Intangible assets, net	2,869			3,175
Goodwill	317			317
Other noncurrent assets	1,884			2,252
Total assets	$	77,836		$	68,789
Liabilities, Convertible Preferred Stock and Stockholders’ Equity (Deficit)
Current Liabilities :
Accounts payable	$	1,715		$	2,254
Accrued liabilities	9,085			8,468
Deferred revenues, current	51,693			46,717
Capital lease obligations, current	1,556			1,987
Total current liabilities	64,049			59,426
Deferred revenues, noncurrent	6,152			4,713
Income taxes payable, noncurrent	504			661
Other noncurrent liabilities	1,189			2,134
Capital lease obligations, noncurrent	1,074			2,406
Total liabilities	72,968			69,340
Commitments and contingencies (Note 6)
Convertible preferred stock:
Series A convertible preferred stock: $0.001 par value; 48,079,860 shares authorized; 4,766,543 shares issued and outstanding at September 30, 2012 and December 31, 2011; aggregate liquidation preference—$28,774	28,603			28,603
Series B convertible preferred stock: $0.001 par value; 110,314,114 shares authorized; 11,031,387 shares issued and outstanding at September 30, 2012 and December 31, 2011; aggregate liquidation preference—$28,862	28,568			28,568
Series C convertible preferred stock: $0.001 par value; 18,006,026 shares authorized; 1,799,328 shares issued and outstanding at September 30, 2012 and December 31, 2011; aggregate liquidation preference— $6,631	6,702			6,702
Total convertible preferred stock	63,873			63,873
Stockholders’ equity (deficit):
Common stock, $0.001 par value; 299,900,000 shares authorized; — 5,964,621 and 5,300,288 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively	6			5
Additional paid-in capital	17,257			12,927
Accumulated other comprehensive loss	(1,001		)	(984		)
Accumulated deficit	(75,267		)	(76,372		)
Total stockholders’ equity (deficit)	(59,005		)	(64,424		)
Total liabilities, convertible preferred stock and stockholders’ equity (deficit)	$	77,836		$	68,789

See accompanying Notes to Condensed Consolidated Financial Statements

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Qualys, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share data)



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
Revenues	$	23,382		$	19,375		$	66,763		$	55,560
Cost of revenues	4,634			3,225			13,423			9,124
Gross profit	18,748			16,150			53,340			46,436
Operating expenses:
Research and development	5,076			4,922			15,325			14,680
Sales and marketing	8,797			7,985			27,827			22,297
General and administrative	3,154			2,249			8,811			6,510
Total operating expenses	17,027			15,156			51,963			43,487
Income from operations	1,721			994			1,377			2,949
Other income (expense), net:
Interest expense	(38		)	(47		)	(153		)	(164		)
Interest income	1			4			2			10
Other income (expense), net	60			(418		)	(44		)	101
Total other income (expense), net	23			(461		)	(195		)	(53		)
Income before provision for income taxes	1,744			533			1,182			2,896
Provision for income taxes	77			81			77			291
Net income	$	1,667		$	452		$	1,105		$	2,605
Net income attributable to common stockholders	$	415		$	102		$	264		$	576
Net income per share attributable to common stockholders:
Basic	$	0.07		$	0.02		$	0.05		$	0.12
Diluted	$	0.06		$	0.02		$	0.04		$	0.11
Weighted average shares used in computing net income per share attributable to common stockholders:
Basic	5,843			5,137			5,540			5,002
Diluted	26,545			24,402			25,972			24,208

See accompanying Notes to Condensed Consolidated Financial Statements

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Qualys, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(in thousands)



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2012		2011			2012			2011
Net income	$	1,667	$	452		$	1,105		$	2,605
Foreign currency translation gain (loss), net of zero tax	41		(106		)	(17		)	(138		)
Other comprehensive income (loss), net	41		(106		)	(17		)	(138		)
Comprehensive income	$	1,708	$	346		$	1,088		$	2,467

See accompanying Notes to Condensed Consolidated Financial Statements

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Qualys, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



	Nine Months Ended September 30,
	2012			2011
Cash flows from operating activities:
Net income	$	1,105		$	2,605
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization expense	5,397			3,781
Bad debt expense	182			171
Loss on disposal of property and equipment	3			—
Stock-based compensation	2,583			1,512
Non-cash interest expense	24			27
Changes in operating assets and liabilities:
Accounts receivable	(2,884		)	(1,973		)
Prepaid expenses and other assets	146			(1,283		)
Accounts payable	(542		)	676
Accrued liabilities	(1,509		)	752
Deferred revenues	6,415			4,724
Income taxes payable	(189		)	311
Other noncurrent liabilities	(62		)	(16		)
Net cash provided by operating activities	10,669			11,287
Cash flows from investing activities:
Purchases of property and equipment	(8,104		)	(4,250		)
Net cash used in investing activities	(8,104		)	(4,250		)
Cash flows from financing activities:
Principal payments under capital lease obligations	(1,763		)	(1,153		)
Payment of consideration related to acquisition	(1,000		)	—
Proceeds from exercise of stock options	1,998			971
Payments for offering costs in connection with initial public offering	(560		)	—
Proceeds from issuance of Series C Preferred Stock	—			128
Net cash used in financing activities	(1,325		)	(54		)
Effect of exchange rate changes on cash	16			(128		)
Net increase in cash	1,256			6,855
Cash at beginning of period	24,548			15,010
Cash at end of period	$	25,804		$	21,865

Non-cash investing and financing activities:
Deferred offering costs not yet paid	$	1,973		$	—
Issuance of common stock for acquisition of license	$	51		$	—

See accompanying Notes to Condensed Consolidated Financial Statements

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


NOTE 1.	The Company and Summary of Significant Accounting Policies

Description of Business

Qualys, Inc. (the “Company”) was incorporated in the state of Delaware on December 30, 1999. The Company is headquartered in Redwood City, California and has majority-owned subsidiaries throughout the world. The Company is a pioneer and leading provider of cloud security and compliance solutions that enable organizations to identify security risks to their IT infrastructures, help protect their IT systems and applications from ever-evolving cyber attacks and achieve compliance with internal policies and external regulations. The Company’s cloud solutions address the growing security and compliance complexities and risks that are amplified by the dissolving boundaries between internal and external IT infrastructures and web environments, the rapid adoption of cloud computing and the proliferation of geographically dispersed IT assets. Organizations can use the Company’s integrated suite of solutions delivered on its QualysGuard Cloud Platform to cost-effectively obtain a unified view of their security and compliance posture across globally-distributed IT infrastructures.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements and condensed footnotes have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP") for interim financial information as well as the instructions to Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in the financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. The condensed consolidated balance sheet as of December 31, 2011, included herein, was derived from the audited financial statements as of that date but does not include all disclosures, including notes required by U.S. GAAP. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of the financial position, results of operations and cash flows for the interim periods. The results of operations for the three and nine month periods ended September 30, 2012 are not necessarily indicative of the results of operations expected for the entire year ending December 31, 2012 or for any other future annual or interim period. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Prospectus dated September 27, 2012, filed with the SEC pursuant to Rule 424(b)(4) under the Securities Act of 1933.

Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications did not change previously reported total assets, liabilities, convertible preferred stock, stockholders' equity (deficit), income from operations or net income.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries, which are located in Brazil, Canada, France, Germany, Hong Kong, India, Japan, Mexico, Singapore, the United Arab Emirates and the United Kingdom. All significant intercompany transactions and balances have been eliminated upon consolidation.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Use of Estimates

The preparation of the condensed consolidated financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported results of operations during the reporting period. The Company’s management regularly assesses these estimates, which primarily affect revenue recognition, the valuation of accounts receivable, goodwill and intangible assets, common stock, stock-based compensation and the valuation allowances associated with deferred tax assets. Actual results could differ from those estimates and such differences may be material to the accompanying condensed consolidated financial statements.

Convertible Preferred Stock

A sale of all or substantially all of the Company’s assets or merger or consolidation of the Company with another entity is treated as a liquidation unless, following such transaction, the Company’s stockholders directly or indirectly own, in the aggregate, more than 50% of the total voting power of the surviving or acquiring entity. These liquidation provisions and the extent of preferred stock holdings resulted in the preferred stock having redemption features that were not solely in the control of the Company. Because a potential purchaser could have acquired a majority of the outstanding voting stock, triggering a redemption that was outside of the Company’s control, all shares of convertible preferred stock were presented outside of permanent equity in the accompanying condensed consolidated balance sheets as of September 30, 2012 and December 31, 2011.

On October 3, 2012, immediately prior to the closing of the Company’s initial public offering ("IPO"), all outstanding shares of convertible preferred stock converted into an equivalent number of shares of common stock. The related carrying value of the convertible preferred stock of $63.9 million was reclassified to common stock and additional paid-in capital at the time of the conversion. See Note 13 for additional information regarding the Company's IPO.

Concentration of Credit Risk

The Company deposits its cash balances with major financial institutions. Cash balances with any one institution at times may be in excess of federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk.

Credit risk with respect to accounts receivable is dispersed due to the large number of customers. In addition, the Company’s credit risk is mitigated by the relatively short collection period. Collateral is not required for accounts receivable. The Company maintains an allowance for potential credit losses based upon the expected collectability of accounts receivable. The Company writes off its receivables when collectability is deemed to be doubtful. As of September 30, 2012, no customer or channel partner accounted for more than 10% of the Company's accounts receivable balance. One channel partner accounted for 13% of the Company’s accounts receivable balance as of December 31, 2011.

Cash

Cash includes highly liquid investments with original maturities of three months or less when acquired. These investments are stated at cost, which approximates fair market value. The Company’s balance of $25,804,000 and $24,548,000 at September 30, 2012 and December 31, 2011, respectively, consists entirely of cash held in banks.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Accounts Receivable

Accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts represents the Company’s best estimate of the amount of probable credit losses and is determined based on a review of existing accounts receivable by aging category to identify significant customers or invoices with collectability issues. For those invoices not specifically reviewed, the reserve is calculated based on the age of the receivable.

Any change in the assumptions used in analyzing a specific account receivable may result in an additional provision for doubtful accounts being recognized in the period in which the change occurs. When the Company ultimately concludes that a receivable is uncollectible, the balance is written off against the allowance for doubtful accounts. Payments subsequently received on such receivables are credited back to the allowance for doubtful accounts.

Deferred Offering Costs

Deferred offering costs relating to the Company’s IPO are capitalized in prepaid expenses and other current assets on the condensed consolidated balance sheet and consist primarily of legal, accounting, printing and filing fees. The deferred offering costs will be offset against the proceeds from the IPO, which closed on October 3, 2012. As of September 30, 2012, the Company had capitalized $2,533,000 of deferred offering costs.

Restricted Cash

Restricted cash includes amounts maintained with banks as security deposits for certain leased facilities and, accordingly, is classified as a non-current asset.

Property and Equipment, net

Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Leasehold improvements are amortized on a straight-line basis over the lesser of the estimated useful life of the asset or the lease term. Property under capital lease is amortized over the term of the respective lease or the estimated useful life of the asset, whichever is shorter.

The Company purchases physical scanner appliances and other computer equipment that are provided on a subscription basis. This equipment is recorded within property and equipment on the accompanying condensed consolidated balance sheet, and the depreciation is recorded to cost of revenues over an estimated useful life of three years.

Upon retirement or disposal, the cost of assets and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in the consolidated statements of operations. Repairs and maintenance that do not extend the life of an asset are expensed as incurred and major improvements are capitalized as property and equipment.

Impairment of Long-Lived Assets

The Company evaluates its long-lived assets, which consist of property and equipment, and intangible assets subject to amortization, for indicators of possible impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Impairment exists if the carrying amounts of such assets exceed the estimates of future undiscounted cash flows expected to be generated by such assets. Should an impairment exist, the impairment loss would be measured based on the excess carrying value of the asset over the asset’s estimated fair value. As of September 30, 2012 and December 31, 2011, the Company has not written down any of its long-lived assets as a result of impairment.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Goodwill and Intangible Assets

Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination and is not subject to amortization. Goodwill and other intangible assets with indefinite lives are not amortized, but tested for impairment annually or if certain circumstances indicate a possible impairment may exist. These tests are performed at the reporting unit level. The Company’s operations are organized as one reporting unit.

In testing for a potential impairment of goodwill, the Company first performs a qualitative assessment of its reporting units to determine if it is more likely than not (a more than 50% likelihood) that the fair value of the reporting unit is less than its carrying amount. If the fair value is not considered to be less than the carrying amount, no further evaluation is necessary. The Company performed the annual qualitative assessment for the year ended December 31, 2011 and concluded there was no impairment of goodwill.

If the qualitative assessment indicates there is more than a 50% likelihood that the fair value is less than the carrying amount, the Company would perform a two-step test. In the first step, the carrying value of the reporting unit is compared to its estimated fair value. If the estimated fair value is less than the carrying value, then potential impairment exists. In the second step, the Company calculates the amount of any impairment by determining the implied fair value of goodwill using a hypothetical purchase price allocation, similar to that which would be applied if it were an acquisition and the purchase price was equivalent to fair value as calculated in the first step. Impairment is equivalent to any excess of goodwill carrying value over its implied fair value.

Certain other intangible assets acquired are amortized over their estimated useful lives and tested for impairment if certain circumstances indicate an impairment may exist. The Company’s intangible assets are comprised primarily of existing technology, patent license, and non-competition agreements and are amortized over periods ranging from three to fourteen years on a straight-line basis.

Software Development Costs

The Company capitalizes qualifying software costs developed or obtained for internal use. These costs generally include internal costs, such as payroll and benefits of those employees directly associated with the development of the software. Total capitalized development costs are $251,000 at September 30, 2012 and December 31, 2011. The capitalized development costs are recorded within other noncurrent assets and were fully amortized at September 30, 2012 and December 31, 2011.

Derivative Financial Instruments

Derivative financial instruments are utilized by the Company to reduce foreign currency exchange risks. The Company uses foreign currency forward contracts to mitigate the impact of foreign currency fluctuations of certain non-U.S. dollar denominated asset positions, primarily cash and accounts receivable. These contracts are recorded within prepaid expenses and other current assets in the condensed consolidated balance sheets. Gains and losses resulting from currency exchange rate movements on these forward contracts are recognized in other income (expense) in the accompanying condensed consolidated statements of operations in the period in which the exchange rates change and offset the foreign currency gains and losses on the underlying exposure being hedged. The Company does not enter into financial instruments for trading or speculative purposes.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

At September 30, 2012, the Company had one outstanding forward contract with a notional amount of 7,600,000 Euros, which expired on October 31, 2012. At December 31, 2011, the Company had one outstanding forward contract with a notional amount of 3,680,000 Euros, which expired on January 31, 2012. These contracts were entered into at the end of each period, and thus the fair value of the contracts was $0 at September 30, 2012 and December 31, 2011. The Company began to use these forward contracts in December 2011. The Company recorded a loss of $362,000 and $91,000 from these contracts, which partially offset the foreign currency transaction gains of $415,000 and $49,000 during the three and nine months ended September 30, 2012, respectively. There were no gains or losses from forward contracts in the three and nine months ended September 30, 2011. These derivatives were not designated as hedges.

Stock-Based Compensation

The Company recognizes stock-based compensation expense for its employee stock options over the requisite service period for awards of equity instruments based on the grant-date fair value of those awards expected to vest. Forfeitures are estimated on the date of grant and revised if actual or expected forfeiture activity differs materially from original estimates.

Option grants to non-employees are accounted for at the fair value of the equity instrument issued, as calculated using the Black-Scholes model. The stock-based compensation expense for non-employees is subject to periodic adjustments as the options vest, and the expense is recognized over the period in which services are received.

Revenue Recognition

The Company derives revenues from subscriptions that require customers to pay a fee in order to access the Company’s cloud solutions. Customers generally enter into one year renewable subscriptions. The subscription fee entitles the customer to an unlimited number of scans for a specified number of networked devices or web applications and, if requested by a customer as part of their subscription, a specified number of physical or virtual scanner appliances. The Company’s physical and virtual scanner appliances are requested by certain customers as part of their subscriptions in order to scan IT infrastructures within their firewalls and do not function without, and are not sold separately from, subscriptions for the Company’s solutions. Customers are required to return physical scanner appliances if they do not renew their subscriptions.

The Company recognizes revenues when all of the following conditions are met:


•	There is persuasive evidence of an arrangement.


•	The service has been provided to the customer.


•	The collection of the fees is reasonably assured.


•	The amount of fees to be paid by the customer is fixed or determinable.

Subscriptions are recognized ratably over the subscription period. The Company recognizes revenues from subscriptions that include physical scanner appliances and other computer equipment ratably over the period of the subscription. Because the customer’s access to the Company’s cloud solutions are delivered at the same time as or within close proximity to the delivery of physical scanner appliances and the terms are commensurate for these services and equipment, the Company considers these elements as a single unit of accounting recognized ratably over the subscription period.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Beginning on January 1, 2011, the Company adopted authoritative accounting guidance on multiple-element arrangements, using the prospective method for all arrangements entered into or materially modified from the date of adoption. As a result of implementing this authoritative guidance, the Company’s revenues for the three and nine months ended September 30, 2012 and 2011 were not materially different from what would have been recognized under the previous guidance for multiple-element arrangements. The Company does not expect that the adoption of this standard will have a significant impact on its revenue recognition in the future.

Deferred revenues consist of revenues billed or received that will be recognized in the future under subscriptions existing at the balance sheet date. The current portion of deferred revenues represents amounts that are expected to be recognized within one year of the balance sheet date.

Costs of shipping and handling charges incurred by the Company associated with physical scanner appliances and other computer equipment are included in cost of revenues.

Sales taxes and other taxes collected from customers to be remitted to government authorities are excluded from revenues.

Advertising Expenses

Advertising costs are expensed as incurred and include costs of advertising, trade show costs and promotional materials. For the three months ended September 30, 2012 and 2011, the Company incurred advertising costs of $830,000 and $1,021,000, respectively, and for the nine months ended September 30, 2012 and 2011, such costs were $2,983,000 and $2,933,000, respectively.

Income Taxes

The Company uses the asset and liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities. Deferred tax assets and liabilities are measured using statutory tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

The Company operates in various tax jurisdictions and is subject to audit by various tax authorities. Tax positions are based upon their technical merits, relevant tax law and the specific facts and circumstances as of each reporting period. Changes in facts and circumstances could result in material changes to the amounts recorded for such tax positions. A tax position is only recognized in the financial statements if it is “more likely than not” to be sustained based solely on its technical merits as of the reporting date. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments that could result in recognition of additional tax benefits or additional charges to the tax provision and may not accurately reflect the actual outcomes. The Company’s policy is to recognize interest and penalties relating to unrecognized tax benefits as a component of the provision for income taxes.

Other Comprehensive Income (Loss)

Other comprehensive income (loss) consists of foreign currency translation adjustments, which are reflected net of tax, that are not included in the Company’s net income. Total comprehensive income includes net income and other comprehensive income (loss) and is included in the condensed consolidated statements of comprehensive income.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Foreign Currency Translation and Transactions

The Company’s operations are conducted in various countries around the world and the financial statements of its foreign subsidiaries are reported in the applicable local foreign currencies (functional currencies). Financial information is translated from the applicable functional currency to the U.S. dollar, the reporting currency, for inclusion in the Company’s condensed consolidated financial statements. Accordingly, the assets and liabilities of the Company’s foreign subsidiaries are translated using exchange rates in effect as of the balance sheet date, and income and expenses are translated at average exchange rates during the period. Resulting translation adjustments are included as a component of accumulated other comprehensive income (loss) in stockholders’ equity (deficit).

Foreign currency transaction gains or losses are recognized in other income (expense). The Company recorded foreign currency transaction gains (losses) of $53,000 and $(418,000) during the three months ended September 30, 2012 and 2011, respectively, and $(42,000) and $97,000 during the nine months ended September 30, 2012 and 2011, respectively.

Fair Value Measurement

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. For certain of the Company’s financial instruments, including cash, accounts receivable, accounts payable, and other current liabilities, the carrying amounts approximate their fair value due to the relatively short maturity of these balances.

The Company has an asset that is valued in accordance with the provisions of the authoritative accounting guidance that addresses fair value measurements. This guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:

Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities.

Level 2—Valuations based on other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Valuations based on inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability.

At September 30, 2012 and December 31, 2011, a derivative financial instrument, consisting of a foreign currency forward contract, was valued at $0 as the contract was entered into on the last day of the period. This instrument was valued using Level 2 inputs.

Net Income Per Share Attributable to Common Stockholders

The Company computes net income attributable to common stockholders using the two-class method required for participating securities. Convertible preferred stock and common stock subject to repurchase resulting from the early exercise of stock options are considered to be participating securities since they contain non-forfeitable rights to dividends or dividend equivalents in the event the Company declares a dividend for common stock. In accordance with the two-class method, earnings allocated to these participating securities are subtracted from net income after deducting preferred stock dividends, if any, to determine total undistributed earnings to be allocated to common stockholders. The holders of our convertible preferred stock do not have a contractual obligation to share in our net losses and such shares are excluded from the computation of basic earnings per share in periods of net loss.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Basic net income per share attributable to common stockholders is computed by dividing net income attributable to common stockholders by the weighted-average number of common shares outstanding during the period. All participating securities are excluded from basic weighted average common shares outstanding. In computing diluted net income attributable to common stockholders, undistributed earnings are reallocated to reflect the potential impact of dilutive securities. Diluted net income per share is computed by dividing net income attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period, adjusted for the effects of potentially dilutive common shares, which comprise outstanding stock options, warrants, convertible preferred stock and contingently issuable shares related to an acquisition. The dilutive potential common shares are computed using the treasury stock method or the as-if converted method, as applicable. The effects of outstanding stock options, warrants, convertible preferred stock and contingently issuable shares related to an acquisition are excluded from the computation of diluted net income per common share in periods in which the effect would be antidilutive.

Recent Accounting Pronouncements

Under the Jumpstart Our Business Startups Act (the "JOBS Act"), the Company meets the definition of an “emerging growth company.” The Company has irrevocably elected to opt out of the extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act. As a result, the Company will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required from non-emerging growth companies.

In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement, which generally represents clarifications of ASC Topic 820, Fair Value Measurement, but also includes some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. ASU 2011-04 results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and International Financial Reporting Standards. ASU 2011-04 should be applied prospectively and is effective for annual periods beginning after December 15, 2011. Early adoption is not permitted. The Company does not expect the adoption of ASU 2011-04 to have a material impact on its consolidated financial statements.

In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. This newly issued accounting standard requires an entity to disclose both gross and net information about instruments and transactions eligible for offset in the statement of financial position as well as instruments and transactions executed under a master netting or similar arrangement and was issued to enable users of financial statements to understand the effects or potential effects of those arrangements on its financial position. This ASU is required to be applied retrospectively and is effective for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. As this accounting standard only requires enhanced disclosure, the adoption of this standard is not expected to have an impact the Company’s financial position or results of operations.

In July 2012, the FASB issued ASU 2012-02, Intangibles—Goodwill and Other (Topic 350)—Testing Indefinite-Lived Intangible Assets for Impairment. This standard allows entities to use a qualitative approach to test indefinite-lived intangible assets for impairment. ASU 2012-02 permits an entity to first perform a qualitative assessment to determine whether it is more likely than not (a more than 50% likelihood) that the fair value of an indefinite-lived intangible asset is less than its carrying amount. If the fair value is not considered to be less than the carrying amount, no further evaluation is necessary. If there is more than 50% likelihood the fair value is less than the carrying amount, it is necessary to perform the currently prescribed quantitative impairment test by comparing the fair value of the indefinite-lived intangible asset with its carrying value. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012 and earlier adoption is permitted. The Company does not expect the adoption of this standard to have a material impact on its consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Reverse Stock Split

In September 2012, the Company’s board of directors and stockholders approved an amendment to the Company’s amended and restated certificate of incorporation effecting a one-for-ten reverse stock split of the Company’s issued and outstanding shares of common and convertible preferred stock. The par value of the common and convertible preferred stock was not adjusted as a result of the reverse stock split. All issued and outstanding common stock, convertible preferred stock, warrants for convertible preferred stock, options for common stock, contingently issuable shares of common stock and per share amounts contained in the Company’s condensed consolidated financial statements have been retroactively adjusted to reflect this reverse stock split for all periods presented.


NOTE 2.	Restatement of Previously Issued Financial Statements

The Company has restated its condensed consolidated balance sheet as of December 31, 2011 to reflect the correction of an error in the 2010 provision for income taxes. The restatement relates to the tax benefit resulting from a reduction of the liability for uncertain tax positions upon the lapse of the statute of limitations for the 2007 tax year of its French subsidiary. The Company did not release the liability at December 31, 2010 due to an error in the determination of when the statute of limitations would expire.

The following table presents the impact of the restatement adjustment on the Company’s condensed consolidated balance sheet as of December 31, 2011:



	Balance as of December 31, 2011
	As Previously Reported			Effect of Restatement			As Restated
	(in thousands)
Income taxes payable, noncurrent	$	1,101		$	(440	)	$	661
Accumulated deficit - beginning of year	(78,766		)	440			(78,326		)
Accumulated deficit - end of year	(76,812		)	440			(76,372		)

This restatement did not have a net impact on the cash provided by (used in) the Company’s operating, investing or financing activities for the nine months ended September 30, 2011.

The accompanying notes to condensed consolidated financial statements have been updated, as necessary, to reflect the impact of the restatement adjustment.


NOTE 3.	Property and Equipment, Net

Property and equipment, which includes assets under capital lease, consists of the following:



	September 30,			December 31,
	2012			2011
	(in thousands)
Computer equipment	$	17,144		$	12,483
Computer software	5,913			5,720
Furniture, fixtures and equipment	1,438			1,330
Scanner appliances	15,894			13,394
Leasehold improvements	1,623			1,418
Total property and equipment	42,012			34,345
Less: accumulated depreciation and amortization	(25,116		)	(20,484		)
Property and equipment, net	$	16,896		$	13,861

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Assets held under capital lease included in computer equipment and software at September 30, 2012 and December 31, 2011 totaled approximately $8,053,000. The related accumulated depreciation at September 30, 2012 and December 31, 2011 totaled $4,558,000 and $3,313,000, respectively. The capital lease obligations are secured by the related equipment and software.

Physical scanner appliances and other computer equipment that are or will be subject to subscriptions by customers have a net carrying value of $4,905,000 and $3,436,000 at September 30, 2012 and December 31, 2011, respectively, including assets that have not been placed in service of $1,170,000 and $210,000, respectively. Other fixed assets not placed in service at September 30, 2012 and December 31, 2011, included in computer equipment and leasehold improvements, relate to new information technology systems and tenant improvements of approximately $1,315,000 and $500,000 respectively. Depreciation and amortization expense relating to property and equipment, including capitalized leases, was $1,739,000 and $1,121,000 for the three months ended September 30, 2012 and 2011, respectively, and $5,066,000 and $3,466,000 for the nine months ended September 30, 2012 and 2011, respectively.


NOTE 4.	Business Combination

On August 31, 2010, the Company acquired Nemean Networks, LLC (“Nemean”), a company developing network security solutions for detection and awareness of external intrusions to computer networks. The Company acquired Nemean to provide additional solutions on its cloud platform. The consideration for this acquisition consisted of $3.7 million in cash and common stock, including a non-contingent payment of $1.0 million in cash and 6,250 shares of common stock, both of which occurred in September 2012. The non-contingent cash payment amount was recorded in current liabilities at December 31, 2011 at its net present value. The Company accounted for this transaction as a business combination.

In addition, the Company acquired an exclusive license to certain patents in connection with the Nemean acquisition and elected to make an annual payment of $25,000 in September 2012 to a third party in order to maintain the exclusivity of the license. This payment was recorded within prepaid expenses and other current assets and is being amortized over a one-year period. The Company has the option to make such annual payments for nine additional years.


NOTE 5.	Goodwill and Intangible Assets, Net

Intangible assets consist primarily of existing technology, patent license and non-competition agreements acquired in business combinations. Acquired intangibles are amortized on a straight-line basis over the respective estimated useful lives of the assets.

The carrying values of intangible assets are as follows (in thousands):



				September 30, 2012					December 31, 2011
	Estimated Lives	Cost		Accumulated Amortization			Net Book Value		Accumulated Amortization			Net Book Value
Existing technology	7 years	$	1,910	$	(568	)	$	1,342	$	(364	)	$	1,546
Patent license	14 years	1,339		(199		)	1,140		(127		)	1,212
Non-competition agreements and other	3 years	171		(79		)	92		(49		)	122
Total intangibles subject to amortization		$	3,420	$	(846	)	2,574		$	(540	)	2,880
Intangible assets not subject to amortization							295					295
Total intangible assets, net							$	2,869				$	3,175

Intangibles amortization expense was $103,000 and $101,000 for the three months ended September 30, 2012 and 2011, respectively, and $306,000 and $304,000 for the nine months ended September 30, 2012 and 2011, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

As of September 30, 2012, the Company expects amortization expense in future periods to be as follows (in thousands):



Remainder of 2012	$	106
2013	414
2014	388
2015	381
2016	369
2017 and thereafter	916
Total expected future amortization expense	$	2,574

Goodwill, which is not subject to amortization, totaled $317,000 as of September 30, 2012 and December 31, 2011. The Company performed its annual goodwill impairment test for the year ended December 31, 2011 using a qualitative assessment and concluded there was no impairment of goodwill as the qualitative assessment performed did not indicate that it is more likely than not that the single reporting unit fair value is less than its carrying value.


NOTE 6.	Commitments and Contingencies

Line of Credit

In March 2009, the Company entered into an equipment line of credit of $1,500,000. The line of credit allowed the Company to borrow to purchase specific equipment. Each advance was immediately amortizable and payable in 30 monthly installments, with the final maturity date to be no later than September 2012. Each advance was secured by the specific equipment and carried an interest rate of 9.0%. In March 2010, the Company amended its equipment line of credit. The amount available for draws at the time of the amendment was increased by $775,000 and was available through February 2011. Each advance was immediately amortizable and payable in 30 monthly installments, with final maturity date to be no later than August 2013, and carried an interest rate of 7.5%. In December 2010, the Company completed a second amendment to its equipment line of credit. The amount available for draws at the time of the amendment was increased by an additional $1,000,000 and was available through February 2012. Each advance is immediately amortizable and payable in 30 monthly installments, with the final maturity date to be no later than August 2014, and carries an interest rate of 6.5%. At September 30, 2012 and December 31, 2011 the Company had $312,000 and $892,000, respectively, in outstanding borrowings under this line of credit, which are recorded in capital lease obligations in the condensed consolidated balance sheets. The remaining amount available for borrowings at December 31, 2011 was $937,000. The line of credit expired in February 2012, and the Company is not able to draw any further funds from the line of credit.

Leases

The Company leases certain computer equipment and its corporate office facilities under noncancelable operating leases for varying periods through 2019. The Company has also entered into capital lease obligations, with varying interest rates from 1.8% to 9.0%, a portion of which are secured by the related computer equipment and software as of September 30, 2012 and December 31, 2011.

In 2011, the Company entered into a $3,100,000 financing arrangement for computer software, accounted for as a capital lease, with minimum quarterly payments scheduled through 2014. In connection with this transaction, the Company also has minimum obligations for related maintenance and support of $1,785,000 and $2,611,000 at September 30, 2012 and December 31, 2011, respectively, Such obligation for maintenance and support is recorded in current and other noncurrent liabilities in the condensed consolidated balance sheets.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The following are the minimum annual lease payments due under these leases at September 30, 2012:



	Operating Leases		Capital Leases
	(in thousands)
Remainder of 2012	$	526	$	238
2013	2,418		1,370
2014	1,685		1,078
2015	1,441		—
2016	1,448		—
2017 and thereafter	1,453		—
Total minimum lease payments	$	8,971	2,686
Less amount representing interest			(56		)
Present value of minimum payments			2,630
Less current portion			(1,556		)
Capital lease obligations, noncurrent			$	1,074

Rent expense was $714,000 and $616,000 for the three months ended September 30, 2012 and 2011, respectively and $2,058,000 and $1,725,000 for the nine months ended September 30, 2012 and 2011, respectively. Although certain of the operating lease agreements provide for escalating rent payments over the terms of the leases, rent expense under these agreements is recognized on a straight-line basis. As of September 30, 2012 and December 31, 2011, the Company has accrued $284,000 and $346,000, respectively, of deferred rent related to these agreements, which is reflected in other noncurrent liabilities in the accompanying condensed consolidated balance sheets.

Sales and Other Taxes

The Company’s software-as-a-service solutions are subject to sales and other taxes in certain jurisdictions where the Company does business. The Company bills sales and other taxes to customers and remits these to the respective government authorities. For those jurisdictions where the Company has not yet billed sales tax to its customers and believes it may have exposure, it has recorded a provision of $388,000 and $345,000 at September 30, 2012 and December 31, 2011, respectively, which is recorded within accrued liabilities in the condensed consolidated balance sheets. However, taxing jurisdictions have differing rules and regulations, which are subject to varying interpretations that may change over time. Other than the liability that the Company has accrued in its condensed consolidated balance sheets, the Company has been unable to assess the probability, or estimate the amount, of its sales tax exposure, if any. There are no pending reviews at September 30, 2012 of which the outcome is expected to result in sales and other taxes due in excess of accrued liabilities. Management does not anticipate that its sales tax exposure, if any, would have a material adverse effect on the financial position, results of operations or cash flows of the Company.

Indemnifications

The Company from time to time enters into certain types of contracts that contingently require it to indemnify various parties against claims from third parties. These contracts primarily relate to (i) the Company's by-laws, under which it must indemnify directors and executive officers, and may indemnify other officers and employees, for liabilities arising out of their relationship, (ii) contracts under which the Company must indemnify directors and certain officers for liabilities arising out of their relationship, and (iii) contracts under which the Company may be required to indemnify customers or resellers from certain liabilities arising from potential infringement of intellectual property rights, as well as potential damages caused by limited product defects. To date, the Company has not incurred and has not recorded any liability in connection with such indemnifications.

The Company maintains director and officer insurance, which may cover certain liabilities arising from its obligation to indemnify its directors.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Contingencies

From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues a liability for such matters when it is probable a loss has been incurred and such loss can be reasonably estimated. At September 30, 2012, the Company has not recorded any such liabilities in accordance with accounting for contingencies.


NOTE 7.	Stockholders' Equity

Common Stock

During the nine months ended September 30, 2012 the Company issued 724,458 shares of common stock, of which 703,440 shares resulted from the exercise of stock options and 21,018 shares were awarded as equity compensation. Additionally, the Company repurchased 60,125 shares of unvested early-exercised stock options.

The Company had reserved shares of common stock for future issuance as follows:



	September 30,	December 31,
	2012	2011
Options outstanding under the stock option plans
2000 Equity Incentive Plan ⁽¹⁾	6,539,099	6,312,041
Options available for future grants under the stock option plans
2000 Equity Incentive Plan	832,838	803,237
2012 Equity Incentive Plan ⁽¹⁾	3,050,000	—
Convertible preferred stock outstanding	17,597,258	17,597,258
Total shares reserved for future issuance	28,019,195	24,712,536

⁽¹⁾See Note 8 for a description of these plans.

Subsequent to September 30, 2012, the Company closed its IPO and issued 7,836,250 shares of common stock on October 3, 2012. Additionally, immediately prior to the closing of the IPO, 17,597,258 outstanding shares of convertible preferred stock converted into an equivalent number of shares of common stock. If the IPO had closed on September 30, 2012, the Company would have had 37,937,228 shares of common stock outstanding on a fully diluted basis, taking into consideration the exercise of 6,539,099 outstanding options as of September 30, 2012. Refer to Note 13 for additional information regarding the Company’s IPO.

Convertible Preferred Stock

As of September 30, 2012, the Company was authorized to issue 176,400,000 shares of convertible preferred stock with a par value of $0.001 per share. The Company had designated 48,079,860 shares as Series A Preferred Stock, 110,314,114 shares as Series B Preferred Stock, and 18,006,026 shares as Series C Preferred Stock (cumulatively referred to as “Series Preferred”).

During 2000 and 2001, the Company issued 1,498,137 shares and 574,998 shares, respectively, of Series A Preferred Stock at an issuance price of $14.00 per share.

During 2003, the Company issued 11,031,387 shares of Series B Preferred Stock at an issuance price of $2.60 per share. Certain of these shares were issued upon the conversion of the Company’s then existing notes payable and related accrued interest at a conversion price per share equal to the price paid by other investors that purchased Series B Preferred Stock for cash.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

In connection with the issuance of the Series B Preferred Stock in 2003, holders of Series A Preferred Stock were entitled to additional shares of Series A Preferred Stock in accordance with the antidilution provisions of the Company’s amended certificate of incorporation. The additional shares issued from the recapitalization resulted in a decrease to the average price of Series A Preferred Stock from $14.00 per share at issuance to $6.00 per share.

During 2004, the Company issued 1,729,636 shares of Series C Preferred Stock at an issuance price of $3.76 per share.

On October 3, 2012, all of the 17,597,258 outstanding shares of convertible preferred stock converted into an equivalent number of shares of common stock immediately prior to the closing of the IPO.

Preferred Stock

Effective October 3, 2012, the Company is authorized to issue 20,000,000 shares of undesignated preferred stock with a par value of $0.001 per share.

Dividends

The holders of Series Preferred are entitled to receive dividends, as may be declared by the Board of Directors, at the rate of eight percent of the original issuance price, as adjusted for any stock dividends, combinations, splits, recapitalizations and the like, in preference to holders of any other capital stock. Holders of Series C Preferred Stock are entitled to receive dividends in preference to holders of Series A Preferred Stock and Series B Preferred Stock. Further, holders of Series B Preferred Stock are entitled to receive dividends in preference to holders of Series A Preferred Stock. On October 3, 20102, all of the 17,597,258 outstanding shares of convertible preferred stock converted into an equivalent number of shares of common stock immediately prior to the closing of the IPO.

Conversion

Any share of Series Preferred is convertible at any time, at the option of holder, into fully paid and nonassessable shares of common stock. The number of shares of common stock to which a holder of Series Preferred is entitled upon conversion is the product obtained by multiplying the conversion rate by the number of shares being converted, subject to certain antidilution provisions. The conversion rate is the quotient obtained by dividing the original issuance price by the conversion price. The conversion price is the original issuance price, as adjusted from time to time due to any recapitalizations, dividends, or distributions. As of September 30, 2012 and December 31, 2011, Series Preferred shares are convertible at a ratio of 1-to-1 into common stock.

Each share of Series Preferred automatically converts into shares of common stock at the effective conversion rate immediately upon the earlier to occur of (i) the Company’s sale of its common stock in a bona fide firm commitment underwriting pursuant to a registration statement filed under the Securities Act of 1933, as amended, at the public offering price of not less than $12.00 per share (as adjusted to reflect subsequent stock dividends, stock splits, or recapitalizations) and $20 million in the aggregate or (ii) the date specified by written consent of agreement of the holders of a majority of the outstanding shares of Series C Preferred Stock. Such conversion took place on October 3, 2012 immediately prior to the closing of the IPO.

Liquidation Rights

Initial Distribution—Series C Preferred

In the event of any liquidation, dissolution, or winding up of the Company, whether voluntary or involuntary, the holders of Series C Preferred Stock are entitled to receive a liquidation payment prior and in preference to any distribution of any of the assets of the Company to holders of Series B Preferred Stock, Series A Preferred Stock, and common stock by reason of their ownership. The liquidation rights will be in an amount per share of Series C

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(Unaudited)

Preferred Stock equal to the original issuance price, adjusted for any stock dividends, combinations, or splits with respect to such shares and amounts equal to declared but unpaid dividends on such shares. At liquidation, if the assets of the Company are insufficient to make payment in full to all holders of Series C Preferred Stock outstanding at that date, then such assets shall be distributed among the holders of Series C Preferred Stock, ratably in proportion to the full amounts to which they would otherwise be respectively entitled.

Secondary Distribution—Series B Preferred

After payment of the full liquidation preference of the Series C Preferred Stock, holders of Series B Preferred Stock are entitled to receive a liquidation payment prior and in preference to any distribution of any of the assets of the Company to holders of Series A Preferred Stock and common stock. The liquidation rights will be in an amount per share of Series B Preferred Stock equal to the original issuance price, adjusted for any stock dividends, combinations, or splits with respect to such shares and amounts equal to declared but unpaid dividends on such shares. At liquidation, if the remaining assets of the Company are insufficient to make payment in full to all holders of Series B Preferred Stock outstanding at that date, then such assets shall be distributed among the holders of Series B Preferred Stock, ratably in proportion to the full amounts to which they would otherwise be respectively entitled.

Tertiary Distribution—Series A Preferred

After full payment of the liquidation preference of the Series C Preferred Stock and Series B Preferred Stock, the holders of Series A Preferred Stock are entitled to receive a liquidation payment prior and in preference to any distribution of any assets of the Company to holders of common stock. The liquidation rights will be in an amount per share of Series A Preferred Stock equal to the original issuance price, adjusted for any stock dividends, combinations, or splits with respect to such shares and amounts equal to declared but unpaid dividends on such shares. At liquidation, if the remaining assets of the Company are insufficient to make payment in full to all holders of Series A Preferred Stock outstanding at that date, then such assets shall be distributed among the holders of Series A Preferred, ratably in proportion to the full amounts to which they would otherwise be entitled.

Remaining Assets Distribution—Common Stock

After full payment of the liquidation preference of the Series Preferred stockholders, any remaining assets of the Company legally available shall be distributed among the holders of common stock on a pro rata basis based on the number of shares of common stock held by each.

Voting

The holder of each share of Series Preferred is entitled to the number of votes equal to the number of shares of common stock into which each share of preferred stock can be converted.


NOTE 8.	Employee Stock and Benefit Plans

Stock Options

2000 Equity Incentive Plan

Under the 2000 Equity Incentive Plan (the "2000 Plan"), the Company has been authorized to grant to eligible participants either incentive stock options (“ISOs”) or nonstatutory stock options (“NSOs”) to purchase up to 11,987,853 shares of common stock. The ISOs may be granted at a price per share not less than the fair market value at the date of grant. The NSOs may be granted at a price per share not less than 85% of the fair market value at the date of grant. Options granted to date are immediately exercisable, and unvested shares are subject to repurchase by the Company.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Options granted generally vest over a period of up to four years, with a maximum term of ten years. Upon termination of employment of an option holder, the Company has the right to repurchase at the original purchase price any issued but unvested common shares. At September 30, 2012 and December 31, 2011, there were 58,534 and 76,437 shares, respectively, that were subject to the Company’s right to repurchase. Shares repurchased by the Company are added to the pool of options available for future grant. The Company repurchased 3,334 unvested common shares in the three months ended September 30, 2011, and 60,125 and 10,001 unvested common shares in the nine months ended September 30, 2012 and 2011, respectively. There were no shares repurchased during the three months ended September 30, 2012. The amounts paid for these shares purchased under an early exercise of stock options are not reported as a component of stockholders’ equity (deficit) until those shares vest. The amounts received in exchange for these shares totaled $358,000 and $414,000 as of September 30, 2012 and December 31, 2011, respectively, have been recorded as an accrued liability in the accompanying condensed consolidated balance sheets and will be reclassified to common stock and additional paid-in capital as the shares vest.

Common shares purchased under the Plan are subject to certain restrictions, including the right of first refusal by the Company for sale or transfer of these shares to third parties. The Company’s right of first refusal terminates upon completion of an initial public offering of common stock.

Subsequent to September 30, 2012, the 2000 Plan was terminated in connection with the closing of the IPO, and accordingly, no shares are currently available for issuance under the 2000 Plan. The 2000 Plan continues to govern outstanding awards granted thereunder.

2012 Equity Incentive Plan

The 2012 Equity Incentive Plan (the "2012 Plan") was adopted and approved in September 2012 and became effective on September 26, 2012. Under the 2012 Plan, the Company has been authorized to grant to eligible participants ISOs, NSOs, stock appreciation rights, restricted stock, restricted stock units, performance units and performance shares equivalent to up to 3,050,000 shares of common stock. The number of shares of common stock available for issuance under the 2012 Plan includes an annual increase on January 1 of each year starting on January 1, 2014 by an amount equal to the least of 3,050,000 shares; 5% of the outstanding shares of stock as of the last day of our immediately preceding fiscal year; or an amount determined by the board of directors. Incentive stock options may only be granted to employees and any subsidiary corporations' employees. All other awards may be granted to employees, directors and consultants and our subsidiary corporations' employees and consultants. As of September 30, 2012, no shares had been granted under the 2012 Plan.

Stock-based employee compensation is included in the condensed consolidated statements of income as follows:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012		2011
	(in thousands)
Cost of revenues	$	68	$	44	$	191	$	94
Research and development	167		118		461		334
Sales and marketing	306		173		746		399
General and administrative	244		204		723		603
Total stock-based employee compensation	$	785	$	539	$	2,121	$	1,430

Compensation cost is recognized on a straight-line basis over the service period. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

As of September 30, 2012 and December 31, 2011, the Company had $5,949,000 and $4,832,000, respectively, of total unrecognized employee compensation cost related to nonvested awards that it expects to recognize over a weighted-average period of 3 years.

The fair value of each option granted to employees is estimated on the date of grant using the Black-Scholes option-pricing model based on the following assumptions:



	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2012	2011	2012	2011
Expected term (in years)	5.3 - 6.0	5.6	5.3 - 6.0	5.6
Volatility	53%	55%	53%	55%
Risk-free interest rate	0.6% - 0.7%	1.0% - 1.6%	0.6% - 0.8%	1.0% - 2.3%
Dividend yield	—	—	—	—

The expected term of the options is based on evaluations of historical and expected future employee exercise behavior. The risk-free interest rate is based on the U.S. Treasury rates at the date of grant with maturity dates approximately equal to the expected term at the grant date. Volatility is based on historical volatility of several public entities that are similar to the Company, as the Company does not have sufficient historical transactions in its own shares on which to base expected volatility. The Company has not historically issued any dividends and does not expect to in the future.

The Company records compensation representing the fair value of stock options granted to non-employees. Stock-based non-employee compensation was $242,000 and $11,000 for the three months ended September 30, 2012 and 2011, respectively, and $431,000 and $71,000 for the nine months ended September 30, 2012 and 2011, respectively. Non-employee stock-based compensation is recognized over the vesting periods of the options. The value of options granted to non-employees is remeasured as they vest over a performance period.

A summary of the Company’s stock option activity is as follows:



	Outstanding Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
						(in thousands)
Balance as of December 31, 2011	6,312,041		$	3.36	6.9	$	16,012
Granted	1,322,906		8.39
Exercised	(703,459	)	2.84
Canceled	(392,389	)	6.85
Balance as of September 30, 2012	6,539,099		4.23		7.0	$	64,953
Vested and expected to vest - September 30, 2012	6,100,152		4.00		6.9
Exercisable - September 30, 2012	6,537,727		4.23		7.0

401(k) Plan

The Company’s 401(k) Plan (the “401(k) Plan”) was established in 2000 to provide retirement and incidental benefits for its employees. As allowed under section 401(k) of the Internal Revenue Code, the 401(k) Plan provides tax-deferred salary deductions for eligible employees. Contributions to the 401(k) Plan are limited to a maximum amount as set periodically by the Internal Revenue Service. To date, the Company has not made any contributions to the 401(k) Plan.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)


NOTE 9.	Other Income (Expense), Net

Other income (expense), net consists of the following:



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2012		2011			2012			2011
	(in thousands)
Foreign exchange gains (losses)	$	53	$	(418	)	$	(42	)	$	97
Other income (expense)	7		—			(2		)	4
Other income (expense), net	$	60	$	(418	)	$	(44	)	$	101


NOTE 10.	Income Taxes

The Company computes its provision for income taxes by applying the estimated annual effective tax rate to income from recurring operations and adjusts the provision for discrete items recorded in the period. The Company's effective tax rate for the three and nine months ended September 30, 2012 was 4.4% and 6.5%, respectively. The Company's effective tax rate for the three and nine months ended September 30, 2011 was 15.2% and 10.0%, respectively.

The provision for income taxes for the nine months ended September 30, 2012 primarily reflects the provision for income taxes for foreign and state taxes, partially offset by a tax benefit of $0.2 million resulting from the reduction of liability for uncertain tax positions in foreign jurisdictions. The provision for income taxes for the nine months ended September 30, 2011 primarily reflects the provision for income taxes for international operations and state taxes.

As of September 30, 2012 and December 31, 2011, unrecognized tax benefits were $1.1 million and $1.2 million, respectively. The total amount of unrecognized tax benefits, if recognized, and in absence of full valuation allowance, would favorably impact the effective tax rate.


NOTE 11.	Segment Information and Information about Geographic Area

The Company operates in one segment. The Company’s chief operating decision maker (“CODM”) is the Chairman, President and Chief Executive Officer, who makes operating decisions, assesses performance and allocates resources on a consolidated basis. All of the Company’s principal operations and decision-making functions are located in the United States. Revenues by geographic area, based on the location of the customer, are as follows:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012		2011
	(in thousands)
United States	$	16,063	$	13,203	$	45,644	$	38,119
Other	7,319		6,172		21,119		17,441
Total revenues	$	23,382	$	19,375	$	66,763	$	55,560

As of September 30, 2012 and December 31, 2011, property and equipment locations outside the United States were not material.

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Qualys, Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)


NOTE 12.	Net Income Per Share Attributable to Common Stockholders

The computations for basic and diluted net income per share attributable to common stockholders are as follows:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
	(in thousands)
Numerator:
Net income	$	1,667		$	452		$	1,105		$	2,605
Net income attributable to participating securities	(1,252		)	(350		)	(841		)	(2,029		)
Net income attributable to common stockholders - basic	415			102			264			576
Undistributed earnings reallocated to participating securities	1,249			349			839			2,026
Net income attributable to common stockholders - diluted	$	1,664		$	451		$	1,103		$	2,602
Denominator:
Weighted-average shares used in computing net income per share attributable to common stockholders - basic	5,843			5,137			5,540			5,002
Effect of potentially dilutive securities:
Convertible preferred stock	17,597			17,597			17,597			17,588
Common stock options	3,105			1,656			2,829			1,604
Warrants	—			—			—			2
Contingently issuable shares related to an acquisition	—			12			6			12
Weighted-average shares used in computing net income per share attributable to common stockholders - diluted	26,545			24,402			25,972			24,208
Net income per share attributable to common stockholders
Basic	$	0.07		$	0.02		$	0.05		$	0.12
Diluted	$	0.06		$	0.02		$	0.04		$	0.11

Potentially dilutive securities not included in the calculation of diluted net income per share because doing so would be antidilutive are as follows:



	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2012	2011	2012	2011
	(in thousands)
Common stock options	1,108	2,806	1,031	2,828


NOTE 13.	Subsequent Events

On October 3, 2012, the Company closed its IPO of 8,711,250 shares of common stock at an offering price of $12.00 per share. The offering included 7,836,250 shares sold and issued by the Company and 875,000 shares sold by selling stockholders. The shares sold in the offering included 1,136,250 shares sold by the Company pursuant to the underwriters’ full exercise of their over-allotment option. The net proceeds to the Company from the offering were approximately $87.5 million after deducting underwriting discounts and commissions, and before deducting total estimated expenses in connection with this offering of approximately $2.5 million. Immediately prior to the closing, all of the Company’s 17,597,258 outstanding shares of convertible preferred stock converted into an equivalent number of shares of common stock.

Additionally, on October 3, 2012, the Company filed its Amended and Restated Certificate of Incorporation increasing the number of shares the Company is authorized to issue to 1,000,000,000 shares of common stock and 20,000,000 shares of preferred stock.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations, should be read in conjunction with (1) our condensed consolidated financial statements (unaudited) and the related notes included elsewhere in this report, and (2) the audited consolidated financial statements and the related notes and management’s discussion and analysis of financial condition and results of operations for the fiscal year ended December 31, 2011 included in the final prospectus for our initial public offering dated as of and filed with the SEC pursuant to Rule 424(b)(4) on September 27, 2012 (File No. 333-182027).

In addition to historical information, this Quarterly Report on Form 10-Q contains “forward-looking” statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Forward-looking statements generally relate to future events or our future financial or operating performance. In some cases, it is possible to identify forward-looking statements because they contain words such as “anticipates,” “believes,” “contemplates,” “continue,” “could,” “estimates,” “expects,” “future,” “intends,” “likely,” “may,” “plans,” “potential,” “predicts,” “projects,” “seek,” “should,” “target” or “will,” or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans or intentions. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview

We are a pioneer and leading provider of cloud security and compliance solutions that enable organizations to identify security risks to their IT infrastructures, help protect their IT systems and applications from ever-evolving cyber attacks and achieve compliance with internal policies and external regulations. Our cloud solutions address the growing security and compliance complexities and risks that are amplified by the dissolving boundaries between internal and external IT infrastructures and web environments, the rapid adoption of cloud computing and the proliferation of geographically dispersed IT assets. Our integrated suite of security and compliance solutions delivered on our QualysGuard Cloud Platform enable our customers to identify their IT assets, collect and analyze large amounts of IT security data, discover and prioritize vulnerabilities, recommend remediation actions and verify the implementation of such actions. Organizations use our integrated suite of solutions delivered on our QualysGuard Cloud Platform to cost-effectively obtain a unified view of their security and compliance posture across globally-distributed IT infrastructures.

We were founded in December 1999 with a vision of transforming the way organizations secure and protect their IT infrastructure and applications and initially launched our first cloud solution, QualysGuard Vulnerability Management, in 2000. This solution has provided the substantial majority of our revenues to date. As this solution gained acceptance, we introduced new solutions to help customers manage increasing IT security and compliance requirements. In 2006, we added our PCI Compliance solution, and in 2008, we added our Policy Compliance solution. In 2009, we broadened the scope of our cloud services by adding Web Application Scanning. We continued our expansion in 2010, launching Malware Detection Service and Qualys SECURE Seal for automated protection of websites.

We provide our solutions through a software-as-a-service model, primarily with renewable annual subscriptions. These subscriptions require customers to pay a fee in order to access our cloud solutions. We invoice our customers for the entire subscription amount at the start of the subscription term, and the invoiced amounts are treated as deferred revenues and are recognized ratably over the term of each subscription. Historically, we have experienced significant revenue growth from existing customers as they renew and purchase additional subscriptions. Revenues from customers existing at or prior to September 30, 2011 grew $4.0 million to $59.6 million during the nine months ended September 30, 2012. We expect this trend to continue.

We market and sell our solutions to enterprises, government entities and to small and medium size businesses across a broad range of industries, including education, financial services, government, healthcare, insurance, manufacturing, media, retail, technology and utilities. As of September 30, 2012, we had over 6,000 customers in more than 100 countries, including a majority of each of the Forbes Global 100 and Fortune 100. In the nine months ended September 30, 2012 and 2011, approximately 68% and 69%, respectively, of our revenues were derived from customers in the United States. We sell our solutions to enterprises and government entities primarily through our field sales force and to small and medium-sized businesses through our inside sales force. We generate a significant portion of sales through our channel partners, including managed service providers, value-added resellers and consulting firms in the United States and internationally.

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We have had strong revenue growth in the three and nine months ended September 30, 2012 compared to the same periods in 2011. Our revenues increased to $23.4 million in the three months ended September 30, 2012 from $19.4 million for the comparable period in 2011. Revenues reached $66.8 million for the nine months ended September 30, 2012, compared to $55.6 million in the nine months ended September 30, 2011, representing period-over-period increases of $4.0 million, and $11.2 million, or 21% and 20%, respectively. For the three months ended September 30, 2012, we had net income of $1.7 million compared to net income of $0.5 million for the three months ended September 30, 2011. For the nine months ended September 30, 2012, we had net income of $1.1 million compared to net income of $2.6 million for the nine months ended September 30, 2011.

On September 28, 2012, our common stock commenced trading on the NASDAQ Stock Market under the trading symbol “QLYS,” and on October 3, 2012 we closed our initial public offering. In our initial public offering, we sold and issued 7,836,250 shares and certain selling stockholders sold an additional 875,000 shares. The net proceeds to us from the offering were approximately $87.5 million, after deducting underwriting discounts and commissions, and before deducting total estimated expenses in connection with this offering of approximately $2.5 million.

Key Metrics

In addition to measures of financial performance presented in our condensed consolidated financial statements, we monitor the key metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies.

Four-Quarter Bookings

We monitor Four-Quarter Bookings, a non-GAAP financial measure, which is calculated as revenues for the preceding four quarters plus the change in current deferred revenues for the same period. We believe this metric provides an additional tool for investors to use in assessing our business performance in a way that more fully reflects current business trends than reported revenues and reduces the variations in any particular quarter caused by customer subscription renewals. We believe Four-Quarter Bookings reflects the material sales trends for our business because it includes sales of subscriptions to new customers, as well as subscription renewals and upsells of additional subscriptions to existing customers. Since over 80% of our subscriptions are one year in length, we use current deferred revenues in this metric in order to focus on revenues to be generated over the next four quarters and to exclude the impact of multi-year subscriptions. Under our revenue recognition policy, we record subscription fees as deferred revenues and recognize revenues ratably over the subscription periods. For this reason, substantially all of our revenues for a period are typically generated from subscriptions commencing in prior periods. In addition, subscription renewals may vary during the year based on the date of our customers’ original subscriptions, customer requests to modify subscription periods or other factors.

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The following table presents the reconciliation of revenues to Four-Quarter Bookings for the four quarters ended September 30, 2012 and 2011.



	Four Quarters Ended
	September 30,
	2012			2011
	(in thousands, except percentages)
Revenues	$	87,416		$	72,816
Deferred revenues, current
Beginning of the Four-Quarter Period	40,413			34,370
Ending	51,693			40,413
Net change	11,280			6,043
Four-Quarter Bookings	$	98,696		$	78,859
Percentage change from prior year period	25		%	22		%

Adjusted EBITDA

We monitor Adjusted EBITDA, a non-GAAP financial measure, to analyze our financial results and believe that it is useful to investors, as a supplement to U.S. GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance. We believe that Adjusted EBITDA helps illustrate underlying trends in our business that could otherwise be masked by the effect of the income or expenses that we exclude in Adjusted EBITDA. Furthermore, we use this measure to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that Adjusted EBITDA provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry.

Adjusted EBITDA should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with U.S. GAAP. We calculate Adjusted EBITDA as net income before (1) other (income) expense, net, which includes interest income, interest expense and other income and expense, (2) provision for income taxes, (3) depreciation and amortization of property and equipment, (4) amortization of intangible assets and (5) stock-based compensation.

The following table presents the reconciliation of net income to Adjusted EBITDA for the three and nine months ended September 30, 2012 and 2011.



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
	(in thousands, except percentages)
Net income	$	1,667		$	452		$	1,105		$	2,605
Other (income) expense, net	(23		)	461			195			53
Provision for income taxes	77			81			77			291
Depreciation and amortization of property and equipment	1,739			1,121			5,066			3,466
Amortization of intangible assets	112			101			331			315
Stock-based compensation	1,027			550			2,583			1,512
Adjusted EBITDA	$	4,599		$	2,766		$	9,357		$	8,242
Percentage of revenues	20		%	14		%	14		%	15		%

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Limitations of Four-Quarter Bookings and Adjusted EBITDA

Four-Quarter Bookings and Adjusted EBITDA, non-GAAP financial measures, have limitations as analytical tools, and should not be considered in isolation from or as a substitute for the measures presented in accordance with U.S. GAAP. Some of these limitations are:


•	Four-Quarter Bookings reflects the amount of revenues over a four-quarter period, plus the net change in the current portion of deferred revenues, while revenues are recognized ratably over the subscription periods;


•	Adjusted EBITDA does not reflect certain cash and non-cash charges that are recurring;


•	Adjusted EBITDA does not reflect income tax payments that reduce cash available to us;


•	Adjusted EBITDA excludes depreciation and amortization of property and equipment and, although these are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future; and


•	Other companies, including companies in our industry, may calculate Four-Quarter Bookings or Adjusted EBITDA differently or not at all, which reduces their usefulness as a comparative measure.

Because of these limitations, Four-Quarter Bookings and Adjusted EBITDA should be considered alongside other financial performance measures, including revenues, net income and our financial results presented in accordance with U.S. GAAP.

Key Components of Results of Operations

Revenues

We derive revenues from the sale of subscriptions to our security and compliance solutions, which are delivered on our cloud platform. We generate the substantial majority of our revenues through the sale of subscriptions to our QualysGuard Vulnerability Management solution, and we also have a growing number of customers who have purchased our additional solutions. Subscriptions to our solutions allow customers to access our cloud security and compliance solutions through a unified, web-based interface. Customers generally enter into one year renewable subscriptions. The subscription fee entitles the customer to an unlimited number of scans for a specified number of networked devices or web applications and, if requested by a customer as part of their subscription, a specified number of physical or virtual scanner appliances. Our physical and virtual scanner appliances are requested by certain customers as part of their subscriptions in order to scan IT infrastructures within their firewalls and do not function without, and are not sold separately from, subscriptions for our solutions. Customers are required to return physical scanner appliances if they do not renew their subscriptions.

We typically invoice our customers for the entire subscription amount at the start of the subscription term. Invoiced amounts are reflected on our consolidated balance sheet as accounts receivable or as cash when collected, and as deferred revenues until earned and recognized ratably over the subscription period. Accordingly, deferred revenues represents the amount billed to customers that has not yet been earned or recognized as revenues, pursuant to subscriptions entered into in current and prior periods.

Cost of Revenues

Cost of revenues consists primarily of personnel expenses, comprised of salaries, benefits, performance-based compensation and stock-based compensation, for employees who operate our data centers and provide support services to our customers. Other expenses include depreciation of data center equipment and physical scanner appliances provided to certain customers as part of their subscriptions, expenses related to the use of third-party data centers, amortization of third-party technology licensing fees, fees paid to contractors who supplement or support our operations center personnel and overhead allocations. We expect to make significant capital investments to expand our data center operations, which will increase the cost of revenues in absolute dollars.

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Operating Expenses

Research and Development

Research and development expenses consist primarily of personnel expenses, comprised of salaries, benefits, performance-based compensation and stock-based compensation, for our research and development teams. Other expenses include third-party contractor fees, amortization of intangibles related to prior acquisitions and overhead allocations. All research and development costs are expensed as incurred. We expect to continue to devote substantial resources to research and development in an effort to continuously improve our existing solutions as well as develop new solutions and expect that research and development expenses will increase in absolute dollars.

Sales and Marketing

Sales and marketing expenses consist primarily of personnel expenses, comprised of salaries, benefits, sales commissions, performance-based compensation and stock-based compensation for our worldwide sales and marketing teams. Other expenses include marketing and promotional events, lead-generation marketing programs, public relations, travel and overhead allocations. All costs are expensed as incurred, including sales commissions. Sales commissions are expensed in the quarter in which the related order is received and are paid in the month subsequent to the end of that quarter, which results in increased expenses prior to the recognition of related revenues. Our new sales personnel are typically not immediately productive, and the resulting increase in sales and marketing expenses we incur when we add new personnel may not result in increased revenues if these new sales personnel fail to become productive. The timing of our hiring of sales personnel and the rate at which they generate incremental revenues may affect our future operating results. We expect that sales and marketing expenses will increase in absolute dollars.

General and Administrative

General and administrative expenses consist primarily of personnel expenses, comprised of salaries, benefits, performance-based compensation and stock-based compensation, for our executive, finance and accounting, legal, human resources and internal information technology support teams as well as professional services fees and overhead allocations. We anticipate that we will incur additional expenses for personnel and for professional services, including auditing and legal services, insurance and other corporate governance-related expenses, including compliance with Section 404 of the Sarbanes-Oxley Act, related to operating as a public company. We expect that general and administrative expenses will increase in absolute dollars, especially in the near term, as we continue to add personnel to support our growth and operate as a public company.

Other Income (Expense), Net

Our other income (expense), net consists primarily of interest expense associated with our capital leases and foreign exchange gains and losses, the majority of which result from fluctuations between the U.S. dollar and the Euro, British pound and Japanese yen.

Provision for Income Taxes

Our provision for income taxes consists primarily of corporate income taxes resulting from profits generated in foreign jurisdictions by wholly-owned subsidiaries, along with state income taxes payable in the United States. The provision for income taxes also includes changes to unrecognized tax benefits related to uncertain tax positions.

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the tax impact of timing differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period when the statutory rate change is enacted into law.

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We maintain a full valuation allowance on our U.S. federal and state deferred tax assets. Our cash tax expense is impacted by each jurisdiction’s individual tax rates, laws on timing of recognition of income and deductions and availability of net operating losses and tax credits. Given the full valuation allowance and sensitivity of current cash taxes to local rules, our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected by increases in non-deductible stock compensation or other non-deductible expenses and to the extent earnings are lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates. Our effective tax rate could also fluctuate due to a change in our earnings projections, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items.

Results of Operations

The following tables set forth selected condensed consolidated statements of operations data for each of the periods presented.



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2012		2011			2012			2011
	(in thousands)
Consolidated Statements of Operations Data:
Revenues	$	23,382	$	19,375		$	66,763		$	55,560
Cost of revenues ⁽¹⁾	4,634		3,225			13,423			9,124
Gross profit	18,748		16,150			53,340			46,436
Operating expenses:
Research and development ⁽¹⁾	5,076		4,922			15,325			14,680
Sales and marketing ⁽¹⁾	8,797		7,985			27,827			22,297
General and administrative ⁽¹⁾	3,154		2,249			8,811			6,510
Total operating expenses	17,027		15,156			51,963			43,487
Income from operations	1,721		994			1,377			2,949
Other income (expense), net	23		(461		)	(195		)	(53		)
Income before provision for income taxes	1,744		533			1,182			2,896
Provision for income taxes	77		81			77			291
Net income	$	1,667	$	452		$	1,105		$	2,605

____________________

(1) Includes stock-based compensation as follows:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012		2011
	(in thousands)
Cost of revenues	$	68	$	44	$	195	$	96
Research and development	167		118		484		340
Sales and marketing	349		163		856		397
General and administrative	443		225		1,048		679
Total stock-based compensation	$	1,027	$	550	$	2,583	$	1,512

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The following table sets forth selected condensed consolidated statements of operations data for each of the periods presented as a percentage of revenues.



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012		2011
Revenues	100	%	100	%	100	%	100	%
Cost of revenues	20		17		20		16
Gross profit	80		83		80		84
Operating expenses:
Research and development	22		25		23		26
Sales and marketing	38		41		42		40
General and administrative	13		12		13		13
Total operating expenses	73		78		78		79
Income from operations	7		5		2		5
Other income (expense), net	—		(2	)	—		—
Income before provision for income taxes	7		3		2		5
Provision for income taxes	—		1		—		—
Net income	7	%	2	%	2	%	5	%

Comparison of Three Months Ended September 30, 2012 and 2011

Revenues



	Three Months Ended
	September 30,				Change
	2012		2011		$		%
	(in thousands, except percentages)
Revenues	$	23,382	$	19,375	$	4,007	21	%

Revenues increased $4.0 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, primarily due to the sale of additional solutions to existing customers and subscriptions to new customers. Of the total increase of $4.0 million, $2.9 million was from customers in the United States and the remaining $1.1 million was from customers in foreign countries. The growth in revenues reflects increased demand for our solutions.

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Cost of Revenues



	Three Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
Cost of revenues	$	4,634		$	3,225		$	1,409	44	%
Percentage of revenues	20		%	17		%
Gross profit percentage	80		%	83		%

Cost of revenues increased $1.4 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, primarily due to $0.6 million of higher depreciation expenses related to additional data center equipment, third-party software and physical scanner appliances deployed to customers, increased personnel expenses of $0.4 million, principally driven by the addition of employees in our operations team, and increased third-party software maintenance expense of $0.2 million. The decrease in gross profit percentage reflects the impact of increased investments to expand our data center infrastructure and to add capacity to deploy new solutions on our cloud platform.

Research and Development Expenses



	Three Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
Research and development	$	5,076		$	4,922		$	154	3	%
Percentage of revenues	22		%	25		%

Research and development expenses were relatively constant in the three months ended September 30, 2012 and 2011, with slight increases due to the addition of employees as we continue to invest in enhancing our platform and developing new solutions.

Sales and Marketing Expenses



	Three Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
Sales and marketing	$	8,797		$	7,985		$	812	10	%
Percentage of revenues	38		%	41		%

Sales and marketing expenses increased $0.8 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, primarily due to an increase in personnel expenses of $1.2 million, principally driven by the addition of employees as we continue to expand our domestic and international sales and marketing efforts, and higher sales commissions as a result of higher bookings, partially offset by decreased marketing expenses of $0.4 million due to the timing of trade show and marketing activities in the third quarter of 2012.

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General and Administrative Expenses



	Three Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
General and administrative	$	3,154		$	2,249		$	905	40	%
Percentage of revenues	13		%	12		%

General and administrative expenses increased $0.9 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, primarily due to an increase in personnel expenses of $0.4 million, principally driven by the addition of employees to support the growth of our business, an increase in stock-based compensation expense of $0.2 million, primarily for advisory board members, and an increase in professional services expenses of $0.2 million.

Other Income (Expense), Net



	Three Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
Other income (expense), net	$	23		$	(461	)	$	484	(105	)%
Percentage of revenues	—		%	2		%

Other income (expense), net increased $0.5 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, primarily due to foreign exchange fluctuations in the Euro. The three months ended September 30, 2012 included $0.1 million of foreign currency exchange gains, compared to $0.4 million of foreign currency exchange losses in the three months ended September 30, 2011.

Provision for Income Taxes



	Three Months Ended
	September 30,						Change
	2012			2011			$			%
	(in thousands, except percentages)
Provision for income taxes	$	77		$	81		$	(4	)	(5	)%
Percentage of revenues	—		%	1		%

Provision for income taxes was unchanged in the three months ended September 30, 2012 compared to the three months ended September 30, 2011. Although pre-tax income was higher in the three months ended September 30, 2012, as we had a full valuation allowance in the United States, the provision for income taxes were primarily a result of foreign and state taxes and did not change significantly from the same quarter a year ago.

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Comparison of Nine Months Ended September 30, 2012 and 2011

Revenues



	Nine Months Ended
	September 30,				Change
	2012		2011		$		%
	(in thousands, except percentages)
Revenues	$	66,763	$	55,560	$	11,203	20	%

Revenues increased $11.2 million in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. Revenues from customers existing at or prior to September 30, 2011 grew $4.0 million to $59.6 million during the nine months ended September 30, 2012 due to increased subscriptions. Subscriptions from new customers added in the twelve months ended September 30, 2012 contributed $7.2 million to the increase in revenues. Of the total increase of $11.2 million, $7.5 million was from customers in the United States and the remaining $3.7 million was from customers in foreign countries. The growth in revenues reflects increased demand for our solutions.

Cost of Revenues



	Nine Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
Cost of revenues	$	13,423		$	9,124		$	4,299	47	%
Percentage of revenues	20		%	16		%
Gross profit percentage	80		%	84		%

Cost of revenues increased $4.3 million in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, primarily due to $1.6 million of higher depreciation expenses related to additional data center equipment, third-party software and physical scanner appliances deployed to customers, increased personnel expenses of $1.3 million, principally driven by the addition of employees in our operations team, and increased third-party software maintenance expense of $0.8 million. The decrease in gross profit percentage reflects the impact of increased investments to expand our data center infrastructure and to add capacity to deploy new solutions on our cloud platform.

Research and Development Expenses



	Nine Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
Research and development	$	15,325		$	14,680		$	645	4	%
Percentage of revenues	23		%	26		%

Research and development expenses increased $0.6 million in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, primarily due to an increase in personnel expenses of $0.7 million, principally driven by the addition of employees as we continue to invest in enhancing our platform and developing new solutions.

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Sales and Marketing Expenses



	Nine Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
Sales and marketing	$	27,827		$	22,297		$	5,530	25	%
Percentage of revenues	42		%	40		%

Sales and marketing expenses increased $5.5 million in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, primarily due to an increase in personnel expenses of $4.2 million, principally driven by the addition of employees as we continue to expand our domestic and international sales and marketing efforts, and higher sales commissions as a result of higher bookings, increased travel and related expense of $0.6 million and increased professional services expenses of $0.2 million.

General and Administrative Expenses



	Nine Months Ended
	September 30,						Change
	2012			2011			$		%
	(in thousands, except percentages)
General and administrative	$	8,811		$	6,510		$	2,301	35	%
Percentage of revenues	13		%	13		%

General and administrative expenses increased $2.3 million in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, primarily due to an increase in personnel expenses of $1.1 million, principally driven by the addition of employees to support the growth of our business, an increase in stock-based compensation of $0.2 million, primarily for advisory board members, and an increase in professional services expenses of $0.5 million.

Other Income (Expense), Net



	Nine Months Ended
	September 30,						Change
	2012			2011			$			%
	(in thousands, except percentages)
Other income (expense), net	$	(195	)	$	(53	)	$	(142	)	268	%
Percentage of revenues	—		%	—