10-Q
Table of Contents

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 March 31, 2016

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  x    No   ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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
x
 
Accelerated filer
o
 
Non-accelerated filer
o
 
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 April 30, 2016 was 34,920,134.


Table of Contents

Qualys, Inc.
TABLE OF CONTENTS
 
 
Page
PART I – FINANCIAL INFORMATION
Item 1.
 
 
 
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
PART II – OTHER INFORMATION
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 



2

Table of Contents

PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
Qualys, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(in thousands, except share and per share data)
 
March 31, 2016
 
December 31, 2015
 
 
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
112,471

 
$
91,698

Short-term investments
93,238

 
87,268

Accounts receivable, net of allowance of $800 and $769 as of March 31, 2016 and December 31, 2015, respectively
42,414

 
42,325

Prepaid expenses and other current assets
7,448

 
7,945

Total current assets
255,571

 
229,236

Long-term investments
34,614

 
43,277

Property and equipment, net
31,786

 
31,329

Deferred tax assets, net
17,165

 
16,079

Intangible assets, net
1,267

 
1,360

Goodwill
317

 
317

Other noncurrent assets
1,942

 
1,916

Total assets
$
342,662

 
$
323,514

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
4,393

 
$
2,368

Accrued liabilities
11,513

 
11,786

Deferred revenues, current
101,557

 
98,025

Total current liabilities
117,463

 
112,179

Deferred revenues, noncurrent
13,092

 
14,564

Other noncurrent liabilities
1,611

 
1,205

Total liabilities
132,166

 
127,948

Commitments and contingencies (Note 5)


 


Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value; 20,000,000 shares authorized, no shares issued and outstanding at March 31, 2016 and December 31, 2015

 

Common stock, $0.001 par value; 1,000,000,000 shares authorized; 34,882,368 and 34,414,631 shares issued and outstanding at March 31, 2016 and December 31, 2015, respectively
35

 
34

Additional paid-in capital
233,133

 
223,228

Accumulated other comprehensive income (loss)
30

 
(211
)
Accumulated deficit
(22,702
)
 
(27,485
)
Total stockholders’ equity
210,496

 
195,566

Total liabilities and stockholders’ equity
$
342,662

 
$
323,514


See accompanying Notes to Condensed Consolidated Financial Statements


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Table of Contents

Qualys, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)

 
Three Months Ended
 
March 31,
 
2016
 
2015
Revenues
$
46,248

 
$
37,493

Cost of revenues
9,416

 
7,964

Gross profit
36,832

 
29,529

Operating expenses:
 
 
 
Research and development
7,834

 
7,150

Sales and marketing
13,933

 
11,443

General and administrative
7,468

 
6,016

Total operating expenses
29,235

 
24,609

Income from operations
7,597

 
4,920

Other income (expense), net:
 
 
 
Interest expense
(13
)
 

Interest income
250

 
101

Other expense, net
(69
)
 
(178
)
Total other income (expense), net
168

 
(77
)
Income before income taxes
7,765

 
4,843

Provision for income taxes
2,982

 
1,841

Net income
$
4,783

 
$
3,002

Net income per share:
 
 
 
Basic
$
0.14

 
$
0.09

Diluted
$
0.13

 
$
0.08

Weighted average shares used in computing net income per share:
 
 
 
Basic
34,619

 
33,775

Diluted
37,838

 
38,235


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
 
March 31,
 
2016
 
2015
Net income
$
4,783

 
$
3,002

Available-for-sale investments:
 
 
 
Change in net unrealized gain (loss) on investments, net of tax
229

 
29

Less: reclassification adjustment for net realized gain (loss) included in net income
12

 
(4
)
Net change, net of tax
241

 
25

Other comprehensive income, net
241

 
25

Comprehensive income
$
5,024

 
$
3,027


See accompanying Notes to Condensed Consolidated Financial Statements



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Qualys, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)


 
Three Months Ended
 
March 31,
 
2016
 
2015
Cash flows from operating activities:
 
 
 
Net income
$
4,783

 
$
3,002

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization expense
3,834

 
3,182

Bad debt expense
80

 
175

Loss on disposal of property and equipment

 
4

Stock-based compensation
4,697

 
3,875

Amortization of premiums and accretion of discounts on investments
208

 
168

Excess tax benefits from stock-based compensation
(3,095
)
 
(91
)
Deferred income taxes
(1,086
)
 
1,362

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(169
)
 
(5,914
)
Prepaid expenses and other assets
573

 
(670
)
Accounts payable
2,026

 
(3,609
)
Accrued liabilities
2,822

 
1,690

Deferred revenues
2,059

 
6,782

Other noncurrent liabilities
406

 
70

Net cash provided by operating activities
17,138

 
10,026

Cash flows from investing activities:
 
 
 
Purchases of investments
(49,450
)
 
(31,781
)
Sales and maturities of investments
52,176

 
25,977

Purchases of property and equipment
(4,181
)
 
(6,148
)
Capitalized software development costs
(118
)
 
(99
)
Net cash used in investing activities
(1,573
)
 
(12,051
)
Cash flows from financing activities:
 
 
 
Proceeds from exercise of stock options
2,113

 
3,448

Excess tax benefits from stock-based compensation
3,095

 
91

Net cash provided by financing activities
5,208

 
3,539

Net increase in cash and cash equivalents
20,773

 
1,514

Cash and cash equivalents at beginning of period
91,698

 
76,504

Cash and cash equivalents at end of period
$
112,471

 
$
78,018

 
 
 
 
Non-cash investing and financing activities:
 
 
 
Vesting of early exercised common stock options
$

 
$
6


See accompanying Notes to Condensed Consolidated Financial Statements



6

Table of Contents
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-based 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 Qualys 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 by the Company 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, 2015, 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 month periods ended March 31, 2016 are not necessarily indicative of the results of operations expected for the entire year ending December 31, 2016 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 Annual Report on Form 10-K for the year ended December 31, 2015 filed with the SEC on February 26, 2016.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany transactions and balances have been eliminated upon consolidation.

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, stock-based compensation and the provision for income taxes. Actual results could differ from those estimates and such differences may be material to the accompanying condensed consolidated financial statements.



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Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

Concentration of Credit Risk

The Company invests its cash and cash equivalents with major financial institutions. Cash balances with any one institution at times may be in excess of federally insured limits. Cash equivalents are invested in high-quality investment grade financial instruments and are diversified. 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. 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 once collection efforts are unsuccessful. As of March 31, 2016 and December 31, 2015, no customer or channel partner accounted for more than 10% of the Company's accounts receivable balance.

Cash, Cash Equivalents, Short-Term and Long-Term Investments

Cash and cash equivalents include cash held in banks, highly liquid money market funds, commercial paper and fixed-income U.S. government agency securities, all with original maturities of three months or less when acquired. The Company’s investments consist of fixed-income U.S. government agency securities, corporate bonds, asset-backed securities, and commercial paper. Management determines the appropriate classification of the Company's investments at the time of purchase and reevaluates such designation at each balance sheet date. The Company classifies its investments as either short-term or long-term based on each instrument's underlying contractual maturity date.

Cash equivalents are stated at cost, which approximates fair market value. Short-term and long-term investments are classified as available-for-sale and are carried at fair value. Unrealized gains and losses in fair value are reported in other comprehensive income (loss). When the available-for-sale securities are sold, cost is based on the specific identification method, and the realized gains and losses are included in other income (expense) in the condensed consolidated statements of operations. Short-term and long-term investments are reviewed quarterly for impairment that is deemed to be other-than-temporary. An investment is considered other-than-temporarily impaired when its fair value is below its amortized cost and (1) there is an intent to sell the security, (2) it is “more likely than not” that the security will be sold before recovery of its amortized cost basis or (3) the present value of expected cash flows from the investment is not expected to recover the entire amortized cost basis. Declines in value that are considered to be other-than-temporary and adjustments to amortized cost for the amortization of premiums and the accretion of discounts are recorded in other income (expense). Interest and dividends are recorded in interest income as earned.

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, and other consulting expenses. Total capitalized development costs are $0.6 million and $0.4 million at March 31, 2016 and December 31, 2015, respectively.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standard Update (“ASU”) amending revenue recognition guidance and requiring more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, the FASB issued an ASU to defer the effective date of ASU 2014-09 for all entities by one year. Thus, ASU 2014-09 will be effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, but entities will be permitted to early adopt the standard only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect


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Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

recognized on date of adoption. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

In April 2015, the FASB issued an ASU amending existing guidance which clarifies that software licenses contained in a cloud computing arrangement should be capitalized if the customer has the right to take possession of the software and the ability to run the software outside of the cloud computing arrangement. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract under existing guidelines. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively to all arrangements entered into or materially modified after the effective date or retrospectively. Early adoption is permitted. The Company adopted this ASU as of January 1, 2016, which had no impact on its consolidated financial statements.

In January 2016, the FASB issued an ASU that will impact certain aspects of recognition, measurement, presentation and disclosure of financial instruments. This guidance is effective for public business entities in fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

In February 2016, the FASB issued an ASU which requires, among other things, lease assets and lease liabilities arising from leases, including operating leases, to be recognized on the balance sheet. In addition, the ASU requires disclosing key information about leasing arrangements. This guidance supersedes existing lease guidance and is effective for public business entities in fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.

In March 2016, the FASB issued an ASU intended to simplify and improve various aspects related to how employee-share based payment transactions are accounted for and presented in the financial statements. The ASU addresses income tax consequences, classification of awards as either equity or liabilities, classification on the statement of cash flows and forfeiture rate calculations. This guidance is effective for public business entities in fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted. The Company is currently evaluating the impact this ASU will have on its consolidated financial statements.



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Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

NOTE 2.
Fair Value of Financial Instruments

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 certain cash equivalents, accounts receivable, accounts payable, and other current liabilities, the carrying amounts approximate their fair values due to the relatively short maturity of these balances.

The Company measures and reports certain cash equivalents, investments and derivative foreign currency forward contracts at fair value 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.

The Company's financial instruments consist of assets and liabilities measured using Level 1 and 2 inputs. Level 1 assets include a highly liquid money market fund, which is valued using unadjusted quoted prices that are available in an active market for an identical asset. Level 2 assets include fixed-income U.S. government agency securities, commercial paper, corporate bonds, asset-backed securities and derivative financial instruments consisting of foreign currency forward contracts. The securities, bonds and commercial paper are valued using prices from independent pricing services based on quoted prices in active markets for similar instruments or on industry models using data inputs such as interest rates and prices that can be directly observed or corroborated in active markets. The foreign currency forward contracts are valued using observable inputs, such as quotations on forward foreign exchange points and foreign interest rates.



10

Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

The Company's cash and cash equivalents, short-term investments, and long-term investments consist of the following:

 
 
March 31, 2016
  
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
 
(in thousands)
Cash and cash equivalents:
 
 
 
 
 
 
 
 
Cash
 
$
69,001

 
$

 
$

 
$
69,001

Money market funds
 
31,872

 

 

 
31,872

Commercial paper
 
11,597

 
1

 

 
11,598

Total
 
112,470

 
1

 

 
112,471

Short-term investments:
 
 
 
 
 
 
 
 
Commercial paper
 
6,823

 
6

 

 
6,829

Corporate bonds
 
12,370

 
1

 
(2
)
 
12,369

Asset-backed securities
 
678

 

 

 
678

U.S. government agencies
 
73,357

 
23

 
(18
)
 
73,362

Total
 
93,228

 
30

 
(20
)
 
93,238

Long-term investments:
 
 
 
 
 
 
 
 
Asset-backed securities
 
5,987

 
2

 
(5
)
 
5,984

U.S. government agencies
 
24,016

 
30

 
(15
)
 
24,031

Corporate bonds
 
4,592

 
11

 
(4
)
 
4,599

Total
 
34,595

 
43

 
(24
)
 
34,614

Total
 
$
240,293

 
$
74

 
$
(44
)
 
$
240,323


 
 
December 31, 2015
  
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
 
(in thousands)
Cash and cash equivalents:
 
 
 
 
 
 
 
 
Cash
 
$
61,372

 
$

 
$

 
$
61,372

Money market funds
 
3,980

 

 

 
3,980

U.S. government agencies
 
8,999

 
1

 

 
9,000

Commercial paper
 
17,345

 
1

 

 
17,346

Total
 
91,696

 
2

 

 
91,698

Short-term investments:
 
 
 
 
 
 
 
 
Commercial paper
 
10,447

 
1

 

 
10,448

Corporate bonds
 
12,448

 

 
(13
)
 
12,435

U.S. government agencies
 
64,422

 
3

 
(40
)
 
64,385

Total
 
87,317

 
4

 
(53
)
 
87,268

Long-term investments:
 
 
 
 
 
 
 
 
Asset-backed securities
 
7,007

 

 
(18
)
 
6,989

U.S. government agencies
 
32,683

 

 
(142
)
 
32,541

Corporate bonds
 
3,751

 

 
(4
)
 
3,747

Total
 
43,441

 

 
(164
)
 
43,277

Total
 
$
222,454

 
$
6

 
$
(217
)
 
$
222,243




11

Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


The following table sets forth by level within the fair value hierarchy the fair value of the Company's available-for-sale securities measured on a recurring basis, excluding cash and money market funds:

 
 
March 31, 2016
 
 
Level 1
 
Level 2
 
Level 3
 
Fair Value
 
 
(in thousands)
Commercial paper
 
$

 
$
18,427

 
$

 
$
18,427

U.S. government agencies
 

 
97,393

 

 
97,393

Corporate bonds
 

 
16,968

 

 
16,968

Asset-backed securities
 

 
6,662

 

 
6,662

Total
 
$

 
$
139,450

 
$

 
$
139,450


 
 
December 31, 2015
 
 
Level 1
 
Level 2
 
Level 3
 
Fair Value
 
 
(in thousands)
Commercial paper
 
$

 
$
27,794

 
$

 
$
27,794

U.S. government agencies
 

 
105,926

 

 
105,926

Corporate bonds
 

 
16,182

 

 
16,182

Asset-backed securities
 

 
6,989

 

 
6,989

Total
 
$

 
$
156,891

 
$

 
$
156,891


There were no transfers between Level 1, Level 2 or Level 3 of the fair value hierarchy, as determined at the end of each reporting period.

The following summarizes the fair value of securities classified as available-for-sale by contractual maturity:

 
 
March 31, 2016
 
 
Mature within One Year
 
After One Year through Two Years
 
Over Two Years
 
Fair Value
 
 
(in thousands)
Commercial paper
 
$
18,427

 
$

 
$

 
$
18,427

U.S. government agencies
 
73,362

 
24,031

 

 
97,393

Corporate bonds
 
16,968

 

 

 
16,968

Asset-backed securities
 
678

 
1,193

 
4,791

 
6,662

Total
 
$
109,435

 
$
25,224

 
$
4,791

 
$
139,450

 
 
December 31, 2015
 
 
Mature within One Year
 
After One Year through Two Years
 
Over Two Years
 
Fair Value
 
 
(in thousands)
Commercial paper
 
$
27,794

 
$

 
$

 
$
27,794

U.S. government agencies
 
73,385

 
32,541

 

 
105,926

Corporate bonds
 
12,435

 
3,747

 

 
16,182

Asset-backed securities
 

 
3,411

 
3,578

 
6,989

Total
 
$
113,614

 
$
39,699

 
$
3,578

 
$
156,891



12

Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

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 or accrued liabilities 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 derivative financial instruments for trading or speculative purposes.

At March 31, 2016, the Company had two outstanding forward contracts with notional amounts of 6.9 million Euros and 4.2 million British Pounds, which expired on April 30, 2016. At December 31, 2015, the Company had two outstanding forward contracts with notional amounts of 6.1 million Euros and 2.6 million British Pounds, which expired on January 31, 2016. These forward contracts were entered into at the end of each month, and thus the fair value of these contracts was $0 at March 31, 2016 and December 31, 2015. The Company recorded a loss of $0.4 million from these forward contracts, which offset other foreign currency transaction gains of $0.4 million for the three months ended March 31, 2016. For the three months ended March 31, 2015, the Company recorded a gain of $0.8 million from these forward contracts, which were more than offset by other foreign currency transaction losses of $0.9 million. These derivatives did not meet the criteria to be designated as hedges. These instruments were valued using Level 2 inputs.


NOTE 3.
Property and Equipment, Net

Property and equipment consists of the following:
 
March 31,
 
December 31,
 
2016
 
2015
 
(in thousands)
Computer equipment
$
50,788

 
$
48,192

Computer software
12,916

 
12,484

Furniture, fixtures and equipment
2,908

 
2,804

Scanner appliances
23,487

 
22,627

Leasehold improvements
3,571

 
3,367

Total property and equipment
93,670

 
89,474

Less: accumulated depreciation and amortization
(61,884
)
 
(58,145
)
Property and equipment, net
$
31,786

 
$
31,329


Physical scanner appliances and other computer equipment that are or will be subject to subscriptions by customers have a net carrying value of $9.0 million and $8.4 million at March 31, 2016 and December 31, 2015, respectively, including assets that have not been placed in service of $1.6 million and $1.4 million, respectively. Other fixed assets not placed in service at March 31, 2016 and December 31, 2015, included in computer equipment and leasehold improvements, are approximately $5.4 million and $4.3 million, respectively. Depreciation and amortization expense relating to property and equipment was $3.7 million and $3.1 million for the three months ended March 31, 2016 and 2015, respectively.


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Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

NOTE 4.
Goodwill and Intangible Assets, Net

Intangible assets consist primarily of existing technology and patent license 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):
 
 
 
 
 
March 31, 2016
 
December 31, 2015
 
Estimated Lives
 
Cost
 
Accumulated Amortization
 
Net Book Value
 
Accumulated Amortization
 
Net Book Value
Existing technology
7 years
 
$
1,910

 
$
(1,524
)
 
$
386

 
$
(1,456
)
 
$
454

Patent license
14 years
 
1,388

 
(547
)
 
841

 
(522
)
 
866

     Total intangibles subject to amortization
 
 
$
3,298

 
$
(2,071
)
 
1,227

 
$
(1,978
)
 
1,320

Intangible assets not subject to amortization
 
 
 
 
 
 
40

 
 
 
40

     Total intangible assets, net
 
 
 
 
 
 
$
1,267

 
 
 
$
1,360


Intangibles amortization expense was $0.1 million for the three months ended March 31, 2016 and 2015.

As of March 31, 2016, the Company expects amortization expense in future periods to be as follows (in thousands):
Remainder of 2016
$
280

2017
282

2018
100

2019
100

2020
100

2021 and thereafter
365

Total expected future amortization expense
$
1,227


Goodwill, which is not subject to amortization, totaled $0.3 million as of March 31, 2016 and December 31, 2015.
 


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Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

NOTE 5.
Commitments and Contingencies
Leases
The Company leases certain computer equipment and its corporate office and data center facilities under noncancelable operating leases for varying periods through 2022.

The following are the minimum annual lease payments due under operating leases at March 31, 2016 (in thousands):
Remainder of 2016
$
3,169

2017
2,782

2018
1,296

2019
873

2020
647

2021 and thereafter
398

Total minimum lease payments
$
9,165


Rent expense was $1.7 million and $1.6 million the three months ended March 31, 2016 and 2015, 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 March 31, 2016 and December 31, 2015, the Company has accrued $0.5 million of deferred rent related to these agreements, which is reflected in accrued liabilities and other noncurrent liabilities in the accompanying condensed consolidated balance sheets.


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.

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 March 31, 2016, the Company has not recorded any material liabilities in accordance with accounting for contingencies.




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Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

NOTE 6.
Stock-based Compensation

Equity Incentive Plans
2012 Equity Incentive Plan

Under the 2012 Equity Incentive Plan (the "2012 Plan"), the Company is authorized to grant to eligible participants incentive stock options (“ISOs”), non-statutory stock options (“NSOs”), stock appreciation rights ("SARs"), restricted stock awards ("RSAs"), restricted stock units ("RSUs"), performance units and performance shares equivalent to up to 8,069,184 shares of common stock. Options may be granted with an exercise price that is at least equal to the fair market value of the Company's stock at the date of grant and are exercisable when vested. As of March 31, 2016, 3,075,341 shares were available for grant under the 2012 Plan.

2000 Equity Incentive Plan

Under the 2000 Equity Incentive Plan (the "2000 Plan"), the Company was authorized to grant to eligible participants either ISOs or NSOs. The 2000 Plan was terminated in connection with the closing of the initial public offering ("IPO"), and accordingly, no shares are currently available for issuance under the 2000 Plan. The 2000 Plan continues to govern outstanding awards granted thereunder.

Stock Options
Employee Stock-based Compensation

Stock-based compensation for employee option awards is included in the condensed consolidated statements of operations as follows:

 
Three Months Ended
 
March 31,
 
2016
 
2015
 
(in thousands)
Cost of revenues
$
379

 
$
328

Research and development
1,295

 
1,152

Sales and marketing
1,249

 
811

General and administrative
1,586

 
1,471

Total employee stock-based compensation
$
4,509

 
$
3,762


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.

As of March 31, 2016, the Company had $23.1 million of total unrecognized employee compensation cost related to unvested option awards that it expects to recognize over a weighted-average period of 2.5 years.



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Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

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
 
March 31,
 
2016
 
2015
Expected term (in years)
5.0 to 5.9
 
4.9 to 5.9
Volatility
45%
 
47% to 48%
Risk-free interest rate
1.3%
 
1.3%
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 declared any dividends and does not expect to in the future.

Non-Employee Stock-based Compensation

The Company records compensation representing the fair value of stock options granted to non-employees. Stock-based non-employee compensation expense was minimal and $0.1 million for the three months ended March 31, 2016 and 2015, 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.

Stock Option Plan Activity

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)
December 31, 2015
7,579,058

 
$
16.88

 
5.9
 
$
131,345

Granted
549,700

 
$
25.17

 
 
 
 
Exercised
(462,737
)
 
$
4.57

 
 
 
 
Canceled
(258,628
)
 
$
32.69

 
 
 
 
March 31, 2016
7,407,393

 
$
17.71

 
5.8
 
$
77,955

Vested and expected to vest - March 31, 2016
6,851,379

 
$
16.57

 
5.5
 
$
77,676

Exercisable - March 31, 2016
5,074,374

 
$
11.54

 
4.9
 
$
76,024


Restricted Stock

The terms and conditions of RSUs and RSAs, including vesting criteria and timing are set by the board of directors. The cost of RSUs and RSAs is determined using the fair value of the Company’s common stock on the date of the grant. Compensation cost is recognized on a straight-line basis over the requisite service period of each grant adjusted for estimated forfeitures.




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Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

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

 
Outstanding RSUs
 
Weighted Average Fair Value
 
 
 
 
December 31, 2015
47,500

 
$
37.28

Granted
14,142

 
$
25.17

Released
(5,000
)
 
$
37.28

Canceled
(42,500
)
 
$
37.28

March 31, 2016
14,142

 
$
25.17

Outstanding and expected to vest
14,142

 
$
25.17



The Company recorded compensation expense of $0.2 million for the three months ended March 31, 2016. The Company did not record compensation expense for RSUs in the three months ended March 31, 2015.

As of March 31, 2016, the Company has $0.4 million of unrecognized compensation cost related to unvested awards that it expects to recognize over a weighted-average period of 2.9 years.

NOTE 7.
Other Income (Expense), Net

Other income (expense), net consists of the following:
 
Three Months Ended
 
March 31,
 
2016
 
2015
 
(in thousands)
Foreign exchange losses
$
(31
)
 
$
(151
)
Other income (expense)
(38
)
 
(27
)
Other income (expense), net
$
(69
)
 
$
(178
)


NOTE 8.
Income Taxes

The Company recorded an income tax provision of $3.0 million and $1.8 million for the three months ended March 31, 2016 and 2015, respectively. The effective income tax rate was approximately 38.4 % and 38.0% for the three months ended March 31, 2016 and 2015, respectively.

As of March 31, 2016, the Company had unrecognized tax benefits of $4.0 million, of which $2.4 million, if recognized, would favorably impact the Company's effective tax rate. As of December 31, 2015, the Company had unrecognized tax benefits of $3.5 million, of which $2.1 million, if recognized, would favorably impact the Company's effective tax rate.




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Table of Contents
Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

NOTE 9.
Segment Information and Information about Geographic Area

The Company operates in one segment. The Company’s chief operating decision maker 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
 
March 31,
 
2016
 
2015
 
(in thousands)
United States
$
32,689

 
$
26,341

Foreign
13,559

 
11,152

Total revenues
$
46,248

 
$
37,493



Property and equipment, net, by geographic area, are as follows:

 
March 31,
 
December 31,
 
2016
 
2015
 
(in thousands)
United States
$
25,736

 
$
25,623

Foreign
6,050

 
5,706

Total property and equipment, net
$
31,786

 
$
31,329




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Qualys, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

NOTE 10.
Net Income Per Share

The computations for basic and diluted net income per share are as follows:
 
Three Months Ended
 
March 31,
 
2016
 
2015
 
(in thousands, except per share data)
Numerator:
 
 
 
Net income
$
4,783

 
$
3,002

Denominator:
 
 
 
Weighted-average shares used in computing net income per share:
 
 
 
Basic
34,619

 
33,775

Effect of potentially dilutive securities:
 
 
 
Common stock options
3,219

 
4,460

Diluted
37,838

 
38,235

Net income per share:
 
 
 
Basic
$
0.14

 
$
0.09

Diluted
$
0.13

 
$
0.08


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
 
March 31,
 
2016
 
2015
 
(in thousands)
Common stock options
3,115

 
535





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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 included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, filed with the Securities and Exchange Commission, or SEC, on February 26, 2016.
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. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:

our financial performance, including our revenues, costs, expenditures, growth rates, operating expenses and ability to generate positive cash flow to fund our operations and sustain profitability;
anticipated technology trends, such as the use of cloud solutions;
our ability to adapt to changing market conditions;
economic and financial conditions, including volatility in foreign exchange rates;
our ability to diversify our sources of revenues, including selling additional solutions to our existing customers and our ability to pursue new customers;
the effects of increased competition in our market;
our ability to innovate and enhance our cloud solutions and platform and introduce new solutions;
our ability to effectively manage our growth;
our anticipated investments in sales and marketing, our infrastructure, new solutions, and research and development, and acquisitions;
maintaining and expanding our relationships with channel partners;
our ability to maintain, protect and enhance our brand and intellectual property;
costs associated with defending intellectual property infringement and other claims;
our ability to attract and retain qualified employees and key personnel, including sales and marketing personnel;
our ability to successfully enter new markets and manage our international expansion;
our expectations, assumptions and conclusions related to our provision for income taxes, our deferred tax assets and our effective tax rate; and
other factors discussed in this Quarterly Report on Form 10-Q in the sections titled Risk Factors” and Management's Discussion and Analysis of Financial Condition and Results of Operations.

We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations and prospects. The results, events and circumstances reflected in these forward-looking statements are subject to risks, uncertainties, assumptions, and other factors including those described in Part II, Item 1A (Risk Factors) of this Quarterly Report and those discussed in other documents we file with the SEC. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements used herein. We cannot provide assurance that the results, events, and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results, events or circumstances could differ materially from those described in the forward-looking statements.




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Overview

We are a pioneer and leading provider of cloud-based 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 Qualys Cloud Platform enables 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 Qualys Cloud Platform to cost-effectively obtain a unified view of their security and compliance posture across globally-distributed IT infrastructures.

We were founded and incorporated 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, Qualys Vulnerability Management (VM), in 2000. As this solution gained acceptance, we introduced new solutions to help customers manage increasing IT security and compliance requirements, including PCI Compliance, Policy Compliance, Web Application Scanning, Malware Detection Service and Qualys SECURE Seal. In 2012, we introduced our virtualized private cloud platform as an additional deployment option of our solutions for customers and partners. In 2014, we released Continuous Monitoring (CM) for internet-facing systems, which allows customers to continuously monitor their mission-critical assets and to be alerted to security vulnerabilities or misconfigurations that may make them more susceptible to a cyber-attack and in 2015, we introduced our Cloud Agent Platform (CAP), which provides customers with the ability to secure IT assets on a continuous basis regardless of where they reside, inside the enterprise, in the cloud or mobile endpoints. Additional offerings, such as CM and CAP, add functionality to our core VM and POL services and expand the scope of our capabilities. We expect the sales of multiple, fully-integrated cloud based security offerings on our platform will contribute to the continuing trend of revenue growth.

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 typically 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. We continue to experience significant revenue growth from existing customers as they renew and purchase additional subscriptions.

We market and sell our solutions to enterprises, government entities and to small and medium-sized businesses across a broad range of industries, including education, financial services, government, healthcare, insurance, manufacturing, media, retail, technology and utilities. In the three month period ended March 31, 2016, approximately 71% 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.

Our revenues increased to $46.2 million in the three months ended March 31, 2016 from $37.5 million for the comparable period in 2015, representing an increase of $8.8 million or 23%.



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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.

 
Three Months Ended
 
March 31,
 
2016
 
2015
 
 (in thousands, except percentages)
Adjusted EBITDA
$
16,128

 
$
11,977

Percentage of revenues
35
%
 
32
%

 
Three Months Ended
 
March 31,
 
2016
 
2015
 
 (in thousands)
Free cash flow
$
12,839

 
$
3,779



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.



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The following unaudited table presents the reconciliation of net income to Adjusted EBITDA for the three months ended March 31, 2016 and 2015:
 
Three Months Ended
 
March 31,
 
2016
 
2015
 
 (in thousands)
Net income
$
4,783

 
$
3,002

Other (income) expense, net 
(168
)
 
77

Provision for income taxes
2,982

 
1,841

Depreciation and amortization of property and equipment
3,724

 
3,084

Amortization of intangible assets
110

 
98

Stock-based compensation
4,697

 
3,875

Adjusted EBITDA
$
16,128

 
$
11,977


Free Cash Flow

We define free cash flow, a non-GAAP measure, as net cash provided by operating activities less purchases of property and equipment and capitalization of software development costs. We monitor free cash flow as a liquidity measure because we believe it provides useful information to management and investors about the amount of cash we generated, that, after the acquisition of property and equipment and capitalized software development costs, can be used for strategic opportunities, including investing in our business, making strategic acquisitions and strengthening the balance sheet. We also believe free cash flow provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods.

A limitation of using free cash flow as a means for evaluating liquidity is that free cash flow does not represent the total increase or decrease in cash and cash equivalents for the period because it excludes cash provided by or used in other investing and financing activities. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a comparative measure. A reconciliation of free cash flow to net cash provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

 
Three Months Ended
 
March 31,
 
2016
 
2015
 
 (in thousands)
Net cash provided by operating activities
$
17,138

 
$
10,026

Less:
 
 
 
Purchases of property and equipment
(4,181
)
 
(6,148
)
Capitalized software development costs
(118
)
 
(99
)
Free cash flow
$
12,839

 
$
3,779


Limitations of Adjusted EBITDA and Free Cash Flow

Adjusted EBITDA and free cash flow, 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:

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


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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;
Free cash flow does not represent the total increase or decrease in the cash and cash equivalents for the period; and
Other companies, including companies in our industry, may calculate Adjusted EBITDA and free cash flow differently or not at all, which reduces their usefulness as a comparative measure.

Because of these limitations, Adjusted EBITDA and free cash flow should be considered alongside other financial performance measures, including revenues, net income, cash flows from operating activities 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. Subscriptions to our solutions allow customers to access our cloud-based 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 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. In some limited cases, we also provide certain computer equipment used to extend our Qualys Cloud Platform into our customers’ private cloud environment. Customers are required to return physical scanner appliances and computer equipment 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 condensed consolidated balance sheets 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 and computer hardware 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 and related maintenance support, fees paid to contractors who supplement or support our operations center personnel and overhead allocations. We expect to continue to make capital investments to expand and support our data center operations which will increase the cost of revenues in absolute dollars.

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 capabilities and expect that research and development expenses will increase in absolute dollars.



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Table of Contents

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, or the participation in new marketing events or programs, and the rate at which these generate incremental revenues may affect our future operating results. We expect to continue to significantly invest in additional sales personnel worldwide and also in more marketing programs to support new solutions on our platform, which will increase sales and marketing expenses 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, insurance, fees, and overhead allocations. We expect that general and administrative expenses will increase in absolute dollars, as we continue to add personnel and incur professional services to support our growth and compliance with legal requirements.

Other Income (Expense), Net
Our other income (expense), net consists primarily of interest and investment income from our short-term and long-term investments; foreign exchange gains and losses, the majority of which result from fluctuations between the U.S. dollar and the Euro, British Pound and Indian Rupee; and losses on disposal of property and equipment.

Provision for Income Taxes
We are subject to federal, state and foreign income taxes for jurisdictions in which we operate, and we use estimates in determining our provision for these income taxes and deferred tax assets. Earnings from our non-U.S. activities are subject to income taxes in the local country which are generally lower than U.S. tax rates, and may be subject to U.S. income taxes. Our effective rates differ from the U.S. statutory rate primarily due to foreign income subject to different tax rates than the U.S., research and development tax credits, non-deductible stock-based compensation expense and other adjustments.
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.
We assess the likelihood that deferred tax assets will be realized, and we recognize a valuation allowance if it is more likely than not that some portion of the deferred tax assets will not be recognized. This assessment requires judgment as to the likelihood and amounts of future taxable income.
Our provision for income taxes in the three months ended March 31, 2016 and 2015 consists of income taxes for federal and certain states in the United States, as well as income taxes for profits generated in foreign jurisdictions by wholly-owned subsidiaries. The provision for income taxes also includes changes to unrecognized tax benefits related to uncertain tax positions.



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Results of Operations
The following tables set forth selected condensed consolidated statements of operations data for each of the periods presented.
 
Three Months Ended
 
March 31,
 
2016
 
2015
 
(in thousands)
Condensed Consolidated Statements of Operations data:
 
 
 
Revenues
$
46,248

 
$
37,493

Cost of revenues (1)
9,416

 
7,964

Gross profit
36,832

 
29,529

Operating expenses:
 
 
 
Research and development (1)
7,834

 
7,150

Sales and marketing (1)
13,933

 
11,443

General and administrative (1)
7,468

 
6,016

Total operating expenses
29,235

 
24,609

Income from operations
7,597

 
4,920

Other income (expense), net
168

 
(77
)
Income before income taxes
7,765

 
4,843

Provision for income taxes
2,982

 
1,841

Net income
$
4,783

 
$
3,002




____________________
(1) Includes stock-based compensation as follows:

 
Three Months Ended
 
March 31,
 
2016
 
2015
 
(in thousands)
Cost of revenues
$
379

 
$
328

Research and development
1,295

 
1,152

Sales and marketing
1,249

 
811

General and administrative
1,774

 
1,584

Total stock-based compensation
$
4,697

 
$
3,875






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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
 
March 31,
 
2016
 
2015
Revenues
100
%
 
100
%
Cost of revenues
20

 
21

Gross profit
80

 
79

Operating expenses:
 
 
 
Research and development
17

 
19

Sales and marketing
30

 
31

General and administrative
16

 
16

Total operating expenses
63

 
66

Income from operations
16

 
13

Other income (expense), net
0

 
0

Income before income taxes
16

 
13

Provision for income taxes
6

 
5

Net income
10
%
 
8
%

Comparison of Three Months Ended March 31, 2016 and 2015
Revenues
 
Three Months Ended
 
 
 
 
 
March 31,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Revenues
$
46,248

 
$
37,493

 
$
8,755

 
23
%

Revenues increased $8.8 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015, due to new customer subscriptions entered into after March 31, 2015 and from an increase in the purchase of subscriptions from existing customers. Of the total increase of $8.8 million, $6.4 million was from customers in the United States and the remaining $2.4 million was from customers in foreign countries. The growth in revenues reflects the continued demand for solutions.



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Cost of Revenues
 
Three Months Ended
 
 
 
 
 
March 31,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Cost of revenues
$
9,416

 
$
7,964

 
$
1,452

 
18
%
Percentage of revenues
20
%
 
21
%
 
 
 
 
Gross profit percentage
80
%
 
79
%
 
 
 
 
Cost of revenues increased $1.5 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015 primarily due to a $0.6 million increase in depreciation expense related to additional computer hardware and software; increased third-party software license and maintenance expense of $0.5
million; increased data center costs of $0.2 million; and increased personnel expenses of $0.2 million to support continued growth of our business.
Research and Development Expenses
 
Three Months Ended
 
 
 
 
 
March 31,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Research and development
$
7,834

 
$
7,150

 
$
684

 
10
%
Percentage of revenues
17
%
 
19
%
 
 
 
 

Research and development expenses increased $0.7 million in the three months ended March 31, 2016 compared to the three months ended March 31, 2015 primarily due to an increase in personnel expenses of $0.7 million, due to new employees and higher stock-based compensation. We continue to significantly invest in and expand our research and development teams to continuously improve our platform and existing solutions, as well as develop new solutions and capabilities.

Sales and Marketing Expenses
 
Three Months Ended
 
 
 
 
 
March 31,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Sales and marketing
$
13,933

 
$
11,443

 
$
2,490

 
22
%
Percentage of revenues
30
%
 
31
%
 
 
 
 

Sales and marketing expenses increased $2.5 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015, primarily due to increased personnel expenses of $0.8 million, principally due to new employees and higher stock based compensation, and also due to an increase in marketing expenses of $1.6 million, primarily due to increased trade shows and program activities as a result of a large security trade show that occurred in the first quarter of 2016 which previously occurred in the second quarter of 2015.



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General and Administrative Expenses
 
Three Months Ended
 
 
 
 
 
March 31,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
General and administrative
$
7,468

 
$
6,016

 
$
1,452

 
24
%
Percentage of revenues
16
%
 
16
%
 
 
 
 

General and administrative expenses increased $1.5 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015 primarily driven by increased personnel expenses of $0.5 million, principally due to additional employees and higher stock-based compensation; and increased professional services of $0.8 million.
Other Income (Expense), Net
 
Three Months Ended
 
 
 
 
 
March 31,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Other income (expense), net
$
168

 
$
(77
)
 
$
245

 
NM
Percentage of revenues
0
%
 
0
%
 
 
 
 

Other income (expense), increased by $0.2 million in the three months ended March 31, 2016 compared to the three months ended March 31, 2015, primarily due to an increase in investment and interest income and lower foreign exchange losses.
Provision for Income Taxes
 
Three Months Ended
 
 
 
 
 
March 31,
 
Change
 
2016
 
2015
 
$
 
%
 
(in thousands, except percentages)
Provision for income taxes
$
2,982

 
$
1,841

 
$
1,141

 
62
%
Effective Tax Rate
38.4
%
 
38.0
%
 
 
 
 

The provision for income taxes increased by $1.1 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015, primarily due to an increase in income before taxes.
Liquidity and Capital Resources

At March 31, 2016, our principal source of liquidity was cash, cash equivalents, and short-term and long-term investments of $240.3 million, including $3.4 million held outside of the United States by our foreign subsidiaries. We do not intend to repatriate these funds generated from foreign operations to fund our domestic operations.

We have experienced positive cash flows from operations during the three months ended March 31, 2016 and 2015. We believe our existing cash, cash equivalents, short-term and long-term investments, and cash from operations will be sufficient to fund our operations for at least the next twelve months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of our spending on research and development efforts, international expansion and investment in data centers. We may also seek to invest in or acquire complementary businesses or technologies.


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Cash Flows
The following summary of cash flows for the periods indicated has been derived from our condensed consolidated financial statements included elsewhere in this report:

 
Three Months Ended
 
March 31,
 
2016
 
2015
 
(in thousands)
Cash provided by operating activities
$
17,138

 
$
10,026

Cash used in investing activities
(1,573
)
 
(12,051
)
Cash provided by financing activities
5,208

 
3,539

Net increase in cash and cash equivalents
$
20,773

 
$
1,514


Cash Flows from Operating Activities

In the three months ended March 31, 2016, cash flows from operating activities of $17.1 million resulted from our net income of approximately $4.8 million, as adjusted by an increase in deferred revenues of $2.1 million, attributable to our continued growth, an increase in accounts payable and accrued liabilities of $4.8 million and by non-cash items including depreciation and amortization expense of $3.8 million and stock-based compensation of $4.7 million. These increases are partially offset by an increase in accounts receivable of $0.2 million due to continued growth, excess tax benefits from stock based compensation of $3.1 million, and additions to deferred income tax assets of $1.1 million.

In the three months ended March 31, 2015, cash flows from operating activities of $10.0 million resulted from our net income of $3.0 million, as adjusted by an increase in deferred revenues of $6.8 million, attributable to our continued growth. These working capital increases are further increased by non-cash items including depreciation and amortization expense of $3.2 million and stock-based compensation expense of $3.9 million. These increases are partially offset by an increase in accounts receivable of $5.9 million, due to timing of orders received relatively later in the quarter, and by a decrease in accounts payable of $3.6 million due to timing of payments.
Cash Flows from Investing Activities
In the three months ended March 31, 2016, cash used in investing activities of $1.6 million was primarily attributable to $4.2 million of cash used for capital expenditures, including computer hardware and software for our data centers to support our growth and development and physical scanner appliances and computer hardware provided to certain customers as part of their subscriptions; and sales and maturities of investments, net of purchases, of $2.7 million.

In the three months ended March 31, 2015, cash used in investing activities of $12.1 million was primarily attributable $6.1 million of cash used for capital expenditures, including computer hardware and software for our data centers to support our growth and development and physical scanner appliances provided to certain customers as part of their subscriptions, and net purchases of investments of $5.8 million.

Cash Flows from Financing Activities

In the three months ended March 31, 2016, cash provided by financing activities of $5.2 million was primarily attributable to $2.1 million of proceeds from the exercise of stock options and $3.1 million of tax benefit from exercise of stock options.

In the three months ended March 31, 2015, cash provided by financing activities of $3.5 million was primarily attributable to $3.4 million of proceeds from the exercise of stock options.


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Contractual Obligations
Our principal commitments consist of obligations under our outstanding leases for office space, third-party data centers and certain office equipment. The following table summarizes our contractual cash obligations at March 31, 2016 and the effect such obligations are expected to have on our liquidity and cash flows in future periods:
 
Payment Due by Period
 
 
Contractual Obligations
Total
 
Remainder of 2016
 
2017-2018
 
2019-2020
 
2021 and thereafter
 
(in thousands)
 
 
Operating lease obligations (1)
$
9,165

 
$
3,169

 
$
4,078

 
$
1,520

 
$
398

Total
$
9,165

 
$
3,169

 
$
4,078

 
$
1,520

 
$
398


(1) Operating lease obligations represent our obligations to make payments under the lease agreements for our facilities, data centers, and office equipment leases. During the three months ended March 31, 2016, we made regular payments on our operating lease obligations of $1.1 million.



Off-Balance Sheet Arrangements
During the periods presented, we did not have, nor do we currently have, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities.

Recent Accounting Pronouncements
See Note 1 to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for a discussion of recent accounting pronouncements.


Critical Accounting Policies and Estimates
Our condensed consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions.

We believe that of our significant accounting policies, which are described in the notes to our consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, filed with the SEC on February 26, 2016, the accounting policies related to revenue recognition, income taxes and stock-based compensation involve the greatest degree of judgment and complexity and have the greatest potential impact on our consolidated financial statements. A critical accounting policy is one that is material to the presentation of our consolidated financial statements and requires us to make difficult, subjective or complex judgments for uncertain matters that could have a material effect on our financial condition and results of operations. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. There have been no material changes to our critical accounting policies and estimates as compared to the critical accounting policies and estimates as described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015.



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Item 3.
Quantitative and Qualitative Disclosures about Market Risk

We have domestic and international operations and we are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate, foreign exchange and inflation risks, as well as risks relating to changes in the general economic conditions in the countries where we conduct business. To reduce certain of these risks, we monitor the financial condition of our large customers and limit credit exposure by collecting subscription fees in advance.

Foreign Currency Risk

Our results of operations and cash flows have been and will continue to be subject to fluctuations because of changes in foreign currency exchange rates, particularly changes in exchange rates between the U.S. dollar and the Euro, British Pound, and Indian Rupee, the currencies of countries where we currently have our most significant international operations. A portion of our invoicing is denominated in the Euro, British Pound and Japanese Yen. Our expenses in international locations are generally denominated in the currencies of the countries in which our operations are located.

Derivative financial instruments are utilized by the Company to reduce foreign currency exchange risks. We use foreign currency forward contracts to partially mitigate the impact of fluctuations in cash and accounts receivable balances denominated in Euros and British Pound. We do not use these contracts for speculative or trading purposes, nor are they designated as hedges. These contracts typically have a maturity of one month, and we record gains and losses from these instruments in other income (expense), net. The effect of an immediate 10% adverse change in foreign exchange rates would not be material to our financial condition, operating results or cash flows.
Interest Rate Sensitivity
We have $240 million in cash, cash equivalents and short-term and long-term investments at March 31, 2016. Cash and cash equivalents include cash held in banks, highly liquid money market funds, U.S. government agency securities, and commercial paper. Investments consist of fixed-income U.S. government agency securities, corporate bonds, asset-backed securities, and commercial paper. We determine the appropriate classification of our investments at the time of purchase and reevaluate such designation at each balance sheet date. We classify our investments as either short-term or long-term based on each instrument's underlying contractual maturity date.
The primary objectives of our investment activities are the preservation of principal and support of our liquidity requirements. We do not enter into investments for trading or speculative purposes. Our investments are subject to market risk due to changes in interest rates, which may affect the interest income we earn and the fair market value. We do not believe that a 10% increase or decrease in interest rates would have a material impact on our operating results or cash flows.


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Item 4.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2016. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of March 31, 2016, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
From time to time we may become involved in legal proceedings or be subject to claims arising in the ordinary course of our business. We are not presently a party to any legal proceedings that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.

Item 1A.
Risk Factors

An investment in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, and all other information contained in this Quarterly Report on Form 10-Q, including our condensed consolidated financial statements and the related notes, before making a decision to invest in our common stock. Our business, operating results, financial condition, or prospects could be materially and adversely affected by any of these risks and uncertainties. In that case, the trading price of our common stock could decline, and you might lose all or part or all of your investment. In addition, the risks and uncertainties discussed below are not the only ones we face. Our business, operating results, financial performance or prospects could also be harmed by risks and uncertainties not currently known to us or that we currently do not believe are material.

Subscriptions to our Qualys Vulnerability Management solution generate most of our revenues, and if we are unable to continue to renew and grow subscriptions for this solution, our operating results would suffer.

We derived approximately 79% of our revenues from subscriptions to our core Vulnerability Management solution for the three months ended March 31, 2016. We expect to continue to derive a majority of our revenues from subscriptions to our VM solution, also including the related portion of additional offerings, such as Continuous Monitoring and Cloud Agent, that expand the scope of capabilities within our platform. The market demand for our Qualys Vulnerability Management solution is critical to our continued success. Demand for this solution is affected by a number of factors beyond our control, including continued market acceptance of our solution for existing and new use cases, the timing of development and release of new products or services by our competitors, technological change, and growth or contraction in our market. Our inability to renew or increase subscriptions for this solution or a decline in price of this solution would harm our business and operating results more seriously than if we derived significant revenues from a variety of solutions.

Our quarterly operating results may vary from period to period, which could result in our failure to meet expectations with respect to operating results and cause the trading price of our stock to decline.

Our operating results have historically varied from period to period, and we expect that they will continue to do so as a result of a number of factors, many of which are outside of our control, including:
the level of demand for our solutions;
publicity regarding security breaches generally and the level of perceived threats to IT security;
sales and marketing expenses associated with our existing and new products and services;
changes in customer renewals of our solutions;
the extent to which customers subscribe for additional solutions;
seasonal buying patterns of our customers;
the level of perceived threats to IT security;
security breaches, technical difficulties or interruptions with our service;
changes in the growth rate of the IT security and compliance market;
the timing and success of new product or service introductions by us or our competitors or any other changes in the competitive landscape of our industry, including consolidation among our competitors;


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the introduction or adoption of new technologies that compete with our solutions;
decisions by potential customers to purchase IT security and compliance products or services from other vendors;
the amount and timing of operating costs and capital expenditures related to the operations and expansion of our business;
the timing of sales commissions relative to the recognition of revenues;
the announcement or adoption of new regulations and policy mandates or changes to existing regulations and policy mandates;
failure of our products and services to operate as designed;
price competition;
the length of our sales cycle for our products and services;
insolvency or credit difficulties confronting our customers, affecting their ability to purchase or pay for our solutions;
changes in foreign currency exchange rates;
general economic conditions, both domestically and in the foreign markets in which we sell our solutions;
future accounting pronouncements or changes in our accounting policies;
our ability to integrate any products or services that we may acquire in the future into our product suite or migrate existing customers of any companies that we may acquire in the future to our products and services;
our effective tax rate;
the timing of expenses related to the development or acquisition of technologies, services or businesses; and
potential goodwill and intangible asset impairment charges associated with acquired businesses.

Each factor above or discussed elsewhere in this Quarterly Report on Form 10-Q or the cumulative effect of some of these factors may result in fluctuations in our operating results. This variability and unpredictability could result in our failure to meet expectations with respect to operating results, or those of securities analysts or investors, for a particular period. In addition, a significant percentage of our operating expenses are fixed in nature and based on forecasted trends in revenues. Accordingly, in the event of shortfalls in revenues, we are generally unable to mitigate the negative impact on margins in the short term by reducing our operating expenses. If we fail to meet or exceed expectations for our operating results for these or any other reasons, the trading price of our common stock could fall and we could face costly lawsuits, including securities class action suits.

If the market for cloud solutions for IT security and compliance does not evolve as we anticipate, our revenues may not grow and our operating results would be harmed.

Our success depends to a significant extent on the willingness of organizations to increase their use of cloud solutions for their IT security and compliance. However, the market for cloud solutions for IT security and compliance is at an early stage relative to on-premise solutions, and as such, it is difficult to predict important market trends, including the potential growth, if any, of the market for cloud security and compliance solutions. To date, some organizations have been reluctant to use cloud solutions because they have concerns regarding the risks associated with the reliability or security of the technology delivery model associated with these solutions. If other cloud service providers experience security incidents, loss of customer data, disruptions in service delivery or other problems, the market for cloud solutions as a whole, including our solutions, may be negatively impacted. Moreover, many organizations have invested substantial personnel and financial resources to integrate on-premise software into their businesses, and as a result may be reluctant or unwilling to migrate to a cloud solution. Organizations that use on-premise security products, such as network firewalls, security information and event management products or data loss prevention solutions, may also believe that these products sufficiently


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protect their IT infrastructure and deliver adequate security. Therefore, they may continue spending their IT security budgets on these products and may not adopt our security and compliance solutions in addition to or as a replacement for such products.

If the market for cloud solutions for IT security and compliance does not evolve in the way we anticipate or if customers do not recognize the benefits of our cloud solutions over traditional on-premise enterprise software products, and as a result we are unable to increase sales of subscriptions to our solutions, then our revenues may not grow or may decline, and our operating results would be harmed.

If we do not successfully anticipate market needs and opportunities or are unable to enhance our solutions and develop new solutions that meet those needs and opportunities on a timely or cost-effective basis, we may not be able to compete effectively and our business and financial condition may be harmed.

The IT security and compliance market is characterized by rapid technological advances, customer price sensitivity, short product and service life cycles, intense competition, changes in customer requirements, frequent new product introductions and enhancements and evolving industry standards and regulatory mandates. Any of these factors could create downward pressure on pricing and gross margins, and could adversely affect our renewal rates, as well as our ability to attract new customers. Our future success will depend on our ability to enhance existing solutions, introduce new solutions on a timely and cost-effective basis, meet changing customer needs, extend our core technology into new applications, and anticipate and respond to emerging standards and business models. We must also continually change and improve our solutions in response to changes in operating systems, application software, computer and communications hardware, networking software, data center architectures, programming tools and computer language technology.

We may not be able to anticipate future market needs and opportunities or develop enhancements or new solutions to meet such needs or opportunities in a timely manner or at all. The market for cloud solutions for IT security and compliance is relatively new, and it is uncertain whether our new solutions will gain market acceptance.

Our solution enhancements or new solutions could fail to attain sufficient market acceptance for many reasons, including:
failure to timely meet market demand for product functionality;
inability to identify and provide intelligence regarding the attacks or techniques used by cyber-attackers;
inability to interoperate effectively with the database technologies, file systems or web applications of our prospective customers;
defects, errors or failures;
delays in releasing our enhancements or new solutions;
negative publicity about their performance or effectiveness;
introduction or anticipated introduction of products by our competitors;
poor business conditions, causing customers to delay IT security and compliance purchases;
easing or changing of external regulations related to IT security and compliance; and
reluctance of customers to purchase cloud solutions for IT security and compliance.

Furthermore, diversifying our solutions and expanding into new IT security and compliance markets will require significant investment and planning, require that our research and development and sales and marketing organizations develop expertise in these new markets, bring us more directly into competition with security and compliance providers that may be better established or have greater resources than we do, require additional investment of time and resources in the development and training of our channel partners and entail significant risk of failure.



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If we fail to anticipate market requirements or fail to develop and introduce solution enhancements or new solutions to satisfy those requirements in a timely manner, such failure could substantially decrease or delay market acceptance and sales of our present and future solutions and cause us to lose existing customers or fail to gain new customers, which would significantly harm our business, financial condition and results of operations.

If we fail to continue to effectively scale and adapt our platform to meet the performance and other requirements of our customers, our operating results and our business would be harmed.

Our future growth depends upon our ability to continue to meet the expanding needs of our customers as their use of our cloud platform grows. As these customers gain more experience with our solutions, the number of users and the number of locations where our solutions are being accessed may expand rapidly in the future. In order to ensure that we meet the performance and other requirements of our customers, we intend to continue to make significant investments to develop and implement new proprietary and third-party technologies at all levels of our cloud platform. These technologies, which include databases, applications and server optimizations, and network and hosting strategies, are often complex, new and unproven. We may not be successful in developing or implementing these technologies. To the extent that we do not effectively scale our platform to maintain performance as our customers expand their use of our platform, our operating results and our business may be harmed.

Our current research and development efforts may not produce successful products or enhancements to our platform that result in significant revenue, cost savings or other benefits in the near future, if at all.

We must continue to dedicate significant financial and other resources to our research and development efforts if we are to maintain our competitive position. However, developing products and enhancements to our platform is expensive and time consuming, and there is no assurance that such activities will result in significant new marketable products or enhancements to our platform, design improvements, cost savings, revenue or other expected benefits. If we spend significant resources on research and development and are unable to generate an adequate return on our investment, our business and results of operations may be materially and adversely affected.

Our platform, website and internal systems may be subject to intentional disruption or other security incidents that could result in liability and adversely impact our reputation and future sales.

We and our service providers could be a target of cyber-attacks or other malfeasance designed to impede the performance of our solutions, penetrate our network security or the security of our cloud platform or our internal systems, misappropriate proprietary information and/or cause interruptions to our services. Our solutions, platforms, and system may also suffer security incidents as a result of non-technical issues, including intentional or inadvertent breaches by our employees or service providers. Because our operations involve providing IT security solutions to our customers, we may be targeted for cyber-attacks and other security incidents. If an actual or perceived breach of our security measures or those of our service providers occurs, it could adversely affect the market perception of our solutions, negatively affecting our reputation, and may expose us to the loss of information, litigation, regulatory actions and possible liability. Any such actual or perceived security breach could also divert the efforts of our technical and management personnel. In addition, any such actual or perceived security breach could impair our ability to operate our business and provide solutions to our customers. If this happens, our reputation could be harmed, our revenues could decline and our business could suffer.

Our business depends substantially on retaining our current customers, and any reduction in our customer renewals or revenues from such customers could harm our future operating results.

We offer our Qualys Cloud Platform and integrated suite of solutions pursuant to a software-as-a-service model, and our customers purchase subscriptions from us that are generally one year in length. Our customers have no obligation to renew their subscriptions after their subscription period expires, and they may not renew their subscriptions at the same or higher levels or at all. As a result, our ability to grow depends in part on customers renewing their existing subscriptions and purchasing additional subscriptions and solutions. Our customers may choose not to renew their subscriptions to our solutions or purchase additional solutions due to a number of factors, including their satisfaction or dissatisfaction with our solutions, the prices of our solutions, the prices of products or services offered by our competitors, reductions in our customers’ spending levels due to the


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macroeconomic environment or other factors. If our customers do not renew their subscriptions to our solutions, renew on less favorable terms, or do not purchase additional solutions or subscriptions, our revenues may grow more slowly than expected or decline and our results of operations may be harmed.

If we are unable to continue to attract new customers and grow our customer base, our growth could be slower than we expect and our business may be harmed.

We believe that our future growth depends in part upon increasing our customer base. Our ability to achieve significant growth in revenues in the future will depend, in large part, upon continually attracting new customers and obtaining subscription renewals to our solutions from those customers. If we fail to attract new customers our revenues may grow more slowly than expected and our business may be harmed.

If we are unable to sell subscriptions to additional solutions, our future revenue growth may be harmed and our business may suffer.

We will need to increase the revenues that we derive from our current and future solutions other than Qualys Vulnerability Management for our business and revenues to grow as we expect. Revenues from our other solutions, including our Web Application Scanning, Policy Compliance, PCI Compliance, Malware Detection Service, and Qualys SECURE Seal, have been relatively modest compared to revenues from our Qualys Vulnerability Management solution. Our future success depends in part on our ability to sell subscriptions to these additional solutions to existing and new customers. This may require more costly sales and marketing efforts and may not result in additional sales. If our efforts to sell subscriptions to additional solutions to existing and new customers are not successful, our business may suffer.

Our sales cycle can be long and unpredictable, and our sales efforts require considerable time and expense. As a result, revenues may vary from period to period, which may cause our operating results to fluctuate and could harm our business.

The timing of sales of subscriptions for our solutions is difficult to forecast because of the length and unpredictability of our sales cycle, particularly with large enterprises. We sell subscriptions to our security and compliance solutions primarily to IT departments that are managing a growing set of user and compliance demands, which has increased the complexity of customer requirements to be met and confirmed during the sales cycle and prolonged our sales cycle. Further, the length of time that potential customers devote to their testing and evaluation, contract negotiation and budgeting processes varies significantly, which has also made our sales cycle long and unpredictable. The length of the sales cycle for our solutions typically ranges from six to twelve months but can be more than eighteen months. In addition, we might devote substantial time and effort to a particular unsuccessful sales effort, and as a result we could lose other sales opportunities or incur expenses that are not offset by an increase in revenues, which could harm our business.

Adverse economic conditions or reduced IT spending may adversely impact our business.

Our business depends on the overall demand for IT and on the economic health of our current and prospective customers. Economic weakness, customer financial difficulties, and constrained spending on IT security may result in decreased revenue and earnings. Such factors could make it difficult to accurately forecast our sales and operating results and could negatively affect our ability to provide accurate forecasts to our contract manufacturers. In addition, continued governmental budgetary challenges in the United States and Europe and geopolitical turmoil in many parts of the world have and may continue to put pressure on global economic conditions and overall spending on IT security. General economic weakness may also lead to longer collection cycles for payments due from our customers, an increase in customer bad debt, restructuring initiatives and associated expenses, and impairment of investments. Furthermore, the continued weakness and uncertainty in worldwide credit markets, including the sovereign debt situation in certain countries in the European Union, may adversely impact our customers' available budgetary spending, which could lead to delays in planned purchases of our solutions.

Uncertainty about future economic conditions also makes it difficult to forecast operating results and to make decisions about future investments. Future or continued economic weakness for us or our customers, failure of our customers and markets to recover from such weakness, customer financial difficulties, and reductions in


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spending on IT security could have a material adverse effect on demand for our platform and consequently on our business, financial condition and results of operations.

Our security and compliance solutions are primarily delivered from four data centers, and any disruption of service at these facilities would interrupt or delay our ability to deliver our solutions to our customers which could reduce our revenues and harm our operating results.

We currently host substantially all of our solutions from third-party data centers located in the United States, Switzerland and the Netherlands. These facilities are vulnerable to damage or interruption from earthquakes, hurricanes, floods, fires, cybersecurity attacks, terrorist attacks, employee negligence, power losses, telecommunications failures and similar events. The facilities also could be subject to break-ins, sabotage, intentional acts of vandalism and other misconduct. The occurrence of a natural disaster, an act of terrorism or misconduct, a decision to close the facilities without adequate notice or other unanticipated problems could result in interruptions in our services.

Our data centers are not currently redundant and we cannot rapidly move customers from one data center to another, which may increase delays in the restoration of our service for our customers if an adverse event occurs. We have added data center facilities to provide additional capacity for our cloud platform and to enable disaster recovery. We continue to build out these facilities; however, these additional facilities may not be operational in the anticipated time-frame and we may incur unplanned expenses.

Additionally, our existing data center facilities providers have no obligations to renew their agreements with us on commercially reasonable terms, or at all. If we are unable to renew our agreements with the facilities providers on commercially reasonable terms or if in the future we add additional data center facility providers, we may experience costs or downtime in connection with the loss of an existing facility or the transfer to, or addition of, new data center facilities.

Any disruptions or other performance problems with our solutions could harm our reputation and business and may damage our customers’ businesses. Interruptions in our service delivery might reduce our revenues, cause us to issue credits to customers, subject us to potential liability and cause customers to terminate their subscriptions or not renew their subscriptions.

If we are unable to increase market awareness of our company and our new solutions, our revenues may not continue to grow, or may decline.

We have a limited operating history, particularly in certain markets and solution offerings, and we believe that we need to continue to develop market awareness in the IT security and compliance market. Market awareness of our capabilities and solutions is essential to our continued growth and success in all of our markets, particularly for the large enterprise, service provider and government markets. If our marketing programs are not successful in creating market awareness of our company and our full suite of solutions, our business, financial condition and results of operations may be adversely affected, and we may not be able to achieve our expected growth.

We face competition in our markets, and we may lack sufficient financial or other resources to maintain or improve our competitive position.

We compete with a large range of established and emerging vulnerability management vendors, compliance vendors and data security vendors in a highly fragmented and competitive environment. We face significant competition for each of our solutions from companies with broad product suites and greater name recognition and resources than we have, as well as from small companies focused on specialized security solutions.

We compete with large and small public companies, such as Barracuda Networks, Inc., Hewlett-Packard Company, Imperva, Inc., International Business Machines Corporation, Symantec Corporation, and Rapid7, Inc., as well as privately held security providers including BeyondTrust Software, Inc., Tripwire, Inc., NetIQ Corporation, Tenable Network Security, Inc. and Trustwave Holdings, Inc. We also seek to replace IT security and compliance solutions that organizations have developed internally. As we continue to extend our cloud platform’s functionality by further developing security and compliance solutions, such as web application scanning and firewalls, we expect to face additional competition in these new markets. Our competitors may also attempt to


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further expand their presence in the IT security and compliance market and compete more directly against one or more of our solutions.

We believe that the principal competitive factors affecting our markets include product functionality, breadth of offerings, flexibility of delivery models, ease of deployment and use, total cost of ownership, scalability and performance, customer support and extensibility of platform. Many of our existing and potential competitors have competitive advantages, including:
    greater brand name recognition;
    larger sales and marketing budgets and resources;
    broader distribution networks and more established relationships with distributors and customers;
    access to larger customer bases;
    greater customer support resources;
    greater resources to make acquisitions;
    greater resources to develop and introduce products that compete with our solutions;
    greater resources to meet relevant regulatory requirements; and
    substantially greater financial, technical and other resources.

As a result, our competitors may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or customer requirements. With the introduction of new technologies, the evolution of our service and new market entrants, we expect competition to intensify in the future.

In addition, some of our larger competitors have substantially broader product offerings and can bundle competing products and services with other software offerings. As a result, customers may choose a bundled product offering from our competitors, even if individual products have more limited functionality than our solutions. These competitors may also offer their products at a lower price as part of this larger sale, which could increase pricing pressure on our solutions and cause the average sales price for our solutions to decline. These larger competitors are also often in a better position to withstand any significant reduction in capital spending, and will therefore not be as susceptible to economic downturns.

Furthermore, our current and potential competitors may establish cooperative relationships among themselves or with third parties that may further enhance their resources and product and services offerings in the markets we address. In addition, current or potential competitors may be acquired by third parties with greater available resources. As a result of such relationships and acquisitions, our current or potential competitors might be able to adapt more quickly to new technologies and customer needs, devote greater resources to the promotion or sale of their products and services, initiate or withstand substantial price competition, take advantage of other opportunities more readily or develop and expand their product and service offerings more quickly than we do. For all of these reasons, we may not be able to compete successfully against our current or future competitors.

If our solutions fail to help our customers achieve and maintain compliance with regulations and industry standards, our revenues and operating results could be harmed.

We generate a portion of our revenues from solutions that help organizations achieve and maintain compliance with regulations and industry standards. For example, many of our customers subscribe to our security and compliance solutions to help them comply with the security standards developed and maintained by the Payment Card Industry Security Standards Council, or the PCI Council, which apply to companies that store cardholder data. Industry organizations like the PCI Council may significantly change their security standards with little or no notice, including changes that could make their standards more or less onerous for businesses. Governments may also adopt new laws or regulations, or make changes to existing laws or regulations, that could impact the demand for or value of our solutions.



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If we are unable to adapt our solutions to changing regulatory standards in a timely manner, or if our solutions fail to assist with or expedite our customers’ compliance initiatives, our customers may lose confidence in our solutions and could switch to products offered by our competitors. In addition, if regulations and standards related to data security, vulnerability management and other IT security and compliance requirements are relaxed or the penalties for non-compliance are changed in a manner that makes them less onerous, our customers may view government and industry regulatory compliance as less critical to their businesses, and our customers may be less willing to purchase our solutions. In any of these cases, our revenues and operating results could be harmed.

We may not maintain profitability in the future.

We may not be able to sustain or increase our growth or maintain profitability in the future. We plan to continue to invest in our infrastructure, new solutions, research and development and sales and marketing, and as a result, we cannot assure you that we will maintain profitability. We may incur losses in the future for a number of reasons, including without limitation, the other risks and uncertainties described in this Quarterly Report on Form 10-Q. Additionally, we may encounter unforeseen operating expenses, difficulties, complications, delays and other unknown factors that may result in losses in future periods. If our revenue growth does not meet our expectations in future periods, our financial performance may be harmed and we may not again achieve or maintain profitability in the future.

The sales prices of our solutions are subject to competitive pressures and may decrease, which may reduce our gross profits and adversely impact our financial results.

The sales prices for our solutions may decline for a variety of reasons, including competitive pricing pressures, discounts, a change in our mix of solutions and subscriptions, anticipation of the introduction of new solutions or subscriptions, or promotional programs. Competition continues to increase in the market segments in which we participate, and we expect competition to further increase in the future, thereby leading to increased pricing pressures. Larger competitors with more diverse product and service offerings may reduce the price of products or subscriptions that compete with ours or may bundle them with other products and subscriptions. Additionally, although we price our products and subscriptions worldwide in U.S. dollars, Euros, British Pound and Japanese Yen, currency fluctuations in certain countries and regions may negatively impact actual prices that partners and customers are willing to pay in those countries and regions, or the effective prices we realize in our reporting currency. We cannot assure you that we will be successful in developing and introducing new offerings with enhanced functionality on a timely basis, or that our new product and subscription offerings, if introduced, will enable us to maintain our prices and gross profits at levels that will allow us to maintain positive gross margins and achieve profitability.

If our solutions fail to detect vulnerabilities or incorrectly detect vulnerabilities, our brand and reputation could be harmed, which could have an adverse effect on our business and results of operations.

If our solutions fail to detect vulnerabilities in our customers’ IT infrastructures, or if our solutions fail to identify and respond to new and increasingly complex methods of attacks, our business and reputation may suffer. There is no guarantee that our solutions will detect all vulnerabilities. Additionally, our security and compliance solutions may falsely detect vulnerabilities or threats that do not actually exist. For example, some of our solutions rely on information on attack sources aggregated from third-party data providers who monitor global malicious activity originating from a variety of sources, including anonymous proxies, specific IP addresses, botnets and phishing sites. If the information from these data providers is inaccurate, the potential for false indications of security vulnerabilities increases. These false positives, while typical in the industry, may impair the perceived reliability or usability of our solutions and may therefore adversely impact market acceptance of our solutions and could result in negative publicity, loss of customers and sales, increased costs to remedy any incorrect information or problem, or claims by aggrieved parties. Similar issues may be generated by the misuse of our tools to identify and exploit vulnerabilities.

In addition, our solutions do not currently extend to cover mobile devices or personal devices that employees may bring into an organization. As such, our solutions would not identify or address vulnerabilities in mobile devices, such as mobile phones or tablets, or personal devices, and our customers’ IT infrastructures may be compromised by attacks that infiltrate their networks through such devices.


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An actual or perceived security breach or theft of the sensitive data of one of our customers, regardless of whether the breach is attributable to the failure of our solutions, could adversely affect the market’s perception of our security solutions.

Incorrect or improper implementation or use of our solutions could result in customer dissatisfaction and harm our business and reputation.

Our solutions are deployed in a wide variety of IT environments, including large-scale, complex infrastructures. If our customers are unable to implement our solutions successfully, customer perceptions of our platform may be impaired or our reputation and brand may suffer. Our customers have in the past inadvertently misused our solutions, which triggered downtime in their internal infrastructure until the problem was resolved. Any misuse of our solutions could result in customer dissatisfaction, impact the perceived reliability of our solutions, result in negative press coverage, negatively affect our reputation and harm our financial results.

Undetected software errors or flaws in our cloud platform could harm our reputation or decrease market acceptance of our solutions, which would harm our operating results.

Our solutions may contain undetected errors or defects when first introduced or as new versions are released. We have experienced these errors or defects in the past in connection with new solutions and solution upgrades and we expect that these errors or defects will be found from time to time in the future in new or enhanced solutions after commercial release of these solutions. Since our customers use our solutions for security and compliance reasons, any errors, defects, disruptions in service or other performance problems with our solutions may damage our customers’ business and could hurt our reputation. If that occurs, we may incur significant costs, the attention of our key personnel could be diverted, our customers may delay or withhold payment to us or elect not to renew, or other significant customer relations problems may arise. We may also be subject to liability claims for damages related to errors or defects in our solutions. A material liability claim or other occurrence that harms our reputation or decreases market acceptance of our solutions may harm our business and operating results.

Our solutions could be used to collect and store personal information of our customers’ employees or customers, and therefore privacy and other data handling concerns could result in additional cost and liability to us or inhibit sales of our solutions.

We collect the names and email addresses of our customers in connection with subscriptions to our solutions. Additionally, the data that our solutions collect to help secure and protect the IT infrastructure of our customers may include additional personal or confidential information of our customers’ employees and their customers. Personal privacy has become a significant issue in the United States and in many other countries where we offer our solutions. The regulatory framework for privacy issues worldwide is currently evolving and is likely to remain uncertain for the foreseeable future. Many federal, state and foreign government bodies and agencies have adopted or are considering adopting laws and regulations regarding the collection, use, disclosure and retention of personal information. In the United States, these include, for example, rules and regulations promulgated under the authority of the Federal Trade Commission, the Health Insurance Portability and Accountability Act of 1996, or HIPAA, the Gramm-Leach-Bliley Act, or GLB, and state breach notification laws. Internationally, virtually every jurisdiction in which we operate has established its own data security and privacy legal framework with which we or our customers must comply, including the Data Protection Directive established in the European Union and the Federal Data Protection Act passed in Germany.

In addition to laws and regulations, privacy advocacy and industry groups or other private parties may propose new and different privacy standards that either legally or contractually apply to us. Because the interpretation and application of privacy and data protection laws, regulations, standards and contractual obligations are uncertain, it is possible that they may be interpreted and applied in a manner that is, or perceived to be, inconsistent with our data management practices or the features of our solutions. If so, in addition to the possibility of regulatory investigations and enforcement actions, fines, lawsuits and other claims, other forms of injunctive or operations-limiting relief, and damage to our reputations and loss of goodwill, we could be required to fundamentally change our business activities and practices or modify our solutions and may face limitations in our ability to develop new solutions and features, any of which could have an adverse effect on our business. Any


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inability to adequately address privacy concerns, even if unfounded, or any actual or perceived inability to comply with applicable privacy or data protection laws, regulations and privacy standards, could result in cost and liability to us, damage our reputation, inhibit sales of subscriptions and harm our business.

Furthermore, the costs of compliance with, and other burdens imposed by, the laws, regulations, and privacy standards that are applicable to the businesses of our customers may limit the use and adoption of, and reduce the overall demand for, our solutions. Privacy concerns, whether valid or not valid, may inhibit market adoption of our solutions particularly in certain industries and foreign countries.

If we are unable to continue the expansion of our sales force, sales of our solutions and the growth of our business would be harmed.

We believe that our growth will depend, to a significant extent, on our success in recruiting and retaining a sufficient number of qualified sales personnel and their ability to obtain new customers, manage our existing customer base and expand the sales of our newer solutions. We plan to continue to expand our sales force and make significant investment in our sales and marketing activities. Our recent hires and planned hires may not become as productive as quickly as we would like, and we may be unable to hire or retain sufficient numbers of qualified individuals in the future in the competitive markets where we do business. Competition for highly skilled personnel is frequently intense, especially in the San Francisco Bay Area, one of the locations in which we have a substantial presence and need for highly skilled personnel and we may not be able to compete for these employees. If we are unable to recruit and retain a sufficient number of productive sales personnel, sales of our solutions and the growth of our business may be harmed. Additionally, if our efforts do not result in increased revenues, our operating results could be negatively impacted due to the upfront operating expenses associated with expanding our sales force.

A significant portion of our customers, channel partners and employees are located outside of the United States, which subjects us to a number of risks associated with conducting international operations and if we are unable to successfully manage these risks, our business and operating results could be harmed.

We market and sell subscriptions to our solutions throughout the world and have personnel in many parts of the world. In addition, we have sales offices and research and development facilities outside the United States and we conduct, and expect to continue to conduct, a significant amount of our business with organizations that are located outside the United States, particularly in Europe and Asia. Therefore, we are subject to risks associated with having international sales and worldwide operations, including:
foreign currency exchange fluctuations;
trade and foreign exchange restrictions;
economic or political instability in foreign markets;
greater difficulty in enforcing contracts, accounts receivable collection and longer collection periods;
changes in regulatory requirements;
tax laws (including U.S. taxes on foreign subsidiaries);
difficulties and costs of staffing and managing foreign operations;
the uncertainty and limitation of protection for intellectual property rights in some countries;
costs of compliance with foreign laws and regulations and the risks and costs of non-compliance with such laws and regulations;
costs of complying with U.S. laws and regulations for foreign operations, including the Foreign Corrupt Practices Act, import and export control laws, tariffs, trade barriers, economic sanctions and other regulatory or contractual limitations on our ability to sell our solutions in certain foreign markets, and the risks and costs of non-compliance;
heightened risks of unfair or corrupt business practices in certain geographies and of improper or fraudulent sales arrangements that may impact financial results and result in restatements of, and irregularities in, financial statements;


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the potential for political unrest, acts of terrorism, hostilities or war;
management communication and integration problems resulting from cultural differences and geographic dispersion; and
multiple and possibly overlapping tax structures.

Our business, including the sales of subscriptions of our solutions, may be subject to foreign governmental regulations, which vary substantially from country to country and change from time to time. Failure to comply with these regulations could adversely affect our business. Further, in many foreign countries it is common for others to engage in business practices that are prohibited by our internal policies and procedures or U.S. regulations applicable to us. Although we have implemented policies and procedures designed to ensure compliance with these laws and policies, there can be no assurance that all of our employees, contractors, channel partners and agents have complied or will comply with these laws and policies. Violations of laws or key control policies by our employees, contractors, channel partners or agents could result in delays in revenue recognition, financial reporting misstatements, fines, penalties or the prohibition of the importation or exportation of our solutions and could have a material adverse effect on our business and results of operations. If we are unable to successfully manage the challenges of international operations, our business and operating results could be adversely affected.

In addition, approximately 44% of our employees are located outside of the United States, with a significant number of these employees located in Pune, India. Accordingly, we are exposed to changes in laws governing our employee relationships in various U.S. and foreign jurisdictions, including laws and regulations regarding wage and hour requirements, fair labor standards, employee data privacy, unemployment tax rates, workers’ compensation rates, citizenship requirements and payroll and other taxes which may have a direct impact on our operating costs. We may continue to expand our international operations and international sales and marketing activities. Expansion in international markets has required, and will continue to require, significant management attention and resources. We may be unable to scale our infrastructure effectively or as quickly as our competitors in these markets and our revenues may not increase to offset any increased costs and operating expenses, which would cause our results to suffer.

Disruptive technologies could gain wide adoption and supplant our cloud security and compliance solutions, thereby weakening our sales and harming our results of operations.

The introduction of products and services embodying new technologies could render our existing solutions obsolete or less attractive to customers. Our business could be harmed if new security and compliance technologies are widely adopted. We may not be able to successfully anticipate or adapt to changing technology or customer requirements on a timely basis, or at all. If we fail to keep up with technological changes or to convince
our customers and potential customers of the value of our solutions even in light of new technologies, our business could be harmed and our revenues may decline.

Our business and operations have experienced significant growth, and if we do not appropriately manage any future growth, or are unable to improve our systems and processes, our operating results may be negatively affected.

We have experienced significant growth over the last several years. From 2013 to 2015, our revenues have grown from $108.0 million to $164.3 million, and our headcount increased from 359 employees at the beginning of 2013 to 540 employees at March 31, 2016. We rely on information technology systems to help manage critical functions such as order processing, revenue recognition and financial forecasts. To manage any future growth effectively we must continue to improve and expand our IT systems, financial infrastructure, and operating and administrative systems and controls, and continue to manage headcount, capital and processes in an efficient manner. We may not be able to successfully implement improvements to these systems and processes in a timely or efficient manner.

Our failure to improve our systems and processes, or their failure to operate in the intended manner, may result in our inability to manage the growth of our business and to accurately forecast our revenues, expenses and earnings, or to prevent certain losses. In addition, as we continue to grow, our productivity and the quality of


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our solutions may also be adversely affected if we do not integrate and train our new employees quickly and effectively. Any future growth would add complexity to our organization and require effective coordination across our organization. Failure to manage any future growth effectively could result in increased costs, harm our results of operations and lead to investors losing confidence in our internal systems and processes.

Forecasts of market growth may prove to be inaccurate, and even if the markets in which we compete achieve the forecasted growth, there can be no assurance that our business will grow at similar rates, or at all.

Growth forecasts relating to the expected growth in the market for IT security and compliance and other markets are subject to significant uncertainty and are based on assumptions and estimates which may prove to be inaccurate. Even if these markets experience the forecasted growth, we may not grow our business at similar rates, or at all. Our growth is subject to many factors, including our success in implementing our business strategy, which is subject to many risks and uncertainties. Accordingly, forecasts of market growth should not be taken as indicative of our future growth.

We rely on third-party channel partners to generate a substantial amount of our revenues, and if we fail to expand and manage our distribution channels, our revenues could decline and our growth prospects could suffer.

Our success significantly depends upon establishing and maintaining relationships with a variety of channel partners and we anticipate that we will continue to depend on these partners in order to grow our business. For the three months ended March 31, 2016, we derived approximately 41% of our revenues from sales of subscriptions for our solutions through channel partners, and the percentage of revenues derived from channel partners may increase in future periods. Our agreements with our channel partners are generally non-exclusive and do not prohibit them from working with our competitors or offering competing solutions, and many of our channel partners have more established relationships with our competitors. If our channel partners choose to place greater emphasis on products of their own or those offered by our competitors, do not effectively market and sell our solutions, or fail to meet the needs of our customers, then our ability to grow our business and sell our solutions may be adversely affected. In addition, the loss of one or more of our larger channel partners, who may cease marketing our solutions with limited or no notice, and our possible inability to replace them, could adversely affect our sales. Moreover, our ability to expand our distribution channels depends in part on our ability to educate our channel partners about our solutions, which can be complex. Our failure to recruit additional channel partners, or any reduction or delay in their sales of our solutions or conflicts between channel sales and our direct sales and marketing activities may harm our results of operations. Even if we are successful, these relationships may not result in greater customer usage of our solutions or increased revenues.

In addition, the financial health of our channel partners and our continuing relationships with them are important to our success. Some of these channel partners may be unable to withstand adverse changes in economic conditions, which could result in insolvency and/or the inability of such distributors to obtain credit to finance purchases of our products and services. In addition, weakness in the end-user market could negatively affect the cash flows of our channel partners who could, in turn, delay paying their obligations to us, which would increase our credit risk exposure. Our business could be harmed if the financial condition of some of these channel partners substantially weakened and we were unable to timely secure replacement channel partners.

Our solutions contain third-party open source software components, and our failure to comply with the terms of the underlying open source software licenses could restrict our ability to sell our solutions.

Our solutions contain software licensed to us by third-parties under so-called “open source” licenses, including the GNU General Public License, or GPL, the GNU Lesser General Public License, or LGPL, the BSD License, the Apache License and others. From time to time, there have been claims against companies that distribute or use open source software in their products and services, asserting that such open source software infringes the claimants’ intellectual property rights. We could be subject to suits by parties claiming that what we believe to be licensed open source software infringes their intellectual property rights. Use and distribution of open source software may entail greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or other contractual protections regarding infringement claims or the quality of the code. In addition, certain open source licenses require that source code for software programs that


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are subject to the license be made available to the public and that any modifications or derivative works to such open source software continue to be licensed under the same terms. If we combine our proprietary software with open source software in certain ways, we could, in some circumstances, be required to release the source code of our proprietary software to the public. Disclosing the source code of our proprietary software could make it easier for cyber attackers and other third parties to discover vulnerabilities in or to defeat the protections of our solutions, which could result in our solutions failing to provide our customers with the security they expect from our services. This could harm our business and reputation. Disclosing our proprietary source code also could allow our competitors to create similar products with lower development effort and time and ultimately could result in a loss of sales for us. Any of these events could have a material adverse effect on our business, operating results and financial condition.

Although we monitor our use of open source software in an effort both to comply with the terms of the applicable open source licenses and to avoid subjecting our solutions to conditions we do not intend, the terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that these licenses could be construed in a way that could impose unanticipated conditions or restrictions on our ability to commercialize our solutions. In this event, we could be required to seek licenses from third parties to continue offering our solutions, to make our proprietary code generally available in source code form, to re-engineer our solutions or to discontinue the sale of our solutions if re-engineering could not be accomplished on a timely basis, any of which could adversely affect our business, operating results and financial condition.

We rely on software-as-a-service vendors to operate certain functions of our business and any failure of such vendors to provide services to us could adversely impact our business and operations.

We rely on third-party software-as-a-service vendors to operate certain critical functions of our business, including financial management and human resource management. If these services become unavailable due to extended outages or interruptions or because they are no longer available on commercially reasonable terms or prices, our expenses could increase, our ability to manage our finances could be interrupted and our processes for managing sales of our solutions and supporting our customers could be impaired until equivalent services, if available, are identified, obtained and integrated, all of which could harm our business.