APPFOLIO INC 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read together with our Condensed Consolidated Financial Statements and the related notes included elsewhere in this Quarterly Report and in our Annual Report. This discussion and analysis contains forward-looking statements that are based on our current expectations and reflect our plans, estimates and anticipated future financial performance. These statements involve numerous risks and uncertainties, including those related to the anticipated impact on our business from, and our response to, the COVID-19 pandemic. Our actual results may differ materially from those expressed or implied by these forward-looking statements as a result of many factors, including those set forth in the section entitled “Risk Factors” in this Quarterly Report and in our 23 Table of Contents Annual Report, as well as our other public filings with the SEC. Please also refer to the section of this Quarterly Report entitled "Cautionary Note Regarding Forward-Looking Statements" for additional information. Overview Our mission is to revolutionize vertical industry businesses by providing great software and services. We offer industry-specific, cloud-based business software solutions, services and data analytics to our customers. Although specific functionality varies by product, our core solutions address common business operations and interactions of our customers' businesses. In addition to our core solutions, we offer a range of optional, but often business-critical, Value+ services. Our Value+ services are built to enhance, automate and streamline processes and support workflows essential to our customers' businesses. Our mobile-optimized software solutions are designed for use across multiple devices and operating systems. Our software solutions are offered as a service for our customers and hosted using a modern cloud-based architecture. This architecture leads to rich data sets that have a consistent schema across our customer base and enables us to deploy data-powered products and services for our customers. The significant majority of our customers in the real estate vertical use our property management solutions, which provide our property management customers, including third-party property managers and owner-operators who manage single- and multi-family residences, community associations, commercial properties, and student housing, as well as mixed real estate portfolios, with a system of record to automate essential business processes, a system of engagement to enhance business interactions between our customers and their clients and other stakeholders, and a system of intelligence to leverage data to predict and optimize business workflows that enable superior customer experiences and increase efficiency across our customers' businesses. We also provide software solutions to real estate investment managers. We have focused on growing our revenue by providing cloud-based business software solutions, services and data analytics that are designed and developed with our customers’ industry-specific business needs in mind, increasing the size of our customer base in the markets we serve, increasing the number of units under management, introducing new or expanded Value+ services, retaining customers, and increasing the adoption and utilization of our Value+ services by new and existing customers. We evaluate the success of our business during the periods presented based on factors such as the development and launch of new and innovative core functionality and Value+ services, enhancements to user experience, customer satisfaction, growth in our revenue and customer base, fluctuations in costs and operating expenses as a percentage of revenue, operating loss or income and cash flows from operating activities. To date, we have experienced rapid revenue growth due to our investments in research and product development, sales and marketing, customer service and support, and infrastructure. We intend to continue to invest in growth areas, organically and via acquisition, based on our market validation findings and customer feedback. Over the long-term, these investments to grow our business are expected to continue to increase our costs and operating expenses on an absolute basis. Many of these investments will occur in advance of our realization of revenue or any other benefit, which will make it difficult to determine if we are allocating our resources effectively and efficiently. We expect our operating margins will improve over the long term, but this trend may be interrupted from time to time as a result of accelerated investment opportunities occurring in advance of realization of revenue. We have managed, and plan to continue to manage, our business towards the achievement of long-term growth that we believe will positively impact long-term stockholder value, and not towards the realization of short-term financial or business metrics, or short-term stockholder value. We have invested, and intend to continue to invest, in our business to capitalize on our market opportunity by working closely with our customers, prospects, partners and other industry participants to inform our product roadmap. Accordingly, if opportunities arise that might cause us to sacrifice our performance with respect to short-term financial or business metrics, but that we believe are in the best interests of our stockholders in the long term, we will take those opportunities. We believe our people are at the heart of our success and our customers’ success, and we have worked hard not only to attract, hire and retain quality individuals but also to nurture and develop our valuable human resources. The professionalism and dedication of our workforce to continue effectively developing and supporting our product and service offerings has persisted notwithstanding the current environment, and the morale and focus of our team, even while working remotely, remains high. We take the health and welfare of our people very seriously, and have encouraged safe practices designed to stem the infection and spread of COVID-19 within our workforce and beyond. At the same time, in an effort to ensure business continuity, we have developed both short and long-term succession plans for key individuals and roles throughout the business. With all of that said, if the COVID-19 pandemic requires remote working conditions for a prolonged period of time, it could have an adverse impact on the productivity of our employees, which would harm our business and impede our ability to achieve our strategic plan. Further, we have a limited history of remote work and the long-term impact on, and the resulting types of continuing investments necessary for, our employee base is uncertain. 24 Table of Contents As of September 30, 2020, we had approximately 1,420 employees, which includes 118 MyCase employees who were terminated in connection with the MyCase Transaction. We continue to consider our relationship with our employees to be very good. We also hire temporary employees and consultants, and believe we have a similarly strong relationship with them. None of our employees is represented by a labor union or covered by a collective bargaining agreement. Our future growth depends, in part, upon our ability to continue to identify, attract and retain the necessary qualified personnel to support our growth plans and the continued service of our executive officers and other key employees. If we fail to do so, our business and operating results may suffer. Recent Developments As previously disclosed, on September 30, 2020, the Company completed the divestiture of 100% of the issued and outstanding equity interests of MyCase, the former wholly owned subsidiary of the Company that provided legal practice and case management software solutions to our legal customers, to an affiliate of certain funds advised by Apax Partners LLP for $193.0 million. In connection with the MyCase Transaction, our Credit Agreement was terminated and all obligations outstanding under the Term Loan and Revolving Facility, including all guarantees and security interests granted with respect to such obligations, were satisfied in full with proceeds from the sale and extinguished. Real Estate Overview In 2008, we entered the real estate vertical with our first product, AppFolio Property Manager ("APM"), a property management solution designed to address the unique operational and business requirements of property management companies. Recognizing that our customers and their stakeholders would benefit from additional business critical services, we launched a series of Value+ services beginning in 2009. Our first Value+ service assisted our customers in the marketing of their rental properties by offering property level website design and hosting services. One year later, we commenced the roll out of our electronic payment services, thereby facilitating the payment of rent via ACH by tenants. In 2011, we launched tenant screening services, further assisting our customers with the leasing process. In 2012, we introduced our legal liability to landlord insurance program, which protects property owners and managers from certain defined losses. We expanded our electronic payment services in 2013 by allowing residents to pay rent by electronic cash payment and credit or debit card. In 2014, we launched a tenant-facing contact center solution to assist our property managers with resolving incoming maintenance requests. In 2015, we expanded the marketing services offered to our property management customers with a premium leads service built on technology acquired with our acquisition of RentLinx, LLC ("RentLinx") and expanded our electronic payment services to facilitate payments made between our customers and property owners and vendors. In 2016, we introduced a tenant debt collection Value+ service to assist our property managers with running a more efficient business. We expanded our insurance services in 2017 to enable tenants to purchase renters insurance from within APM, protecting both our property management customers and their tenants. In 2018, we acquired substantially all of the assets of WegoWise, Inc. ("WegoWise"), a provider of cloud-based utility analytics software solutions, and began offering AppFolio Utility Management as a Value+ service to our property management customers in mid-2019. That same year, we released AppFolio Property Manager PLUS ("APM PLUS"), a new tier of APM designed for larger businesses with more complex needs. APM PLUS builds upon the core functionality of APM and also offers data analytics, configurable workflows, and revenue management and optimization functionality for our customers. In January 2019, we acquired Dynasty Marketplace, Inc. ("Dynasty"), a provider of advanced artificial intelligence ("AI") solutions for the real estate vertical, and began offering an AI Leasing Assistant, which we refer to as "Lisa", as a Value+ service to our property management customers in mid-2019. In April 2019, we launched AppFolio Investment Management, which enables real estate investment managers to better manage their investor relationships by increasing transparency and streamlining certain business processes. The significant majority of our customers in the real estate vertical use our property management solutions. We define our property management customer base as the number of customers subscribing to our property management core solutions. Customer count and property management units under management are presented in the table below: Quarter Ended September 30, June 30, March 31, December 31, September 30, June 30, March 31, 2020 2019 Property manager customers 15,352 15,011 14,729 14,385 14,034 13,737 13,409 Property manager units under management (in millions) 5.12 4.94 4.80 4.64 4.41 4.23 4.08 Legal Overview 25 Table of Contents We entered the legal vertical with the acquisition of MyCase in 2012. As stated above, on September 30, 2020, we exited the legal vertical upon the completion of our divestiture of 100% of the issued and outstanding equity interests of MyCase to an affiliate of certain funds advised by Apax Partners LLP, for $193.0 million. As of September 30, 2020, our legal customers directly and indirectly accounted for approximately 10% of our annual revenue. We do not expect there will be a material impact to our operating income as a result of the MyCase Transaction. We formerly defined our legal customer base as the number of customers subscribed to MyCase core solutions, exclusive of free trial periods. Our historical legal customer count is summarized in the table below for the periods presented therein: Quarter Ended September 30, June 30, March 31, December 31, September 30, June 30, March 31, 2020 2019 Law firm customers 11,592 11,305 11,115 10,971 10,781 10,631 10,485 Trends and Uncertainties Related to the COVID-19 Pandemic During early calendar year 2020, the novel coronavirus disease ("COVID-19") spread globally, including to every state in the United States. The global pandemic has created and may continue to create significant uncertainty in a wide variety of industries and markets and has prompted many federal, state, local, and foreign governments to various orders and restrictions in an attempt to control the spread and mitigate the impact of the disease, which may reduce demand for our core solutions and/or Value+ services, impact the productivity of our workforce, reduce our access to capital, and harm our business and results of operations. Such restrictions or orders, or the perception that such restrictions or orders could be implemented, have resulted in business closures, work stoppages, slowdowns and delays, work-from-home policies, travel restrictions and the cancellation or postponement of events. These potential impacts are only amplified by the length of time they remain in place, as the cumulative effect upon our customers and their businesses may only exacerbate potential harm to our business and results of operations. Beginning in March 2020, in an effort to protect our employees and comply with applicable government orders, we restricted non-essential employee travel and transitioned our employees to a remote work environment. We currently expect our employees to continue working remotely at least through the end of the first quarter of 2021. The professionalism and dedication of our workforce to continue effectively developing and supporting our product and service offerings has persisted notwithstanding the current environment, and the morale and focus of our team, even while working remotely, remains high. We take the health and welfare of our people very seriously, and have encouraged safe practices designed to stem the infection and spread of COVID-19 within our workforce and beyond. With all of that said, if the COVID-19 pandemic requires remote working conditions for a prolonged period of time, it could have an adverse impact on the productivity of our employees, which would harm our business and impede our ability to achieve our strategic plan. For example, certain our employees with younger children have been required to respond to ongoing school closures and adapt to a distance learning environment, and may be required to continue to do so for the foreseeable future. Further, we have a limited history of remote work and the long-term impact on, and the resulting types of continuing investments necessary for, our employee base is uncertain. We began fiscal year 2020 with healthy demand for our products and services, many of which are designed to enable our customers to manage their businesses virtually. During the three and nine months ended September 30, 2020, we experienced some variability in demand for certain Value+ services after government restrictions were implemented. We expect demand variability for our products and services could continue as a result of the COVID-19 pandemic, although it is presently unclear whether the cumulative impacts will be positive or negative. We continue to actively communicate with and listen to our customers to best ensure that we are responding to their needs in the current environment with innovative solutions that will not only be beneficial now but also over the long-term as well. However, our ability to interact with customers has been impacted by the current environment. For example, we believe that our inability to meet in-person with current or prospective customers, as well as the cancellation or postponement of Company-sponsored events or third-party events at which our products are featured, may have a negative impact on our business. We continue to monitor developments related to COVID-19 and remain flexible in our response to the challenges presented by the pandemic. To mitigate the adverse impact COVID-19 may have on our business and operations, we have implemented a number of measures to protect the health and safety of our employees, as well as to strengthen our financial position. These efforts include increasing our cash position and eliminating, reducing, or deferring non-essential expenditures, as well as complying with local and state government recommendations to protect our workforce. 26 Table of Contents Our reported results for the three and nine months ended September 30, 2020 may not be reflective of current market conditions, or of our results for any future periods, which may be negatively impacted by the COVID-19 pandemic to a greater extent than the reported period. The impact of the COVID-19 pandemic may also exacerbate other risks discussed in this Quarterly Report. Refer to Item 1A. “Risk Factors” in this Quarterly Report for a complete description of the material risks that we currently face. Key Components of Results of Operations Revenue We charge our customers on a subscription basis for our core solutions and certain of our Value+ services. Our subscription fees are designed to scale to the size of our customers’ businesses. We recognize subscription revenue over time on a straight-line basis over the contract term beginning on the date that our service is made available to the customer. We generally invoice our customers for subscription services in monthly or annual installments, typically in advance of the subscription period. Revenue from subscription services is impacted by a number of factors, including the change in the number and type of our customers, the size and needs of our customers’ businesses, our customer renewal rates, pricing for our solutions, and the level of adoption of our Value+ subscription services by new and existing customers. We also charge our customers usage-based fees for using certain Value+ services. Certain of the usage-based fees are paid by either our customers or clients of our customers. Usage-based fees are charged on a flat fee per transaction basis with no minimum usage commitments. We recognize revenue for usage-based services in the period the service is rendered. We generally invoice our customers for usage-based services on a monthly basis for services rendered in the preceding month. Other usage-based fees are collected at the time of service. Revenue from usage-based services is impacted by a number of factors, including the number of new and existing customers that adopt and utilize our Value+ services, the size and needs of our customers, and our customer renewal rates. We experience limited seasonality in our Value+ services revenue, primarily with respect to certain leasing-related services we provide to our property management customers, including our tenant screening services and new tenant applications which impact electronic payment services revenue. Our property management customers historically have processed fewer applications for new tenants during the fourth quarter. As a result of this seasonal decline in activity, we have typically experienced overall slower sequential revenue growth or a sequential decline in revenue in the fourth quarter of each of our most recent fiscal years. We expect this seasonality to continue in the foreseeable future. We offer assistance to our customers with on-boarding to our core solutions, as well as website design services. We generally invoice our customers for these other services in advance of the services being completed. We recognize revenue for these other services upon completion of the related service. We generate revenue from RentLinx, WegoWise, and Dynasty stand-alone customers by providing services outside of our property management core solution platform. Revenue derived from customers using these services is recorded in Other revenue. Costs and Operating Expenses Cost of Revenue . Cost of revenue consists of fees paid to third-party service providers associated with delivering certain of our Value+ services (including legal fees and costs associated with the delivery and provision of those services, as well as loss reserves and other costs associated with our legal liability to landlord insurance services), personnel-related costs (including salaries, performance-based compensation, benefits, and stock-based compensation) for our employees focused on customer service and the support of our operations, platform infrastructure costs (such as data center operations and hosting-related costs), payment processing fees and allocated shared and other costs. Cost of revenue excludes depreciation of property and equipment, and amortization of capitalized software development costs and intangible assets. We intend to continue to invest in customer service and support, and the expansion of our technology infrastructure as our business grows. Sales and Marketing . Sales and marketing expense consists of personnel-related costs (including salaries, sales commissions, performance-based compensation, benefits, and stock-based compensation) for our employees focused on sales and marketing, costs associated with sales and marketing activities, and allocated shared costs. Marketing activities include advertising, online lead generation, lead nurturing, customer and industry events, and the creation of industry-related content and collateral. Sales commissions and other incremental costs to acquire customers and grow adoption and utilization of our Value+ services by our new and existing customers are deferred and then amortized on a straight-line basis over a period of benefit, which we have determined to be three years. We focus our sales and marketing efforts on generating awareness of our software solutions, creating sales leads, establishing and promoting our brands, and cultivating an educated community of successful and vocal customers. We intend to continue to invest in sales and marketing to increase our customer base and increase the adoption and utilization of Value+ services by our new and existing customers. Research and Product Development. Research and product development expense consists of personnel-related costs (including salaries, performance-based compensation, benefits, and stock-based compensation) for our employees focused on 27 Table of Contents research and product development, fees for third-party development resources, and allocated shared costs. Our research and product development efforts are focused on enhancing functionality and the ease of use of our existing software solutions by adding new core functionality, Value+ services and other improvements, as well as developing new products and services for new and existing markets. We capitalize our software development costs which meet the criteria for capitalization. Amortization of capitalized software development costs is included in depreciation and amortization expense. We intend to continue to invest in research and product development as we continue to introduce new core functionality, roll out new Value+ services, develop new products and services, and expand into adjacent markets and new verticals. General and Administrative. General and administrative expense consists of personnel-related costs (including salaries, a majority of total performance-based compensation, benefits, and stock-based compensation) for employees in our executive, finance, information technology, human resources, corporate development, legal, and administrative organizations. In addition, general and administrative expense includes fees for third-party professional services (including audit, legal, tax, and consulting services), transaction costs related to business combinations, regulatory fines and penalties, other corporate expenses, and allocated shared costs. We intend to continue to incur incremental general and administrative costs associated with supporting the growth of our business. Depreciation and Amortization. Depreciation and amortization expense includes depreciation of property and equipment, amortization of capitalized software development costs, and amortization of intangible assets. We depreciate or amortize property and equipment, software development costs, and intangible assets over their expected useful lives on a straight-line basis, which approximates the pattern in which the economic benefits of the assets are consumed. As we continue to invest in our research and product development organization and the development or acquisition of new technology, we expect to have increased capitalized software development costs and incremental amortization. Further, we may incur additional amortization expense to the extent we enter into additional arrangements to acquire or invest in new technologies or markets adjacent to those we serve today or entirely new verticals. Finally, as we expand our facilities footprint and increase our base of employees, we expect to have increased property and equipment expenditures and incremental depreciation expense. Other Income (Expense), Net. Other income (expense), net includes gains and losses associated with the sale of businesses, property and equipment and investment securities. Interest Expense, Net . Interest expense includes interest paid on outstanding borrowings under our former Credit Agreement. Interest income includes interest earned on investment securities, amortization and accretion of the premium and discounts paid from the purchase of investment securities, and interest earned on notes receivable and on cash deposited in our bank accounts. Provision for (Benefit from) Income Taxes. Provision for (benefit from) income taxes consists of federal and state income taxes in the United States. 28 Table of Contents Results of Operations The following table sets forth our results of operations for the periods presented in dollars (in thousands) and as a percentage of revenue: Three Months Ended September 30, Nine Months Ended September 30, 2020 2019 2020 2019 Amount % Amount % Amount % Amount % Consolidated Statements of Operations Data: Revenue $ 84,086 100.0 % $ 67,935 100.0 % $ 237,624 100.0 % $ 188,650 100.0 % Costs and operating expenses: Cost of revenue (exclusive of depreciation and amortization) (1) 32,752 39.0 25,930 38.2 89,124 37.5 75,239 39.9 Sales and marketing (1) 14,894 17.7 12,636 18.6 43,117 18.1 37,087 19.7 Research and product development (1) 13,454 16.0 10,602 15.6 36,794 15.5 28,422 15.1 General and administrative (1) 12,946 15.4 8,955 13.2 36,303 15.3 25,361 13.4 Depreciation and amortization 6,680 7.9 5,678 8.4 19,751 8.3 16,169 8.6 Total costs and operating expenses 80,726 96.0 63,801 93.9 225,089 94.7 182,278 96.6 Income from operations 3,360 4.0 4,134 6.1 12,535 5.3 6,372 3.4 Other income (expense), net 187,747 223.3 (11) — 187,759 79.0 (68) — Interest expense, net (853) (1.0) (400) (0.6) (1,909) (0.8) (1,324) (0.7) Income before provision for (benefit from) income taxes 190,254 226.3 3,723 5.5 198,385 83.5 4,980 2.6 Provision for (benefit from) income taxes 52,578 62.5 (1,255) (1.8) 39,469 16.6 (26,874) (14.2) Net income $ 137,676 163.7 % $ 4,978 7.3 % $ 158,916 66.9 % $ 31,854 16.9 % (1) Includes stock-based compensation expense as follows (in thousands): Three Months Ended September 30, Nine Months Ended September 30, 2020 2019 2020 2019 Stock-based compensation expense included in costs and operating expenses: Cost of revenue (exclusive of depreciation and amortization) $ 452 $ 334 $ 1,098 $ 1,073 Sales and marketing 367 354 1,069 904 Research and product development 474 353 1,348 1,024 General and administrative 1,803 1,151 3,293 2,430 Total stock-based compensation expense $ 3,096 $ 2,192 $ 6,808 $ 5,431 29 Table of Contents Comparison of the Three and Nine Months Ended September 30, 2020 and 2019 Revenue Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) Core solutions $ 27,117 $ 22,503 $ 4,614 21 % $ 78,080 $ 64,934 $ 13,146 20 % Value+ services 53,392 41,645 11,747 28 % 149,122 114,399 34,723 30 % Other 3,577 3,787 (210) (6) % 10,422 9,317 1,105 12 % Total revenue $ 84,086 $ 67,935 $ 16,151 24 % $ 237,624 $ 188,650 $ 48,974 26 % For the three and nine months ended September 30, 2020 and 2019, we derived approximately 90% of our revenue directly and indirectly from the software solutions, services and data analytics we offer to our real estate vertical customers, most notably from our property management solutions. The majority of our revenue is derived from our property management core solutions and Value+ services utilized by property managers, residents, applicants and owners. The increase in core solutions and Value+ services revenue was mainly attributable to a growing base of property management customers and additional residents, applicants and owners utilizing our Value+ services. During the comparative three and nine months ended September 30, 2020, we experienced growth of 16% and 17%, respectively, in the average number of property management units under management resulting from 9% and 10% growth, respectively, in the average number of property management customers during the same periods. In addition, the increase in core solutions revenue was also attributable to growth of 7% in the average number of law firm customers coupled with a core solutions price increase rolled out during the period. A significant majority of our Value+ services revenue comes directly and indirectly from our customers' use of our electronic payment services, tenant screening services, and insurance services. Our electronic payment services experienced increased demand during the most recent quarter as residents, property managers, owners and customers transacted more business online. It is unclear whether the trend will continue over the long term. During the comparative periods, we also introduced new Value+ services and expanded the functionality of others, which resulted in incremental revenue. The decrease in Other revenue for the three months ended September 30, 2020 compared to the three months ended September 30, 2019 was primarily attributable to a decrease in fees associated with our property management customers upgrading to a new website hosting platform, partially offset by increases in revenue from WegoWise and Dynasty. The increase in Other revenue for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 was primarily attributable to increases in revenue from WegoWise and Dynasty. Cost of Revenue (Exclusive of Depreciation and Amortization) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) Cost of revenue (exclusive of depreciation and amortization) $ 32,752 $ 25,930 $ 6,822 26 % $ 89,124 $ 75,239 $ 13,885 18 % Percentage of revenue 39.0 % 38.2 % 37.5 % 39.9 % The increase in cost of revenue (exclusive of depreciation and amortization) for the three months ended September 30, 2020 compared to the three months ended September 30, 2019, was primarily attributable to increased costs associated with servicing the incremental $16.2 million in revenue over the same period. 30 Table of Contents For the three months ended September 30, 2020, expenditures to third-party service providers related to the delivery of our Value+ services increased $4.0 million, which was directly associated with the increased adoption and utilization of our Value+ services, as evidenced by the $11.7 million increase in Value+ services revenue. Personnel-related costs, including performance-based compensation, necessary to support growth and key investments in the business, increased $2.2 million. Allocated and other costs increased by $0.6 million primarily driven by an increase in platform infrastructure, payment processing and other costs associated with the delivery and provision of our Value+ services, partially offset by a reduction of workplace-related expenses and the reduction of other non-essential expenditures in response to the impact of the COVID-19 pandemic. The increase in cost of revenue (exclusive of depreciation and amortization) for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019, was primarily attributable to increased costs associated with servicing the incremental $49.0 million in revenue over the same period, partially offset by third-party service provider incentives earned of $2.1 million. For the nine months ended September 30, 2020, expenditures to third-party service providers related to the delivery of our Value+ services increased $7.7 million, which was directly associated with the increased adoption and utilization of our Value+ services, as evidenced by the $34.7 million increase in Value+ services revenue. Partially offsetting this volume increase was $2.1 million of annual maximum incentives earned during the period from third-party service providers related to programs intended to increase adoption and utilization of online payments and favorable trends in loss reserves in our insurance services business. Personnel-related costs, including performance-based compensation, necessary to support growth and key investments in the business, increased $4.8 million. Allocated and other costs increased by $1.4 million primarily driven by an increase in platform infrastructure, payment processing and other costs associated with the delivery and provision of our Value+ services, partially offset by a reduction of workplace-related expenses and the reduction of other non-essential expenditures in response to the impact of the COVID-19 pandemic. As a percentage of revenue, cost of revenue (exclusive of depreciation and amortization) fluctuates primarily based on the mix and prices of Value+ services utilized during the period, and investments made in advance of expected revenue generation. Excluding the third-party service provider incentives earned during the period, as a percentage of revenue, cost of revenue (exclusive of depreciation and amortization) increased to 39.0% from 38.2% for the three months ended September 30, 2020 compared to the three months ended September 30, 2019, and decreased to 38.4% from 39.9% for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. These fluctuations in cost as a percentage of revenue were primarily driven by the mix of Value+ services revenue with varying underlying costs. Sales and Marketing Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) Sales and marketing $ 14,894 $ 12,636 $ 2,258 18 % $ 43,117 $ 37,087 $ 6,030 16 % Percentage of revenue 17.7 % 18.6 % 18.1 % 19.7 % The increase in sales and marketing expense for the three months ended September 30, 2020 compared to the three months ended September 30, 2019, was primarily due to a $1.6 million increase in personnel-related costs, including performance-based compensation, necessary to support growth and key investments in the business. Advertising and promotion costs increased by $1.1 million due to increased online advertising and virtual marketing events aimed at increasing revenue and supporting growth in the business. In addition, there was a decrease in allocated and other costs of $0.4 million related to a reduction of workplace-related expenses, the elimination of event-related travel from cancelled or postponed events and the reduction of other non-essential expenditures in response to the impact of the COVID-19 pandemic. The investment we make in sales and marketing is key to acquiring new customers, expanding the adoption and utilization of Value+ services, and growing revenue over time. We intend to continue to invest in sales and marketing to increase our customer base and increase the adoption and utilization of Value+ services over time. The increase in sales and marketing expense for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019, was primarily due to a $6.1 million increase in personnel-related costs, including performance-based compensation, necessary to support growth and key investments in the business. Advertising and promotion costs increased by $0.9 million due to increased online advertising and virtual marketing events aimed at increasing revenue and supporting growth in the business. In addition, there was a decrease in allocated and other costs of $0.9 million related to a reduction of workplace-related expenses, the elimination of event-related travel from cancelled or postponed events and the reduction of other non-essential expenditures in response to the impact of the COVID-19 pandemic. 31 Table of Contents As a percentage of revenue, sales and marketing expense decreased to 17.7% from 18.6% for the three months ended September 30, 2020 compared to the three months ended September 30, 2019 and 18.1% from 19.7% for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019. This leverage in cost as a percentage of revenue was primarily driven by the reduction of event related travel and other non-essential expenditures as a result of the COVID-19 pandemic. Notwithstanding the leverage in cost as a percentage of revenue, we intend to continue to invest in sales and marketing to increase our customer base and increase the adoption and utilization of Value+ services over time. Research and Product Development Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) Research and product development $ 13,454 $ 10,602 $ 2,852 27 % $ 36,794 $ 28,422 $ 8,372 29 % Percentage of revenue 16.0 % 15.6 % 15.5 % 15.1 % The increase in research and product development expense for the three months ended September 30, 2020 compared to the three months ended September 30, 2019, was the result of an increase in personnel-related costs, net of capitalized software development costs, of $3.7 million due to investments in headcount growth within our research and product development organization. This increase was partially offset by a decrease in allocated and other costs of $0.8 million primarily related to a reduction of workplace-related expenses and the reduction of other non-essential expenditures in response to the impact of the COVID-19 pandemic. The increase in research and product development expense for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019, was the result of an increase in personnel-related costs, net of capitalized software development costs, of $9.3 million due to investments in headcount growth within our research and product development organization. This increase was partially offset by a decrease in allocated and other costs of $0.9 million primarily related to a reduction of workplace related expenses and the reduction of other non-essential expenditures in response to the impact of the COVID-19 pandemic. General and Administrative Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) General and administrative $ 12,946 $ 8,955 $ 3,991 45 % $ 36,303 $ 25,361 $ 10,942 43 % Percentage of revenue 15.4 % 13.2 % 15.3 % 13.4 % The increase in general and administrative expense for the three months ended September 30, 2020 compared to the three months ended September 30, 2019 was primarily due to a $1.8 million increase in personnel-related costs, including performance-based compensation, due to investments in headcount growth within our general and administrative organizations. In addition, there was an increase in professional services fees and other costs of $2.3 million related to the MyCase Transaction. The increase in general and administrative expense for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019, was primarily due to a $5.0 million increase in personnel-related costs, including performance-based compensation, due to investments in headcount growth within our general and administrative organizations. In addition, there was a $4.3 million expense recorded during the current period related to the probable loss associated with the FTC Investigation. There was also an increase in professional services fees and other costs of $2.3 million related to the MyCase Transaction. Allocated and other costs decreased $0.7 million primarily due to a reduction of workplace-related expenses and the reduction of other non-essential expenditures in response to the impact of the COVID-19 pandemic. We expect stock-based compensation expense will continue to decrease for certain executives in light of our adoption of the Long-Term Cash Bonus Plan in 2018. No accrual has yet been made under this plan as a result of the high degree of uncertainty regarding potential future payments under the plan. 32 Table of Contents Depreciation and Amortization Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) Depreciation and amortization $ 6,680 $ 5,678 $ 1,002 18 % $ 19,751 $ 16,169 $ 3,582 22 % Percentage of revenue 7.9 % 8.4 % 8.3 % 8.6 % The increase in depreciation and amortization expense for the three and nine months ended September 30, 2020 compared to the three and nine months ended September 30, 2019, was primarily due to increased amortization expense associated with higher accumulated capitalized software development balances. Other Income (Expense), net Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) Other income (expense), net $ 187,747 $ (11) $ 187,758 n/a $ 187,759 $ (68) $ 187,827 n/a Percentage of revenue 223.3 % — % 79.0 % — % The increase in other income (expense), net for the three and nine months ended September 30, 2020 compared to the three and nine months ended September 30, 2019, was primarily due to the gain of $187.6 million associated with the MyCase Transaction. We expect to recognize additional other income beginning in the fourth quarter of 2020 relating to income from certain post-closing transition services to be provided by the Company to MyCase. Provision for (Benefit from) Income Taxes Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 Amount % 2020 2019 Amount % (dollars in thousands) Provision for (benefit from) income taxes $ 52,578 $ (1,255) $ 53,833 (4,289) % $ 39,469 $ (26,874) $ 66,343 (247) % Percentage of revenue 62.5 % (1.8) % 16.6 % (14.2) % We calculate our provision for income taxes on a quarterly basis by applying an estimated annual effective tax rate to income from operations and by calculating the tax effect of discrete items recognized during the quarter. For the three and nine months ended September 30, 2020, we recorded income tax expense of $52.6 million and $39.5 million, respectively. The tax provision for the three months ended September 30, 2020 includes a discrete tax expense of $47.9 million relating to the MyCase Transaction which includes $48.9 million of current tax expense less a $1.0 million benefit from the reversal of deferred tax liabilities. The effective tax rate as compared to the U.S. federal statutory rate of 21% differs primarily due to the significance of the benefits associated with stock-based compensation expense and research and development tax credits in relation to the forecasted pre-tax results for the year. For the three and nine months ended September 30, 2019, we recorded an income tax benefit of $1.3 million and $26.9 million, respectively. The tax benefits recorded were primarily due to the release of the valuation allowance during the second quarter of 2019. Liquidity and Capital Resources Cash and Cash Equivalents As of September 30, 2020, our principal sources of liquidity were cash and cash equivalents and investment securities, which had an aggregate balance of $181.9 million. During the nine months ended September 30, 2020, our cash and cash equivalents increased primarily as a result of the proceeds from the MyCase Transaction. 33 Table of Contents Working Capital As of September 30, 2020, we had working capital of $145.7 million, compared to working capital of $14.3 million as of December 31, 2019. The increase in our working capital was primarily due to an increase in cash and cash equivalents as a result of the net proceeds from the MyCase Transaction, an increase in investment securities-current, a decrease in other current liabilities due to the payment of contingent consideration related to the Dynasty acquisition, a decrease in deferred revenue, and an increase in accounts receivable primarily driven by increased usage of our Value+ services. The increase in our working capital was partially offset by an increase in income taxes payable related to the MyCase Transaction, and increases in accrued expenses, accounts payable and accrued employee expenses. Liquidity Requirements We believe that our existing cash and cash equivalents, investment securities, and cash generated from operating activities will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. Capital Requirements Our future capital requirements will depend on many factors, including continued market acceptance of our software solutions, changes in the number of our customers, adoption and utilization of our Value+ services by new and existing customers, the timing and extent of the introduction of new core functionality, products and Value+ services, the timing and extent of our expansion into adjacent or new markets, the timing and extent of our investments across our organization, and the impact of the COVID-19 pandemic on the customers we serve and on our business. In addition, we have in the past entered into, and may in the future enter into, arrangements to acquire or invest in new technologies or markets adjacent to those we serve today or entirely new verticals. Furthermore, our Board of Directors has authorized our management to repurchase up to $100.0 million of shares of our Class A common stock from time to time. To date, we have repurchased $4.2 million of our Class A common stock under the Share Repurchase Program. For additional information regarding our share repurchase program, refer to Note 10, Share Repurchase Program, of our Condensed Consolidated Financial Statements. Cash Flows The following table summarizes our cash flows for the periods indicated (in thousands): Nine Months Ended September 30, 2020 2019 Net cash provided by operating activities $ 45,216 $ 23,413 Net cash provided by (used in) investing activities 152,542 (70,728) Net cash used in financing activities (69,541) (6,639) Net increase (decrease) in cash, cash equivalents and restricted cash $ 128,217 $ (53,954) Cash Provided by Operating Activities Our primary source of operating cash inflows is cash collected from our customers in connection with their use of our core solutions and Value+ services. Our primary uses of cash from operating activities are for personnel-related expenditures and third-party costs incurred to support the delivery of our software solutions. For the nine months ended September 30, 2020, net cash provided by operating activities was $45.2 million resulting from net income of $158.9 million, adjusted by the gain on the sale of MyCase of $187.6 million, non-cash charges of $52.6 million and a net increase in our operating assets and liabilities of $21.3 million. The non-cash charges primarily consist of an increase in deferred taxes of $22.9 million, $19.8 million of depreciation and amortization costs, stock-based compensation expense of $6.8 million, and $3.0 million of amortization of operating lease right-of-use assets. The net increase in our operating assets and liabilities was mostly attributable to a $16.5 million increase in other liabilities primarily driven by income taxes payable due to the MyCase Transaction, a $5.9 million increase in accrued expenses which was primarily due to a $4.3 million accrual recorded during the current period related to our reasonable estimate of the probable loss associated with the FTC Investigation, a $1.9 million increase in accrued employee expenses primarily due to an increase in accrued paid time off, and a $0.8 million increase in deferred revenue driven by growth in the number of customers invoiced during the period. These increases were partially offset by a $2.2 million increase in accounts receivable primarily driven by growth of our Value+ services, a $1.1 million decrease in operating lease liabilities, and a $0.9 million increase in prepaid expenses and other current assets. 34 Table of Contents For the nine months ended September 30, 2019, net cash provided by operating activities was $23.4 million resulting from net income of $31.9 million, adjusted by non-cash charges of $2.3 million and a net decrease in our operating assets and liabilities of $6.2 million. The non-cash charges primarily consist of a one-time benefit of $27.0 million related to the release of the valuation allowance for our deferred tax assets, offset by $16.2 million of depreciation and amortization of our property and equipment and capitalized software development costs, $5.4 million of stock-based compensation and $3.0 million of amortization of operating lease right-of-use ("ROU") assets in accordance with ASU 2016-02. The net decrease in our operating assets and liabilities was mostly attributable to an increase of $4.4 million in prepaid expenses and other current assets, a $2.9 million decrease in operating lease liabilities, and a $2.8 million increase in accounts receivable primarily driven by growth of our Value+ services. The decrease in our operating assets and liabilities was partially offset by a $1.1 million decrease in other assets, a $1.0 million increase in deferred revenue, a $1.0 million increase in other liabilities, and a $0.5 million increase in accrued employee expenses. Cash Provided by (Used in) Investing Activities Cash provided by (used in) investing activities is generally comprised of proceeds from divestitures, purchases, maturities and sales of investment securities, purchases of property and equipment, additions to capitalized software development, and cash paid for business acquisitions. For the nine months ended September 30, 2020, investing activities provided $152.5 million in cash primarily due to net proceeds from the MyCase Transaction of $191.4 million and the sales and maturities of investment securities of $13.9 million and $13.3 million, respectively. These sources of cash were partially offset by purchases of investment securities of $29.9 million, capitalized software development costs of $19.7 million, and capital expenditures of $16.6 million to purchase property and equipment for the continued growth and expansion of our business. For the nine months ended September 30, 2019, investing activities used $70.7 million in cash primarily due to $54.0 million used to acquire Dynasty, as well as capitalized software development costs of $15.7 million for the continued investment in our software development, purchases of investment securities of $10.7 million, and capital expenditures of $4.1 million to purchase property and equipment for the continued growth and expansion of our business. These uses were partially offset by sales and maturities of investment securities of $2.8 million and $11.0 million, respectively. Cash Used in Financing Activities Cash used in financing activities is generally comprised of proceeds from the exercise of stock options, net share settlements for employee tax withholdings associated with the vesting of RSUs, the payment of contingent consideration under acquisition arrangements, activities associated with our former Credit Facility, and activities related to the repurchase of our Class A common stock. For the nine months ended September 30, 2020, financing activities used $69.5 million in cash primarily as a result of the payment of all outstanding amounts due under the Credit Facility of $99.6 million, net share settlements for employee tax withholdings associated with the vesting of RSUs of $11.0 million, payment of contingent consideration related to the Dynasty acquisition of $6.0 million, and the repurchase of outstanding shares of Class A common stock in the amount of $4.2 million. These uses of cash were partially offset by net proceeds from the Revolving Facility of $50.8 million. For the nine months ended September 30, 2019, financing activities used $6.6 million in cash primarily as a result of net share settlements for employee tax withholdings associated with the vesting of RSUs of $5.5 million, as well as principal payments on debt of $2.6 million, and payments of debt issuance costs of $0.4 million, partially offset by proceeds from issuance of debt of $1.7 million and proceeds from stock option exercises of $0.3 million. Contractual Obligations and Other Commitments There have been no material changes to our contractual obligations and other commitments as disclosed in our Annual Report. Off-Balance Sheet Arrangements As of September 30, 2020, we did not have any off-balance sheet arrangements. 35 Table of Contents Critical Accounting Policies and Estimates Our Condensed Consolidated Financial Statements and the related notes are prepared in accordance with accounting principles generally accepted in the United States. The preparation of our Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting period. COVID-19 has created and may continue to create significant uncertainty in a wide variety of industries and markets, which may reduce demand for our core solutions and/or Value+ services, impact the productivity of our workforce, reduce our access to capital, and harm our business and results of operations. As of the date of our Condensed Consolidated Financial Statements, we are not aware of any specific event or circumstance that would require us to update our estimates or judgments, or to revise the carrying value of our assets or liabilities. However, these estimates may change as new events occur and additional information is obtained, which may result in changes being recognized in our consolidated financial statements in future periods. While we considered the effects of COVID-19 in our estimates and assumptions, due to the current level of uncertainty over the economic and operational impacts of COVID-19 on our business, there may be other judgments and assumptions that were not currently considered. Such judgments and assumptions could result in a meaningful impact to our financial statements in future periods. Actual results could differ from those estimates and any such differences may have a material impact on our financial statements. There have been no changes to our critical accounting policies and estimates described in our Annual Report that have had a material impact on our Condensed Consolidated Financial Statements and related notes. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, refer to Note 2, Summary of Significant Accounting Policies , of our Condensed Consolidated Financial Statements. Item 3. Qualitative and Quantitative Disclosure about Market Risk Interest Rate Risk Short-Term Investments As of September 30, 2020, we had cash and cash equivalents of $144.0 million consisting of bank deposits, money market funds, and treasury securities, and $37.8 million of investment securities consisting of treasury securities, United States government agency securities and corporate bonds. The primary objective of our investment policy is to invest in securities to support our liquidity and capital needs. We have not purchased investments for trading or speculative purposes and have not used any derivative financial instruments to manage our credit risk or interest rate risk exposure. Our investment securities are exposed to market risk due to interest rate fluctuations. While fluctuations in interest rates do not impact our interest income from our investment securities as all of these securities have fixed interest rates, changes in interest rates may impact the fair value of the investment securities. Since our investment securities are held as available for sale, all changes in fair value impact our other comprehensive income unless an investment security is considered impaired in which case changes in fair value are reported in other expense. As of September 30, 2020 a hypothetical 100 basis point change in interest rates would not have resulted in a material change in the fair value of our investment securities. This estimate is based on a sensitivity model which measured an instant change in interest rates by 100 basis points as of September 30, 2020. Credit Facility We were exposed to interest rate risk as a result of our Credit Facility prior to its termination. Outstanding borrowings under the Credit Facility accrued interest as described in Note 8, Long-Term Debt, of our Condensed Consolidated Financial Statements. Our borrowings under the Credit Facility were subject to interest rate fluctuations, which could have had a material impact on our cash flows and results of operations depending on the magnitude of the fluctuations and the outstanding borrowings. In order to determine the potential impact of changes in interest rates on our cash flows and result of operations, we performed a sensitivity analysis. A hypothetical 100 basis point increase in interest rates during the period ended September 30, 2020 would not have had a material impact on our cash flows or results of operations. In connection with the MyCase Transaction, and as required by the terms of the Credit Agreement, the Credit Agreement was terminated and all obligations outstanding under the Term Loan and Revolving Facility thereunder, including all guarantees and security interests granted with respect to such obligations, were satisfied in full with proceeds from the MyCase Transaction and extinguished. 36 Table of Contents Inflation Risk We have not been exposed to, nor do we anticipate being exposed to, material risks due to changes in inflation rates. Foreign Currency Risk We have not been exposed to, nor do we anticipate being exposed to, material risks relating to foreign currency fluctuations.