BLACKBAUD 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 in conjunction with our unaudited, condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis presents financial information denominated in millions of dollars which can lead to differences from rounding when compared to similar information contained in the unaudited, condensed consolidated financial statements and related notes which are primarily denominated in thousands of dollars. Executive Summary We are the leading software provider exclusively dedicated to powering social impact. Serving the nonprofit and education sectors, companies committed to social responsibility and individual change makers, our essential software is built to accelerate impact in fundraising, nonprofit financial management, digital giving, grantmaking, corporate social responsibility and education management. A remote-first company, we have operations in the United States, Australia, Canada, Costa Rica and the United Kingdom, supporting users in 100+ countries. Our revenue is primarily generated from the following sources: (i) charging for the use of our software solutions in cloud and hosted environments; (ii) providing payment and transactional services; (iii) providing Impact-as-a-Service ™ digital educational content; (iv) providing software maintenance and support services; and (v) providing professional services, including implementation, consulting, training, analytic and other services. Update on Five Key Operational Initiatives 1 Product Innovation and Delivery 2 Bookings Growth and Acceleration 3 Transactional Revenue Optimization and Expansion 4 Modernized Approach to Pricing and Multi-Year Customer Contracts 5 Keen Attention to Cost Management 1. Product Innovation and Delivery Product is core at Blackbaud, and we strive to bring increased value to our customers through their software subscriptions with improved and innovative capabilities. For example, we recently released a new, next generation donation form in Raiser’s Edge NXT with the goal of increasing the conversion rate and donations our customers raise. We match the new donation form with Prospect Insights, which utilizes artificial intelligence ("AI") to identify and qualify candidates for major gifts. For years, we have been using AI-enabled capabilities in our analytics offerings. We are expanding our strategy into next-generation and generative AI technology that addresses specific challenges of our customers. As recently announced, we will be rolling out an extensive new set of capabilities across our product portfolio over upcoming quarters, including: • AI for Peer-to-Peer (P2P) Fundraisers: Enabling P2P participants to use Generative AI-based features to make sharing their own story easier and more effective for their fundraiser. • AI for Online Giving: Providing a personalized experience to online donors through predictive AI capabilities. • AI for Major Giving Officers: Expanding Prospect Insights to include AI-driven insights into planned and major giving vehicles and likelihood. • AI for Donor Stewardship: Enabling organizations to automate the creation of key donor stewardship documents such as thank you notes through a built-in Generative AI experience. 24 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) • AI for Educators: Assisting teachers with personalized, AI-driven content that has appropriate guardrails to drive more classroom engagement. • AI for School Administrators: Leveraging AI to automate review and recommendations for financial aid submissions. • AI for Corporate Impact: Empowering Corporate Social Responsibility teams to capture, visualize and tell the story of their corporate social impact missions through inclusion of modern AI services. 2. Bookings Growth and Acceleration We drove strong bookings performance in the first quarter, up significantly versus last year, led by our corporate sector (YourCause and EVERFI solutions) which more than doubled its bookings over the first quarter of 2022. We signed several notable large contracts during the second quarter. As previously disclosed, there can be volatility quarter-to-quarter on bookings. 3. Transactional Revenue Optimization and Expansion Transactional revenue, which is about one-third of total revenue, has proven to be resilient so far in 2023 following the lower average donation sizes we experienced during the fourth quarter of 2022. A rate increase on Blackbaud Merchant Services in the U.S. took effect on August 1, 2023, which is incremental to the January 2023 rate change previously disclosed. Our Blackbaud Tuition Management and JustGiving platforms continue to perform well against plan. And as we look ahead, our teams are hard at work to drive innovation across our payments solutions that are a win-win for both our customers and Blackbaud. We have already introduced our two fee cover models, and we are also looking at ways to optimize our payments solutions to drive a better donor experience. 4. Modernized Approach to Pricing and Multi-Year Contracts Last summer, we put in place an updated pricing policy primarily for our social sector customers that directly reflects the value we provide to them, is in-line with the broader market and reflects the inflationary pressures that all businesses are facing. In November 2022, we started notifying customers with a March 2023 contract renewal that we would be making important contract changes. First, we are offering 3-year contract renewal terms as our standard, replacing one-year renewal terms. This process was already being implemented outside of the pricing changes. Second, we are implementing a more significant rate increase on the 1-year renewal option versus the 3-year renewal option. And third, the 3-year renewal option includes annual rate increases. Our 3-year renewal options did not historically include annual rate increases. These efforts are well on their way. We have already notified customers with December 2023 contract renewals of the new terms. Through July 2023, nearly 70% of our 2023 contracts eligible for renewal rate increases have already renewed. The close day-to-day management of renewals, the mix of 3-year and 1-year contracts, and the impact of pricing are progressing well, and we expect more impact from the compounding effect of these rate increases over time as we layer in future year contract renewals and annual rate increases. For example, over 50% of our planned 2023 revenue will renew in a little over 3 years and approximately 35% of that renewable base is expected to renew this year. These contracts are renewing every day and create revenue growth that we expect to accelerate with each successive quarter this year. We expect that to lead to an even greater impact in 2024, 2025 and beyond as we begin to see the full-year impact of the rate increases. Approximately 30% of the renewable base is up for renewal in 2024 and more than 20% in 2025. The adoption of 3-year renewals as a standard, with more customers opting for this option than we originally expected, are expected to have an added benefit of higher retention which provides greater revenue assurance and predictability. Looking even further ahead, the cycle starts fresh in 2026 as the 2023 signed contracts will begin to renew. We expect that this will be a sustainable and meaningful revenue growth stream for us. 5. Keen Attention to Cost Management We closed four legacy data centers during 2022, and we plan to close more this year. We renegotiated key vendor contracts including Microsoft Azure and AWS and made the difficult decision to further reduce our staff in the first quarter. Because we have organized to achieve much better scale efficiencies, we have significantly reduced our headcount since the third quarter of 2022. Our goal is to run the business at about this headcount level for the foreseeable future, such that our revenue growth will better drive margin acceleration. Second Quarter 2023 Form 10-Q 25 Table of Contents Blackbaud, Inc. (Unaudited) Financial Summary Total revenue ($M) Income (Loss) from operations ($M) YoY Growth (%) YoY Growth (%) Total revenue increased by $6.1 million and $10.7 million during the three and six months ended June 30, 2023, respectively, when compared to the same periods in 2022, driven largely by the following: + Growth in recurring revenue primarily related to: • increases in transactional recurring revenue of $6.0 million and $11.0 million, respectively, primarily due to increases in volume for our Blackbaud Tuition Management and JustGiving solutions and positive results related to a pricing initiative we implemented at the beginning of 2023; also offsetting the increases in transactional recurring revenue were decreases related to fluctuations in foreign currency exchange rates of $0.6 million and $2.2 million, respectively; and • increases in contractual recurring revenue of $3.9 million and $7.0 million, respectively, related to the performance of our cloud solutions and, to a lesser extent, the early impact of our pricing initiatives; partially offset by decreases in maintenance revenue as customers migrate to our cloud solutions; also offsetting the increases in contractual recurring revenue were decreases related to fluctuations in foreign currency exchange rates of $0.3 million and $1.1 million, respectively - Decreases in one-time service and other revenue primarily related to: • decreases in one-time consulting revenue due primarily to less sales of creative services and implementation and customization services, in line with our multi-year strategic shift from a license-based and one-time services business model to a cloud subscription business model, which generally requires less implementation and customization services; and • decreases in one-time analytics revenue as analytics are generally integrated in our cloud solutions For additional information on the impact of foreign currency fluctuations on our financial results, see Foreign Currency Exchange Rates below on page 47 . 26 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) We have a number of multi-year pricing initiatives underway, some to bring our pricing in line with the market while others are model changes that are expected to drive greater revenue for both us and our customers. As a result, we expect to see an acceleration in growth in the second half of 2023 when compared to the first half of the year as we begin to see the full-year effect of some of these pricing initiatives. We expect that the one-time services and other revenue will continue to significantly decrease during 2023 compared to 2022 driven by our continued migration to the cloud in our core business. Income from operations increased by $0.2 million during the three months ended June 30, 2023, when compared to the same period in 2022, driven largely by the following: + Decreases in compensation costs other than stock-based compensation of $10.1 million and commission expense of $0.8 million due to our targeted workforce reductions discussed below + Increase in total revenue, as described above + Decrease in acquisition and disposition-related costs of $3.1 million primarily related to the release of $1.4 million in accrued contingent consideration related to our Kilter acquisition during the three months ended June 30, 2023 and a $2.0 million noncash impairment of certain insignificant intangible assets that were held for sale during the three months ended June 30, 2022 which did not reoccur in the comparable 2023 period + A $2.3 million noncash impairment charge during the three months ended June 30, 2022 against previously capitalized software development costs that reduced the carrying value of those assets to zero. The impairment charge resulted primarily from our decision to end customer support for certain solutions and did not reoccur in 2023 + Decrease in third-party contractor costs of $1.8 million primarily due to a decrease in our use of third-party software developers + Decrease in hosting and data center costs of $1.5 million as we continue to migrate our cloud infrastructure to leading public cloud service providers and make investments in security; currently, we expect our cloud infrastructure migration efforts and increased level of cybersecurity investments to continue for the foreseeable future + Decrease in other corporate costs of $1.2 million primarily related to the release of certain accrued tax liabilities due to favorable sales tax rulings + Net decrease of $0.9 million primarily related to a decrease in rent and utilities, partially offset by higher third-party software costs due to the number of licenses needed and also price increases for the software being used - Increase in Security Incident-related expenses of $18.4 million. See "Security Incident update" below. - Increase in stock-based compensation expense of $5.5 million primarily due to estimated overall Company performance against 2023 goals, partially offset by the targeted workforce reductions during the fourth quarter of 2022 and first quarter of 2023 - Increase in transaction-based costs of $1.2 million related to the increase in the volume of transactions for which we process payments and, to a lesser extent, increases in vendor rates - Increase in advertising costs of $1.1 million - Net decrease of $0.8 million due to an increase in amortization of capitalized software and content development costs, partially offset by an increase in software and content development costs that were required to be capitalized under the internal-use software guidance - Increase in amortization of intangible assets from business combinations of $0.7 million due to our acquisition of EVERFI Second Quarter 2023 Form 10-Q 27 Table of Contents Blackbaud, Inc. (Unaudited) Income from operations decreased by $3.7 million during the six months ended June 30, 2023, when compared to the same period in 2022, driven largely by the following: - Increase in Security Incident-related expenses of $29.0 million. See "Security Incident update" below. - Increase in stock-based compensation expense of $7.6 million primarily due to 2022 performance-based equity award adjustments and estimated overall Company performance against 2023 goals, partially offset by the targeted workforce reductions during the fourth quarter of 2022 and first quarter of 2023 - Increase in transaction-based costs of $3.3 million related to the increase in the volume of transactions for which we process payments and, to a lesser extent, increases in vendor rates - Net decrease of $1.7 million due to an increase in amortization of capitalized software and content development costs, partially offset by an increase in software and content development costs that were required to be capitalized under the internal-use software guidance - Increase in amortization of intangible assets from business combinations of $1.3 million due to our acquisition of EVERFI - Net increase of $1.0 million primarily related to higher third-party software costs due to the number of licenses needed and also price increases for the software being used, partially offset by a decrease in rent and utilities + Decreases in compensation costs other than stock-based compensation of $17.8 million and commission expense of $1.5 million, partially offset by a corresponding increase in severance costs of $4.5 million due to our targeted workforce reductions discussed below + Increase in total revenue, as described above + Decrease in third-party contractor costs of $3.7 million primarily due to a decrease in our use of third-party software developers + Decrease in hosting and data center costs of $3.6 million as we continue to migrate our cloud infrastructure to leading public cloud service providers and make investments in security; currently, we expect our cloud infrastructure migration efforts and increased level of cybersecurity investments to continue for the foreseeable future + Decrease in acquisition and disposition-related costs of $3.5 million primarily related to the release of $1.4 million in accrued contingent consideration related to our Kilter acquisition during the six months ended June 30, 2023 and a $2.0 million noncash impairment of certain insignificant intangible assets that were held for sale during the three months ended June 30, 2022 which did not reoccur in the comparable 2023 period + A $2.3 million noncash impairment charge during the six months ended June 30, 2022 against previously capitalized software development costs that reduced the carrying value of those assets to zero. The impairment charge resulted primarily from our decision to end customer support for certain solutions + Decrease in other corporate costs of $1.6 million primarily related to the release of certain accrued tax liabilities due to favorable sales tax rulings We are continuing to make critical investments in the business in areas such as digital marketing, innovation, cybersecurity, customer success and our continued shift of cloud infrastructure to leading public cloud service providers. Our profitability during the first half of 2023 reflects some of these incremental investments. In the second half of 2023, we expect our financial performance to improve each quarter as our pricing and cost initiatives continue to take hold. We continuously seek opportunities to optimize our portfolio of solutions to focus time and resources on innovation that will have the greatest impact for our customers and the markets we serve, and drive the highest return on investment. To that end, we will continue to simplify and rationalize our portfolio through product sunsets and divestitures of non-core businesses and technologies. 28 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Gross dollar retention Our recurring subscription contracts are typically for a term of three years at contract inception. We have been for several years successfully shifting our legacy customer base away from annual renewals and moving them onto multi-year renewal contracts. A key factor to our overall success is the renewal and expansion of our existing subscription agreements with our customers. Management uses gross dollar retention in analyzing our success at delighting our customers with innovative and cloud solutions. Gross dollar retention is defined as contracted annual recurring revenue ("CARR") divided by beginning CARR with a measurement period of twelve months. For the twelve months ended June 30, 2023, our gross dollar retention was approximately 90%. This gross dollar retention rate is relatively consistent with our rate for the full year ended December 31, 2022. We are continually investing in innovation, which we believe will increase gross dollar retention over the long-term. Although some customer attrition is normal, our new contract pricing and renewal model (as described above on page 24) does not appear to have had a significant impact on customer attrition to date. Balance sheet and cash flow At June 30, 2023, our cash and cash equivalents were $29.0 million and the carrying amount of our debt under the 2020 Credit Facility was $786.8 million. Our net leverage ratio was 2.67 to 1.00 . During the six months ended June 30, 2023, we generated $75.0 million in cash from operations, had a net decrease in borrowings of $13.8 million, and had aggregate cash outlays of $31.5 million for purchases of property and equipment and capitalized software and content development costs. Security Incident update As discussed in Note 8 to our unaudited, condensed consolidated financial statements included in this report, t otal costs related to the Security Incident exceeded the limit of our insurance coverage in the first quarter of 2022 . Accordingly, the Security Incident has negatively impacted, and we expect it to continue for the foreseeable future to negatively impact, our GAAP profitab ility and GAAP cash flow (see discussion regarding non-GAAP adjusted free cash flow on page 42 ). For the three and six months ended June 30, 2023, we incurred net pre-tax expenses of $26.8 million and $44.6 million, respectively, related to the Security Incident, which included $7.0 million and $14.6 million, respectively, for ongoing legal fees and additional accruals for loss contingencies of $19.8 million and $30.0 million, respectively. During the six months ended June 30, 2023, we had net cash outlays of $15.8 million related to the Security Incident, which included ongoing legal fees and the $3.0 million civil penalty paid during the first quarter of 2023 related to the SEC settlement (as discussed in Note 8). In line with our policy, legal fees are expensed as incurred. For full year 2023, we currently expect net pre-tax expense of approximately $20.0 million to $30.0 million and net cash outlays of approximately $25.0 million to $35.0 million for ongoing legal fees related to the Security Incident. Not included in these ranges are our previous settlements or current accruals for loss contingencies related to the matters discussed below. As of June 30, 2023, we have recorded approximately $50.0 million in aggregate liabilities for loss contingencies based primarily on recent negotiations with certain governmental agencies related to the Security Incident that we believe we can reasonably estimate in accordance with our loss contingency procedures described in Note 8. It is reasonably possible that our estimated or actual losses may change in the near term for those matters and be materially in excess of the amounts accrued, but we are unable at this time to reasonably estimate the possible additional loss. Second Quarter 2023 Form 10-Q 29 Table of Contents Blackbaud, Inc. (Unaudited) There are other Security Incident-related matters, including customer claims, customer constituent class actions and governmental investigations, for which we have not recorded a liability for a loss contingency as of June 30, 2023 because we are unable at this time to reasonably estimate the possible loss or range of loss. Each of these matters could, separately or in the aggregate, result in an adverse judgment, settlement, fine, penalty or other resolution, the amount, scope and timing of which we are currently unable to predict, but could have a material adverse impact on our results of operations, cash flows or financial condition. Fixed asset impairment On July 31, 2023, we entered into a sublease for a portion of our Washington, DC office location, which we previously closed in February 2023 to align with our remote-first workforce strategy. We considered our entry into the sublease an impairment indicator. As a result, we currently expect to incur pre-tax costs between $6.0 million and $8.0 million in the third quarter of 2023, consisting of noncash impairment charges against certain operating lease right-of-use assets and property and equipment assets. 30 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Results of Operations Comparison of the three and six months ended June 30, 2023 and 2022 Revenue and Cost of Revenue Recurring Revenue ($M) Cost of revenue ($M) Gross profit ($M) and gross margin (%) YoY Growth (%) YoY Growth (%) Recurring revenue is comprised of fees for the use of our subscription-based software solutions, which includes providing access to cloud solutions, Impact-as-a-Service ™ digital educational content, hosting services, payment services, online training programs and subscription-based analytic services. Recurring revenue also includes fees from maintenance services for our on-premises solutions, services included in our renewable subscription contracts, retained and managed services contracts that we expect to have a term consistent with our cloud solution contracts, and variable transaction revenue associated with the use of our solutions. Cost of recurring revenue is primarily comprised of compensation costs for customer support and production IT personnel, hosting and data center costs, third-party contractor expenses, third-party royalty and data expenses, allocated depreciation, facilities and IT support costs, amortization of intangible assets from business combinations, amortization of software development costs, transaction-based costs related to payments services including remittances of amounts due to third-parties and other costs incurred in providing support and recurring services to our customers. Our customers continue to prefer cloud subscription offerings with integrated analytics, training and payment services. We intend to continue focusing on innovation, quality and integration of our cloud solutions, which we believe will drive future revenue growth. Second Quarter 2023 Form 10-Q 31 Table of Contents Blackbaud, Inc. (Unaudited) Recurring revenue increased by $9.9 million, or 3.9%, and $18.0 million, or 3.6%, during the three and six months ended June 30, 2023, respectively, when compared to the same periods in 2022, driven primarily by the following: + Increases in transactional recurring revenue of $6.0 million and $11.0 million, respectively, primarily due to increases in volume for our Blackbaud Tuition Management and JustGiving solutions and positive results related to a pricing initiative we implemented at the beginning of 2023; also offsetting the increases in transactional recurring revenue were decreases related to fluctuations in foreign currency exchange rates of $0.6 million and $2.2 million, respectively + Increases in contractual recurring revenue of $3.9 million and $7.0 million, respectively, related to the performance of our cloud solutions and, to a lesser extent, the early impact of our pricing initiatives; partially offset by decreases in maintenance revenue as customers migrate to our cloud solutions; also offsetting the increases in contractual recurring revenue were decreases related to fluctuations in foreign currency exchange rates of $0.3 million and $1.1 million, respectively For additional information on the impact of foreign currency fluctuations on our financial results, see Foreign Currency Exchange Rates below on page 47 . Cost of recurring revenue decreased by $0.6 million, or 0.5%, during the three months ended June 30, 2023, when compared to the same period in 2022, driven primarily by the following: - Decrease in compensation costs other than stock-based compensation of $2.6 million primarily due to our targeted workforce reductions discussed above - Decrease in hosting and data center costs of $1.5 million as we continue to migrate our cloud infrastructure to leading public cloud service providers and make investments in security; currently, we expect our cloud infrastructure migration efforts and increased level of cybersecurity investments to continue for the foreseeable future + Increase in amortization of software development costs of $1.4 million due to our continued investments in the innovation and security of our solutions + Increase in transaction-based costs of $1.2 million related to the increase in the volume of transactions for which we process payments and, to a lesser extent, increases in vendor rates + Increase in amortization of intangible assets from business combinations of $0.7 million primarily due to our acquisition of EVERFI in December 2021 Cost of recurring revenue increased by $1.8 million, or 0.8%, during the six months ended June 30, 2023, when compared to the same period in 2022, driven primarily by the following: + Increase in transaction-based costs of $3.3 million related to the increase in the volume of transactions for which we process payments and, to a lesser extent, increases in vendor rates + Increase in amortization of software development costs of $2.7 million due to our continued investments in the innovation and security of our solutions + Increase in amortization of intangible assets from business combinations of $1.4 million primarily due to our acquisition of EVERFI in December 2021 + Increase in third-party software costs of $1.1 million primarily related to a higher number of licenses needed and also price increases for the software being used + Increase in stock-based compensation costs of $0.7 million primarily due to 2022 performance-based equity award adjustments and estimated overall Company performance against 2023 goals, partially offset by the targeted workforce reductions during the fourth quarter of 2022 and first quarter of 2023 - Decrease in compensation costs other than stock-based compensation of $4.8 million primarily due to our targeted workforce reductions discussed above - Decrease in hosting and data center costs of $3.6 million as we continue to migrate our cloud infrastructure to leading public cloud service providers and make investments in security; currently, we expect our cloud infrastructure migration efforts and increased level of cybersecurity investments to continue for the foreseeable future Recurring gross margin increased by 190 and 120 basis points for the three and six months ended June 30, 2023, respectively, when compared to the same periods in 2022, primarily due to the increases in recurring revenue outpacing the changes in cost of recurring revenue. 32 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) One-time services and other Revenue ($M) Cost of revenue ($M) Gross profit ($M) and gross margin (%) YoY Growth (%) YoY Growth (%) One-time services and other revenue is comprised of fees for one-time consulting, analytic and onsite training services, fees for retained and managed services contracts that we do not expect to have a term consistent with our cloud solution contracts, revenue from the sale of our software sold under perpetual license arrangements, and third-party software referral fees. Cost of one-time services and other is primarily comprised of compensation costs for professional services and onsite training personnel, other costs incurred in providing onsite customer training, third-party contractor expenses, data expense incurred to perform one-time analytic services, third-party software royalties, allocated depreciation, facilities and IT support costs and amortization of intangible assets from business combinations. One-time services and other revenue decreased by $3.8 million, or 30.3%, and $7.2 million, or 29.0%, during the three and six months ended June 30, 2023, when compared to the same periods in 2022, driven primarily by the following: - Decreases in one-time consulting revenue of $2.7 million and $5.7 million, respectively, primarily due to less sales of creative services and implementation and customization services, in line with our multi-year strategic shift from a license-based and one-time services business model to a cloud subscription business model, which generally requires less implementation and customization services. - Decreases in one-time analytics revenue of $0.8 million and $1.6 million, respectively, as analytics are generally integrated in our cloud solutions Cost of one-time services and other decreased by $3.6 million, or 32.1%, and $6.1 million, or 27.6%, during the three and six months ended June 30, 2023, respectively, when compared to the same periods in 2022, driven primarily by the following: - Decreases in compensation costs of $2.5 million and $5.0 million, respectively, primarily related to our targeted workforce reductions discussed above and a continued shift in resources historically supporting one-time services and other towards recurring revenue Second Quarter 2023 Form 10-Q 33 Table of Contents Blackbaud, Inc. (Unaudited) One-time services and other gross margin increased by 230 basis points during the three months ended June 30, 2023, when compared to the same period in 2022, primarily due to the decrease in compensation costs discussed above outpacing the decrease in one-time services and other revenue. One-time services and other gross margin decreased by 190 basis points during the six months ended June 30, 2023, when compared to the same period in 2022, primarily due to the decrease of one-time services and other revenue outpacing the decrease compensation costs discussed above. Operating Expenses Sales, marketing and customer success ($M) Research and development ($M) General and administrative ($M) Percentages indicate expenses as a percentage of total revenue Sales, marketing and customer success Sales, marketing and customer success expense includes compensation costs, variable sales commissions, travel-related expenses, advertising and marketing materials, public relations costs, variable reseller commissions and allocated depreciation, facilities and IT support costs. We see a large market opportunity in the long-term and will continue to make investments to drive sales effectiveness. We have also implemented software tools to enhance our digital footprint and drive lead generation. The enhancements we are making in our go-to-market approach are expected to reduce our average customer acquisition cost per customer as well as the related payback period while increasing sales velocity. 34 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Sales, marketing and customer success expense increased by $0.5 million or 0.9%, during the three months ended June 30, 2023, when compared to the same period in 2022, primarily driven by the following: + Increase in stock-based compensation costs of $1.9 million primarily due to estimated overall Company performance against 2023 goals, partially offset by the targeted workforce reductions during the fourth quarter of 2022 and first quarter of 2023 + Increase in advertising costs of $1.1 million - Net decrease in the following costs primarily due to our targeted workforce reductions discussed above: • Decrease in compensation costs other than stock-based compensation of $2.0 million; and • Decrease in commissions expense of $0.9 million Sales, marketing and customer success expense decreased by $0.4 million, or 0.3%, during the six months ended June 30, 2023, when compared to the same period in 2022, primarily driven by the following: - Net decrease in the following costs primarily due to our targeted workforce reductions discussed above: • Increase in severance costs of $2.1 million; • Decrease in compensation costs other than stock-based compensation of $3.4 million; and • Decrease in commissions expense of $1.5 million + Increases in stock-based compensation costs of $2.4 million primarily due to 2022 performance-based equity award adjustments and estimated overall Company performance against 2023 goals, partially offset by the targeted workforce reductions during the fourth quarter of 2022 and first quarter of 2023 Research and development Research and development expense includes compensation costs for engineering and product management personnel, third-party contractor expenses, software development tools and other expenses related to developing new solutions or upgrading and enhancing existing solutions that do not qualify for capitalization, and allocated depreciation, facilities and IT support costs. We continue to make investments to delight our customers with innovative and secure cloud solutions. Research and development expenses decreased by $2.2 million, or 5.7%, and $1.5 million or 2.0%, during the three and six months ended June 30, 2023, respectively, when compared to the same periods in 2022, primarily driven by the following: - Decreases in third-party contractor costs of $2.4 million and $3.6 million, respectively, primarily due to a decrease in our use of third-party software developers - Decreases in compensation costs other than stock-based compensation of $1.3 million and $1.9 million, respectively, primarily due to our targeted workforce reductions discussed above + Increases in stock-based compensation of $1.7 million and $2.8 million, respectively, primarily due to estimated overall Company performance against 2023 goals, partially offset by the targeted workforce reductions during the fourth quarter of 2022 and first quarter of 2023. 2022 performance-based equity award adjustments also contributed to the increase in stock-based compensation expense during the six months ended June 30, 2023 + Increase in severance costs of $1.1 million, for the six months ended June 30, 2023, primarily due to our targeted workforce reductions discussed above Not included in research and development expense for the three months ended June 30, 2023 and 2022 were $15.4 million and $14.8 million, respectively, and for the six months ended June 30, 2023 and 2022 were $29.6 million and $28.5 million, respectively, of qualifying costs associated with software and content development activities that are required to be capitalized under GAAP, such as those for our cloud solutions, as well as development costs associated with acquired companies. Qualifying capitalized development costs associated with our cloud solutions are subsequently amortized to cost of recurring revenue over the related assets' estimated useful life, which generally range from three to seven years. Second Quarter 2023 Form 10-Q 35 Table of Contents Blackbaud, Inc. (Unaudited) General and administrative General and administrative expense consists primarily of compensation costs for general corporate functions, including senior management, finance, accounting, legal, human resources and corporate development, Security Incident-related expenses (including legal fees, settlements and loss contingency accruals), third-party professional fees, insurance, allocated depreciation, facilities and IT support costs, acquisition-related expenses and other administrative expenses. General and administrative expense increased by $11.8 million or 24.8%, and $20.8 million or 22.9%, during the three and six months ended June 30, 2023, respectively, when compared to the same periods in 2022, primarily driven by the following: + Increases in Security Incident-related expenses of $18.4 million and $29.0 million, respectively. See "Security Incident update" on page 29 + Increases in stock-based compensation costs of $1.5 million and $2.2 million, respectively, primarily due to estimated overall Company performance against 2023 goals, partially offset by the targeted workforce reductions during the fourth quarter of 2022 and first quarter of 2023. 2022 performance-based equity award adjustments also contributed to the increase in stock-based compensation expense during the six months ended June 30, 2023 - Decreases in acquisition and disposition-related costs of $3.1 million and $3.5 million, respectively, primarily related to the release of $1.4 million in accrued contingent consideration related to our Kilter acquisition during the three and six months ended June 30, 2023 and a $2.0 million noncash impairment of certain insignificant intangible assets that were held for sale during the three and six months ended June 30, 2022 which did not reoccur in the comparable 2023 periods - Decreases in compensation costs other than stock-based compensation of $2.0 million and $3.3 million, respectively, primarily due to our targeted workforce reductions discussed above - A $2.3 million noncash impairment charge during the three and six months ended June 30, 2022 against previously capitalized software development costs that reduced the carrying value of those assets to zero. The impairment charge resulted primarily from our decision to end customer support for certain solutions and did not reoccur in 2023 Fixed Asset Impairment On July 31, 2023, we entered into a sublease for a portion of our Washington, DC office location, which we previously closed in February 2023 to align with our remote-first workforce strategy. We considered our entry into the sublease an impairment indicator. As a result, we currently expect to incur pre-tax costs between $6.0 million and $8.0 million in the third quarter of 2023, consisting of noncash impairment charges against certain operating lease right-of-use assets and property and equipment assets. We expect the impairment charge to be recorded in general and administrative expense. 36 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Interest Expense Interest expense ($M) Percentages indicate expenses as a percentage of total revenue The increases in interest expense in dollars and as a percentage of total revenue during the three and six months ended June 30, 2023, when compared to the same period in 2022, were primarily due to an increase in our weighted average effective interest rates. We currently expect interest expense for the full year 2023 to be approximately $37 million to $41 million although our interest expense in connection with the variable rate portion of our outstanding debt could increase in a rising interest rate environment. See Note 7 to our condensed consolidated financial statements in this report for more information regarding our derivative instruments, which we use to manage our variable interest rate risk, and Item 3. Quantitative and Qualitative Disclosures about Market Risk: Interest Rate Risk (below) for more information about our variable interest rate exposure and related risk. Deferred Revenue The table below compares the components of deferred revenue from our consolidated balance sheets: (dollars in millions) June 30, 2023 December 31, 2022 Change Deferred revenue (1) $ 438.2 $ 385.2 13.7 % Less: Long-term portion 3.5 2.8 25.0 % Current portion (1) $ 434.6 $ 382.4 13.7 % (1) The individual amounts for each year may not sum to deferred revenue or current portion of deferred revenue due to rounding. To the extent that our customers are billed for our solutions and services in advance of delivery, we record such amounts in deferred revenue. Our recurring revenue contracts are generally for a term of three years at contract inception, billed annually in advance, and non-cancelable. We have been for several years successfully shifting our legacy customer base away from annual renewals and moving them onto multi-year renewal contracts. We generally invoice our customers with recurring revenue contracts in annual cycles 30 days prior to the end of each one-year period. The increase in deferred revenue during the six months ended June 30, 2023 was primarily due to a seasonal increase in customer contract renewals . Historically, due to the timing of customer budget cycles, we have an increase in customer contract renewals at or near the beginning of our third quarter. Generally, our lowest balance of deferred revenue during the year is at the end of our first quarter. Second Quarter 2023 Form 10-Q 37 Table of Contents Blackbaud, Inc. (Unaudited) Income Taxes Income tax benefit ($M) Percentages indicate effective income tax rates The increases in our effective income tax rate for the three and six months ended June 30, 2023, when compared to the same periods in 2022 were primarily attributable to unfavorable impact of non-deductible Security Incident accruals. See Note 8 to our unaudited, condensed consolidated financial statements included in this report for additional information about our loss contingency accruals related to the Security Incident. For the three and six months ended June 30, 2022, we utilized the discrete effective tax rate method, as allowed by ASC 740-270-30-18, Income Taxes—Interim Reporting , to calculate its interim income tax provision. The discrete method is applied when the application of the estimated annual effective tax rate is impractical because it is not possible to reliably estimate the annual effective tax rate. The discrete method treats the year-to-date period as if it was the annual period and determines the income tax expense or benefit on that basis. For the three and six months ended June 30, 2023 we have utilized the annual effective tax rate method, as we believe it can now be reliably estimated. This methodology requires us to apply our estimated annual effective tax rate to year-to-date pre-tax earnings. During the second quarter of 2023, our estimated annual effective tax rate increased due to the unfavorable impacts of non-deductible Security Incident accruals and its impact on pre-tax earnings. This increase, when applied to quarter-to-date and year-to-date date pre-tax losses, resulted in recognition of income tax benefits at 126.0% and 52.8%, respectively. Non-GAAP Financial Measures The operating results analyzed below are presented on a non-GAAP basis. We use non-GAAP financial measures internally in analyzing our operational performance. Accordingly, we believe these non-GAAP measures are useful to investors, as a supplement to GAAP measures, in evaluating our ongoing operational performance. While we believe these non-GAAP measures provide useful supplemental information, non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be completely comparable to similarly titled measures of other companies due to potential differences in the exact method of calculation between companies. The non-GAAP financial measures discussed below exclude the impact of certain transactions because we believe they are not directly related to our operating performance in any particular period, but are for our long-term benefit over multiple periods. We believe that these non-GAAP financial measures reflect our ongoing business in a manner that allows for meaningful period-to-period comparisons and analysis of trends in our business. 38 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Three months ended June 30, Six months ended June 30, (dollars in millions, except per share amounts) 2023 2022 Change 2023 2022 Change GAAP Revenue $ 271.0 $ 264.9 2.3 % $ 532.8 $ 522.1 2.1 % GAAP gross profit $ 149.6 $ 139.3 7.4 % $ 288.2 $ 273.1 5.5 % GAAP gross margin 55.2 % 52.6 % 54.1 % 52.3 % Non-GAAP adjustments: Add: Stock-based compensation expense 4.1 3.8 10.1 % 8.1 7.9 2.3 % Add: Amortization of intangibles from business combinations 13.1 12.4 5.9 % 26.2 24.9 5.4 % Add: Employee severance 0.1 0.4 (85.8) % 0.8 0.4 109.2 % Subtotal (1) 17.3 16.5 4.7 % 35.1 33.2 5.9 % Non-GAAP gross profit (1) $ 166.9 $ 155.9 7.1 % $ 323.3 $ 306.3 5.6 % Non-GAAP gross margin 61.6 % 58.8 % 60.7 % 58.7 % GAAP income (loss) from operations $ 0.3 $ 0.1 444.4 % $ (9.7) $ (5.9) 62.9 % GAAP operating margin 0.1 % — % (1.8) % (1.1) % Non-GAAP adjustments: Add: Stock-based compensation expense 33.4 27.9 19.8 % 63.3 55.7 13.6 % Add: Amortization of intangibles from business combinations 13.9 13.2 5.4 % 27.8 26.5 4.9 % Add: Employee severance 0.6 0.5 36.8 % 5.0 0.5 972.3 % Add: Acquisition and disposition-related costs (2) (0.8) 2.3 (137.0) % (0.2) 3.2 (107.1) % Add: Restructuring and other real estate activities — — — % — 0.1 (100.0) % Add: Security Incident-related costs, net of insurance (3) 26.8 8.3 220.8 % 44.6 15.5 186.6 % Add: Impairment of capitalized software development costs — 2.3 (100.0) % — 2.3 (100.0) % Subtotal (1) 73.8 54.4 35.7 % 140.4 103.8 35.2 % Non-GAAP income from operations (1) $ 74.1 $ 54.5 36.1 % $ 130.7 $ 97.9 33.5 % Non-GAAP operating margin 27.4 % 20.6 % 24.5 % 18.8 % GAAP loss before provision for income taxes $ (8.1) $ (5.8) 39.8 % $ (26.7) $ (18.2) 46.3 % GAAP net income (loss) $ 2.1 $ (3.4) (161.5) % $ (12.6) $ (13.8) (8.9) % Shares used in computing GAAP diluted earnings (loss) per share 53,643,124 51,660,739 3.8 % 52,389,112 51,431,501 1.9 % GAAP diluted earnings (loss) per share $ 0.04 $ (0.07) (157.1) % $ (0.24) $ (0.27) (11.1) % Non-GAAP adjustments: Less: GAAP income tax benefit (10.2) (2.4) 330.9 % (14.1) (4.4) 219.2 % Add: Total non-GAAP adjustments affecting income from operations 73.8 54.4 35.7 % 140.4 103.8 35.2 % Non-GAAP income before provision for income taxes 65.8 48.6 35.2 % 113.7 85.6 32.9 % Assumed non-GAAP income tax provision (4) 13.2 9.7 35.2 % 22.7 17.1 32.9 % Non-GAAP net income (1) $ 52.6 $ 38.9 35.2 % $ 90.9 $ 68.5 32.9 % Shares used in computing non-GAAP diluted earnings per share 53,643,124 51,985,530 3.2 % 53,168,985 51,954,151 2.3 % Non-GAAP diluted earnings per share $ 0.98 $ 0.75 30.7 % $ 1.71 $ 1.32 29.5 % (1) The individual amounts for each year may not sum to subtotal, non-GAAP gross profit, non-GAAP income from operations, non-GAAP income before provision for income taxes or non-GAAP net income due to rounding. (2) Includes a $2.0 million noncash impairment of certain intangible assets held for sale during the three and six months ended June 30, 2022. (3) Includes Security Incident-related costs incurred during the three and six months ended June 30, 2023 of $26.8 million and $44.6 million, respectively, which includes approximately $19.8 million and $30.0 million, respectively, in recorded liabilities for loss contingencies, net of insurance recoveries during the same periods of $0.0 million each and during the three and six months ended June 30, 2022 of $8.4 million and $17.4 million, respectively, net of insurance recoveries during the same periods that were insignificant and $1.9 million, respectively. Recorded expenses consisted primarily of payments to third-party service providers and consultants, including legal fees, as well as settlements of customer claims and accruals for certain loss contingencies. Not included in this adjustment were costs associated with enhancements to our cybersecurity program. For full year 2023, we currently expect net pre-tax expense of approximately $20 million to $30 million and net cash outlays of approximately $25 million to $35 million for ongoing legal fees related to the Security Incident. Not included in these ranges are our previous settlements or current accruals for loss contingencies related to the matters discussed below. In line with our policy, legal fees are expensed as incurred. As of June 30, 2023, we have recorded approximately $50.0 million in aggregate liabilities for loss contingencies based primarily on recent negotiations with certain governmental agencies related to the Security Incident that we believe we can reasonably estimate. It is reasonably possible that our estimated or actual losses may change in the near term for those matters and be materially in excess of the amounts accrued, but we are unable at this time to reasonably estimate the possible additional loss. There are other Security Incident-related matters, including customer claims, customer constituent class actions and governmental investigations, for which we have not recorded a liability for a loss contingency as of June 30, 2023 because we are unable at this time to reasonably estimate the possible loss or range of loss. Each of these matters could, separately or in the aggregate, result in an adverse judgment, settlement, fine, penalty or other resolution, Second Quarter 2023 Form 10-Q 39 Table of Contents Blackbaud, Inc. (Unaudited) the amount, scope and timing of which we are currently unable to predict, but could have a material adverse impact on our results of operations, cash flows or financial condition. (4) We apply a non-GAAP effective tax rate of 20.0% when calculating non-GAAP net income and non-GAAP diluted earnings per share. Non-GAAP organic revenue growth In addition, we use non-GAAP organic revenue growth, non-GAAP organic revenue growth on a constant currency basis and non-GAAP organic recurring revenue growth, in analyzing our operating performance. We believe that these non-GAAP measures are useful to investors, as a supplement to GAAP measures, for evaluating the periodic growth of our business on a consistent basis. Each of these measures of non-GAAP organic revenue growth excludes incremental acquisition-related revenue attributable to companies acquired in the current fiscal year. For companies, if any, acquired in the immediately preceding fiscal year, each of these non-GAAP organic revenue growth measures reflects presentation of full year incremental non-GAAP revenue derived from such companies as if they were combined throughout the prior period. In addition, each of these non-GAAP organic revenue growth measures excludes prior period revenue associated with divested businesses. The exclusion of the prior period revenue is to present the results of the divested businesses within the results of the combined company for the same period of time in both the prior and current periods. We believe this presentation provides a more comparable representation of our current business’ organic revenue growth and revenue run-rate. (dollars in millions) Three months ended June 30, Six months ended June 30, 2023 2022 2023 2022 GAAP revenue $ 271.0 $ 264.9 $ 532.8 $ 522.1 GAAP revenue growth 2.3 % 2.1 % Less: Non-GAAP revenue from divested businesses (1) — (1.3) — (2.6) Non-GAAP organic revenue (2) $ 271.0 $ 263.6 $ 532.8 $ 519.4 Non-GAAP organic revenue growth 2.8 % 2.6 % Non-GAAP organic revenue (2) $ 271.0 $ 263.6 $ 532.8 $ 519.4 Foreign currency impact on Non-GAAP organic revenue (3) 1.0 — 3.7 — Non-GAAP organic revenue on constant currency basis (3) $ 272.0 $ 263.6 $ 536.5 $ 519.4 Non-GAAP organic revenue growth on constant currency basis 3.2 % 3.3 % GAAP recurring revenue $ 262.4 $ 252.5 $ 515.1 $ 497.2 GAAP recurring revenue growth 3.9 % 3.6 % Less: Non-GAAP recurring revenue from divested businesses (1) — (1.3) — (2.5) Non-GAAP organic recurring revenue (2) $ 262.4 $ 251.2 $ 515.1 $ 494.6 Non-GAAP organic recurring revenue growth 4.4 % 4.1 % Non-GAAP organic recurring revenue (2) $ 262.4 $ 251.2 $ 515.1 $ 494.6 Foreign currency impact on non-GAAP organic recurring revenue (3) 0.9 — 3.4 — Non-GAAP organic recurring revenue on constant currency basis (3) $ 263.3 $ 251.2 $ 518.5 $ 494.6 Non-GAAP organic recurring revenue growth on constant currency basis 4.8 % 4.8 % (1) Non-GAAP revenue from divested businesses excludes revenue associated with divested businesses. The exclusion of the prior period revenue is to present the results of the divested business with the results of the combined company for the same period of time in both the prior and current periods. (2) Non-GAAP organic revenue and non-GAAP organic recurring revenue for the prior year periods presented herein may not agree to non-GAAP organic revenue and non-GAAP organic recurring revenue presented in the respective prior period quarterly financial information solely due to the manner in which non-GAAP organic revenue growth and non-GAAP organic recurring revenue growth are calculated. (3) To determine non-GAAP organic revenue growth and non-GAAP organic recurring revenue growth on a constant currency basis, revenues from entities reporting in foreign currencies were translated to U.S. Dollars using the comparable prior period's quarterly weighted average foreign currency exchange rates. The primary foreign currencies creating the impact are the Australian Dollar, British Pound, Canadian Dollar and EURO. 40 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Rule of 40 We previously defined Rule of 40 as non-GAAP organic revenue growth plus non-GAAP adjusted EBITDA margin. Non-GAAP adjusted EBITDA is defined as GAAP net income plus interest, net; income tax provision (benefit); depreciation; amortization of intangible assets from business combinations; amortization of software and content development costs; stock-based compensation; employee severance; acquisition and disposition-related costs; restructuring and other real estate activities; Security Incident-related costs, net of insurance; and impairment of capitalized software development costs. Beginning in the fiscal quarter ended June 30, 2022, we now also include in non-GAAP adjusted EBITDA impairment of capitalized software development costs because we believe it is not directly related to our operating performance in any particular period. Three months ended June 30, Six months ended June 30, (dollars in millions) 2023 2022 Change 2023 2022 Change GAAP net income (loss) $ 2.1 $ (3.4) (161.5) % $ (12.6) $ (13.8) (8.9) % Non-GAAP adjustments: Add: Interest, net 8.9 8.9 — % 18.3 16.3 11.9 % Less: GAAP income tax benefit (10.2) (2.4) 330.9 % (14.1) (4.4) 219.2 % Add: Depreciation 3.3 3.6 (8.7) % 6.6 7.1 (7.2) % Add: Amortization of intangibles from business combinations 13.9 13.2 5.4 % 27.8 26.5 4.9 % Add: Amortization of software and content development costs (1) 10.9 9.5 15.2 % 21.5 18.7 15.0 % Subtotal (2) 26.8 32.8 (18.3) % 60.1 64.3 (6.4) % Non-GAAP EBITDA (2) $ 28.9 $ 29.4 (1.6) % $ 47.5 $ 50.5 (5.8) % Non-GAAP EBITDA margin 10.7 % 8.9 % Non-GAAP adjustments: Add: Stock-based compensation expense 33.4 27.9 19.8 % 63.3 55.7 13.6 % Add: Employee severance 0.6 0.5 36.8 % 5.0 0.5 972.3 % Add: Acquisition and disposition-related costs (3) (0.8) 2.3 (137.0) % (0.2) 3.2 (107.1) % Add: Restructuring and other real estate activities — — — % — 0.1 (100.0) % Add: Security Incident-related costs, net of insurance (3) 26.8 8.3 220.8 % 44.6 15.5 186.6 % Add: Impairment of capitalized software development costs — 2.3 (100.0) % — 2.3 (100.0) % Subtotal (2) 59.9 41.2 45.4 % 112.6 77.3 45.6 % Non-GAAP Adjusted EBITDA (2) $ 88.8 $ 70.6 25.9 % $ 160.1 $ 127.8 25.3 % Non-GAAP Adjusted EBITDA margin 32.8 % 30.1 % Rule of 40 (4) 35.6 % 32.7 % Non-GAAP adjusted EBITDA 88.8 70.6 25.9 % 160.1 127.8 25.3 % Foreign currency impact on Non-GAAP adjusted EBITDA (5) 0.6 1.7 (65.2) % 1.9 2.2 (13.1) % Non-GAAP adjusted EBITDA on constant currency basis (5) $ 89.4 $ 72.2 23.8 % $ 162.0 $ 129.9 24.7 % Non-GAAP adjusted EBITDA margin on constant currency basis 32.9 % 30.2 % Rule of 40 on constant currency basis (6) 36.1 % 33.5 % (1) Includes amortization expense related to software development costs and amortization expense from capitalized cloud computing implementation costs. (2) The individual amounts for each year may not sum to subtotal, non-GAAP EBITDA, non-GAAP adjusted EBITDA or non-GAAP adjusted EBITDA on a constant currency basis due to rounding. (3) See additional details in the reconciliation of GAAP to Non-GAAP operating income above. (4) Measured by non-GAAP organic revenue growth plus non-GAAP adjusted EBITDA margin. See Non-GAAP organic revenue growth table above. (5) To determine non-GAAP adjusted EBITDA on a constant currency basis, non-GAAP adjusted EBITDA from entities reporting in foreign currencies were translated to U.S. Dollars using the comparable prior period's quarterly weighted average foreign currency exchange rates. The primary foreign currencies creating the impact are the Australian Dollar, British Pound, Canadian Dollar and EURO. (6) Measured by non-GAAP organic revenue growth on constant currency basis plus non-GAAP adjusted EBITDA margin on constant currency basis. See Non-GAAP organic revenue growth table above. Second Quarter 2023 Form 10-Q 41 Table of Contents Blackbaud, Inc. (Unaudited) Non-GAAP free cash flow and non-GAAP adjusted free cash flow Non-GAAP free cash flow is defined as operating cash flow less capital expenditures, including costs required to be capitalized for software and content development, and capital expenditures for property and equipment. Non-GAAP adjusted free cash flow is defined as operating cash flow less capital expenditures, including costs required to be capitalized for software and content development and capital expenditures for property and equipment, plus cash outflows, net of insurance, related to the Security Incident. We believe non-GAAP free cash flow and non-GAAP adjusted free cash flow provides useful measures of the Company's operating performance. Non-GAAP adjusted free cash flow is not intended to represent and should not be viewed as the amount of residual cash flow available for discretionary expenditures. Six months ended June 30, (dollars in millions) 2023 2022 Change GAAP net cash provided by operating activities $ 75.0 $ 81.8 (8.3) % Less: purchase of property and equipment (2.8) (7.5) (63.0) % Less: capitalized software and content development costs (28.8) (27.2) 5.8 % Non-GAAP free cash flow (1) $ 43.5 $ 47.1 (7.7) % Add: Security Incident-related cash flows, net of insurance 15.8 5.2 206.4 % Non-GAAP adjusted free cash flow (1) $ 59.3 $ 52.2 13.5 % (1) The individual amounts for each year may not sum to non-GAAP free cash flow or non-GAAP adjusted free cash flow due to rounding. Seasonality Our revenues normally fluctuate as a result of certain seasonal variations in our business. Our first quarter has historically been the seasonal low for bookings, with the second and fourth quarters historically being seasonally higher, and our bookings tend to be back-end loaded within individual quarters given our quarterly quota plans. Transactional revenue is non-contractual and less predictable given the susceptibility to certain drivers such as timing and number of events and marketing campaigns, as well as fluctuations in donation volumes and tuition payments. Our transactional revenue has historically been at its lowest in the first quarter due to the timing of customer fundraising initiatives and events. We have historically experienced seasonal highs during the fourth quarter due to year-end giving campaigns and during the second quarter when a large number of events are held. Our revenue from professional services has historically been lower in the first quarter when many of those services commence and in the fourth quarter due to the holiday season. As a result of these and other factors, our total revenue has historically been lower in the first quarter than in the remainder of our fiscal year, with the fourth quarter historically achieving the highest total revenue. Our expenses, other than transaction-based costs related to our payments services, do not vary significantly as a result of these factors, but do fluctuate on a quarterly basis due to varying timing of expenditures. Our cash flow from operations normally fluctuates quarterly due to the combination of the timing of customer contract renewals including renewals associated with customers of acquired companies, delivery of professional services and occurrence of customer events, as well as merit-based salary increases, among other factors. Historically, due to lower revenues in our first quarter, combined with the payment of certain annual vendor contracts, our cash flow from operations has been lowest in our first quarter. Due to the timing of customer contract renewals and student enrollments, many of which take place at or near the beginning of our third quarter, our cash flow from operations has generally been lower in our second quarter as compared to our third and fourth quarters. Partially, offsetting these favorable drivers of cash flow from operations in our third and fourth quarters are base salary merit increases, which occur in July. In addition, deferred revenues can vary on a seasonal basis due to the timing of customer contract renewals and student enrollments or significant acquisitions. Our cash flow from financing is negatively impacted in our first quarter when most of our equity awards vest, as we pay taxes on behalf of our employees related to the settlement or exercise of equity awards. These patterns may change as a result of the continued shift to online giving, growth in volume of transactions for which we process payments, large dollar customer bookings and contract renewals, or as a result of acquisitions, new market opportunities, new solution introductions or other factors. 42 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Liquidity and Capital Resources The following table presents selected financial information about our financial position: (dollars in millions) June 30, 2023 December 31, 2022 Change Cash and cash equivalents $ 29.0 $ 31.7 (8.4) % Property and equipment, net 104.7 107.4 (2.6) % Software and content development costs, net 151.2 141.0 7.2 % Total carrying value of debt 846.6 859.0 (1.5) % Working capital (316.6) (312.0) (1.5) % The following table presents selected financial information about our cash flows: Six months ended June 30, (dollars in millions) 2023 2022 Change Net cash provided by operating activities $ 75.0 $ 81.8 (8.3) % Net cash used in investing activities (31.5) (53.7) (41.3) % Net cash provided by (used in) financing activities 10.4 (194.1) (105.4) % Our principal sources of liquidity are our operating cash flow, funds available under the 2020 Credit Facility and cash on hand. Our operating cash flow depends on continued customer renewal of our subscription and maintenance arrangements, market acceptance of our solutions and services, the volume and size of transactions for which we process payments and our customers' ability to pay. Based on current estimates of revenue and expenses, we believe that the currently available sources of funds and anticipated cash flows from operations will be adequate for at least the next twelve months to finance our operations, fund anticipated capital expenditures and meet our debt obligations. We also believe that we will be able to continue to meet our long-term cash requirements due to our anticipated cash flow from operations, solid financial position and ability to access capital from financial markets. To the extent we undertake future material acquisitions or investments or unanticipated capital or operating expenditures, including in connection with the Security Incident, we may require additional capital. In that context, we regularly evaluate opportunities to enhance our capital structure, including through potential debt or equity issuances. In the near term, excluding any future material events noted above or otherwise, we intend to reduce our net leverage to our target level of 2 to 1. As a well-known seasoned issuer, we filed an automatic shelf registration statement for an undetermined amount of debt and equity securities with the SEC on January 14, 2022. Under this universal shelf registration statement we may offer and sell, from time to time, debt securities, common stock, preferred stock, depositary shares, warrants, stock purchase contracts and stock purchase units. Subject to certain conditions, this registration statement will be effective through January 13, 2024. At June 30, 2023, our total cash and cash equivalents balance included approximately $17.3 million of cash that was held by operations outside the U.S. While these funds may not be needed to fund our U.S. operations for at least the next twelve months, if we need these funds, we may be required to accrue and pay taxes to repatriate the funds. We currently do not intend nor anticipate a need to repatriate our cash held outside the U.S. Second Quarter 2023 Form 10-Q 43 Table of Contents Blackbaud, Inc. (Unaudited) Operating Cash Flow Our cash flows from operations are derived principally from: (i) our earnings from on-going operations prior to non-cash expenses such as depreciation, amortization, stock-based compensation, deferred taxes, amortization of deferred financing costs and debt discount and adjustments to our provision for credit losses and sales returns; and (ii) changes in our working capital. Working capital changes are composed of changes in accounts receivable, prepaid expenses and other assets, trade accounts payable, accrued expenses and other liabilities, and deferred revenue. Net cash provided by operating activities decreased by $6.8 million during the six months ended June 30, 2023, when compared to the same period in 2022, primarily due to a $11.2 million decrease in net income adjusted for non-cash expenses and a $4.5 million increase in cash flow from operations associated with working capital. The increase in cash flow from operations associated with working capital during the six months ended June 30, 2023 , when compared to the same period in 2022, was primarily due to: • an increase in accrued expenses related to the Security Incident; partially offset by • fluctuations in the timing of vendor payments; and • a decrease in taxes payable. Security Incident update As discussed in Note 8 to our unaudited, condensed consolidated financial statements included in this report, t otal costs related to the Security Incident exceeded the limit of our insurance coverage in the first quarter of 2022 . Accordingly, the Security Incident has negatively impacted, and we expect it to continue for the foreseeable future to negatively impact, our GAAP profitab ility and GAAP cash flow (see discussion regarding non-GAAP adjusted free cash flow on page 42 ). For full year 2023, we currently expect net pre-tax expense of approximately $20 million to $30 million and net cash outlays of approximately $25 million to $35 million for ongoing legal fees related to the Security Incident. In line with our policy, legal fees are expensed as incurred. Not included in these ranges are our previous settlements or current accruals for loss contingencies related to the matters discussed below. As of June 30, 2023, we have recorded approximately $50.0 million in aggregate liabilities for loss contingencies based primarily on recent negotiations with certain governmental agencies related to the Security Incident that we believe we can reasonably estimate in accordance with our loss contingency procedures described in Note 8. It is reasonably possible that our estimated or actual losses may change in the near term for those matters and be materially in excess of the amounts accrued, but we are unable at this time to reasonably estimate the possible additional loss. There are other Security Incident-related matters, including customer claims, customer constituent class actions and governmental investigations, for which we have not recorded a liability for a loss contingency as of June 30, 2023 because we are unable at this time to reasonably estimate the possible loss or range of loss. Each of these matters could, separately or in the aggregate, result in an adverse judgment, settlement, fine, penalty or other resolution, the amount, scope and timing of which we are currently unable to predict, but could have a material adverse impact on our results of operations, cash flows or financial condition. Investing Cash Flow Net cash used in investing activities of $31.5 million decreased by $22.2 million during the six months ended June 30, 2023, when compared to the same period in 2022. During the six months ended June 30, 2022, we used $19.0 million for our acquisition of EVERFI comprised of (i) $17.4 million that had not been paid by EVERFI to its former option holders as of December 31, 2021, solely due to the timing of the acquisition on the last day of 2021; and (ii) $2.6 million that was paid to a number of EVERFI's selling shareholders after determining they would be paid in cash, rather than shares of our common stock. During the six months ended June 30, 2023, we used $28.8 million for software and content development costs, which was up $1.6 million from cash spent during the same period in 2022. We also spent $2.8 million of cash for purchases of property and 44 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) equipment during the six months ended June 30, 2023, which was a decrease of $4.7 million when compared to the same period in 2022. Financing Cash Flow During the six months ended June 30, 2023, we had a net decrease in borrowings of $13.8 million. We paid $33.7 million to satisfy tax obligations of employees upon settlement of equity awards during the six months ended June 30, 2023 compared to $35.6 million during the same period in 2022. The amount of taxes paid by us on behalf of employees related to the settlement of equity awards varies from period to period based upon the timing of grants and vesting, as well as the market price for shares of our common stock at the time of settlement. Most of our equity awards currently vest in our first quarter. During the six months ended June 30, 2023, cash flow from financing activities associated with changes in restricted cash due to customers increased $61.3 million, compared to a decrease of $141.0 million during the same period in 2022. This line in the statement of cash flows represents the change in the amount of restricted cash held and payable by us to customers from one period to the next. Stock repurchase program In December 2021, our Board of Directors reauthorized and replenished our stock repurchase program that authorizes us to purchase up to $250.0 million of our outstanding shares of common stock. The program does not have an expiration date. Under the stock repurchase program, we are authorized to repurchase shares from time to time in accordance with applicable laws both on the open market, including under trading plans established pursuant to Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, and in privately negotiated transactions. The timing and amount of repurchases depends on several factors, including market and business conditions, the trading price of our common stock and the nature of other investment opportunities. The repurchase program may be limited, suspended or discontinued at any time without prior notice. During the three and six months ended June 30, 2023, we did not purchase any shares. The remaining amount available to purchase stock under the stock repurchase program was $250.0 million as of June 30, 2023. While we intend to reduce our net leverage to our 2 to 1 target level in the near term, as we gain visibility into the timing and magnitude of probable costs related to the Security Incident over time, we expect to resume stock repurchases. 2020 Credit Facility Historically, we have drawn on our credit facility from time to time to help us meet financial needs, primarily due to the seasonality of our cash flows from operations and financing for business acquisitions. At June 30, 2023, our available borrowing capacity under the 2020 Credit Facility was $325.8 million. The 2020 Credit Facility matures in October 2025. At June 30, 2023, the carrying amount of our debt under the 2020 Credit Facility was $786.8 million. Our average daily borrowings during the three and six months ended June 30, 2023 were $823.4 million and $814.9 million, respectively. The following is a summary of the financial covenants under the 2020 Credit Facility: Financial covenant Requirement Ratio as of June 30, 2023 Net leverage ratio (1) ≤ 4.00 to 1.00 2.67 to 1.00 Interest coverage ratio ≥ 2.50 to 1.00 7.59 to 1.00 (1) Under the terms of the 2020 Credit Facility, the Net Leverage Ratio requirement may be increased by up to 0.50 provided we satisfy certain requirements, including a permitted business acquisition, and provided that the maximum Net Leverage Ratio shall not exceed 4.25 to 1.00. Under the 2020 Credit Facility, we also have restrictions on our ability to declare and pay dividends and our ability to repurchase shares of our common stock. In order to pay any cash dividends and/or repurchase shares of stock: (i) no default or event of default shall have occurred and be continuing under the 2020 Credit Facility, and (ii) our pro forma net leverage ratio, as set forth in the 2020 Credit Facility, must be 0.25 less than the net leverage ratio requirement at the time of dividend declaration or share repurchase. At June 30, 2023, we were in compliance with our debt covenants under the 2020 Credit Facility. See Note 6 to our unaudited, condensed consolidated financial statements included in this report for additional information regarding the 2020 Credit Facility. Second Quarter 2023 Form 10-Q 45 Table of Contents Blackbaud, Inc. (Unaudited) Commitments and Contingencies Payments due by period (in millions) Less than 1 year More than 1 year Total (1) Recorded contractual obligations: Debt $ 19.2 $ 829.5 $ 848.7 Operating leases 9.5 51.2 60.7 Interest payment on debt — 3.1 3.1 Contingent consideration — 1.4 1.4 Unrecorded contractual obligations: Purchase obligations 75.5 194.9 270.4 Interest payments on debt 38.9 84.1 123.0 Total contractual obligations (1) $ 143.0 $ 1,164.2 $ 1,307.2 (1) The individual amounts may not sum to the total due to rounding. Debt As of June 30, 2023, we had total remaining principal payments of $848.7 million. These payments represent principal payments only, under the following assumptions: (i) that the amounts outstanding under the 2020 Credit Facility, our real estate loans and our other debt at June 30, 2023 will remain outstanding until maturity, with minimum payments occurring as currently scheduled, and (ii) that there are no assumed future borrowings on the revolving credit loans under the 2020 Credit Facility for the purposes of determining minimum commitment amounts. See Note 6 to our unaudited, condensed consolidated financial statements in this report for more information. Interest payments on debt In addition to principal payments, as of June 30, 2023, we expect to pay interest expense over the life of our debt obligations of approximately $123.0 million. These payments represent our estimated future interest payments on debt using our debt balances and the related weighted average effective interest rates as of June 30, 2023, which includes the effect of interest rate swap agreements. The actual interest expense recognized in our consolidated statements of comprehensive income will depend on the amount of debt, the length of time the debt is outstanding and the interest rate, which could be different from our assumptions on our remaining principal payments described above. Operating leases As of June 30, 2023, we had remaining operating lease payments of $60.7 million. These payments have not been reduced by sublease income, incentive payments, reimbursement of leasehold improvements or the amount representing imputed interest of $9.8 million. Our operating leases are generally for corporate offices, subleased offices and certain equipment and furnit ure. Given our remote-first workforce strategy and real estate footprint optimization efforts, as discussed above, we do not anticipate entering any new, material operating leases for offices for the foreseeable future. See Note 8 to our unaud ited, condensed consolidated financial statements in this report for more information. Purchase obligations As of June 30, 2023, we had remaining purchase obligations of $270.4 million. These purchase obligations are for third-party technology used in our solutions and for other services we purchase as part of our normal operations. In certain cases, these arrangements require a minimum annual purchase commitment by us. Our purchase obligations are not recorded as liabilities on our consolidated balance sheets as of June 30, 2023, as we had not received the related services. See Note 8 to our unaudited, condensed consolidated financial statements in this report for more information. The total liability for uncertain tax positions as of June 30, 2023 was $3.3 million . Our accrued interest and penalties related to tax positions taken on our tax returns was insignificant as of June 30, 2023. 46 Second Quarter 2023 Form 10-Q Table of Contents Blackbaud, Inc. (Unaudited) Contingent consideration In connection with our acquisition of Kilter in August 2022, we may be required to pay up to a maximum of $3.0 million in additional cash consideration if, during the two-year period commencing January 1, 2023, Kilter meets certain application participation targets. As of June 30, 2023, a liability for the contingent consideration is recorded at its current estimated fair value of $1.4 million in other liabilities in our consolidated balance sheet. Foreign Currency Exchange Rates Approximately 15% of our total revenue for the six months ended June 30, 2023 was generated from operations outside the U.S. We do not have significant operations in countries in which the economy is considered to be highly inflationary. Our consolidated financial statements are denominated in U.S. dollars and, accordingly, changes in the exchange rate between foreign currencies and the U.S. dollar will affect the translation of our subsidiaries’ financial results into U.S. dollars for purposes of reporting our consolidated financial results. The accumulated currency translation adjustment, recorded within accumulated other comprehensive income as a component of stockholders’ equity, was a loss of $9.7 million as of June 30, 2023 and a loss of $14.9 million as of December 31, 2022. We have entered into foreign currency forward contracts to hedge a portion of the foreign currency exposure that arises on translation of our investments denominated in British Pounds into U.S. dollars. The vast majority of our contracts are entered into by our U.S. or U.K. entities. The contracts entered into by the U.S. entity are almost always denominated in U.S. dollars or Canadian dollars, and contracts entered into by our U.K., Australian and Irish subsidiaries are generally denominated in British Pounds, Australian dollars and Euros, respectively. Historically, as the U.S. dollar weakened, foreign currency translation resulted in an increase in our revenues and expenses denominated in non-U.S. currencies. Conversely, as the U.S. dollar strengthened, foreign currency translation resulted in a decrease in our revenue and expenses denominated in non-U.S. currencies. During the six months ended June 30, 2023, foreign translation resulted in decreases in our revenues and expenses denominated in non-U.S. currencies. Though we have exposure to fluctuations in currency exchange rates, primarily those between the U.S. dollar and both the British Pound and Canadian dollar, the impact has generally not been material to our consolidated results of operations or financial position. However, we currently expect that fluctuations in foreign currency exchange rates will have a significant negative impact on our total revenue for the full year 2023. For the six months ended June 30, 2023, the fluctuation in foreign currency exchange rates reduced our total revenue and our income from operations by $3.7 million and $0.6 million, respectively. We have entered into foreign currency forward contracts to hedge revenues denominated in the Canadian dollar against changes in the exchange rate with the U.S. dollar. We will continue monitoring such exposure and take action as appropriate. To determine the impacts on revenue (or income from operations) from fluctuations in currency exchange rates, current period revenues (or income from operations) from entities reporting in foreign currencies were translated into U.S. dollars using the comparable prior year period's weighted average foreign currency exchange rates. These impacts are non-GAAP financial information and are not in accordance with, or an alternative to, information prepared in accordance with GAAP. Critical Accounting Policies and Estimates There have been no significant changes in our critical accounting policies and estimates during the six months ended June 30, 2023 as compared to those disclosed in “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, 2022. Recently Issued Accounting Pronouncements For a discussion of the impact that recently issued accounting pronouncements are expected to have on our financial position and results of operations when adopted in the future, see Note 2 to our unaudited, condensed consolidated financial statements in this report. Second Quarter 2023 Form 10-Q 47 Table of Contents Blackbaud, Inc. (Unaudited)