Five9, Inc. 10-K

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report. Overview We are a pioneer and leading provider of intelligent cloud software for contact centers, facilitating more than seven billion call minutes between our more than 2,000 clients and their customers per year. We believe we achieved this leadership position through our expertise and technology, which has empowered us to help organizations of all sizes transition from legacy on-premise contact center systems to our cloud solution. Our solution, comprised of our VCC cloud platform and applications, allows simultaneous management and optimization of customer interactions across voice, chat, email, web, social media and mobile channels, either directly or through our APIs. Our VCC cloud platform matches each customer interaction with an appropriate agent resource and delivers relevant customer data to the agent in real-time through integrations with adjacent enterprise applications, such as CRM software, to optimize the customer experience and improve agent productivity. Unlike legacy on-premise contact center systems, our solution requires minimal up-front investment, can be rapidly deployed and adjusted depending on our client’s requirements. Since founding our business in 2001, we have focused exclusively on delivering cloud contact center software. We initially targeted smaller contact center opportunities with our telesales team and, over time, invested in expanding the breadth and depth of the functionality of our cloud platform to meet the evolving requirements of our clients. In 2009, we made a strategic decision to expand our market opportunity to include larger contact centers. This decision drove further investments in research and development and the establishment of our field sales team to meet the requirements of these larger contact centers. We believe this shift has helped us diversify our client base, while significantly enhancing our opportunity for future revenue growth. To complement these efforts, we have also focused on building client awareness and driving adoption of our solution through marketing activities, which include internet advertising, digital marketing campaigns, social media, trade shows, industry events, telemarketing and out of home campaigns. We provide our solution through a SaaS business model with recurring subscriptions. We offer a comprehensive suite of applications delivered on our VCC cloud platform that are designed to enable our clients to 52 Table of Contents manage and optimize interactions across inbound and outbound contact centers. We primarily generate revenue by selling subscriptions and related usage of our VCC cloud platform. We charge our clients monthly subscription fees for access to our solution, primarily based on the number of agent seats, as well as the specific functionalities and applications our clients deploy. We define agent seats as th e maximum number of named agents allowed to concurrently access our solution. Our clients typically have more named agents than agent seats, and multiple named agents may use an agent seat, though not simultaneously. Substantially all of our clients purchase both subscriptions and related telephony usage from us. A small percentage of our clients subscribe to our platform but purchase telephony usage directly from wholesale telecommunications service providers. We do not sell telephony usage on a stand-alone basis to any client. The related usage fees are based on the volume of minutes for inbound and outbound interactions. We also offer bundled plans, generally for smaller deployments, where the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. We offer monthly, annual and multiple-year contracts to our clients, generally with 30 days’ notice required for reductions in the number of agent seats. Increases in the number of agent seats can be provisioned almost immediately. Our clients, therefore, are able to adjust the number of agent seats used to meet their changing contact center volume needs. Our larger clients typically choose annual contracts, which generally include an implementation and ramp period of several months. Fixed subscription fees, including bundled plans, are generally billed monthly in advance, while related usage fees are billed in arrears. For the years ended December 31, 2020, 2019 and 2018, subscription and related usage fees accounted for 92%, 92% and 93% of our revenue, respectively. The remainder was comprised of professional services revenue from the implementation and optimization of our solution. Effects of COVID-19 In December 2019, a novel coronavirus disease known as COVID-19 was reported and on March 11, 2020, the WHO characterized COVID-19 as a pandemic. This pandemic has resulted in a widespread health crisis that has significantly harmed the U.S. and global economies and caused significant fluctuation in financial markets, including those on which our common stock and our convertible senior notes trade, and may impact demand for our solution. In accordance with the various social distancing and other office closure orders and recommendations of applicable government agencies, all of our employees have transitioned to work-from-home operations and we have canceled all business travel by our employees except where necessary and properly authorized, which has changed how we operate our business. Our clients and business partners are also subject to various and changing social distancing and office closure orders and recommendations and travel restrictions and prohibitions, which have changed the way we interact with our clients and business partners. COVID-19 had a moderately positive impact on our 2020 financial results due to the shift from brick-and-mortar to virtual. The severity and duration of the COVID-19 pandemic, and its impact on the U.S. and global economy, is uncertain, but we believe that there will be a continuing net benefit to us longer term. See Part I, Item 1A. Risk Factors, for further discussion of the impact of the COVID-19 pandemic on our business and operations. Key GAAP Operating Results Our revenue increased to $434.9 million for the year ended December 31, 2020, from $328.0 million and $257.7 million for the years ended December 31, 2019 and 2018, respectively. Revenue growth was primarily attributable to our larger clients, driven by an increase in our sales and marketing activities and our improved brand awareness. For each of the years ended December 31, 2020, 2019 and 2018, no single client accounted for more than 10% of our total revenue. As of December 31, 2020, we had over 2,000 clients across multiple industries. Our clients’ subscriptions generally range in size from fewer than 10 agent seats to approximately 9,000 agent seats. We had a net loss of $42.1 million, $4.6 million and $0.2 million for the years ended December 31, 2020, 2019 and 2018, respectively. We have continued to make significant expenditures and investments, including in sales and marketing, research and development and infrastructure. We primarily evaluate the success of our business based on revenue growth and the efficiency and effectiveness of our investments. The growth of our business and our future success depend on many factors, including our ability to continue to expand our base of larger clients, grow revenue from our existing client base, innovate and expand internationally. While these areas represent significant opportunities for us, they also pose risks and challenges that we must successfully address in order to sustain the growth of our business and improve our operating results, including the impact of the COVID-19 pandemic. 53 Table of Contents Due to our continuing investments to grow our business, increase our sales and marketing efforts, pursue new opportunities, enhance our solution and build our technology, we expect our cost of revenue and operating expenses to increase in absolute dollars in the long term. However, we expect cost of revenue and certain operating expenses to fluctuate as a percentage of revenue in the near term taking into consideration the impact of COVID-19 and the macroeconomic environment. Key Operating and Non-GAAP Financial Performance Metrics In addition to measures of financial performance presented in our consolidated financial statements, we monitor the key metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. Annual Dollar-Based Retention Rate We believe that our Annual Dollar-Based Retention Rate provides insight into our ability to retain and grow revenue from our clients, and is a measure of the long-term value of our client relationships. Prior Calculation - Net Invoicing. Our Annual Dollar-Based Retention Rate is calculated by dividing our Retained Net Invoicing by our Retention Base Net Invoicing on a monthly basis, which we then average using the rates for the trailing twelve months for the period being presented. We define Retention Base Net Invoicing as recurring net invoicing from all clients in the comparable prior year period, and we define Retained Net Invoicing as recurring net invoicing from that same group of clients in the current period. We define recurring net invoicing as subscription and related usage revenue excluding the impact of service credits, reserves and deferrals. Historically, the difference between recurring net invoicing and our subscription and related usage revenue has been within 10%. The following table shows our Annual Dollar-Based Retention Rate based on Net Invoicing for the periods presented: Twelve Months Ended December 31, 2020 2019 Annual Dollar-Based Retention Rate 110% 105% Our Dollar-Based Retention Rate improved year over year primarily due to our larger clients increasing their number of agent seats. New Calculation - Net Revenue . Starting from the fourth quarter of 2020, we revised our Annual Dollar-Based Retention Rate calculation to be based on Net Revenue, rather than Net Invoicing. We now have eight quarters of trended Annual Dollar-Based Retention Rates based on ASC 606 Net Revenue and, consistent with our peers, we are using Net Revenue rather than Net Invoicing and will no longer report the Net Invoicing calculation going forward. The following table shows our Annual Dollar-Based Retention Rate based on Net Revenue for the periods presented: Twelve Months Ended December 31, 2020 2019 Annual Dollar-Based Retention Rate 117% 112% Our Dollar-Based Retention Rate based on Net Revenue improved year-over-year primarily due to our larger clients increasing their number of agent seats. Adjusted EBITDA We monitor adjusted EBITDA, a non-GAAP financial measure, to analyze our financial results and believe that it is useful to investors, as a supplement to U.S. GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance. We believe that adjusted EBITDA helps illustrate underlying trends in our business that could otherwise be masked by the effect of the income or expenses that we exclude from adjusted EBITDA. Furthermore, we use this measure to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that adjusted EBITDA provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry. 54 Table of Contents Adjusted EBITDA should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with U.S. GAAP, and our calculation of adjusted EBITDA may differ from that of other companies in our industry. We compensate for the inherent limitations associated with using adjusted EBITDA through disclosure of these limitations, presentation of our financial statements in accordance with U.S. GAAP and reconciliation of adjusted EBITDA to the most directly comparable U.S. GAAP measure, net loss. We calculate adjusted EBITDA as net loss before (1) depreciation and amortization, (2) stock-based compensation, (3) interest income, expense and other, (4) loss on early extinguishment of debt, (5) acquisition-related transaction costs and one-time integration costs, (6) COVID-19 relief bonuses for employees, (7) provision for (benefit from) income taxes, and (8) other items that do not directly affect what we consider to be our core operating performance. The following table shows a reconciliation of net loss to adjusted EBITDA for the periods presented (in thousands): Year Ended December 31, 2020 2019 Net loss $ (42,130) $ (4,552) Non-GAAP adjustments: Depreciation and amortization (1) 25,087 14,374 Stock-based compensation (2) 64,747 42,065 Interest expense 28,348 13,794 Interest (income) and other (3,034) (6,079) Legal settlement (3) — 420 Legal and indemnification fees related to settlement — 356 Acquisition related transaction costs and one-time integration costs 6,335 338 COVID-19 relief bonuses for employees 1,817 — Loss on early extinguishment of debt 6,964 — Provision for (benefit from) income taxes (2,453) 104 Adjusted EBITDA $ 85,681 $ 60,820 (1) See ITEM 6 of this Form 10-K for depreciation and amortization expenses included in our results of operations for the periods presented. (2) See Note 7 to the consolidated financial statements for stock-based compensation expense included in our results of operations for the periods presented. (3) See “Legal Matters” in Note 10 to the consolidated financial statements for additional information. Key Components of Our Results of Operations Revenue Our revenue consists of subscription and related usage as well as professional services. We consider our subscription and related usage to be recurring revenue. This recurring revenue includes fixed subscription fees for the delivery and support of our VCC cloud platform, as well as related usage fees. The related usage fees are generally based on the volume of minutes for inbound and outbound client interactions. We also offer bundled plans, generally for smaller deployments, where the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. We offer monthly, annual and multiple-year contracts for our clients, generally with 30 days’ notice required for reductions in the number of agent seats. Increases in the number of agent seats can be provisioned almost immediately. Our clients, therefore, are able to adjust the number of agent seats used to meet their changing contact center volume needs. Our larger clients typically choose annual contracts, which generally include an implementation and ramp period of several months. Fixed subscription fees, including plans with bundled usage, are generally billed monthly in advance, while variable usage fees are billed in arrears. Fixed subscription fees are recognized on a straight-line basis over the 55 Table of Contents applicable term, which is predominantly the monthly contractual billing period. Support activities include technical assistance for our solution and upgrades and enhancements on a when and if available basis, which are not billed separately. Variable subscription related usage fees for non-bundled plans are billed in arrears based on client-specific per minute rate plans and are recognized as actual usage occurs. We generally require advance deposits from clients based on estimated usage. All fees, except usage deposits, are non-refundable. In addition, we generate professional services revenue from assisting clients in implementing our solution and optimizing use. These services include application configuration, system integration and education and training services. Professional services are primarily billed on a fixed-fee basis and are typically performed by us directly. In limited cases, our clients choose to perform these services themselves or engage their own third-party service providers to perform such services. Professional services are recognized as the services are performed using the proportional performance method, with performance measured based on labor hours, provided all other criteria for revenue recognition are met. Cost of Revenue Our cost of revenue consists primarily of personnel costs, including stock-based compensation, fees that we pay to telecommunications providers for usage, USF costs which have been increasing, contributions and other regulatory costs, depreciation and related expenses of the servers and equipment, costs to build out and maintain co-location data centers, costs of public cloud-based data centers, allocated office and facility costs and amortization of acquired technology. Cost of revenue can fluctuate based on a number of factors, including the fees we pay to telecommunications providers, which vary depending on our clients’ usage of our VCC cloud platform, the timing of capital expenditures and related depreciation charges and changes in headcount. We expect to continue investing in our network infrastructure and operations and client support function to maintain high quality and availability of service, resulting in absolute dollar increases in cost of revenue but percentage of revenue declines in the long-term through economies of scale. In the near-term, however, we expect cost of revenue to increase both in absolute dollars and as a percentage of revenue, primarily due to increased investments in public cloud. Operating Expenses We classify our operating expenses as research and development, sales and marketing, and general and administrative expenses. Research and Development . Our research and development expenses consist primarily of salary and related expenses, including stock-based compensation, for personnel related to the development of improvements and expanded features for our services, as well as quality assurance, testing, product management and allocated overhead. We expense research and development expenses as they are incurred except for internal use software development costs that qualify for capitalization. We believe that continued investment in our solution is important for our future growth, and we expect our research and development expenses to increase in absolute dollars and as a percentage of revenue in the near term. Sales and Marketing . Sales and marketing expenses consist primarily of salaries and related expenses, including stock-based compensation, for personnel in sales and marketing, sales commissions, as well as advertising, marketing, corporate communications, travel costs and allocated overhead. We believe it is important to continue investing in sales and marketing to continue to generate revenue growth, and we expect sales and marketing expenses to increase in absolute dollars over the long term and fluctuate as a percentage of revenue as we continue to support our growth initiatives. General and Administrative. General and administrative expenses consist primarily of salary and related expenses, including stock-based compensation, for management, finance and accounting, legal, information systems and human resources personnel, professional fees, compliance costs, other corporate expenses and allocated overhead. We expect that general and administrative expenses will fluctuate in absolute dollars and as a percentage of revenue in the near term, due to among other things, the impact of COVID-19 and the resulting macroeconomic conditions, but to increase in absolute dollars and decline as a percentage of revenue over time. 56 Table of Contents Results of Operations for the Years Ended December 31, 2020 and 2019 Based on the consolidated statements of operations and comprehensive loss set forth in this annual report, the following table sets forth our operating results as a percentage of revenue for the periods indicated: Year Ended December 31, 2020 2019 Revenue 100 % 100 % Cost of revenue 41 % 41 % Gross profit 59 % 59 % Operating expenses: Research and development 16 % 14 % Sales and marketing 30 % 29 % General and administrative 15 % 15 % Total operating expenses 61 % 58 % Income (loss) from operations (2) % 1 % Other income (expense), net: Interest expense (7) % (4) % Loss on early extinguishment of debt (2) % — % Interest income and other 1 % 2 % Total other income (expense), net (8) % (2) % Income (loss) before income taxes (10) % (1) % Provision for income taxes — % — % Net loss (10) % (1) % Year-to-year comparisons between 2019 and 2018 have been omitted from this Form 10-K but may be found in “Management's Discussion and Analysis of Financial Condition” in Part II, Item 7 of our Form 10-K for the fiscal year ended December 31, 2019, which specific discussion is incorporated herein by reference. Comparison of the Years Ended December 31, 2020 and 2019 Revenue Year Ended December 31, 2020 2019 $ Change % Change (in thousands, except percentages) Revenue $434,908 $328,006 $106,902 33% The increase in revenue for 2020 compared to 2019 was primarily attributable to our larger clients, driven by an increase in our sales and marketing activities and our improved brand awareness. Cost of Revenue Year Ended December 31, 2020 2019 $ Change % Change (in thousands, except percentages) Cost of revenue $180,284 $134,511 $45,773 34% % of Revenue 41% 41% The increase in cost of revenue for 2020 compared to 2019 was primarily due to a $11.6 million increase in personnel costs, including stock-based compensation costs, driven mainly by increased headcount and a higher fair value of employee equity awards due primarily to our increased stock price, a $10.2 million increase in depreciation and data center costs driven by increased capital expenditures to support our growing capacity needs and continuing expansion of our existing data center facilities, a $6.8 million increase in third-party hosted software costs driven by increased client activities, a $6.0 million increase in amortization expense due to the acquisitions of Virtual Observer 57 Table of Contents in April 2020 and Inference in November 2020 and the acquisition of certain intangible assets from Whendu in November 2019, a $4.5 million increase in USF contributions and other federal telecommunication service fees due primarily to increased client usage and an increase in the USF contribution rate, and a $1.9 million increase in office, facilities and related costs. Gross Profit Year Ended December 31, 2020 2019 $ Change % Change (in thousands, except percentages) Gross profit $254,624 $193,495 $61,129 32% % of Revenue 59% 59% The increase in gross profit for 2020 compared to 2019 was primarily due to increases in subscription and related revenues. Gross margin for 2020 was flat compared to 2019. Operating Expenses Research and Development Year Ended December 31, 2020 2019 $ Change % Change (in thousands, except percentages) Research and development $68,747 $45,190 $23,557 52% % of Revenue 16% 14% The increase in research and development expenses for 2020 compared to 2019 was primarily due to a $18.6 million increase in personnel-related costs including stock-based compensation costs, driven mainly by increased headcount and a higher fair value of employee equity awards due primarily to our increased stock price. Sales and Marketing Year Ended December 31, 2020 2019 $ Change % Change (in thousands, except percentages) Sales and marketing $132,413 $95,592 $36,821 39% % of Revenue 30% 29% The increase in sales and marketing expenses for 2020 compared to 2019 was primarily due to a $25.5 million increase in personnel-related costs, including stock-based compensation costs driven mainly by increased headcount and higher fair value of equity awards due primarily to our increased stock price, a $6.7 million increase in sales commission expenses driven by the growth in sales and bookings of our solution, and a $1.8 million increase in facilities and related costs. The remaining net increase in sales and marketing expenses was primarily due to the execution of our growth strategy to acquire new clients, increase the number of agent seats within our existing client base, and increased advertising and other marketing expenses to increase our brand awareness. General and Administrative Year Ended December 31, 2020 2019 $ Change % Change (in thousands, except percentages) General and administrative $65,769 $49,446 $16,323 33% % of Revenue 15% 15% The increase in general and administrative expenses for 2020 compared to 2019 was primarily due to a $11.6 million increase in personnel-related costs including stock-based compensation costs, driven mainly by increased headcount and a higher fair value of equity awards due primarily to our increased stock price, and a $5.0 million increase in legal and other professional service costs mainly related to our acquisitions. 58 Table of Contents Other Income (Expense), Net Year Ended December 31, 2020 2019 $ Change % Change (in thousands, except percentages) Interest expense $ (28,348) $ (13,794) $ (14,554) (106) % Loss on early extinguishment of debt (6,964) — (6,964) (100) % Interest income and other 3,034 6,079 (3,045) 50 % Total other income (expense), net $ (32,278) $ (7,715) $ (24,563) (318) % % of Revenue (7) % (2) % The increase in interest expense for 2020 compared to 2019 was primarily due to increased interest expense under our 2025 convertible senior notes issued in May and June 2020, offset in part by the decrease in interest expense as a result of the 2023 Note Repurchase Transactions and other 2023 convertible senior note settlements, which decreased the aggregate outstanding principal amount of our 2023 convertible senior notes. The $7.0 million of loss was from the early extinguishment of our 2023 convertible senior notes during 2020. The decrease in interest income and other for 2020 compared to 2019 was primarily from lower interest income on our marketable investments. Liquidity and Capital Resources To date, we have financed our operations, primarily through sales of our solution, lease facilities and net proceeds from our equity and debt financings, including the issuance of our 2025 convertible senior notes in May and June 2020 and of our 2023 convertible senior notes in May 2018. As of December 31, 2020, we had $585.6 million in working capital, which included $220.4 million in cash and cash equivalents, $383.2 million in short-term marketable investments and $42.1 million in long-term marketable investments. In May and June 2020, we issued $747.5 million aggregate principal amount of our 2025 convertible senior notes in a private offering. The 2025 convertible senior notes mature on June 1, 2025 and are our senior unsecured obligations. The 2025 convertible senior notes bear interest at a fixed rate of 0.50% per annum, payable semiannually in arrears on June 1 and December 1 of each year, beginning December 1, 2020. The total net proceeds from the offering, after deducting initial purchasers’ discounts and commissions and estimated debt issuance costs, were approximately $728.8 million. In May 2018, we issued $258.8 million aggregate principal amount of our 2023 convertible senior notes in a private offering. The 2023 convertible senior notes mature on May 1, 2023 and are our senior unsecured obligations. The 2023 convertible senior notes bear interest at a fixed rate of 0.125% per annum, payable semiannually in arrears on May 1 and November 1 of each year. The total net proceeds from the offering, after deducting the initial purchasers’ discounts and estimated debt issuance costs, were approximately $250.8 million. As of December 31, 2020, after giving effect to the 2023 Note Repurchase Transactions and other settlements upon conversion requests, approximately $58.9 million aggregate principal amount of 2023 convertible senior notes remained outstanding. For additional information regarding the convertible senior notes and related transactions, see Note 6 to the consolidated financial statements included in this report. We believe our existing cash and cash equivalents will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Our future capital requirements will depend on many factors including our growth rate, continuing market acceptance of our solution, client retention, our ability to gain new clients, the timing and extent of spending to support research and development efforts, the outcome of any pending or future litigation or other claims by third parties or governmental entities, the expansion of sales and marketing activities and personnel, the introduction of new and enhanced offerings, and the impact of the COVID-19 pandemic on these or other factors. We may also acquire or invest in complementary businesses, technologies and intellectual property rights, which may increase our use of cash and future capital requirements, either to pay acquisition costs or to support our combined operations. We may raise additional capital through equity or engage in debt financings at any time to fund these or other requirements. However, we may not be able to raise additional capital through equity or debt financings when needed on terms acceptable to us or at all, depending on our financial performance, market conditions and other factors, including the length and severity of the impact of the COVID-19 pandemic on general economic conditions and potential future impacts on the financial markets. If we are unable to raise additional capital as needed, our business, operating results and financial condition could be harmed. In addition, if our 59 Table of Contents operating performance during the next twelve months is below our expectations, our liquidity and ability to operate our business also could be harmed. If we raise additional funds by issuing equity or equity-linked securities, the ownership of our existing stockholders would be diluted. If we raise additional funds through the incurrence of additional indebtedness, we will be subject to increased debt service obligations and could also be subject to restrictive covenants and other operating restrictions that could negatively impact our ability to operate our business. Cash Flows The following table summarizes our cash flows for the periods presented (in thousands): Year Ended December 31, 2020 2019 Net cash provided by operating activities $ 67,302 $ 51,221 Net cash used in investing activities (382,330) (63,631) Net cash provided by financing activities 457,424 8,474 Net increase (decrease) in cash and cash equivalents $ 142,396 $ (3,936) Year-to-year comparisons between 2019 and 2018 have been omitted from this Form 10-K but may be found in “Management's Discussion and Analysis of Financial Condition” in Part II, Item 7 of our Form 10-K for the fiscal year ended December 31, 2019, which specific discussion is incorporated herein by reference. Cash Flows from Operating Activities Cash provided by operating activities is primarily influenced by our personnel-related expenditures, data center and telecommunications carrier costs, office and facility related costs, USF contributions and other regulatory costs and the amount and timing of client payments. If we continue to improve our financial results, we expect net cash provided by operating activities to increase. Our largest source of operating cash inflows is cash collections from our clients for subscription and related usage services. Payments from clients for these services are typically received monthly. Net cash provided by operating activities was $67.3 million during the year ended December 31, 2020. Net cash provided by operating activities resulted from our net loss of $42.1 million adjusted for non-cash items of $128.8 million, primarily consisting of $64.7 million of stock-based compensation, $25.7 million of amortization of discount and issuance costs on our convertible senior notes, $25.1 million of depreciation and amortization and $7.0 million of loss from the early extinguishment of our 2023 convertible senior notes, offset by use of cash for operating assets and liabilities of $19.4 million primarily due to the timing of cash payments to vendors and cash receipts from customers. Cash Flows from Investing Activities Net cash used in investing activities of $382.3 million in 2020 was comprised of $620.9 million related to purchases of marketable investments, $165.3 million, net of cash acquired, in connection with the acquisitions of Inference and Virtual Observer, and $30.4 million in capital expenditures, offset in part by $434.5 million related to cash proceeds from maturities of marketable investments. Cash Flows from Financing Activities Net cash provided by financing activities of $457.4 million in 2020 related to net cash proceeds of $728.8 million from the issuance of the 2025 convertible senior notes, net of initial purchasers' discounts and commissions and estimated debt issuance costs, cash proceeds of $11.7 million from exercise of stock options, and $11.5 million from the sale of common stock under our employee stock purchase plan, partially offset by $181.5 million of cash paid in connection with the 2023 Note Repurchase Transactions, $18.9 million of cash paid in connection with other 2023 convertible senior note settlements, $90.5 million of cash paid in connection with the 2025 Capped Call Transactions and $3.7 million of payments related to finance leases. 60 Table of Contents Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies are described in Note 1 to the consolidated financial statements. Revenue Recognition Revenue is recognized when control of the promised services is transferred to customers, in an amount that reflects the consideration that we expect to receive in exchange for those services. We generate all of our revenue from contracts with customers. In contracts with multiple performance obligations, we identify each performance obligation and evaluate whether the performance obligations are distinct within the context of the contract at contract inception. Performance obligations that are not distinct at contract inception are combined. We allocate the transaction price to each distinct performance obligation proportionately based on the estimated standalone selling price for each performance obligation. We then look to how services are transferred to the customer in order to determine the timing of revenue recognition. Most services provided under our agreements result in the transfer of control over time. Our revenue consists of subscription services and related usage as well as professional services. We charge clients subscription fees, usually billed on a monthly basis, for access to our VCC solution. The subscription fees are primarily based on the number of agent seats, as well as the specific VCC functionalities and applications deployed by the client. Agent seats are defined as the maximum number of named agents allowed to concurrently access the VCC cloud platform. Clients typically have more named agents than agent seats. Multiple named agents may use an agent seat, though not simultaneously. Substantially all of our clients purchase both subscriptions and related telephony usage. A small percentage of our clients subscribe to our platform but purchase telephony usage directly from a wholesale telecommunications service provider. We do not sell telephony usage on a stand-alone basis to any client. The related usage fees are based on the volume of minutes used for inbound and outbound client interactions. Revenue generated from telephony usage is presented in revenue and cost of sales on a gross basis, as we are the party that controls the service and are responsible for fulfilling the promise to provide the call service by diverting the calls to selected carriers. We also offer bundled plans, generally for smaller deployments, whereby the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. Professional services revenue is derived primarily from VCC implementations, including application configuration, system integration, optimization, education and training services. Clients are not permitted to take possession of our software. We offer monthly, annual and multiple-year contracts to our clients, generally with 30 days’ notice required for reductions in the number of agent seats. Increases in the number of agent seats can be provisioned almost immediately. Our clients, therefore, are able to adjust the number of agent seats used to meet their changing contact center volume needs. Our larger clients typically choose annual contracts, which generally include an implementation and ramp period of several months. Fixed subscription fees, including bundled plans, are generally billed monthly in advance, while related usage fees are billed in arrears. Support activities include technical assistance for our solution and upgrades and enhancements to our VCC cloud platform on a when-and-if-available basis, which are not billed separately. Professional services are primarily billed on a fixed-fee basis and are performed by us directly or, alternatively, clients may also choose to perform these services themselves or engage their own third-party service providers. Revenue for professional services is recognized over time, as services are performed. The estimation of variable consideration for each performance obligation requires us to make subjective judgments. In the early stages of our larger contracts, in order to allocate the overall transaction fee on a relative stand-alone selling price basis to our multiple performance obligations, we estimate variable consideration to be included in the transaction fee to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. When services are included in the contract with the customer and are not sold at their stand-alone selling price, this requires us to estimate the number of seats the customer will use, especially during the initial ramp period of the contract, during which we bill under an ‘actual usage’ model for subscription-related services. 61 Table of Contents We recognize revenue on fixed fee professional services performance obligations based on the proportion of labor hours expended compared to the total hours expected to complete the related performance obligation. The revenue recognition standards include guidance relating to any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added and excise taxes. We record USF contributions and other regulatory costs on a gross basis in our consolidated statements of operations and comprehensive loss and record surcharges and sales, use and excise taxes billed to our clients on a net basis. The cost of gross USF contributions payable to the USAC and suppliers is presented as a cost of revenue in the consolidated statements of operations and comprehensive loss. Business Combinations, Goodwill, and Acquisition-Related Intangible Assets Accounting for business combinations requires us to make significant estimates and assumptions. We allocate the purchase consideration to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair value at the acquisition dates, with the excess recorded to goodwill. Critical estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows, expected asset lives, royalty rates, and discount rates. The amounts and useful lives assigned to acquisition-related intangible assets impact the amount and timing of future amortization expense. We use estimates, assumptions, and judgments when performing a goodwill impairment test or assessing the recoverability of acquisition-related finite-lived intangible assets. We test goodwill for impairment on an annual basis in the fourth quarter and more frequently if a significant event or circumstance indicates impairment, and assess the recoverability of acquisition-related intangible assets whenever events or circumstances indicate that the carrying amounts of such assets may not be recoverable. We also evaluate the estimated remaining useful lives of acquisition-related intangible assets for changes in circumstances that warrant a revision to the remaining periods of amortization. Recent Accounting Pronouncements Refer to Note 1 in Item 8 of this Form 10-K for information related to recent accounting pronouncements. Off Balance Sheet Arrangements As of December 31, 2020, we did not have any off balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K, such as the use of unconsolidated subsidiaries, structured finance, special purpose entities or variable interest entities. Contractual Obligations Commitments Our principal contractual obligations consist of future payment obligations under our convertible senior notes, finance leases to finance data centers and other computer and networking equipment, operating leases for office facilities, and agreements with third parties to provide co-location hosting, telecommunication usage and equipment maintenance services. 62 Table of Contents The following table summarizes our significant contractual obligations as of December 31, 2020 (in thousands). Payment Due by Period Less Than More than Total 1 Year 1-3 Years 3-5 Years 5 Years Convertible senior notes (1) $ 806,367 $ — $ 58,867 $ 747,500 $ — Finance lease obligations (2) 628 628 — — — Operating lease obligations (3) 9,800 4,138 4,986 676 — Operating lease not yet commenced (3) 46,387 1,094 8,955 11,965 24,373 Cloud services (4) 11,400 7,000 4,400 — — Hosting services (5) 1,975 792 1,183 — — Telecommunication usage (6) 5,372 3,304 2,017 51 — Equipment maintenance (7) 25 25 — — — Total $ 881,954 $ 16,981 $ 80,408 $ 760,192 $ 24,373 (1) Represents the outstanding principal balance under our 2025 convertible seniors and our 2023 convertible senior notes. See Note 6 to the consolidated financial statements for more information. (2) Represents financing of computer and networking equipment and software purchases for our co-location data centers. (3) Represents our obligations to make payments under the lease agreements for our office facilities and office equipment leases. The operating lease not yet commenced relates to our Bishop Ranch Building Lease, or the Bishop Ranch Lease, that we entered into on July 29, 2020, which commenced on February 1, 2021. (4) Represents a three-year cloud services agreement that grants us a license to access and use certain cloud services. (5) Represents guaranteed minimum payments for co-location facilities and services. (6) Represents guaranteed minimum payments for telecommunication services. (7) Represents our payment obligations under maintenance services contracts for certain data center equipment. The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. Indemnification Agreements In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify clients, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of breach of such agreements, services to be provided by us or from intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors, officers and certain employees that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees. Other than as described below, there are no claims that we are aware of that could have a material effect on our consolidated balance sheet, consolidated statement of operations and comprehensive loss, or consolidated statements of cash flows. Contingencies — Legal and Regulatory We are subject to certain legal and regulatory proceedings, and from time to time may be involved in a variety of claims, lawsuits, investigations, and proceedings relating to contractual disputes, intellectual property rights, employment matters, regulatory compliance matters, and other litigation matters relating to various claims that arise in the normal course of business. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing specific litigation and regulatory matters using reasonably available information. We develop our views on estimated losses in consultation with inside and outside counsel, which involves a subjective analysis of potential results and outcomes, assuming various combinations of appropriate litigation and settlement strategies. Legal fees 63 Table of Contents are expensed in the period in which they are incurred. See Note 10 to the consolidated financial statements for more details.