HEALTHEQUITY, INC. 10-Q

Item 1. Financial statements HealthEquity, Inc. and subsidiaries Condensed consolidated balance sheets (in thousands, except par value) October 31, 2020 January 31, 2020 (unaudited) Assets Current assets Cash and cash equivalents $ 299,356 $ 191,726 Accounts receivable, net of allowance for doubtful accounts of $ 3,458 and $ 1,216 as of October 31, 2020 and January 31, 2020, respectively 64,291 70,863 Other current assets 32,383 34,711 Total current assets 396,030 297,300 Property and equipment, net 31,774 33,486 Operating lease right-of-use assets 92,314 83,178 Intangible assets, net 776,311 783,279 Goodwill 1,326,793 1,332,631 Deferred tax asset 21 18 Other assets 34,019 35,089 Total assets $ 2,657,262 $ 2,564,981 Liabilities and stockholders’ equity Current liabilities Accounts payable $ 6,746 $ 3,980 Accrued compensation 34,839 50,121 Accrued liabilities 33,380 46,372 Current portion of long-term debt 62,500 39,063 Operating lease liabilities 13,894 12,401 Total current liabilities 151,359 151,937 Long-term liabilities Long-term debt, net of issuance costs 938,558 1,181,615 Operating lease liabilities, non-current 76,666 68,017 Other long-term liabilities 11,429 2,625 Deferred tax liability 123,993 130,492 Total long-term liabilities 1,150,646 1,382,749 Total liabilities 1,302,005 1,534,686 Commitments and contingencies (see Note 6) Stockholders’ equity Preferred stock, $ 0.0001 par value, 100,000 shares authorized, no shares issued and outstanding as of October 31, 2020 and January 31, 2020, respectively — — Common stock, $ 0.0001 par value, 900,000 shares authorized, 76,951 and 71,051 shares issued and outstanding as of October 31, 2020 and January 31, 2020, respectively 8 7 Additional paid-in capital 1,140,268 818,774 Accumulated earnings 214,981 211,514 Total stockholders’ equity 1,355,257 1,030,295 Total liabilities and stockholders’ equity $ 2,657,262 $ 2,564,981 See accompanying notes to condensed consolidated financial statements. -3- HealthEquity, Inc. and subsidiaries Condensed consolidated statements of operations and comprehensive income (loss) (unaudited) Three months ended October 31, Nine months ended October 31, (in thousands, except per share data) 2020 2019 2020 2019 Revenue Service revenue $ 104,562 $ 87,620 $ 319,638 $ 140,710 Custodial revenue 48,544 46,972 142,352 132,538 Interchange revenue 26,245 22,526 83,411 57,545 Total revenue 179,351 157,118 545,401 330,793 Cost of revenue Service costs 65,936 52,278 202,195 92,672 Custodial costs 4,762 4,384 14,805 12,716 Interchange costs 4,095 4,421 13,985 13,177 Total cost of revenue 74,793 61,083 230,985 118,565 Gross profit 104,558 96,035 314,416 212,228 Operating expenses Sales and marketing 12,880 12,654 36,502 30,015 Technology and development 30,758 23,511 92,490 46,061 General and administrative 22,099 19,222 61,590 37,193 Amortization of acquired intangible assets 19,126 13,051 56,905 16,036 Merger integration 8,193 17,675 31,328 20,459 Total operating expenses 93,056 86,113 278,815 149,764 Income from operations 11,502 9,922 35,601 62,464 Other expense Interest expense ( 6,952 ) ( 10,225 ) ( 28,110 ) ( 10,355 ) Other expense, net ( 421 ) ( 30,949 ) ( 2,009 ) ( 8,347 ) Total other expense ( 7,373 ) ( 41,174 ) ( 30,119 ) ( 18,702 ) Income (loss) before income taxes 4,129 ( 31,252 ) 5,482 43,762 Income tax provision (benefit) 2,340 ( 9,918 ) 2,015 3,908 Net income (loss) and comprehensive income (loss) $ 1,789 $ ( 21,334 ) $ 3,467 $ 39,854 Net income (loss) per share: Basic $ 0.02 $ ( 0.30 ) $ 0.05 $ 0.61 Diluted $ 0.02 $ ( 0.30 ) $ 0.05 $ 0.59 Weighted-average number of shares used in computing net income (loss) per share: Basic 76,701 70,524 73,358 65,727 Diluted 77,845 70,524 74,665 67,150 See accompanying notes to condensed consolidated financial statements. -4- HealthEquity, Inc. and subsidiaries Condensed consolidated statements of stockholders’ equity (unaudited) Three months ended October 31, Nine months ended October 31, (in thousands) 2020 2019 2020 2019 Total stockholders' equity, beginning balance $ 1,340,336 $ 1,017,031 $ 1,030,295 $ 477,079 Common stock: Beginning balance 8 7 7 6 Issuance of common stock upon exercise of stock options, and for restricted stock — — — — Other issuance of common stock — — 1 1 Ending balance 8 7 8 7 Additional paid-in capital: Beginning balance 1,127,136 783,986 818,774 305,223 Issuance of common stock upon exercise of stock options, and for restricted stock 1,651 712 4,402 7,363 Other issuance of common stock 2 3,776 286,779 462,270 Stock-based compensation 11,479 17,576 30,313 31,194 Ending balance 1,140,268 806,050 1,140,268 806,050 Accumulated earnings Beginning balance 213,192 233,038 211,514 171,850 Net income (loss) 1,789 ( 21,334 ) 3,467 39,854 Ending balance 214,981 211,704 214,981 211,704 Total stockholders' equity, ending balance $ 1,355,257 $ 1,017,761 $ 1,355,257 $ 1,017,761 See accompanying notes to condensed consolidated financial statements. -5- HealthEquity, Inc. and subsidiaries Condensed consolidated statements of cash flows (unaudited) Nine months ended October 31, (in thousands) 2020 2019 Cash flows from operating activities: Net income $ 3,467 $ 39,854 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 85,485 28,791 Stock-based compensation 30,313 31,194 Amortization of debt issuance costs 3,818 1,138 Gains on marketable equity securities — ( 27,570 ) Other non-cash items 1,727 139 Deferred taxes ( 973 ) 690 Changes in operating assets and liabilities: Accounts receivable 8,063 ( 1,901 ) Other assets 3,309 ( 4,863 ) Operating lease right-of-use assets 8,344 3,340 Accrued compensation ( 15,251 ) ( 8,012 ) Accounts payable, accrued liabilities, and other current liabilities ( 7,936 ) 14,179 Operating lease liabilities, non-current ( 8,361 ) ( 2,859 ) Other long-term liabilities 8,712 ( 50 ) Net cash provided by operating activities 120,717 74,070 Cash flows from investing activities: Purchases of property and equipment ( 11,388 ) ( 5,180 ) Purchases of software and capitalized software development costs ( 37,242 ) ( 17,232 ) Acquisition of intangible member assets ( 28,100 ) ( 9,070 ) Purchases of marketable securities — ( 53,845 ) Acquisitions, net of cash acquired — ( 1,630,066 ) Net cash used in investing activities ( 76,730 ) ( 1,715,393 ) Cash flows from financing activities: Proceeds from follow-on equity offering, net of payments for offering costs 286,779 458,495 Principal payments on long-term debt ( 223,438 ) — Settlement of client-held funds obligation, net ( 4,189 ) ( 230,928 ) Proceeds from exercise of common stock options 4,491 7,342 Proceeds from long-term debt — 1,250,000 Payment of debt issuance costs — ( 30,504 ) Net cash provided by financing activities 63,643 1,454,405 Increase (decrease) in cash and cash equivalents 107,630 ( 186,918 ) Beginning cash and cash equivalents 191,726 361,475 Ending cash and cash equivalents $ 299,356 $ 174,557 See accompanying notes to condensed consolidated financial statements. -6- HealthEquity, Inc. and subsidiaries Condensed consolidated statements of cash flows (unaudited) (continued) Nine months ended October 31, (in thousands) 2020 2019 Supplemental cash flow data: Interest expense paid in cash $ 22,849 $ 249 Income taxes paid in cash, net of refunds received 1,053 9,127 Supplemental disclosures of non-cash investing and financing activities: Property and equipment included in accounts payable or accrued liabilities $ 167 $ 168 Software and capitalized software development costs included in accounts payable, accrued liabilities, or accrued compensation 1,346 316 Intangible member assets included in accounts payable or accrued liabilities 289 ( 151 ) Decrease in goodwill due to measurement period adjustments, net 5,838 — Exercise of common stock options receivable 89 21 Equity-based acquisition consideration — 3,776 See accompanying notes to condensed consolidated financial statements. -7- Table of Contents HealthEquity, Inc. and subsidiaries Notes to condensed consolidated financial statements Note 1. Summary of business and significant accounting policies Business HealthEquity, Inc. ("HealthEquity" or the "Company") was incorporated in the state of Delaware on September 18, 2002. HealthEquity is a leader in administering health savings accounts (“HSAs”) and complementary consumer-directed benefits (“CDBs”), which empower consumers to access tax-advantaged healthcare savings while also providing corporate tax advantages for employers. Principles of consolidation The condensed consolidated financial statements include the accounts of HealthEquity and its direct and indirect subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Basis of presentation The accompanying condensed consolidated financial statements as of October 31, 2020 and for the three and nine months ended October 31, 2020 and 2019 are unaudited and have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP") and the applicable rules and regulations of the Securities and Exchange Commission ("SEC") regarding interim financial reporting. In the opinion of management, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for the interim periods. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2020. The fiscal year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. Certain reclassifications have been made to prior year amounts to conform to the current year presentation. Follow-on equity offering In July 2020, the Company closed a follow-on public offering of 5,290,000 shares of common stock at a public offering price of $ 56.00 per share, less the underwriters' discount. The Company received net proceeds of approximately $ 286.8 million after deducting underwriting discounts and commissions of approximately $ 8.9 million and other offering expenses of approximately $ 0.6 million. The Company used $ 200.0 million of such proceeds to repay debt under its term loan facility. Significant accounting policies There have been no material changes in the Company’s significant accounting policies as compared to the significant accounting policies described in the Company’s Annual Report on Form 10-K for the fiscal year ended January 31, 2020. Recently adopted accounting pronouncements In June 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which requires financial assets measured at amortized cost be presented at the net amount expected to be collected. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company adopted the new standard as of February 1, 2020 using the modified retrospective transition method. The adoption of this standard did not have a material effect on the Company’s condensed consolidated financial statements. In August 2018, the FASB issued ASU 2018-13, Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”), which amends ASC 820, "Fair Value Measurement." ASU 2018-13 modifies the disclosure requirements for fair value measurements by removing, modifying and adding certain disclosures. This ASU is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. The Company adopted the new standard as of February 1, 2020. The adoption of this standard did not have a material effect on the Company’s condensed consolidated financial statements. -8- Table of Contents In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes as part of its overall simplification initiative to reduce costs and complexity of applying accounting standards while maintaining or improving the usefulness of the information provided to users of financial statements. The Company adopted the new standard as of February 1, 2020. The Company retrospectively adopted the provision related to the classification of taxes partially based on income, and prospectively adopted the provisions related to intraperiod tax allocation and interim recognition of enactment of tax laws. The adoption of this standard did not have a material effect on the Company’s current- or prior-period condensed consolidated financial statements. Note 2. Net income (loss) per share The following table sets forth the computation of basic and diluted net income (loss) per share: Three months ended October 31, Nine months ended October 31, (in thousands, except per share data) 2020 2019 2020 2019 Numerator (basic and diluted): Net income (loss) $ 1,789 $ ( 21,334 ) $ 3,467 $ 39,854 Denominator (basic): Weighted-average common shares outstanding 76,701 70,524 73,358 65,727 Denominator (diluted): Weighted-average common shares outstanding 76,701 70,524 73,358 65,727 Weighted-average dilutive effect of stock options and restricted stock units 1,144 — 1,307 1,423 Diluted weighted-average common shares outstanding 77,845 70,524 74,665 67,150 Net income (loss) per share: Basic $ 0.02 $ ( 0.30 ) $ 0.05 $ 0.61 Diluted $ 0.02 $ ( 0.30 ) $ 0.05 $ 0.59 For the three months ended October 31, 2020 and 2019, approximately 1.0 million and 3.2 million shares, respectively, attributable to stock options and restricted stock units were excluded from the calculation of diluted earnings per share as their inclusion would have been anti-dilutive. For the nine months ended October 31, 2020 and 2019, approximately 0.6 million and 0.3 million shares, respectively, attributable to stock options and restricted stock units were excluded from the calculation of diluted earnings per share as their inclusion would have been anti-dilutive. Note 3. Business combination Acquisition of WageWorks On August 30, 2019, the Company closed the acquisition (the "Acquisition") of WageWorks, Inc. ("WageWorks") for $ 51.35 per share in cash, or approximately $ 2.0 billion to WageWorks stockholders. The Company financed the transaction through a combination of $ 816.9 million cash on hand plus net borrowings of approximately $ 1.22 billion, after deducting lender fees of approximately $ 30.5 million, under a term loan facility. The Acquisition was accounted for under the acquisition method of accounting for business combinations. Consideration paid was allocated to the tangible and intangible assets acquired and liabilities assumed based on their fair values as of the Acquisition date. The initial allocation of the consideration paid was based on a preliminary valuation and was subject to adjustment during the measurement period (up to one year from the Acquisition date). The purchase price allocation was finalized in the third quarter of fiscal 2021. -9- Table of Contents The following table summarizes the Company's allocation of the consideration paid in the Acquisition: (in millions) Initial Allocation Adjustments Updated Allocation Cash and cash equivalents $ 406.8 $ ( 14.5 ) $ 392.3 Other current assets 56.5 2.5 59.0 Property, plant, and equipment 26.6 — 26.6 Operating lease right-of-use assets 42.5 — 42.5 Intangible assets 715.3 — 715.3 Goodwill 1,330.5 ( 8.4 ) 1,322.1 Other assets 5.9 — 5.9 Client-held funds obligation ( 237.5 ) 17.2 ( 220.3 ) Other current liabilities ( 69.1 ) ( 3.3 ) ( 72.4 ) Other long-term liabilities ( 26.7 ) — ( 26.7 ) Deferred tax liability ( 128.7 ) 6.5 ( 122.2 ) Total consideration paid $ 2,122.1 $ — $ 2,122.1 Adjustments to the initial allocation were based on more detailed information obtained about the specific assets acquired, liabilities assumed, and tax-related matters. Pro forma information The unaudited pro forma results presented below include the effects of the Acquisition as if it had been consummated as of February 1, 2018, with adjustments to give effect to pro forma events that are directly attributable to the Acquisition, which include adjustments related to the amortization of acquired intangible assets, interest income and expense, and depreciation. The unaudited pro forma results do not reflect any operating efficiencies or potential cost savings from the integration of WageWorks. Accordingly, these unaudited pro forma results are presented for informational purposes only and are not necessarily indicative of what the actual results of operations of the combined company would have been if the Acquisition had occurred at the beginning of the period presented, nor are they indicative of future results of operations. The estimated pro forma revenue and net income (loss) include the alignment of accounting policies, the effect of fair value adjustments related to the Acquisition, associated tax effects and the impact of the borrowings to finance the Acquisition and related expenses. (in thousands) Three months ended October 31, 2019 Nine months ended October 31, 2019 Revenue $ 194,450 $ 598,815 Net income (loss) $ ( 3,286 ) $ 34,559 Note 4. Supplemental financial statement information Selected condensed consolidated balance sheet and condensed consolidated statement of operations and comprehensive income components consist of the following: Property and equipment Property and equipment consisted of the following as of October 31, 2020 and January 31, 2020: (in thousands) October 31, 2020 January 31, 2020 Leasehold improvements $ 22,310 $ 19,240 Furniture and fixtures 9,219 7,929 Computer equipment 27,378 22,074 Property and equipment, gross 58,907 49,243 Accumulated depreciation ( 27,133 ) ( 15,757 ) Property and equipment, net $ 31,774 $ 33,486 Depreciation expense for the three months ended October 31, 2020 and 2019 was $ 4.0 million and $ 3.6 million, respectively, and $ 12.0 million and $ 5.4 million for the nine months ended October 31, 2020 and 2019, respectively. -10- Table of Contents Contract balances The Company does not recognize revenue in advance of invoicing its customers and therefore has no related contract assets. The Company records a receivable when revenue is recognized prior to payment and the Company has unconditional right to payment. Alternatively, when payment precedes the related services, the Company records a contract liability, or deferred revenue, until its performance obligations are satisfied. As of October 31, 2020 and January 31, 2020, the balance of deferred revenue was $ 7.0 million and $ 3.7 million, respectively. The balances are related to cash received in advance for an interchange revenue arrangement, other up-front fees and other commuter deferred revenue, and are generally recognized within twelve months, with the exception of the interchange arrangement, which is recognized over a term of approximately ten years . During the three and nine months ended October 31, 2020, approximately $ 0.4 million and $ 2.2 million of revenue, respectively, was recognized that was included in the balance of deferred revenue as of January 31, 2020. Leases The components of operating lease costs were as follows: Three months ended October 31, Nine months ended October 31, (in thousands) 2020 2019 2020 2019 Operating lease expense $ 3,777 3,354 12,297 5,515 Sublease income ( 450 ) ( 249 ) ( 1,349 ) ( 249 ) Net operating lease expense $ 3,327 $ 3,105 $ 10,948 $ 5,266 Supplemental cash flow information related to the Company's operating leases was as follows: Nine months ended October 31, (in thousands) 2020 2019 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 9,739 $ 4,575 Operating lease right-of-use assets obtained in exchange for new operating lease obligations $ 17,480 $ 34,394 Other expense, net Other expense, net, consisted of the following: Three months ended October 31, Nine months ended October 31, (in thousands) 2020 2019 2020 2019 Interest income $ 174 $ 2,046 $ 850 $ 5,273 Gain on equity securities — 285 — 27,570 Acquisition costs ( 13 ) ( 32,932 ) ( 79 ) ( 40,712 ) Other expense ( 582 ) ( 348 ) ( 2,780 ) ( 478 ) Total other expense, net $ ( 421 ) $ ( 30,949 ) $ ( 2,009 ) $ ( 8,347 ) -11- Table of Contents Note 5. Intangible assets and goodwill Intangible assets The gross carrying amount and associated accumulated amortization of intangible assets were as follows as of October 31, 2020 and January 31, 2020: (in thousands) October 31, 2020 January 31, 2020 Amortizable intangible assets: Software and software development costs $ 116,206 $ 76,221 Acquired HSA portfolios 121,159 92,770 Acquired customer relationships 601,381 601,381 Acquired developed technology 96,925 96,925 Acquired trade names 12,300 12,300 Amortizable intangible assets, gross 947,971 879,597 Accumulated amortization ( 172,276 ) ( 98,851 ) Total amortizable intangible assets, net 775,695 780,746 Acquired in process software development costs 616 2,533 Total intangible assets, net $ 776,311 $ 783,279 During the three months ended October 31, 2020 and 2019, the Company expensed a total of $ 10.5 million and $ 6.2 million, respectively, and $ 31.1 million and $ 13.8 million for the nine months ended October 31, 2020 and 2019, respectively, in software development costs primarily related to the post-implementation and operation stages of its proprietary software. Amortization expense for the three months ended October 31, 2020 and 2019 was $ 25.3 million and $ 15.7 million, respectively, and $ 73.5 million and $ 23.6 million for the nine months ended October 31, 2020 and 2019, respectively. Goodwill During the three and nine months ended October 31, 2020, goodwill decreased by $ 7.0 million and $ 5.8 million, respectively, due to measurement period adjustments related to the Acquisition of WageWorks. Note 6. Commitments and contingencies Commitments The Company’s principal commitments consist of a term loan facility, operating lease obligations for office space, data storage facilities, and other leases, a processing services agreement with a vendor, and contractual commitments related to network infrastructure, equipment, and certain maintenance agreements under long-term, non-cancelable commitments. Except for the $ 200 million principal prepayment on our term loan facility, there were no material changes during the three and nine months ended October 31, 2020, outside of the ordinary course of business, in our commitments from those disclosed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2020. Contingencies In the normal course of business, the Company enters into contracts and agreements that contain a variety of representations and warranties and provide for general indemnifications. The Company’s exposure under these agreements is unknown because it involves claims that may be made against the Company in the future, but have not yet been made. The Company accrues a liability for such matters when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. Legal matters WageWorks is pursuing affirmative claims against the Office of Personnel Management ("OPM") to obtain payment for services provided by WageWorks between March 1, 2016 and August 31, 2016 pursuant to its contract with OPM. In connection with WageWorks' claims against OPM, OPM has also claimed that an erroneous statement in a certificate signed by a former executive officer constituted a violation of the False Claims Act and moved to dismiss part of WageWorks' claim against OPM as a result. As with all legal proceedings, no assurance can be provided as to the outcome of these matters or if WageWorks or OPM will be successful. -12- Table of Contents On March 9, 2018, a putative class action was filed in the U.S. District Court for the Northern District of California (the “Securities Class Action”). On May 16, 2019, a consolidated amended complaint was filed by the lead plaintiffs asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, against WageWorks, its former Chief Executive Officer and its former Chief Financial Officer on behalf of purchasers of WageWorks common stock between May 6, 2016 and March 1, 2018. The complaint also alleges claims under the Securities Act of 1933, as amended, arising from WageWorks’ June 19, 2017 common stock offering against those same defendants, as well as the members of its board of directors at the time of that offering. On June 22, 2018 and September 6, 2018, two derivative lawsuits were filed against certain of WageWorks’ former officers and directors and WageWorks (as nominal defendant) in the Superior Court of the State of California, County of San Mateo. The actions were consolidated. On July 23, 2018, a similar derivative lawsuit was filed against certain former WageWorks’ officers and directors and WageWorks (as nominal defendant) in the U.S. District Court for the Northern District of California (together, the “Derivative Suits”). The allegations in the Derivative Suits relate to substantially the same facts as those underlying the Securities Class Action described above. The plaintiffs seek unspecified damages and fees and costs. Plaintiffs in the Superior Court action filed an amended consolidated complaint on October 28, 2019, naming as defendants certain former officers and directors of WageWorks and alleging a direct claim of "inseparable fraud/breach of fiduciary duty" on behalf of a class. WageWorks was not named as a party in that complaint. On June 24, 2020, the court granted the defendants’ motion to dismiss the amended complaint. The plaintiffs subsequently filed a notice of appeal. WageWorks voluntarily contacted the San Francisco office of the SEC Division of Enforcement regarding the restatement of WageWorks' financial statements and related independent investigation. WageWorks is providing information and documents to the SEC and continues to cooperate with the SEC’s investigation into these matters. The U.S. Attorney’s Office for the Northern District of California also opened an investigation. WageWorks has provided documents and information to the U.S. Attorney’s Office and continues to cooperate with any inquiries by the U.S. Attorney’s Office regarding the matter. WageWorks previously entered into indemnification agreements with its former directors and officers and, pursuant to these indemnification agreements, is covering the defense of its former directors and officers in the legal proceedings described above. The Company and its subsidiaries are involved in various other litigation, governmental proceedings and claims, not described above, that arise in the normal course of business. While it is not possible to determine the ultimate outcome or the duration of such litigation, governmental proceedings or claims, the Company believes, based on current knowledge, that such litigation, proceedings and claims will not have a material impact on the Company’s financial position, results of operations and cash flows for the period. The Company maintains liability insurance coverage that is intended to cover the legal matters described above; however, it is possible that claims may be denied by our insurance carriers or could exceed the amount of our applicable insurance coverage, we may be required by our insurance carriers to contribute to the payment of claims, and our insurance coverage may not continue to be available to us on acceptable terms or in sufficient amounts. As required under GAAP, the Company records a provision for contingent losses when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Based on currently available information, the Company does not believe that any liabilities relating to these matters are probable or that the amount of any resulting loss is estimable. However, litigation is subject to inherent uncertainties and the Company’s view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on the Company’s financial position, results of operations and cash flows for the period in which the unfavorable outcome occurs, and potentially in future periods. Note 7. Income taxes The Company follows FASB Accounting Standards Codification 740-270, Income Taxes - Interim Reporting , for the computation and presentation of its interim period tax provision. Accordingly, management estimated the effective annual tax rate and applied this rate to the year-to-date pre-tax book income to determine the interim benefit or provision for income taxes. For the three and nine months ended October 31, 2020, the Company recorded income tax expense of $ 2.3 million and $ 2.0 million, respectively. This resulted in an effective income tax expense rate of 56.7 % and 36.8 % for the three and nine months ended October 31, 2020, respectively, compared with an effective income tax benefit rate of 31.7 % and an effective income tax expense rate of 8.9 % for the three and nine months ended October 31, 2019, respectively. For the three and nine months ended October 31, 2020 and 2019, the net -13- Table of Contents impact of discrete tax items caused a 6.0 percentage point expense and a 9.6 percentage point benefit and a 1.1 and 8.7 percentage point benefit, respectively, to the effective income tax rate primarily due to the excess tax benefit on stock-based compensation expense and return-to-provision adjustments, which were partially offset by state apportionment changes recognized in the provision for income taxes relative to pre-tax book income. Due to significantly lower pre-tax book income during the nine months ended October 31, 2020, discrete items had a greater impact on the effective income tax rate than during the nine months ended October 31, 2019. As of October 31, 2020 and January 31, 2020, the Company’s total gross unrecognized tax benefit was $ 10.0 million and $ 9.4 million, respectively. As of October 31, 2020 and January 31, 2020, a net unrecognized tax benefit of $ 0.5 million was recorded in the condensed consolidated balance sheets. If recognized, $ 9.2 million of the total gross unrecognized tax benefits would affect the Company's effective tax rate as of October 31, 2020. The Company files income tax returns with U.S. federal and state taxing jurisdictions and is currently under examination with the state of Texas. As a result of the Company's net operating loss carryforwards and tax credit carryforwards, the Company remains subject to examination by one or more jurisdictions for tax years after 2000. Note 8. Indebtedness As of October 31, 2020, long-term debt consisted of the following: (in millions) October 31, 2020 Term loan facility $ 1,018.8 Less: unamortized loan issuance costs (1) 17.7 Long-term debt, net of issuance costs $ 1,001.1 (1) In addition to the $ 17.7 million of unamortized issuance costs related to the term loan facility, $ 5.3 million of unamortized issuance costs related to our revolving credit facility are included within other assets on the October 31, 2020 condensed consolidated balance sheet. In connection with the closing of the Acquisition, on August 30, 2019, the Company entered into a credit facility (the "Credit Agreement”) that provided for: (i) a five-year senior secured term loan A facility (the “Term Loan Facility”), in an aggregate principal amount of $ 1.25 billion, the proceeds of which were used to finance the Acquisition, to refinance substantially all outstanding indebtedness of HealthEquity and WageWorks and to pay related fees and expenses; and (ii) a five-year senior secured revolving credit facility (the “Revolving Credit Facility” and, together with the Term Loan Facility, the “Credit Facilities”), in an aggregate principal amount of up to $ 350.0 million, which may be used for working capital and general corporate purposes, including acquisitions and other investments. No amounts were drawn under the Revolving Credit Facility as of October 31, 2020. Borrowings under the Credit Facilities bear interest at an annual rate equal to, at the option of HealthEquity, either (i) LIBOR (adjusted for reserves) plus a margin ranging from 1.25 % to 2.25 % or (ii) an alternate base rate plus a margin ranging from 0.25 % to 1.25 %, with the applicable margin determined by reference to a leverage-based pricing grid set forth in the Credit Agreement. As of October 31, 2020, the stated interest rate was 1.65 % and the effective interest rate was 2.18 %. The Company is also required to pay certain fees to the lenders, including, among others, a quarterly commitment fee on the average unused amount of the Revolving Credit Facility at a rate ranging from 0.20 % to 0.40 %, with the applicable rate also determined by reference to a leverage-based pricing grid set forth in the Credit Agreement. The loans made under the Term Loan Facility are required to be repaid as described in the following table: Fiscal year ending January 31, (in millions) Principal payments Remaining 2021 $ 15.6 2022 62.5 2023 70.3 2024 101.6 2025 (1) 768.8 Total principal payments $ 1,018.8 (1) The amount required to be repaid in 2025 reflects the $ 200.0 million prepayment made in July 2020 with proceeds from the follow-on offering. The Credit Agreement contains customary affirmative and negative covenants, including covenants that limit, among other things, the ability of the Company to incur additional indebtedness, create liens, merge or dissolve, -14- Table of Contents make investments, dispose of assets, engage in sale and leaseback transactions, make distributions and dividends and prepayments of junior indebtedness, engage in transactions with affiliates, enter into restrictive agreements, amend documentation governing junior indebtedness, modify its fiscal year and modify its organizational documents, in each case, subject to customary exceptions, thresholds, qualifications and “baskets.” In addition, the Credit Agreement contains financial performance covenants, which require the Company to maintain (i) a maximum total net leverage ratio, measured as of the last day of each fiscal quarter, of no greater than 5.00 to 1.00, which steps down to 4.50 to 1.00 beginning with the fiscal quarter ending July 31, 2021 (subject to a customary “acquisition holiday” provision that allows the maximum total net leverage ratio to increase to 5.00 to 1.00 for the four fiscal quarter period ending on or following the date of a permitted acquisition by the Company in excess of $ 100.0 million), and (ii) a minimum interest coverage ratio, measured as of the last day of each fiscal quarter, of no less than 3.00 to 1.00. The Company was in compliance with all covenants under the Credit Agreement as of October 31, 2020, and for the period then ended. The obligations of HealthEquity under the Credit Agreement are required to be unconditionally guaranteed by WageWorks and each of the Company's subsequently acquired or organized direct and indirect domestic subsidiaries and are secured by security interests in substantially all assets of HealthEquity and the guarantors, in each case, subject to certain customary exceptions. Note 9. Stock-based compensation The following table shows a summary of stock-based compensation in the Company's condensed consolidated statements of operations and comprehensive income (loss) during the periods presented: Three months ended October 31, Nine months ended October 31, (in thousands) 2020 2019 2020 2019 Cost of revenue $ 2,209 $ 1,415 $ 5,737 $ 3,285 Sales and marketing 2,035 1,304 4,810 3,469 Technology and development 2,641 2,171 8,051 5,600 General and administrative 4,594 3,332 11,715 9,486 Merger Integration — 1,220 — 1,220 Other expense, net — 13,714 — 13,714 Total stock-based compensation expense $ 11,479 $ 23,156 $ 30,313 $ 36,774 Stock award plans Incentive Plan. The Company grants stock options, restricted stock units ("RSUs"), and restricted stock awards ("RSAs") under the HealthEquity, Inc. 2014 Equity Incentive Plan (as amended and restated, the "Incentive Plan"), which provided for the issuance of stock awards to the directors and team members of the Company to purchase up to an aggregate of 2.6 million shares of common stock. In addition, under the Incentive Plan, the number of shares of common stock reserved for issuance under the Incentive Plan automatically increases on February 1 of each year, beginning as of February 1, 2015 and continuing through and including February 1, 2024, by 3 % of the total number of shares of the Company’s capital stock outstanding on January 31 of the preceding fiscal year, or a lesser number of shares determined by the board of directors. As of October 31, 2020, 6.4 million shares were available for grant under the Incentive Plan. WageWorks Incentive Plan. At the closing of the Acquisition, and in accordance with the merger agreement related to the Acquisition, certain RSUs with respect to WageWorks common stock, granted under WageWorks, Inc. 2010 Equity Incentive Plan (the "WageWorks Incentive Plan"), were replaced by the Company and converted into RSUs with respect to 0.5 million shares of common stock of the Company. No additional shares were issued under the WageWorks Incentive Plan, and the period during which the remaining 5.3 million shares were available to be utilized expired on May 26, 2020. -15- Table of Contents Stock options A summary of stock option activity is as follows: Outstanding stock options (in thousands, except for exercise prices and term) Number of options Range of exercise prices Weighted- average exercise price Weighted- average contractual term (in years) Aggregate intrinsic value Outstanding as of January 31, 2020 2,040 $ 0.10 - 82.39 $ 30.35 5.90 $ 74,009 Granted 16 $ 66.06 $ 66.06 Exercised ( 183 ) $ 0.10 - 44.53 $ 24.09 Forfeited ( 10 ) $ 25.45 - 44.53 $ 38.02 Outstanding as of October 31, 2020 1,863 $ 1.25 - 82.39 $ 31.23 5.10 $ 42,046 Vested and expected to vest as of October 31, 2020 1,863 $ 31.23 5.10 $ 42,046 Exercisable as of October 31, 2020 1,584 $ 26.55 4.70 $ 41,025 Restricted stock units and restricted stock awards A summary of RSU and RSA activity is as follows: RSUs and PRSUs RSAs and PRSAs (in thousands, except weighted-average grant date fair value) Shares Weighted-average grant date fair value Shares Weighted-average grant date fair value Outstanding as of January 31, 2020 1,380 $ 63.33 235 $ 61.91 Granted 1,220 56.57 14 74.81 Vested ( 446 ) 54.78 ( 10 ) 62.80 Forfeited ( 262 ) 66.77 ( 32 ) 62.41 Outstanding as of October 31, 2020 1,892 $ 60.51 207 $ 62.66 Performance restricted stock units and awards. In March 2018, the Company awarded 227,760 performance-based RSAs ("PRSAs"). The Company records stock-based compensation related to PRSAs when it is considered probable that the performance conditions will be met. The underlying shares were issued at 200 % of the target level of achievement at the grant date. In March 2020, the Compensation Committee modified the awards by deeming the performance condition related to two-thirds of the awards to be achieved at 100 % and creating a new performance condition related to the remaining one-third of the awards to reflect the state of the Company after the Acquisition of WageWorks. The new performance condition is based on the achievement of certain financial criteria measured on January 31, 2021. The modification affected 10 team members and did not result in an adjustment to stock-based compensation expense. The PRSAs cliff vest upon approval by the Compensation Committee. The modified performance condition for the one-third tranche allows for a range of vesting from 0 % to 200 % based on the level of achievement of the performance condition, and the Company believes it is probable that the PRSAs will vest at least in part. As the underlying shares were issued at grant date, they are subject to clawback based on actual Company performance. In March 2019, the Company awarded 129,963 PRSUs. The Company records stock-based compensation related to PRSUs when it is considered probable that the performance conditions will be met. In March 2020, the Compensation Committee modified the awards by deeming the performance condition related to one-third of the awards to be achieved at 100 % and creating new performance conditions related to the remaining two-thirds of the awards to reflect the state of the Company after the Acquisition of WageWorks. The new performance conditions are based on the achievement of certain financial criteria measured on January 31, 2021 and 2022. The modification affected 12 team members and resulted in incremental stock-based compensation expense of $ 6.6 million, which will be recognized over the remaining service period, adjusted for the level of achievement of the performance conditions and any forfeitures. Prior to the modification, the Company did not believe the PRSUs were likely to vest, and as a result, $ 2.9 million of previously recorded stock-based compensation expense was reversed during the three months ended April 30, 2020. The PRSUs cliff vest upon approval by the Compensation Committee. The modified performance conditions for the two-thirds tranche allow for a range of vesting from 0 % to 200 % based on the level of achievement of the new performance conditions, and the Company believes it is probable that the PRSUs will vest at least in part. -16- Table of Contents During the first and second quarters of fiscal 2021, the Company awarded 277,950 PRSUs subject to a market condition based on the Company’s total shareholder return ("TSR") relative to the Russell 2000 index as measured on January 31, 2023. The Company used a Monte Carlo simulation to determine that the grant date fair value of the awards was approximately $ 20.8 million. Compensation expense is recorded if the service condition is met regardless of whether the market condition is satisfied. The market condition allows for a range of vesting from 0 % to 200 % based on the level of performance achieved. The PRSUs cliff vest upon approval by the Compensation Committee. Note 10. Fair value Fair value measurements are made at a specific point in time, based on relevant market information. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. Accounting standards specify a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs have created the following fair value hierarchy: • Level 1—quoted prices in active markets for identical assets or liabilities; • Level 2—inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and • Level 3—unobservable inputs based on the Company’s own assumptions. Level 1 instruments are valued based on publicly available daily net asset values. Level 1 instruments consist primarily of cash and cash equivalents. The carrying value of cash and cash equivalents approximate fair values as of October 31, 2020 due to the short-term nature of these instruments. Our long-term debt is considered a Level 2 instrument and is recorded at book value in our condensed consolidated financial statements. Our long-term debt reprices frequently due to variable interest rate terms and entails no significant changes in credit risk. As a result, we believe the fair value of our long-term debt approximates carrying value. -17- Table of Contents