PEGASYSTEMS INC 10-Q

ITEM 1. FINANCIAL STATEMENTS PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) June 30, 2021 December 31, 2020 Assets Current assets: Cash and cash equivalents $ 139,878 $ 171,899 Marketable securities 271,459 293,269 Total cash, cash equivalents, and marketable securities 411,337 465,168 Accounts receivable 166,226 215,827 Unbilled receivables 236,451 207,155 Other current assets 96,215 88,760 Total current assets 910,229 976,910 Unbilled receivables 144,065 113,278 Goodwill 82,173 79,231 Other long-term assets 466,103 434,843 Total assets $ 1,602,570 $ 1,604,262 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 22,931 $ 24,028 Accrued expenses 64,093 59,261 Accrued compensation and related expenses 84,900 123,012 Deferred revenue 242,194 232,865 Other current liabilities 16,126 20,969 Total current liabilities 430,244 460,135 Convertible senior notes, net 589,092 518,203 Operating lease liabilities 42,063 59,053 Other long-term liabilities 18,703 24,699 Total liabilities 1,080,102 1,062,090 Stockholders’ equity: Preferred stock, 1,000 shares authorized; none issued — — Common stock, 200,000 shares authorized; 81,456 and 80,890 shares issued and outstanding at June 30, 2021 and December 31, 2020, respectively 815 809 Additional paid-in capital 147,670 204,432 Retained earnings 375,069 339,879 Accumulated other comprehensive (loss) ( 1,086 ) ( 2,948 ) Total stockholders’ equity 522,468 542,172 Total liabilities and stockholders’ equity $ 1,602,570 $ 1,604,262 See notes to unaudited condensed consolidated financial statements. 3 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) Three Months Ended June 30, Six Months Ended June 30, 2021 2020 2021 2020 Revenue Software license $ 116,892 $ 53,323 $ 233,853 $ 147,239 Maintenance 78,782 72,222 154,343 145,917 Pega Cloud 73,293 48,838 141,151 92,304 Consulting 56,735 52,992 109,854 107,506 Total revenue 325,702 227,375 639,201 492,966 Cost of revenue Software license 656 979 1,306 1,663 Maintenance 4,995 5,591 10,781 11,167 Pega Cloud 24,051 18,988 46,608 36,521 Consulting 54,829 51,133 108,283 106,868 Total cost of revenue 84,531 76,691 166,978 156,219 Gross profit 241,171 150,684 472,223 336,747 Operating expenses Selling and marketing 156,423 127,607 305,162 263,631 Research and development 64,395 58,869 126,837 117,596 General and administrative 19,161 15,655 37,431 31,285 Total operating expenses 239,979 202,131 469,430 412,512 Income (loss) from operations 1,192 ( 51,447 ) 2,793 ( 75,765 ) Foreign currency transaction (loss) gain ( 403 ) 4,256 ( 5,501 ) ( 1,691 ) Interest income 236 242 389 849 Interest expense ( 1,959 ) ( 5,529 ) ( 3,839 ) ( 7,835 ) Gain on capped call transactions 26,309 19,419 7,192 827 Other income, net — — 106 1,374 Income (loss) before (benefit from) income taxes 25,375 ( 33,059 ) 1,140 ( 82,241 ) (Benefit from) income taxes ( 11,916 ) ( 12,319 ) ( 29,534 ) ( 36,129 ) Net income (loss) $ 37,291 $ ( 20,740 ) $ 30,674 $ ( 46,112 ) Earnings (loss) per share Basic $ 0.46 $ ( 0.26 ) $ 0.38 $ ( 0.58 ) Diluted $ 0.43 $ ( 0.26 ) $ 0.36 $ ( 0.58 ) Weighted-average number of common shares outstanding Basic 81,316 80,224 81,161 80,016 Diluted 90,320 80,224 86,006 80,016 See notes to unaudited condensed consolidated financial statements. 4 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (in thousands) Three Months Ended June 30, Six Months Ended June 30, 2021 2020 2021 2020 Net income (loss) $ 37,291 $ ( 20,740 ) $ 30,674 $ ( 46,112 ) Other comprehensive income, net of tax Unrealized gain on available-for-sale securities 121 — 1,131 100 Foreign currency translation adjustments 1,461 2,028 731 1,514 Total other comprehensive income, net of tax $ 1,582 $ 2,028 $ 1,862 $ 1,614 Comprehensive income (loss) $ 38,873 $ ( 18,712 ) $ 32,536 $ ( 44,498 ) See notes to unaudited condensed consolidated financial statements. 5 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands, except per share amounts) Common Stock Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive (Loss) Total Stockholders’ Equity Number of Shares Amount December 31, 2019 79,599 $ 796 $ 140,523 $ 410,919 $ ( 13,228 ) $ 539,010 Equity component of convertible senior notes, net — — 61,604 — — 61,604 Repurchase of common stock ( 87 ) ( 1 ) ( 5,999 ) — — ( 6,000 ) Issuance of common stock for stock compensation plans 564 6 ( 23,017 ) — — ( 23,011 ) Stock-based compensation — — 23,199 — — 23,199 Cash dividends declared ($ 0.03 per share) — — — ( 2,405 ) — ( 2,405 ) Other comprehensive (loss) — — — — ( 414 ) ( 414 ) Net (loss) — — — ( 25,372 ) — ( 25,372 ) March 31, 2020 80,076 $ 801 $ 196,310 $ 383,142 $ ( 13,642 ) $ 566,611 Repurchase of common stock ( 23 ) — ( 2,199 ) — — ( 2,199 ) Issuance of common stock for stock compensation plans 349 3 ( 14,085 ) — — ( 14,082 ) Issuance of common stock under the employee stock purchase plan 18 — 1,403 — — 1,403 Stock-based compensation — — 25,674 — — 25,674 Cash dividends declared ($ 0.03 per share) — — — ( 2,413 ) — ( 2,413 ) Other comprehensive income — — — — 2,028 2,028 Net (loss) — — — ( 20,740 ) — ( 20,740 ) June 30, 2020 80,420 $ 804 $ 207,103 $ 359,989 $ ( 11,614 ) $ 556,282 December 31, 2020 80,890 $ 809 $ 204,432 $ 339,879 $ ( 2,948 ) $ 542,172 Cumulative-effect adjustment from adoption of ASU 2020-06 , net — — ( 61,604 ) 9,399 — ( 52,205 ) Repurchase of common stock ( 70 ) ( 1 ) ( 9,145 ) — — ( 9,146 ) Issuance of common stock for stock compensation plans 402 4 ( 25,513 ) — — ( 25,509 ) Issuance of common stock under the employee stock purchase plan 24 — 2,288 — — 2,288 Stock-based compensation — — 30,100 — — 30,100 Cash dividends declared ($ 0.03 per share) — — — ( 2,438 ) — ( 2,438 ) Other comprehensive income — — — — 280 280 Net (loss) — — — ( 6,617 ) — ( 6,617 ) March 31, 2021 81,246 $ 812 $ 140,558 $ 340,223 $ ( 2,668 ) $ 478,925 Repurchase of common stock ( 81 ) ( 1 ) ( 10,245 ) — — ( 10,246 ) Issuance of common stock for stock compensation plans 267 3 ( 16,199 ) — — ( 16,196 ) Issuance of common stock under the employee stock purchase plan 24 1 2,858 — — 2,859 Stock-based compensation — — 30,698 — — 30,698 Cash dividends declared ($ 0.03 per share) — — — ( 2,445 ) — ( 2,445 ) Other comprehensive income — — — — 1,582 1,582 Net income — — — 37,291 — 37,291 June 30, 2021 81,456 $ 815 $ 147,670 $ 375,069 $ ( 1,086 ) $ 522,468 See notes to unaudited condensed consolidated financial statements. 6 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Six Months Ended June 30, 2021 2020 Operating activities Net income (loss) $ 30,674 $ ( 46,112 ) Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities Stock-based compensation 60,788 48,831 (Gain) on capped call transactions ( 7,192 ) ( 827 ) Deferred income taxes ( 28,232 ) ( 18,399 ) Amortization of deferred commissions 21,202 16,061 Amortization of debt discount and issuance costs 1,348 6,033 Amortization of intangible assets and depreciation 15,504 10,134 Amortization of investments 1,988 — Foreign currency transaction loss 5,501 1,691 Other non-cash ( 4,869 ) 6,445 Change in operating assets and liabilities, net ( 77,302 ) ( 45,056 ) Cash provided by (used in) operating activities 19,410 ( 21,199 ) Investing activities Purchases of investments ( 51,601 ) ( 1,769 ) Proceeds from maturities and called investments 68,798 — Sales of investments 2,450 1,424 Payments for acquisitions, net of cash acquired ( 4,993 ) — Investment in property and equipment ( 4,161 ) ( 19,059 ) Cash provided by (used in) investing activities 10,493 ( 19,404 ) Financing activities Proceeds from issuance of convertible senior notes — 600,000 Purchase of capped calls related to convertible senior notes — ( 51,900 ) Payment of debt issuance costs — ( 14,527 ) Proceeds from employee stock purchase plan 5,146 1,403 Dividend payments to stockholders ( 4,865 ) ( 4,793 ) Common stock repurchases ( 60,998 ) ( 44,890 ) Cash (used in) provided by financing activities ( 60,717 ) 485,293 Effect of exchange rate changes on cash and cash equivalents ( 1,207 ) ( 942 ) Net (decrease) increase in cash and cash equivalents ( 32,021 ) 443,748 Cash and cash equivalents, beginning of period 171,899 68,363 Cash and cash equivalents, end of period $ 139,878 $ 512,111 See notes to unaudited condensed consolidated financial statements. 7 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. BASIS OF PRESENTATION Pegasystems Inc. (together with its subsidiaries, “the Company”) has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all the information required by accounting principles generally accepted in the United States of America (“U.S.”) for complete financial statements. These financial statements should be read in conjunction with the Company’s audited financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2020. In the opinion of management, the Company has prepared the accompanying unaudited condensed consolidated financial statements on the same basis as its audited financial statements, and these financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of the interim periods presented. All intercompany transactions and balances were eliminated in consolidation. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year 2021. NOTE 2. NEW ACCOUNTING PRONOUNCEMENTS Convertible debt In August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts in an entity’s own equity. The standard eliminates the liability and equity separation model for convertible instruments with a cash conversion feature. As a result, after adoption, entities will no longer separately present in stockholders’ equity an embedded conversion feature for such debt. Additionally, the debt discount resulting from separating the embedded conversion feature will no longer be amortized into income as interest expense over the instrument’s life. Instead, entities will account for a convertible debt instrument wholly as debt unless (1) a convertible instrument contains features that require bifurcation as a derivative under ASC Topic 815, “Derivatives and Hedging”, or (2) a convertible debt instrument was issued at a substantial premium. The standard also requires the convertible instruments’ impact on diluted earnings per share (“EPS”) be determined using the if-converted method. The Company adopted ASU 2020-06 using the modified retrospective approach on January 1, 2021. Upon adoption, the book value of the Company’s Convertible Senior Notes (the “Notes”) increased by $ 69.5 million to $ 587.7 million, and retained earnings increased by $ 9.4 million. The retained earnings adjustment reflects the tax effected difference between the value of the Notes and the embedded conversion feature before adoption and the combined convertible instrument's amortized cost after adoption. See "Note 8. Debt" for additional information. NOTE 3. MARKETABLE SECURITIES June 30, 2021 December 31, 2020 (in thousands) Amortized Cost Unrealized Gains Unrealized Losses Fair Value Amortized Cost Unrealized Gains Unrealized Losses Fair Value Government debt $ 2,000 $ — $ — $ 2,000 $ 39,996 $ — $ ( 8 ) $ 39,988 Corporate debt 269,649 20 ( 210 ) 269,459 253,345 88 ( 152 ) 253,281 $ 271,649 $ 20 $ ( 210 ) $ 271,459 $ 293,341 $ 88 $ ( 160 ) $ 293,269 As of June 30, 2021, marketable securities’ maturities ranged from July 2021 to May 2024, with a weighted-average remaining maturity of approximately 1.3 years. 8 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 4. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE Receivables (in thousands) June 30, 2021 December 31, 2020 Accounts receivable $ 166,226 $ 215,827 Unbilled receivables 236,451 207,155 Long-term unbilled receivables 144,065 113,278 $ 546,742 $ 536,260 Unbilled receivables Unbilled receivables are client-committed amounts for which revenue recognition precedes billing, and billing is solely subject to the passage of time. Unbilled receivables by expected billing date: (Dollars in thousands) June 30, 2021 1 year or less $ 236,451 62 % 1-2 years 88,350 23 % 2-5 years 55,715 15 % $ 380,516 100 % Unbilled receivables by contract effective date: (Dollars in thousands) June 30, 2021 2021 $ 140,395 37 % 2020 131,618 34 % 2019 55,282 15 % 2018 26,688 7 % 2017 and prior 26,533 7 % $ 380,516 100 % Major clients Clients accounting for 10% or more of the Company’s total receivables: June 30, 2021 December 31, 2020 Client A 13 % * * Client accounted for less than 10% of total receivables. Contract assets Contract assets are client-committed amounts for which revenue recognized exceeds the amount billed to the client, and billing is subject to conditions other than the passage of time, such as completing a related performance obligation. (in thousands) June 30, 2021 December 31, 2020 Contract assets (1) $ 14,031 $ 15,296 Long-term contract assets (2) 10,097 7,777 $ 24,128 $ 23,073 (1) Included in other current assets. (2) Included in other long-term assets. Deferred revenue Deferred revenue consists of billings and payments received in advance of revenue recognition. (in thousands) June 30, 2021 December 31, 2020 Deferred revenue $ 242,194 $ 232,865 Long-term deferred revenue (1) 6,041 8,991 $ 248,235 $ 241,856 (1) Included in other long-term liabilities. The change in deferred revenue in the six months ended June 30, 2021 was primarily due to new billings in advance of revenue recognition, offset by $ 172.1 million of revenue recognized that was included in deferred revenue as of December 31, 2020. 9 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 5. DEFERRED COMMISSIONS (in thousands) June 30, 2021 December 31, 2020 Deferred commissions (1) $ 109,803 $ 108,624 (1) Included in other long-term assets. Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2021 2020 2021 2020 Amortization of deferred commissions (1) $ 9,706 $ 7,564 $ 21,202 $ 16,061 (1) Included in selling and marketing expense . NOTE 6. GOODWILL AND OTHER INTANGIBLES Goodwill Change in goodwill: Six Months Ended June 30, (in thousands) 2021 2020 January 1, $ 79,231 $ 79,039 Acquisition 2,701 — Currency translation adjustments 241 ( 364 ) June 30, $ 82,173 $ 78,675 Intangibles Intangible assets are recorded at cost and amortized using the straight-line method over their estimated useful lives. June 30, 2021 (in thousands) Useful Lives Cost Accumulated Amortization Net Book Value (1) Client-related 4 - 10 years $ 63,186 $ ( 56,638 ) $ 6,548 Technology 2 - 10 years 67,142 ( 57,644 ) 9,498 Other 1 - 5 years 5,361 ( 5,361 ) — $ 135,689 $ ( 119,643 ) $ 16,046 (1) Included in other long-term assets. December 31, 2020 (in thousands) Useful Lives Cost Accumulated Amortization Net Book Value (1) Client-related 4 - 10 years $ 63,168 $ ( 55,877 ) $ 7,291 Technology 2 - 10 years 64,843 ( 56,386 ) 8,457 Other 1 - 5 years 5,361 ( 5,361 ) — $ 133,372 $ ( 117,624 ) $ 15,748 (1) Included in other long-term assets. 10 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Amortization of intangible assets: Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2021 2020 2021 2020 Cost of revenue $ 629 $ 647 $ 1,258 $ 1,294 Selling and marketing 373 370 746 740 $ 1,002 $ 1,017 $ 2,004 $ 2,034 Future estimated intangibles assets amortization: (in thousands) June 30, 2021 2021 $ 1,983 2022 3,886 2023 3,618 2024 2,849 2025 2,509 2026 and thereafter 1,201 $ 16,046 NOTE 7. LEASES Headquarters lease In February 2021, the Company agreed to accelerate its exit from its Cambridge, Massachusetts headquarters to October 1, 2021, in exchange for a one-time payment from the Company’s landlord of $ 18 million, which is being amortized over the remaining lease term. Upon modification, the Company reduced its lease liabilities by $ 21.1 million and accelerated depreciation related to its corporate headquarters. Expense Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2021 2020 2021 2020 Fixed lease costs (1) $ ( 3,972 ) $ 4,943 $ ( 3,672 ) $ 9,761 Short-term lease costs 515 371 974 826 Variable lease costs 1,340 969 2,727 2,247 $ ( 2,117 ) $ 6,283 $ 29 $ 12,834 (1) The decrease in fixed lease costs in three and six months ended June 30, 2021 was due to the modification of the Headquarters Lease. Right of use assets and lease liabilities (in thousands) June 30, 2021 December 31, 2020 Right of use assets (1) $ 51,058 $ 67,651 Lease liabilities (2) $ 13,682 $ 18,541 Long-term lease liabilities $ 42,063 $ 59,053 (1) Represents the Company’s right to use the leased asset during the lease term. Included in other long-term assets. (2) Included in other current liabilities. Weighted-average remaining lease term and discount rate for the Company’s leases were: June 30, 2021 December 31, 2020 Weighted-average remaining lease term 4.9 years 4.7 years Weighted-average discount rate (1) 4.6 % 5.4 % (1) The rates implicit in most of the Company’s leases are not readily determinable. Therefore, the Company uses its incremental borrowing rate as the discount rate when measuring operating lease liabilities. The incremental borrowing rate represents an estimate of the interest rate the Company would incur to borrow an amount equal to the lease payments on a collateralized basis over the lease term in a similar economic environment. 11 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Maturities of lease liabilities: (in thousands) June 30, 2021 Remainder of 2021 $ 8,783 2022 13,888 2023 13,300 2024 10,021 2025 6,913 2026 2,653 Thereafter 7,170 Total lease payments 62,728 Less: imputed interest (1) ( 6,983 ) $ 55,745 (1) Lease liabilities are measured at the present value of the remaining lease payments using a discount rate determined at lease commencement, unless the discount rate is updated due to a lease reassessment event. Cash flow information Six Months Ended June 30, (in thousands) 2021 2020 Cash paid for leases $ 11,605 $ 10,945 Right of use assets recognized for new leases and amendments (non-cash) $ 10,160 $ 10,077 NOTE 8. DEBT Convertible senior notes and capped calls Convertible senior notes In February 2020, the Company issued Convertible Senior Notes (the "Notes") with an aggregate principal of $ 600 million, due March 1, 2025, in a private placement. No principal payments are required before maturity. The Notes accrue interest at an annual rate of 0.75 %, payable semi-annually in arrears on March 1 and September 1, beginning on September 1, 2020. Conversion rights The conversion rate is 7.4045 shares of common stock per $ 1,000 principal amount of the Notes, representing an initial conversion price of $ 135.05 per share of common stock. The Company will settle conversions by paying or delivering cash, shares of its common stock, or a combination of cash and shares of its common stock, at the Company’s election, based on the applicable conversion rate. The conversion rate will be adjusted upon certain events, including spin-offs, tender offers, exchange offers, and certain stockholder distributions. Beginning on September 1, 2024, noteholders may convert their Notes at any time at their election. Before September 1, 2024, noteholders may convert their Notes in the following circumstances: • During any calendar quarter commencing after June 30, 2020 (and only during such calendar quarter), if the last reported sale price per share of the Company’s common stock exceeds 130 % of the conversion price for each of at least 20 trading days (whether or not consecutive) during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter. • During the five consecutive business days immediately after any five consecutive trading day period (the “Measurement Period”), if the trading price per $1,000 principal amount of Notes for each trading day of the Measurement Period was less than 98 % of the product of the last reported sale price per share of common stock on such trading day and the conversion rate on such trading day. • Upon certain corporate events or distributions or if the Company calls any Notes for redemption, noteholders may convert before the close of business on the business day immediately before the related redemption date (or, if the Company fails to pay the redemption price in full on the redemption date, until the Company pays the redemption price). As of June 30, 2021, the Notes were not eligible for conversion at the noteholders’ election. Repurchase rights On or after March 1, 2023 and on or before the 40th scheduled trading day immediately before the maturity date, the Company may redeem for cash all or part of the Notes at a repurchase price equal to 100 % of the principal amount, plus accrued and unpaid interest, if the last reported sale price of the Company’s common stock exceeded 130 % of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which the Company provides a redemption notice. 12 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) If certain corporate events that constitute a “Fundamental Change” occur, each noteholder will have the right to require the Company to repurchase for cash all of such noteholder’s Notes, or any portion of the principal thereof that is equal to $1,000 or a multiple of $1,000, at a repurchase price equal to 100 % of the principal amount thereof, plus accrued and unpaid interest. A Fundamental Change relates to mergers, changes in control of the Company, liquidation/dissolution of the Company, or the delisting of the Company’s common stock. Impact of the Notes The Company adopted ASU 2020-06 using the modified retrospective approach on January 1, 2021. The standard eliminates the liability and equity separation model for convertible instruments with a cash conversion feature. See "Note 2. New Accounting Pronouncements" for additional information. Until January 1, 2021, the Notes were separated into liability and equity components. • The initial carrying amount of the liability component was calculated by measuring a similar debt instrument’s fair value that does not have an associated conversion feature. The excess of the Notes’ principal amount over the initial carrying amount of the liability component, the debt discount, was amortized as interest expense over the Notes’ contractual term. • The equity component was recorded as an increase to additional paid-in capital and not remeasured. Upon adoption of ASU 2020-06, the book value of the Notes increased by $ 69.5 million to $ 587.7 million, and retained earnings increased by $ 9.4 million. The retained earnings adjustment reflects the tax effected difference between the value of the Notes and the embedded conversion feature before adoption and the combined convertible instrument's amortized cost after adoption. Carrying value of the Notes: (in thousands) June 30, 2021 December 31, 2020 Principal $ 600,000 $ 600,000 Unamortized debt discount — ( 71,222 ) Unamortized issuance costs ( 10,908 ) ( 10,575 ) Convertible senior notes, net $ 589,092 $ 518,203 Conversion options $ — $ 84,120 Issuance costs — ( 2,037 ) Deferred taxes — ( 20,479 ) Additional paid-in capital $ — $ 61,604 Interest expense related to the Notes: Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2021 2020 2021 2020 Contractual interest expense ( 0.75 % coupon) $ 1,125 $ 1,125 $ 2,250 $ 1,575 Amortization of debt discount — 3,757 — 5,253 Amortization of issuance costs 675 558 1,348 780 $ 1,800 $ 5,440 $ 3,598 $ 7,608 13 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) The effective interest rate for the Notes: Six Months Ended June 30, 2021 2020 Weighted-average effective interest rate 1.2 % 4.3 % Future payments of principal and contractual interest: June 30, 2021 (in thousands) Principal Interest Total 2021 $ — $ 2,250 $ 2,250 2022 — 4,500 4,500 2023 — 4,500 4,500 2024 — 4,500 4,500 2025 600,000 1,488 601,488 $ 600,000 $ 17,238 $ 617,238 Capped call transactions In February 2020, the Company entered into privately negotiated capped call transactions (the “Capped Call Transactions”) with certain financial institutions. The Capped Call Transactions cover approximately 4.4 million shares (representing the number of shares for which the Notes are initially convertible) of the Company’s common stock. The Capped Call Transactions are generally expected to reduce common stock dilution and/or offset any potential cash payments the Company must make, other than for principal and interest, upon conversion of the Notes, with such reduction and/or offset subject to a cap of $ 196.44 . The cap price of the Capped Call Transactions is subject to adjustment upon the occurrence of specified extraordinary events affecting the Company, including mergers and tender offers. The Capped Call Transactions are accounted for as derivative instruments and do not qualify for the Company’s own equity scope exception in ASC 815 since, in some cases of early settlement, the settlement value of the Capped Call Transactions, calculated in accordance with the governing documents, may not represent a fair value measurement. The Capped Call Transactions are classified as other long-term assets and remeasured to fair value at the end of each reporting period, resulting in a non-operating gain or loss. Change in capped call transactions: Six Months Ended June 30, (in thousands) 2021 2020 January 1, $ 83,597 $ — Issuance — 51,900 Fair value adjustment 7,192 827 June 30, $ 90,789 $ 52,727 Credit facility In November 2019, and as amended as of February 2020, July 2020, and September 2020, the Company entered into a five-year $ 100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association. The Company may use borrowings to finance working capital needs and for general corporate purposes. Subject to specific conditions, the Credit Facility allows the Company to increase the aggregate commitment to $ 200 million. The commitments expire on November 4, 2024, and any outstanding loans will be payable on such date. The Credit Facility, as amended, contains customary covenants, including, but not limited to, those relating to additional indebtedness, liens, asset divestitures, and affiliate transactions. The Company is also required to comply with financial covenants, including: • Beginning with the fiscal quarter ended September 30, 2020 and ending with the fiscal quarter ended December 31, 2021, at least $ 200 million in cash and investments held by Pegasystems Inc. • Beginning with the quarter ended March 31, 2022, a maximum net consolidated leverage ratio of 3.5 to 1.0 (with a step-up in the event of certain acquisitions) and a minimum consolidated interest coverage ratio of 3.5 to 1.0. As of June 30, 2021 and December 31, 2020, the Company had no outstanding borrowings under the Credit Facility. 14 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 9. FAIR VALUE MEASUREMENTS Assets and liabilities measured at fair value on a recurring basis The Company records its cash equivalents, marketable securities, Capped Call Transactions, and venture investments at fair value on a recurring basis. Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants based on assumptions that market participants would use in pricing an asset or liability. As a basis for classifying the fair value measurements, a three-tier fair value hierarchy, which classifies the fair value measurements based on the inputs used in measuring fair value, was established as follows: • Level 1 - observable inputs such as quoted prices in active markets for identical assets or liabilities; • Level 2 - significant other inputs that are observable either directly or indirectly; and • Level 3 - significant unobservable inputs on which there is little or no market data, which require the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and minimize unobservable inputs when determining fair value. The fair value of the Capped Call Transactions at the end of each reporting period is determined using a Black-Scholes option-pricing model. The valuation models use various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield. The Company applies judgment when determining expected volatility. The Company considers both historical and implied volatility levels of the underlying equity security. The Company’s venture investments are recorded at fair value based on valuation methods, including observable public companies and transaction prices and unobservable inputs, including the volatility, rights, and obligations of the securities the Company holds. Assets and liabilities measured at fair value on a recurring basis: June 30, 2021 December 31, 2020 (in thousands) Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 Total Cash equivalents $ 4,650 $ — $ — $ 4,650 $ 42,339 $ 14,000 $ — $ 56,339 Marketable securities $ — $ 271,459 $ — $ 271,459 $ — $ 293,269 $ — $ 293,269 Capped Call Transactions (1) $ — $ 90,789 $ — $ 90,789 $ — $ 83,597 $ — $ 83,597 Venture investments (1) (2) $ — $ — $ 9,779 $ 9,779 $ — $ — $ 8,345 $ 8,345 (1) Included in other long-term assets. (2) Investments in privately-held companies. Changes in venture investments: Six Months Ended June 30, (in thousands) 2021 2020 January 1, $ 8,345 $ 4,871 New investments 500 1,769 Sales of investments ( 400 ) ( 1,424 ) Changes in foreign exchange rates 14 ( 50 ) Changes in fair value: included in other income 100 1,374 included in other comprehensive income 1,220 100 June 30, $ 9,779 $ 6,640 The carrying value of certain other financial instruments, including receivables and accounts payable, approximates fair value due to these items’ relatively short maturity. Fair value of the Notes The Notes’ fair value (inclusive of the conversion feature embedded in the Notes) was $ 726.2 million as of June 30, 2021 and $ 706.5 million as of December 31, 2020. The fair value was determined based on the Notes’ quoted price in an over-the-counter market on the last trading day of the reporting period and classified within Level 2 in the fair value hierarchy. See "Note 8. Debt" for additional information. 15 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 10. REVENUE Geographic revenue Three Months Ended June 30, Six Months Ended June 30, (Dollars in thousands) 2021 2020 2021 2020 U.S. $ 189,297 58 % $ 142,811 63 % $ 383,865 60 % $ 315,228 63 % Other Americas 14,058 4 % 8,930 4 % 25,959 4 % 24,272 5 % United Kingdom (“U.K.”) 32,553 10 % 21,259 9 % 60,765 10 % 43,096 9 % Europe (excluding U.K.), Middle East, and Africa 45,798 14 % 34,878 15 % 97,457 15 % 66,816 14 % Asia-Pacific 43,996 14 % 19,497 9 % 71,155 11 % 43,554 9 % $ 325,702 100 % $ 227,375 100 % $ 639,201 100 % $ 492,966 100 % Revenue streams Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2021 2020 2021 2020 Perpetual license $ 12,596 $ 9,057 $ 18,048 $ 12,716 Term license 104,296 44,266 215,805 134,523 Revenue recognized at a point in time 116,892 53,323 233,853 147,239 Maintenance 78,782 72,222 154,343 145,917 Pega Cloud 73,293 48,838 141,151 92,304 Consulting 56,735 52,992 109,854 107,506 Revenue recognized over time 208,810 174,052 405,348 345,727 $ 325,702 $ 227,375 $ 639,201 $ 492,966 (in thousands) Three Months Ended June 30, Six Months Ended June 30, 2021 2020 2021 2020 Pega Cloud $ 73,293 $ 48,838 $ 141,151 $ 92,304 Client Cloud $ 183,078 $ 116,488 $ 370,148 $ 280,440 Maintenance 78,782 72,222 154,343 145,917 Term license 104,296 44,266 215,805 134,523 Subscription (1) 256,371 165,326 511,299 372,744 Perpetual license 12,596 9,057 18,048 12,716 Consulting 56,735 52,992 109,854 107,506 $ 325,702 $ 227,375 $ 639,201 $ 492,966 (1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license). Remaining performance obligations ("Backlog") Expected future revenue on existing non-cancellable contracts: June 30, 2021 (Dollars in thousands) Perpetual license Term license Maintenance Pega Cloud Consulting Total 1 year or less $ 6,707 $ 46,146 $ 214,645 $ 281,793 $ 17,863 $ 567,154 56 % 1- 2 years 234 15,708 59,164 194,841 2,675 272,622 26 % 2- 3 years — 909 36,076 88,855 762 126,602 12 % Greater than 3 years — 255 26,564 37,246 693 64,758 6 % $ 6,941 $ 63,018 $ 336,449 $ 602,735 $ 21,993 $ 1,031,136 100 % June 30, 2020 (Dollars in thousands) Perpetual license Term license Maintenance Pega Cloud Consulting Total 1 year or less $ 8,120 $ 53,550 $ 186,618 $ 191,187 $ 21,923 $ 461,398 57 % 1- 2 years 1,700 6,187 40,153 140,860 1,986 190,886 23 % 2- 3 years — 6,460 20,671 88,273 631 116,035 14 % Greater than 3 years — 646 10,517 37,071 626 48,860 6 % $ 9,820 $ 66,843 $ 257,959 $ 457,391 $ 25,166 $ 817,179 100 % 16 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Major clients Clients accounting for 10% or more of the Company’s total revenue: Three Months Ended June 30, Six Months Ended June 30, (Dollars in thousands) 2021 2020 2021 2020 Total revenue $ 325,702 $ 227,375 $ 639,201 $ 492,966 Client A 13 % * * * *Client accounted for less than 10% of total revenue. NOTE 11. STOCK-BASED COMPENSATION Expense Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2021 2020 2021 2020 Cost of revenue $ 5,849 $ 5,384 $ 11,774 $ 10,536 Selling and marketing 14,748 11,592 28,468 21,310 Research and development 6,343 5,805 13,113 11,302 General and administrative 3,748 2,874 7,433 5,683 $ 30,688 $ 25,655 $ 60,788 $ 48,831 Income tax benefit $ ( 6,192 ) $ ( 5,107 ) $ ( 12,183 ) $ ( 9,689 ) As of June 30, 2021, the Company had $ 157.3 million of unrecognized stock-based compensation expense, net of estimated forfeitures, which is expected to be recognized over a weighted-average period of 2.2 years. Grants Six Months Ended June 30, 2021 (in thousands) Shares Total Fair Value RSUs 753 $ 97,483 Non-qualified stock options 1,368 $ 51,594 NOTE 12. INCOME TAXES Effective income tax rate Three Months Ended June 30, Six Months Ended June 30, (Dollars in thousands) 2021 2020 2021 2020 (Benefit from) income taxes $ ( 11,916 ) $ ( 12,319 ) $ ( 29,534 ) $ ( 36,129 ) Effective income tax benefit rate ( 2,591 ) % 44 % The change in the effective income tax benefit rate was primarily due to the impact of discrete tax items on a proportionately larger income (loss) before income taxes in the prior period. The most significant discrete items were excess tax benefits from stock-based compensation and the impact of changes in statutory tax rates applicable to our U.K.-based deferred tax assets. NOTE 13. EARNINGS (LOSS) PER SHARE Basic earnings (loss) per share is calculated using the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share is calculated using the weighted-average number of common shares outstanding during the period, plus the dilutive effect of outstanding stock options, RSUs, and convertible senior notes. 17 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Calculation of earnings (loss) per share: Three Months Ended June 30, Six Months Ended June 30, (in thousands, except per share amounts) 2021 2020 2021 2020 Net income (loss) $ 37,291 $ ( 20,740 ) $ 30,674 $ ( 46,112 ) Weighted-average common shares outstanding 81,316 80,224 81,161 80,016 Earnings (loss) per share, basic $ 0.46 $ ( 0.26 ) $ 0.38 $ ( 0.58 ) Net income (loss) $ 37,291 $ ( 20,740 ) $ 30,674 $ ( 46,112 ) Interest expense associated with convertible debt instruments, net of tax 1,351 — — — Numerator for diluted EPS $ 38,642 $ ( 20,740 ) $ 30,674 $ ( 46,112 ) Weighted-average effect of dilutive securities: Convertible debt (1) 4,443 — — — Stock options 3,266 — 3,416 — RSUs 1,295 — 1,429 — Effect of dilutive securities (2) 9,004 — 4,845 — Weighted-average common shares outstanding, assuming dilution (1) (2) (3) 90,320 80,224 86,006 80,016 Earnings (loss) per share, diluted $ 0.43 $ ( 0.26 ) $ 0.36 $ ( 0.58 ) Outstanding anti-dilutive stock options and RSUs (4) 19 5,929 22 5,939 (1) The shares underlying the conversion options in the Company’s Notes are included using the if-converted method, if dilutive in the period. If the outstanding conversion options were fully exercised, the Company would issue an additional 4.4 million shares. (2) In periods of loss, all dilutive securities are excluded as their inclusion would be anti-dilutive. (3) The Company’s Capped Call Transactions convert to approximately 4.4 million shares of the Company’s common stock (representing the number of shares for which the Notes are initially convertible). The Capped Call Transactions are generally expected to reduce common stock dilution and/or offset any potential cash payments the Company must make, other than for principal and interest, upon conversion of the Notes, with such reduction and/or offset subject to a cap of $ 196.44 . The Capped Call Transactions are excluded from weighted-average common shares outstanding, assuming dilution, in all periods as their effect would be anti-dilutive. (4) Outstanding stock options and RSUs that were anti-dilutive under the treasury stock method in the period were excluded from the computation of diluted earnings (loss) per share. These awards may be dilutive in the future. NOTE 14. SUBSEQUENT EVENTS On July 6, 2021, the Company entered into an office space lease (the “Lease”) for 131 thousand square feet in Waltham, Massachusetts. The lease term of approximately 11 years is expected to commence on August 1, 2021 (the “Lease Commencement Date”), subject to certain adjustments for the initial occupancy date. The annual rent equals the base rent plus the Company’s portion of building operating costs and real estate taxes for the year. Rent first becomes payable on August 1, 2022, subject to adjustment based on the Lease Commencement Date. Base rent for the first year is $ 6 million and will increase by 3 % annually. In addition, the Company will receive an improvement allowance from the landlord of $ 11.8 million. 18