What changed in this filing

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Item 7. Management’s Discussion and Analysis

2022-02-16 compared with 2021-02-17 · 116 added, 120 removed, 174 unchanged (58% of the section changed)

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BUSINESS OVERVIEW

We develop, market, license, host, and support enterprise software applications that help organizations transform how they engage with their customers and process work.

We also license our low code Pega Platform™ for rapid application development to clients that wish to build and extend their business applications.

Our cloud-architected portfolio of customer engagement and digital process automation applications leverages artificial intelligence (“AI”), case management, and robotic automation technology, built on our unified low code Pega Platform, empowering businesses to quickly design, extend, and scale their enterprise applications to meet strategic business needs.

Our target clients are Global 3000 organizations and government agencies that require applications to differentiate themselves in the markets they serve.

Our applications achieve and facilitate differentiation by increasing business agility, driving growth, improving productivity, attracting and retaining customers, and reducing risk.

We deliver applications tailored to our clients’ specific industry needs.

Cloud Transition

We are in the process of transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud (“Cloud Transition”).

Until we substantially complete our Cloud Transition, which we anticipate will occur in early 2023, we expect to continue to experience lower revenue growth and lower operating cash flow growth or negative cash flow.

The actual mix of revenue and new arrangements in a given period can fluctuate based on client preferences.

We develop, market, license, host, and support enterprise software that helps organizations simplify business complexity.

Our powerful low-code platform for workflow automation and AI-powered decisioning enables the world’s leading brands and government agencies to hyper-personalize customer experiences, streamline customer service, and automate mission-critical business processes and workflows.

With Pega, our clients can leverage our intelligent technology and scalable architecture to accelerate their digital transformation.

Our client success teams, world-class partners, and clients themselves leverage our Pega Express™ methodology to design and deploy mission-critical applications quickly and collaboratively.

Our target clients are Global 3000 organizations and government agencies that require solutions to distinguish themselves in the markets they serve.

Our solutions achieve and facilitate differentiation by increasing business agility, driving growth, improving productivity, attracting and retaining customers, and reducing risk.

Along with our partners, we deliver solutions tailored to our clients’ specific industry needs.

Subscription transition

We are transitioning our business to sell software primarily through subscription arrangements.

Until we fully complete our subscription transition, which we expect will occur in 2023, our revenue and operating cash flow growth may be impacted.

Operating performance and the actual mix of revenue and new arrangements in each period can fluctuate based on client preferences for our perpetual and subscription offerings.

See risk factor "If we fail to manage our transition to a more subscription-based business model successfully, our results of operations and/or cash flows could be negatively impacted" in Item 1A of this Annual Report for additional information.

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As of December 31, 2021, COVID-19 has not had a material impact on our results of operations or financial condition.

COVID-19's ultimate impact on our operational and financial performance will depend on future developments, including the duration and spread of the outbreak and the impact of COVID-19 on our sales cycles, partners, vendors, and employees, all of which is uncertain and unpredictable.

Our shift towards subscription-based revenue streams, the industry mix of our clients, the substantial size and available resources of our clients, and the critical nature of our products to our clients may reduce or delay the impact of COVID-19 on our business.

However, it is not possible to estimate the ultimate impact that COVID-19 will have on our business at this time.

See “Coronavirus (“COVID-19”)” in Item 1A of this Annual Report for additional information.

Relocation of Corporate Headquarters

On February 12, 2021, we entered into an agreement with our landlord to vacate our Cambridge, Massachusetts corporate headquarters on October 1, 2021, in exchange for a one-time payment to us of $18 million.

We expect to enter into a new lease agreement for a facility within the greater Boston area.

Performance metrics

We utilize several performance metrics to analyze and assess our overall performance, make operating decisions, and forecast and plan for future periods, including:

We use performance metrics to analyze and assess our overall performance, make operating decisions, and forecast and plan for future periods, including:

Annual contract value (“ACV”) | Increased 20% since December 31, 2020

• ACV, as reported, represents the annualized value of our active contracts as of the measurement date.

ACV represents the annualized value of our active contracts as of the measurement date.

The contract's total value is divided by its duration in years to calculate ACV for term license and Pega Cloud contracts.

Maintenance revenue for the quarter then ended is multiplied by four to calculate ACV for maintenance.

Client Cloud ACV is composed of maintenance ACV and ACV from term license contracts.

ACV is a performance measure that we believe provides useful information to our management and investors, particularly during our Cloud Transition.

Reported amounts have not been adjusted for changes in foreign exchange rates.

Foreign currency contributed 1%-2% to ACV growth in 2020.

ACV is a performance measure that we believe provides useful information to our management and investors, particularly during our subscription transition.

Foreign currency exchange rate changes were a 1% headwind to ACV growth in 2021.

Remaining performance obligations (“Backlog”) | Increased 25% since December 31, 2020

• Backlog represents contracted revenue that has not yet been recognized and includes deferred revenue and non-cancellable amounts expected to be invoiced and recognized as revenue in future periods.

Pega Cloud revenue | Increased 56% since 2019

• Pega Cloud revenue is revenue as reported under U.S.

GAAP for cloud contracts.

Expected future revenue from existing non-cancellable contracts:

RESULTS OF OPERATIONS

Cloud Transition

We are in the process of transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud.

Revenue growth has and is expected to continue to be slower during this transition Revenue from Pega Cloud arrangements is typically recognized over the contract term.

In contrast, revenue from license sales is generally recognized upfront when the license rights become effective.

Subscription transition

We are transitioning our business to sell software primarily through subscription arrangements.

This transition has impacted revenue growth as revenue is recognized differently for subscription services than for license sales.

Revenue from Pega Cloud and maintenance arrangements is typically recognized over the contract term, while revenue from license sales is recognized when the license rights become effective, typically upfront.

(Dollars in thousands) 2021 2020 Change

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Maintenance 320,257 26 % 296,709 30 % 23,548 8 %

Term license 266,352 26 % 199,433 22 % 66,919 34 %

Subscription (1)

Subscription services 621,223 51 % 504,977 50 % 116,246 23 %

Subscription license (A)

336,248 28 % 266,352 26 % 69,896 26 %

Subscription 957,471 79 % 771,329 76 % 186,142 24 %

Perpetual license 32,172 3 % 28,558 3 % 3,614 13 %

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$ 1,211,653 100 % $ 1,017,517 100 % $ 194,136 19 %

(1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license).

The change in total revenue since 2019 generally reflects the impact of our Cloud Transition.

(A) Revenue from term licenses.

The change in revenue in 2021 generally reflects the impact of our subscription transition.

Additional contributing factors were:

• An increasing portion of our term license contracts include multi-year committed maintenance periods instead of annually renewable maintenance periods.

Under such arrangements, a larger portion of the total contract value is recognized as maintenance revenue over the contract term rather than as term license revenue upon effectiveness of the license rights.

In 2020, multi-year committed maintenance contributed $10.2 million to maintenance revenue growth and reduced term revenue growth by $20.8 million.

• An increasing portion of our term license contracts include multi-year committed maintenance periods instead of annually renewable maintenance.

Under multi-year committed maintenance arrangements, a larger portion of the total contract value is recognized as maintenance revenue over the contract term rather than upon the effectiveness of the license rights as subscription license revenue.

In 2021, multi-year committed maintenance contributed $17.1 million to maintenance revenue growth and reduced subscription license revenue growth by $4.0 million.

• Maintenance renewal rates remained over 90% in 2021.

• The slight increase in consulting revenue in 2020 was primarily due to increased billable hours, which offset the impact of reduced billable travel expenses due to COVID-19.

• The increase in perpetual revenue was primarily due to license rights becoming effective in 2021 related to several large software license contracts entered into in prior years.

• The increase in consulting revenue in 2021 was primarily due to an increase in billable hours, which offset the impact of reduced billable travel expenses due to COVID-19.

As part of our long-term strategy, we intend to continue growing and increasingly leveraging our ecosystem of partners on future implementation projects, potentially reducing our future consulting revenue growth rate.

(Dollars in thousands) 2021 2020 Change

Software license $ 291,982 99 % $ 275,792 99 % $ 16,190 6 %

Maintenance 274,398 92 % 254,924 91 % 19,474 8 %

Pega Cloud $ 202,171 67 % $ 131,693 63 % $ 70,478 54 %

Maintenance 298,606 93 % 274,398 92 % 24,208 9 %

Subscription services 500,777 81 % 406,091 80 % 94,686 23 %

Subscription license 333,859 99 % 263,708 99 % 70,151 27 %

Subscription 834,636 87 % 669,799 87 % 164,837 25 %

Perpetual license 31,943 99 % 28,274 99 % 3,669 13 %

Consulting 8,711 4 % 8,531 4 % 180 2 %

$ 875,290 72 % $ 706,604 69 % $ 168,686 24 %

• The increase in gross profit in 2020 was primarily due to cost-efficiency gains as Pega Cloud grows and scales as a result of our Cloud Transition and overall revenue growth.

• The increase in consulting gross profit in 2020 was primarily due to a decrease in travel and entertainment expenses and an increase in consultant utilization.

Consultant utilization is impacted by several factors, including the timing of new implementation projects and our scope and level of involvement in these projects compared to that of our consulting partners and enabled clients.

The increase in gross profit in 2021 was primarily due to overall revenue growth and cost-efficiency gains as Pega Cloud grows and scales because of our subscription transition.

Operating expenses

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General and administrative $ 83,506 7 % $ 67,452 7 % $ 16,054 24 %

• The increase in selling and marketing in 2020 was primarily due to an increase in compensation and benefits of $97.2 million, attributable to increases in headcount and equity compensation, partially offset by a decrease in travel and entertainment of $27.2 million due to COVID-19.

• The increase in selling and marketing in 2021 was primarily due to an increase in compensation and benefits of $82.7 million, attributable to increases in headcount and incentive compensation.

The increase in headcount reflects our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts.

• The increase in research and development in 2020 was primarily due to an increase in compensation and benefits of $30.2 million, attributable to increases in headcount and equity compensation.

The increase in headcount reflects additional investments in the development of our products, particularly for Pega Cloud.

• The increase in general and administrative in 2020 was primarily due to an increase in compensation and benefits of $4.0 million, attributable to increases in headcount and equity compensation to support the growth in our operations and an increase in professional services fees of $4.2 million.

Other income (expense), net

• The increase in research and development in 2021 was primarily due to an increase in compensation and benefits of $24.8 million, attributable to increases in headcount and incentive compensation.

The increase in headcount reflects additional investments in the development of our solutions, particularly for Pega Cloud.

• The increase in general and administrative in 2021 was primarily due to an increase of $14.4 million in legal fees and related expenses arising from proceedings that originated outside of the ordinary course of business.

We have incurred and expect to continue to incur additional expenses for these proceedings in 2022.

See "Note 19.

Commitments And Contingencies" in Item 8 of this Annual Report for additional information.

• In February 2021, we agreed to accelerate our exit from our prior Cambridge, Massachusetts headquarters to October 1, 2021, in exchange for a one-time payment from our landlord of $18 million.

This agreement was the primary contributor to decreases in facilities expenses of $5.1 million in selling and marketing, $5.6 million in research and development, and $2.7 million in general and administrative, in 2021.

Other income and expenses

(Dollars in thousands) 2021 2020 Change

Foreign currency transaction gain (loss) 3,704 (2,335) $ 6,039 *

Foreign currency transaction (loss) gain $ (6,459) $ 3,704 $ (10,163) *

Interest income 704 1,223 (519) (42) %

Interest expense (7,956) (19,356) 11,400 59 %

Gain on capped call transactions 31,697 — 31,697 *

Other (loss) income, net 1,370 559 811 145 %

(Loss) gain on capped call transactions (23,633) 31,697 (55,330) *

Other income, net 89 1,370 (1,281) (94) %

$ (37,255) $ 18,638 $ (55,893) *

* not meaningful

• The change in foreign currency transaction gain (loss) in 2020 was primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency-denominated cash, accounts receivable, and intercompany receivables and payables held by our United Kingdom (“U.K.”) subsidiary.

• The decrease in interest income in 2020 was due to the significant decline in market interest rates despite the significant increase in our interest-bearing investment balances.

• The increase in interest expense in 2020 was due to our issuance of $600 million in aggregate principal amount of the Notes on February 24, 2020.

• The change in foreign currency transaction (loss) gain in 2021 was primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency-denominated cash, receivables, and intercompany balances held by our subsidiary in the United Kingdom.

• The decrease in interest income in 2021 was primarily due to declines in market interest rates and invested funds.

• The decrease in interest expense in 2021 was primarily due to our adoption of Accounting Standards Update 2020-06 on January 1, 2021.

See "Note 11.

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Interest expense related to the Notes:

December 31, Change

(in thousands) 2020 2019

(in thousands) 2021 2020 Change

Contractual interest expense (0.75% coupon)

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$ 7,477 $ 18,638 $ (11,161)

• The increase in the gain on capped call transactions in 2020 was due to fair value adjustments on the Capped Call Transactions.

• The decrease in the (loss) gain on capped call transactions in 2021 was due to fair value adjustments on the Capped Call Transactions.

See "Note 11.

Debt" in Item 8 of this Annual Report for additional information.

• The increase in other (loss) income, net in 2020 was due to a gain from our venture investments portfolio.

• The decrease in other income, net in 2021 was due to a smaller gain from our venture investments portfolio in 2021.

(Benefit from) income taxes

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Effective income tax benefit rate 52 % 51 %

During 2020, the increase in our effective income tax benefit rate was primarily due to an increase in excess tax benefits from stock-based compensation and a carryback claim benefit due to the Coronavirus Aid, Relief, and Economic Security Act (“Cares Act”).

During 2021, the change in our effective income tax benefit rate was primarily due to the impact of excess tax benefits from stock-based compensation and changes in statutory tax rates applicable to our U.K.-based deferred tax assets.

See "Note 17.

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Stock-based compensation increases the variability of our effective tax rates.

The impact of stock-based compensation on a given period depends on our profitability, the attributes of our stock compensation awards we grant, and award holders' exercise behavior.

The impact on our effective tax rate in each period depends on our profitability and the tax deductions from our stock compensation activity, which depend upon our stock price and the award holders' exercise behavior.

LIQUIDITY AND CAPITAL RESOURCES

(in thousands) 2021 2020

Cash provided by (used in)

Cash (used in) provided by

Operating activities $ 39,118 $ (563)

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Effect of exchange rate on cash and cash equivalents (1,712) 2,334

Net increase (decrease) in cash and cash equivalents $ 103,536 $ (46,059)

Net (decrease) increase in cash and cash equivalents $ (11,934) $ 103,536

(in thousands)

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Total cash, cash equivalents, and marketable securities $ 362,779 $ 465,168

We believe that our current cash, cash flow from operations, and borrowing capacity will be sufficient to fund our operations, stock repurchases, and quarterly cash dividends for at least the next 12 months.

Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results, and the investments required to respond to the possible increased demand for our services.

If we require additional capital resources to grow our business, we may seek to finance our operations from available funds or additional external financing.

If it became necessary to repatriate foreign funds, we may be required to pay U.S.

Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our future growth, operating results, and the investments needed to support our operations.

If we require additional capital resources, we may utilize available funds or additional external financing.

If it becomes necessary to repatriate foreign funds, we may have to pay U.S.

and foreign taxes upon repatriation.

Due to the complexity of income tax laws and regulations, and the Tax Reform Act’s effects, it is impracticable to estimate the amount of taxes we would have to pay.

Due to the complexity of income tax laws and regulations, it is impracticable to estimate the amount of taxes we would have to pay.

See risk factor "If it becomes necessary or desirable to repatriate any of our foreign cash balances to the United States, we may be subject to increased taxes, other restrictions, and limitations" in Item 1A of this Annual Report for additional information.

Cash (used in) operating activities

We are in the process of transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud.

This transition has and is expected to continue to impact our billings and resulting timing of cash collections.

Pega Cloud and term license arrangements are generally billed and collected over the contract term while perpetual license arrangements are generally billed in full and collected upfront when the license rights become effective.

As client preferences continue to shift in favor of Pega Cloud arrangements, we could continue to experience slower operating cash flow growth, or negative cash flow, in the near term

In 2020, COVID-19 did not have a material impact on our cash flows from operations.

See “Coronavirus (“COVID-19”)” in Item 1A.

of this Annual Report for additional information.

The change in cash (used in) operating activities in 2020 was primarily due to improved cash collections.

The increased cash collections were partially offset by increased costs as we accelerated investments in our Pega Cloud offering and selling and marketing activities to support future growth.

Cash (used in) provided by investing activities

The change in cash (used in) provided by investing activities in 2020 was primarily driven by purchases of financial instruments and property and equipment investments for our offices.

Cash provided by (used in) financing activities

Convertible senior notes

In February 2020, we issued $600 million in aggregate principal amount of our convertible senior notes (the “Notes”) due March 1, 2025, which provided proceeds as follows:

Cash provided by (used in) operating activities

We are transitioning our business to sell software primarily through subscription arrangements.

This transition has impacted and is expected to continue impacting our billings and cash collections, as the timing of billings and cash collections generally differs between our subscription and perpetual license arrangements.

Subscription license and services are generally billed and collected over the contract term, while perpetual license arrangements usually are billed and collected upfront when the license rights become effective.

The change in cash provided by (used in) operating activities in 2021 was primarily due to a significant increase in client collections.

In addition, in 2021 we incurred $18.2 million in legal fees and related expenses arising from proceedings that originated outside of the ordinary course of business.

We have incurred and expect to continue to incur additional expenses for these proceedings in 2022.

See "Note 19.

Commitments And Contingencies" in Item 8 of this Annual Report for additional information.

Corporate headquarters

In February 2021, we agreed to accelerate our exit from our previous corporate headquarters to October 1, 2021, in exchange for a one-time payment from our landlord of $18 million, which was received in October 2021.

The accelerated exit from this lease reduced our future lease liabilities by $21.1 million.

On March 31, 2021 we leased office space at One Main Street, Cambridge, Massachusetts, to serve as our corporate headquarters.

The 4.5 year lease includes a base rent of $2 million per year.

New Waltham Office

On July 6, 2021, we entered into an office space lease for 131 thousand square feet in Waltham, Massachusetts.

The lease term of 11 years began on August 1, 2021.

The annual rent equals the base rent plus a portion of building operating costs and real estate taxes.

Rent first becomes payable on August 1, 2022.

Base rent for the first year is approximately $6 million and will increase by 3% annually.

In addition, we will receive an improvement allowance from the landlord of up to $11.8 million.

This lease increased our lease liabilities and lease-related right of use assets by $42.1 million on August 1, 2021.

Investing activities

The change in cash provided by (used in) investing activities in 2021 was primarily driven by investments in financial instruments, an acquisition, and a decrease in office space related capital expenditures.

Financing activities

Debt financing

In February 2020, we issued $600 million in aggregate principal amount of convertible senior notes which mature on March 1, 2025.

(in thousands) Amount

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Capped Call Transactions (51,900)

A portion of the proceeds of the Notes was used to fund the Capped Call Transactions, with the remainder to be used for working capital and other general corporate purposes.

The Notes mature on March 1, 2025;

however, under certain circumstances, holders may surrender their Notes for conversion prior to the maturity date.

We may settle conversion by paying or delivering, as applicable, cash, shares of our common

stock or a combination of cash and shares of our common stock.

See "Note 10.

Debt" in Item 8 of this Annual Report for additional information.

Credit facility

In November 2019, and as amended as of February 2020, July 2020, and September 2020, we entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association (“PNC”).

In November 2019, and as amended as of February 2020, July 2020, and September 2020, we entered into a five-year $100 million senior secured revolving credit agreement with PNC Bank, National Association.

As of December 31, 2021, we had no outstanding borrowings under the Credit Facility.

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(in thousands) Shares Amount Shares Amount

Tax withholdings for net settlement of equity awards 725 $ 75,560 645 $ 44,857

Repurchases paid 422 $ 52,411 276 $ 27,974

Repurchases unpaid at period end 10 1,199 2 300

Stock repurchase program 432 53,610 278 28,274

Tax withholdings for net settlement of equity awards 550 69,925 725 75,560

982 $ 123,535 1,003 $ 103,834

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Dividend payments to stockholders $ 9,761 $ 9,628

We currently intend to pay a quarterly cash dividend of $0.03 per share.

We intend to pay a quarterly cash dividend of $0.03 per share.

However, the Board of Directors may terminate or modify the dividend program at any time without prior notice.

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Payments due by period

(in thousands) 2021 2022 2023 2024 2025 and after Other Total

(in thousands) 2022 2023 2024 2025 2026 and thereafter Other Total

Convertible senior notes (1)

$ 4,500 $ 4,500 $ 4,500 $ 602,250 $ — $ — $ 615,750

Purchase obligations (2)

102,452 11,989 2,569 479 — — 117,489

Operating lease obligations 8,942 17,705 16,411 13,553 58,298 — 114,909

Investment commitments (3) 500 — — — — — 500

Liability for uncertain tax positions (3)

— — — — — 1,690 1,690

$ 115,894 $ 34,194 $ 23,480 $ 616,282 $ 58,298 $ 1,690 $ 849,838

(1) Includes principal and interest.

(2) Represents the fixed or minimum amounts due under purchase obligations for hosting services and sales and marketing programs.

(3) Represents the maximum funding under existing venture investment agreements.

Our investment agreements generally allow us to withhold unpaid funds at our discretion.

(3) We are unable to reasonably estimate the timing of the cash outflow due to uncertainties in the timing of the effective settlement of tax positions.

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Management’s discussion and analysis of the financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S.

and the rules and regulations of the SEC for annual financial reporting.

and the rules and regulations of the U.S.

Securities and Exchange Commission for annual financial reporting.

The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.

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Revenue recognition

Our contracts with clients typically contain promises by us to provide multiple products and services.

Our client contracts typically contain promises by us to provide multiple products and services.

Specifically, contracts associated with Pega Platform sales and other software applications, sold either as licenses to use functional intellectual property or as a cloud-based solution, typically include consulting services.

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We review client contracts to identify all separate promises to transfer goods and services that would be considered performance obligations.

Judgment is also required in determining whether an option to acquire additional products and services within a client contract represents a material right that the client would not receive without entering into the contract.

A contract modification is a legally binding change to the scope, price, or both of an existing contract.

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We maximize the use of observable inputs by maintaining pricing analyses that consider our pricing policies, historical stand-alone sales when they exist, and historical renewal prices charged to clients.

We have concluded that the stand-alone selling prices of certain performance obligations, specifically the stand-alone selling prices of software licenses and Pega Cloud arrangements, are highly variable.

We have concluded that the stand-alone selling prices of certain performance obligations, specifically software licenses and Pega Cloud arrangements, are highly variable.

In these instances, we estimate the stand-alone selling prices using the residual approach, determined based on total transaction price minus the stand-alone selling price of other performance obligations promised in the contract.

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• whether it is expected that the asset will be sold or disposed of before the end of its originally estimated useful life.

If indicators of impairment are present, we compare the estimated undiscounted cash flows that the specific asset is expected to generate to its carrying value.

If indicators of impairment are present, we compare the estimated undiscounted cash flows that the asset is expected to generate to the carrying value.

The key assumptions of the cash flow model involve significant subjectivity.

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Future realization of our deferred tax assets ultimately depends on sufficient taxable income within the available carryback or carryforward periods.

We record a valuation allowance to reduce our deferred tax assets to an amount we believe is more likely than not to be realized.

Changes in our valuation allowance impact income tax expense in the period of adjustment.

Our deferred tax valuation allowance requires significant judgment and uncertainties, including assumptions about future taxable income based on historical and projected information.

We recognize deferred tax assets to the extent that we believe that these assets are more likely than not to be realized.

In making such a determination, we consider all available objective and verifiable negative and positive evidence, including future reversals of existing taxable temporary differences, our firm contractual backlog, projected future taxable income (inclusive of the impact of enacted legislation), tax-planning strategies and results of recent operations.

Based on our firm contractual backlog and our current projections of taxable income, we determined that it is more likely than not that we will be able to realize our net deferred tax asset as of December 31, 2021.

We assess our income tax positions and record tax benefits based upon management’s evaluation of the facts, circumstances, and information available at the reporting date.

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We estimate our exposure to unfavorable outcomes related to these uncertainties and estimate the probability of such outcomes.

Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome will not be different from what is reflected in our historical income tax provisions, returns, and accruals.

Although we believe our estimates are reasonable, no guarantee can be given that the final tax outcome will not be different from what is reflected in our historical income tax provisions, returns, and accruals.

Such differences, or changes in estimates relating to potential differences, could have a material impact on our income tax provision and operating results in the period in which such a determination is made.

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Income Taxes" in Item 8 of this Annual Report for additional information.

Convertible senior notes and capped call transactions

Capped call transactions

In February 2020, we issued Convertible Senior Notes (the "Notes") with an aggregate principal amount of $600 million, due March 1, 2025, in a private placement.

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The Capped Call Transactions cover 4.4 million shares (representing the number of shares for which the Notes are initially convertible) of our common stock and are generally expected to reduce potential dilution of our common stock upon any conversion of the Notes.

In accounting for the convertible senior notes and Capped Call Transactions:

• 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, is amortized as interest expense over the Notes’ contractual term.

The fair value was determined utilizing a discounted cash flow model and required us to make various estimates including, implied credit spread, expected volatility, and the risk-free rate for notes with a similar term.

• The equity component was recorded as an increase to additional paid-in capital and is not remeasured as long as it continues to meet the conditions for equity classification.

The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the par value of the Convertible Senior Notes.

• The Capped Call Transactions are accounted for as derivative instruments.

The Capped Call Transactions 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 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 following the governing documents, may not represent a fair value measurement.

Applying the accounting framework for the Capped Call Transactions requires the exercise of judgment and the determination of the fair value of the Capped Call Transactions requires us to make significant estimates and assumptions.

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, as applicable.

Management applies judgment in its determination of expected volatility.

We consider both historical and implied volatility levels of the underlying equity security and, to a lesser extent, historical peer group volatility levels.

Applying the accounting framework for the Convertible Senior Notes and the Capped Call Transactions requires the exercise of judgment and the determination of the fair value of the liability component of the convertible notes and the fair value of the Capped Call Transactions requires the Company to make significant estimates and assumptions.

The valuation models use various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield.

Management applies judgment when determining expected volatility.

We consider both historical and implied volatility levels of the underlying equity security.

As of December 31, 2021, a hypothetical 10% increase in our stock price would have increased the fair value of the capped call to $72.4 million, while a hypothetical 10% decrease in our stock price would have decreased the fair value of the capped call to $47.8 million.

2 unchanged sentences

Fair Value Measurements" in Item 8 of this Annual Report for additional information.

New accounting pronouncements

Significant Accounting Policies" in Item 8 of this Annual Report for additional information.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7. Management’s Discussion and Analysis