PEGASYSTEMS INC 10-Q

ITEM 1. FINANCIAL STATEMENTS PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) September 30, 2022 December 31, 2021 Assets Current assets: Cash and cash equivalents $ 107,626 $ 159,965 Marketable securities 168,085 202,814 Total cash, cash equivalents, and marketable securities 275,711 362,779 Accounts receivable 139,670 182,717 Unbilled receivables 182,403 226,714 Other current assets 62,457 68,008 Total current assets 660,241 840,218 Unbilled receivables 108,285 129,789 Goodwill 81,201 81,923 Other long-term assets 316,731 541,601 Total assets $ 1,166,458 $ 1,593,531 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 13,562 $ 15,281 Accrued expenses 61,012 63,890 Accrued compensation and related expenses 85,999 120,946 Deferred revenue 245,146 275,844 Other current liabilities 8,253 9,443 Total current liabilities 413,972 485,404 Convertible senior notes, net 592,884 590,722 Operating lease liabilities 82,705 87,818 Other long-term liabilities 11,936 13,499 Total liabilities 1,101,497 1,177,443 Commitments and contingencies (Note 14) Stockholders’ equity: Preferred stock, 1,000 shares authorized; none issued — — Common stock, 200,000 shares authorized; 82,164 and 81,712 shares issued and outstanding at September 30, 2022 and December 31, 2021, respectively 822 817 Additional paid-in capital 204,189 145,810 (Accumulated deficit) retained earnings ( 111,126 ) 276,449 Accumulated other comprehensive (loss) ( 28,924 ) ( 6,988 ) Total stockholders’ equity 64,961 416,088 Total liabilities and stockholders’ equity $ 1,166,458 $ 1,593,531 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 September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Revenue Subscription services $ 174,885 $ 161,557 $ 516,750 $ 457,051 Subscription license 31,112 35,421 210,245 251,226 Perpetual license 9,223 2,874 18,929 20,922 Consulting 55,511 56,416 175,451 166,270 Total revenue 270,731 256,268 921,375 895,469 Cost of revenue Subscription services 34,541 30,817 103,104 88,206 Subscription license 628 606 1,923 1,811 Perpetual license 103 50 173 151 Consulting 57,778 52,749 171,162 161,032 Total cost of revenue 93,050 84,222 276,362 251,200 Gross profit 177,681 172,046 645,013 644,269 Operating expenses Selling and marketing 153,517 152,479 472,951 457,641 Research and development 75,342 64,728 221,173 191,565 General and administrative 26,043 20,176 94,530 57,607 Total operating expenses 254,902 237,383 788,654 706,813 (Loss) from operations ( 77,221 ) ( 65,337 ) ( 143,641 ) ( 62,544 ) Foreign currency transaction gain (loss) 3,826 518 8,415 ( 4,983 ) Interest income 520 166 1,036 555 Interest expense ( 1,992 ) ( 1,908 ) ( 5,882 ) ( 5,747 ) (Loss) on capped call transactions ( 6,876 ) ( 14,735 ) ( 56,381 ) ( 7,543 ) Other (loss) income, net ( 29 ) 2 6,497 108 (Loss) before provision for (benefit from) income taxes ( 81,772 ) ( 81,294 ) ( 189,956 ) ( 80,154 ) Provision for (benefit from) income taxes 11,748 ( 24,826 ) 190,239 ( 54,360 ) Net (loss) $ ( 93,520 ) $ ( 56,468 ) $ ( 380,195 ) $ ( 25,794 ) (Loss) per share Basic $ ( 1.14 ) $ ( 0.69 ) $ ( 4.65 ) $ ( 0.32 ) Diluted $ ( 1.14 ) $ ( 0.69 ) $ ( 4.65 ) $ ( 0.32 ) Weighted-average number of common shares outstanding Basic 81,996 81,526 81,842 81,284 Diluted 81,996 81,526 81,842 81,284 See notes to unaudited condensed consolidated financial statements. 4 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) (in thousands) Three Months Ended September 30, Nine Months Ended September 30, 2022 2021 2022 2021 Net (loss) $ ( 93,520 ) $ ( 56,468 ) $ ( 380,195 ) $ ( 25,794 ) Other comprehensive (loss), net of tax Unrealized (loss) gain on available-for-sale securities ( 73 ) 53 ( 1,000 ) 1,184 Foreign currency translation adjustments ( 6,700 ) ( 4,400 ) ( 20,936 ) ( 3,669 ) Total other comprehensive (loss), net of tax $ ( 6,773 ) $ ( 4,347 ) $ ( 21,936 ) $ ( 2,485 ) Comprehensive (loss) $ ( 100,293 ) $ ( 60,815 ) $ ( 402,131 ) $ ( 28,279 ) 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 Deficit) Accumulated Other Comprehensive (Loss) Total Stockholders’ Equity Number of Shares Amount 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 Repurchase of common stock ( 96 ) ( 1 ) ( 12,795 ) — — ( 12,796 ) Issuance of common stock for stock compensation plans 286 3 ( 18,117 ) — — ( 18,114 ) Issuance of common stock under the employee stock purchase plan 24 — 2,639 — — 2,639 Stock-based compensation — — 28,701 — — 28,701 Cash dividends declared ($ 0.03 per share) — — — ( 2,451 ) — ( 2,451 ) Other comprehensive (loss) — — — — ( 4,347 ) ( 4,347 ) Net (loss) — — — ( 56,468 ) — ( 56,468 ) September 30, 2021 81,670 $ 817 $ 148,098 $ 316,150 $ ( 5,433 ) $ 459,632 6 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands, except per share amounts) Common Stock Additional Paid-In Capital Retained Earnings (Accumulated Deficit) Accumulated Other Comprehensive (Loss) Total Stockholders’ Equity Number of Shares Amount December 31, 2021 81,712 $ 817 $ 145,810 $ 276,449 $ ( 6,988 ) $ 416,088 Repurchase of common stock ( 242 ) ( 2 ) ( 22,581 ) — — ( 22,583 ) Issuance of common stock for stock compensation plans 297 3 ( 12,131 ) — — ( 12,128 ) Issuance of common stock under the employee stock purchase plan 35 — 2,446 — — 2,446 Stock-based compensation — — 28,227 — — 28,227 Cash dividends declared ($ 0.03 per share) — — — ( 2,455 ) — ( 2,455 ) Other comprehensive (loss) — — — — ( 2,548 ) ( 2,548 ) Net (loss) — — — ( 379 ) — ( 379 ) March 31, 2022 81,802 $ 818 $ 141,771 $ 273,615 $ ( 9,536 ) $ 406,668 Repurchase of common stock ( 38 ) — ( 1,925 ) — — ( 1,925 ) Issuance of common stock for stock compensation plans 117 1 ( 3,252 ) — — ( 3,251 ) Issuance of common stock under the employee stock purchase plan 59 — 2,357 — — 2,357 Stock-based compensation — — 31,300 — — 31,300 Cash dividends declared ($ 0.03 per share) — — — ( 2,459 ) — ( 2,459 ) Other comprehensive (loss) — — — — ( 12,615 ) ( 12,615 ) Net (loss) — — — ( 286,296 ) — ( 286,296 ) June 30, 2022 81,940 $ 819 $ 170,251 $ ( 15,140 ) $ ( 22,151 ) $ 133,779 Issuance of common stock for stock compensation plans 138 2 ( 2,198 ) — — ( 2,196 ) Issuance of common stock under the employee stock purchase plan 86 1 2,362 — — 2,363 Stock-based compensation — — 33,774 — — 33,774 Cash dividends declared ($ 0.03 per share) — — — ( 2,466 ) — ( 2,466 ) Other comprehensive (loss) — — — — ( 6,773 ) ( 6,773 ) Net (loss) — — — ( 93,520 ) — ( 93,520 ) September 30, 2022 82,164 $ 822 $ 204,189 $ ( 111,126 ) $ ( 28,924 ) $ 64,961 See notes to unaudited condensed consolidated financial statements. 7 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Nine Months Ended September 30, 2022 2021 Operating activities Net (loss) $ ( 380,195 ) $ ( 25,794 ) Adjustments to reconcile net (loss) to cash (used in) operating activities Stock-based compensation 93,301 89,483 Deferred income taxes 169,489 ( 53,638 ) Loss on capped call transactions 56,381 7,543 Amortization of deferred commissions 39,752 31,388 Lease expense 11,500 9,274 Amortization of intangible assets and depreciation 12,381 24,030 Foreign currency transaction (gain) loss ( 8,415 ) 4,983 Other non-cash ( 1,705 ) 5,246 Change in operating assets and liabilities, net ( 5,935 ) ( 97,836 ) Cash (used in) operating activities ( 13,446 ) ( 5,321 ) Investing activities Purchases of investments ( 39,056 ) ( 67,170 ) Proceeds from maturities and called investments 53,952 96,859 Sales of investments 18,415 25,123 Payments for acquisitions, net of cash acquired ( 922 ) ( 4,993 ) Investment in property and equipment ( 22,285 ) ( 7,089 ) Cash provided by investing activities 10,104 42,730 Financing activities Proceeds from employee stock purchase plan 7,166 7,786 Dividend payments to stockholders ( 7,368 ) ( 7,310 ) Common stock repurchases ( 43,282 ) ( 91,907 ) Cash (used in) financing activities ( 43,484 ) ( 91,431 ) Effect of exchange rate changes on cash and cash equivalents ( 5,513 ) ( 1,466 ) Net (decrease) in cash and cash equivalents ( 52,339 ) ( 55,488 ) Cash and cash equivalents, beginning of period 159,965 171,899 Cash and cash equivalents, end of period $ 107,626 $ 116,411 See notes to unaudited condensed consolidated financial statements. 8 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 and 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, 2021. 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 do not necessarily indicate the expected results for the full year 2022. Certain prior period amounts reported in our condensed consolidated financial statements and notes thereto have been reclassified to conform to the current year’s presentation. Such reclassifications did not affect total revenues, operating income, or net income. NOTE 2. MARKETABLE SECURITIES September 30, 2022 December 31, 2021 (in thousands) Amortized Cost Unrealized Gains Unrealized Losses Fair Value Amortized Cost Unrealized Gains Unrealized Losses Fair Value Government debt $ 2,992 $ — $ ( 67 ) $ 2,925 $ 2,000 $ — $ ( 10 ) $ 1,990 Corporate debt 168,894 — ( 3,734 ) 165,160 201,659 2 ( 837 ) 200,824 $ 171,886 $ — $ ( 3,801 ) $ 168,085 $ 203,659 $ 2 $ ( 847 ) $ 202,814 As of September 30, 2022, marketable securities’ maturities ranged from November 2022 to November 2024, with a weighted-average remaining maturity of 0.7 years. NOTE 3. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE Receivables (in thousands) September 30, 2022 December 31, 2021 Accounts receivable $ 139,670 $ 182,717 Unbilled receivables 182,403 226,714 Long-term unbilled receivables 108,285 129,789 $ 430,358 $ 539,220 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) September 30, 2022 1 year or less $ 182,403 63 % 1-2 years 78,893 27 % 2-5 years 29,392 10 % $ 290,688 100 % Unbilled receivables by contract effective date: (Dollars in thousands) September 30, 2022 2022 $ 87,874 30 % 2021 130,196 45 % 2020 45,589 16 % 2019 15,747 5 % 2018 and prior 11,282 4 % $ 290,688 100 % 9 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Major clients Clients accounting for 10% or more of the Company’s total receivables: September 30, 2022 December 31, 2021 Client A Accounts receivable * 1 % Unbilled receivables * 15 % Total receivables * 10 % * Client accounted for less than 10% of 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 the completion of a related performance obligation. (in thousands) September 30, 2022 December 31, 2021 Contract assets (1) $ 12,429 $ 12,530 Long-term contract assets (2) 10,541 10,643 $ 22,970 $ 23,173 (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) September 30, 2022 December 31, 2021 Deferred revenue $ 245,146 $ 275,844 Long-term deferred revenue (1) 3,949 5,655 $ 249,095 $ 281,499 (1) Included in other long-term liabilities. The change in deferred revenue in the nine months ended September 30, 2022 was primarily due to new billings in advance of revenue recognition offset by $ 252.8 million of revenue recognized during the period that was included in deferred revenue as of December 31, 2021. NOTE 4. DEFERRED COMMISSIONS (in thousands) September 30, 2022 December 31, 2021 Deferred commissions (1) $ 122,673 $ 135,911 (1) Included in other long-term assets. Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2022 2021 2022 2021 Amortization of deferred commissions (1) $ 11,597 $ 10,186 $ 39,752 $ 31,388 (1) Included in selling and marketing expense . 10 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 5. GOODWILL AND OTHER INTANGIBLES Goodwill Change in goodwill: Nine Months Ended September 30, (in thousands) 2022 2021 January 1, $ 81,923 $ 79,231 Acquisition — 2,701 Currency translation adjustments ( 722 ) 22 September 30, $ 81,201 $ 81,954 Intangibles Intangible assets are recorded at cost and amortized using the straight-line method over their estimated useful lives. September 30, 2022 (in thousands) Useful Lives Cost Accumulated Amortization Net Book Value (1) Client-related 4 - 10 years $ 63,007 $ ( 58,211 ) $ 4,796 Technology 2 - 10 years 68,038 ( 60,913 ) 7,125 Other 1 - 5 years 5,361 ( 5,361 ) — $ 136,406 $ ( 124,485 ) $ 11,921 (1) Included in other long-term assets. December 31, 2021 (in thousands) Useful Lives Cost Accumulated Amortization Net Book Value (1) Client-related 4 - 10 years $ 63,165 $ ( 57,342 ) $ 5,823 Technology 2 - 10 years 67,142 ( 58,902 ) 8,240 Other 1 - 5 years 5,361 ( 5,361 ) — $ 135,668 $ ( 121,605 ) $ 14,063 (1) Included in other long-term assets. Amortization of intangible assets: Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2022 2021 2022 2021 Cost of revenue $ 705 $ 629 $ 2,017 $ 1,887 Selling and marketing 343 373 1,028 1,119 $ 1,048 $ 1,002 $ 3,045 $ 3,006 Future estimated intangibles assets amortization: (in thousands) September 30, 2022 Remainder of 2022 $ 1,048 2023 3,917 2024 3,147 2025 2,608 2026 874 2027 327 $ 11,921 NOTE 6. OTHER ASSETS AND LIABILITIES Other current assets (in thousands) September 30, 2022 December 31, 2021 Income tax receivables $ 11,948 $ 25,691 Contract assets 12,429 12,530 Other 38,080 29,787 $ 62,457 $ 68,008 11 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Other long-term assets (in thousands) September 30, 2022 December 31, 2021 Deferred income taxes $ 6,041 $ 180,656 Deferred commissions 122,673 135,911 Right of use assets 80,163 87,521 Capped call transactions 3,583 59,964 Property and equipment 45,350 26,837 Venture investments 11,910 7,648 Intangible assets 11,921 14,063 Contract assets 10,541 10,643 Other 24,549 18,358 $ 316,731 $ 541,601 Other current liabilities (in thousands) September 30, 2022 December 31, 2021 Operating lease liabilities $ 5,787 $ 6,989 Dividends payable 2,466 2,454 $ 8,253 $ 9,443 Other long-term liabilities (in thousands) September 30, 2022 December 31, 2021 Deferred revenue $ 3,949 $ 5,655 Other 7,987 7,844 $ 11,936 $ 13,499 NOTE 7. LEASES Corporate headquarters In February 2021, the Company agreed to accelerate its exit from its previous corporate headquarters to October 1, 2021, in exchange for a one-time payment from its landlord of $ 18 million, which was amortized over the remaining lease term. The exit accelerated depreciation on the related leasehold improvements and reduced the Company’s future lease liabilities by $ 21.1 million and right of use assets by $ 20.3 million. On March 31, 2021, the Company leased office space at One Main Street, Cambridge, Massachusetts, to serve as its corporate headquarters. The 4.5 year lease includes a base rent of $ 2 million per year. New Waltham office On July 6, 2021, the Company 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 became payable on August 1, 2022. Base rent for the first year is approximately $ 6 million and will increase by 3 % annually. In addition, the Company will receive an improvement allowance from the landlord of up to $ 11.8 million. This lease increased the Company’s lease liabilities and lease-related right of use assets by $ 42.1 million on August 1, 2021. Expense Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2022 2021 2022 2021 Fixed lease costs (1) $ 4,688 $ ( 3,108 ) $ 14,747 $ ( 6,780 ) Short-term lease costs 916 542 2,510 1,516 Variable lease costs 905 1,099 2,395 3,826 $ 6,509 $ ( 1,467 ) $ 19,652 $ ( 1,438 ) (1) The lower fixed lease costs in the nine months ended September 30, 2021 was due to the modification of the corporate headquarters lease. 12 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Right of use assets and lease liabilities (in thousands) September 30, 2022 December 31, 2021 Right of use assets (1) $ 80,163 $ 87,521 Operating lease liabilities (2) $ 5,787 $ 6,989 Long-term operating lease liabilities $ 82,705 $ 87,818 (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: September 30, 2022 December 31, 2021 Weighted-average remaining lease term 7.4 years 7.7 years Weighted-average discount rate (1) 4.2 % 4.4 % (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. Maturities of lease liabilities: (in thousands) September 30, 2022 Remainder of 2022 $ ( 4,717 ) 2023 18,804 2024 16,841 2025 14,778 2026 11,257 2027 and thereafter 48,397 Total lease payments 105,360 Less: imputed interest (1) ( 16,868 ) $ 88,492 (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 Nine Months Ended September 30, (in thousands) 2022 2021 Cash paid for leases $ 11,628 $ 14,403 Right of use assets recognized for new leases and amendments (non-cash) $ 6,618 $ 54,716 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 due 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 beginning 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. 13 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) • 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 September 30, 2022, the Notes were not eligible for conversion. 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. 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. Carrying value of the Notes: (in thousands) September 30, 2022 December 31, 2021 Principal $ 600,000 $ 600,000 Unamortized issuance costs ( 7,116 ) ( 9,278 ) Convertible senior notes, net $ 592,884 $ 590,722 Interest expense related to the Notes: Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2022 2021 2022 2021 Contractual interest expense ( 0.75 % coupon) $ 1,125 $ 1,125 $ 3,375 $ 3,375 Amortization of issuance costs 724 677 2,163 2,025 $ 1,849 $ 1,802 $ 5,538 $ 5,400 The effective interest rate for the Notes: Nine Months Ended September 30, 2022 2021 Weighted-average effective interest rate 1.2 % 1.2 % Future payments of principal and contractual interest: September 30, 2022 (in thousands) Principal Interest Total 2023 $ — $ 4,500 $ 4,500 2024 — 4,500 4,500 2025 600,000 2,250 602,250 $ 600,000 $ 11,250 $ 611,250 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 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 specified extraordinary events affecting the Company, including mergers and tender offers. 14 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) 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. The Capped Call Transactions are classified as other long-term assets and remeasured to fair value each reporting period, resulting in a non-operating gain or loss. Change in capped call transactions: Nine Months Ended September 30, (in thousands) 2022 2021 January 1, $ 59,964 $ 83,597 Fair value adjustment ( 56,381 ) ( 7,543 ) September 30, $ 3,583 $ 76,054 Credit facility In November 2019, and as since amended, 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 for general corporate purposes and to finance working capital needs. 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 required to comply with financial covenants, including: • Beginning with the fiscal quarter ended March 31, 2022 and ending with the fiscal quarter ended December 31, 2022, Pegasystems Inc. must maintain at least $ 200 million in cash, investments, and availability under the Revolving Credit Loan. • Beginning with the fiscal quarter ended March 31, 2023, a maximum net consolidated leverage ratio of 3.5 to 1.0 (with a step-up for certain acquisitions) and a minimum consolidated interest coverage ratio of 3.5 to 1.0. As of September 30, 2022 and December 31, 2021, the Company had no outstanding cash borrowings under the Credit Facility. As of September 30, 2022, the Company had $ 27.3 million in outstanding letters of credit which reduce the available borrowing capacity under the Credit Facility. 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 model uses 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 multiple valuation methods, including observable public companies and transaction prices and unobservable inputs, including the volatility, rights, and obligations of the securities the Company holds. 15 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Assets and liabilities measured at fair value on a recurring basis: September 30, 2022 December 31, 2021 (in thousands) Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 Total Cash equivalents $ 20,899 $ — $ — $ 20,899 $ 3,216 $ — $ — $ 3,216 Marketable securities $ — $ 168,085 $ — $ 168,085 $ — $ 202,814 $ — $ 202,814 Capped Call Transactions (1) $ — $ 3,583 $ — $ 3,583 $ — $ 59,964 $ — $ 59,964 Venture investments (1) (2) $ — $ — $ 11,910 $ 11,910 $ — $ — $ 7,648 $ 7,648 (1) Included in other long-term assets. (2) Investments in privately-held companies. Changes in venture investments: Nine Months Ended September 30, (in thousands) 2022 2021 January 1, $ 7,648 $ 8,345 New investments 400 500 Sales of investments ( 3,954 ) ( 400 ) Changes in foreign exchange rates ( 675 ) ( 52 ) Changes in fair value: included in other income 5,989 100 included in other comprehensive income 2,502 1,220 September 30, $ 11,910 $ 9,713 The carrying value of certain other financial instruments, including receivables and accounts payable, approximates fair value due to these items’ short maturities. Fair value of the Notes The Notes’ fair value (including the conversion feature embedded in the Notes) was $ 488.3 million as of September 30, 2022 and $ 642.0 million as of December 31, 2021. 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. NOTE 10. REVENUE Geographic revenue Three Months Ended September 30, Nine Months Ended September 30, (Dollars in thousands) 2022 2021 2022 2021 U.S. $ 148,200 55 % $ 132,016 52 % $ 513,197 56 % $ 515,881 58 % Other Americas 18,546 7 % 17,510 7 % 80,558 9 % 43,469 5 % United Kingdom (“U.K.”) 24,074 9 % 25,982 10 % 83,837 9 % 86,747 10 % Europe (excluding U.K.), Middle East, and Africa 46,212 17 % 46,306 18 % 140,586 15 % 143,763 15 % Asia-Pacific 33,699 12 % 34,454 13 % 103,197 11 % 105,609 12 % $ 270,731 100 % $ 256,268 100 % $ 921,375 100 % $ 895,469 100 % Revenue streams Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2022 2021 2022 2021 Perpetual license $ 9,223 $ 2,874 $ 18,929 $ 20,922 Subscription license 31,112 35,421 210,245 251,226 Revenue recognized at a point in time 40,335 38,295 229,174 272,148 Maintenance 77,526 83,188 235,568 237,531 Pega Cloud 97,359 78,369 281,182 219,520 Consulting 55,511 56,416 175,451 166,270 Revenue recognized over time 230,396 217,973 692,201 623,321 Total revenue $ 270,731 $ 256,268 $ 921,375 $ 895,469 16 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2022 2021 2022 2021 Pega Cloud $ 97,359 $ 78,369 $ 281,182 $ 219,520 Maintenance 77,526 83,188 235,568 237,531 Subscription services 174,885 161,557 516,750 457,051 Subscription license 31,112 35,421 210,245 251,226 Subscription 205,997 196,978 726,995 708,277 Perpetual license 9,223 2,874 18,929 20,922 Consulting 55,511 56,416 175,451 166,270 $ 270,731 $ 256,268 $ 921,375 $ 895,469 Remaining performance obligations ("Backlog") Expected future revenue from existing non-cancellable contracts: As of September 30, 2022: (Dollars in thousands) Subscription services Subscription license Perpetual license Consulting Total Maintenance Pega Cloud 1 year or less $ 191,045 $ 328,111 $ 69,753 $ 814 $ 27,968 $ 617,691 53 % 1-2 years 55,141 213,304 4,113 4,505 6,699 283,762 25 % 2-3 years 24,496 115,416 1,420 2,252 1,648 145,232 13 % Greater than 3 years 16,198 82,807 1,734 — 508 101,247 9 % $ 286,880 $ 739,638 $ 77,020 $ 7,571 $ 36,823 $ 1,147,932 100 % As of September 30, 2021: (Dollars in thousands) Subscription services Subscription license Perpetual license Consulting Total Maintenance Pega Cloud 1 year or less $ 196,667 $ 284,359 $ 49,265 $ 15,686 $ 31,673 $ 577,650 56 % 1-2 years 59,360 177,214 16,872 1,064 6,561 261,071 25 % 2-3 years 37,734 79,775 420 4,094 5,165 127,188 12 % Greater than 3 years 33,935 30,113 245 2,127 1,697 68,117 7 % $ 327,696 $ 571,461 $ 66,802 $ 22,971 $ 45,096 $ 1,034,026 100 % NOTE 11. STOCK-BASED COMPENSATION Expense Three Months Ended September 30, Nine Months Ended September 30, (in thousands) 2022 2021 2022 2021 Cost of revenue $ 6,797 $ 5,114 $ 19,754 $ 16,889 Selling and marketing 12,933 13,376 36,524 41,844 Research and development 7,724 6,231 22,425 19,343 General and administrative 6,320 3,974 14,598 11,407 $ 33,774 $ 28,695 $ 93,301 $ 89,483 Income tax benefit $ ( 600 ) $ ( 5,845 ) $ ( 1,505 ) $ ( 18,028 ) As of September 30, 2022, the Company had $ 161.0 million of unrecognized stock-based compensation expense, net of estimated forfeitures, which is expected to be recognized over a weighted-average period of 2.1 years. Grants Nine Months Ended September 30, 2022 (in thousands) Shares Total Fair Value Restricted stock units 1,436 $ 112,303 Non-qualified stock options 4,529 $ 102,332 Common stock 14 $ 600 17 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 12. INCOME TAXES Effective income tax rate Three Months Ended September 30, Nine Months Ended September 30, (Dollars in thousands) 2022 2021 2022 2021 Provision for (benefit from) income taxes $ 11,748 $ ( 24,826 ) $ 190,239 $ ( 54,360 ) Effective income tax rate (benefit rate) 100 % ( 68 ) % The change in the effective income tax rate (benefit rate) in the nine months ended September 30, 2022 was primarily due to the recognition of a $ 191.9 million valuation allowance recognized at June 30, 2022, on the Company’s U.S. and U.K deferred tax assets. As a result of recording the valuation allowance, the Company is no longer recording any income tax benefit on its U.S and U.K losses. The $ 11.7 million provision for (benefit from) income taxes for the three months ended September 30, 2022 primarily represents non-U.K. foreign income taxes. The Company recognizes deferred tax assets to the extent that it believes that these assets are more likely than not to be realized. Future realization of deferred tax assets ultimately depends on sufficient taxable income within the available carryback or carryforward periods. The Company’s deferred tax valuation allowance requires significant judgment and uncertainties, including assumptions about future taxable income based on historical and projected information. On a quarterly basis, the Company reassesses the need for a valuation allowance on its existing net deferred tax assets by tax-paying jurisdiction, weighing positive and negative evidence to assess its recoverability. In making such a determination, the Company considers all available and objectively verifiable negative and positive evidence, including future reversals of existing taxable temporary differences, committed contractual backlog (“Backlog”), projected future taxable income inclusive of the impact of enacted legislation, tax-planning strategies, and results of recent operations. The weight given to the potential effect of negative and positive evidence is commensurate with the extent to which it can be objectively verified. As of June 30, 2022, the Company’s Backlog balance was not sufficient to recover our net deferred tax assets. The Backlog balance and other unsettled circumstances, impacting the Company’s operations, reduced the Backlog’s weight as objectively verifiable positive evidence to generate sufficient taxable income to recover its net deferred tax assets. These unsettled circumstances include growing and extended geopolitical turmoil, increasing inflation, and an uncertain global economic outlook. As of June 30, 2022, the combination of the above factors caused the Company to conclude there is not sufficient objectively verifiable positive evidence to support that it is more likely than not the Company will generate sufficient future taxable income to recover the Company’s U.S. and U.K. net deferred tax assets. Accordingly, the Company recorded a valuation allowance of $ 191.9 million in income tax expense during the three months ended June 30, 2022. The Company intends to continue maintaining a full valuation allowance on our U.S and U.K deferred tax assets until there is sufficient evidence to support the realization of these deferred tax assets. NOTE 13. (LOSS) PER SHARE Basic (loss) per share is calculated using the weighted-average number of common shares outstanding during the period. Diluted (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. Calculation of (loss) per share: Three Months Ended September 30, Nine Months Ended September 30, (in thousands, except per share amounts) 2022 2021 2022 2021 Net (loss) $ ( 93,520 ) $ ( 56,468 ) $ ( 380,195 ) $ ( 25,794 ) Weighted-average common shares outstanding 81,996 81,526 81,842 81,284 (Loss) per share, basic $ ( 1.14 ) $ ( 0.69 ) $ ( 4.65 ) $ ( 0.32 ) Net (loss) $ ( 93,520 ) $ ( 56,468 ) $ ( 380,195 ) $ ( 25,794 ) Weighted-average common shares outstanding, assuming dilution (1) (2) (3) 81,996 81,526 81,842 81,284 (Loss) per share, diluted $ ( 1.14 ) $ ( 0.69 ) $ ( 4.65 ) $ ( 0.32 ) Outstanding anti-dilutive stock options and RSUs (4) 3,019 5,815 3,589 6,136 (1) In periods of loss, all dilutive securities are excluded as their inclusion would be anti-dilutive. (2) 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 approximately 4.4 million shares. 18 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) (3) The Company’s Capped Call Transactions represent the equivalent of 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 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 (loss) per share. These awards may be dilutive in the future. NOTE 14. COMMITMENTS AND CONTINGENCIES Commitments See "Note 7. Leases" for additional information. Legal proceedings In addition to the matters below, the Company is, or may become, involved in a variety of claims, demands, suits, investigations, and proceedings that arise from time to time relating to matters incidental to the ordinary course of the Company’s business, including actions concerning contracts, intellectual property, employment, benefits, and securities matters. Regardless of the outcome, legal disputes can have a material effect on the Company because of defense and settlement costs, diversion of management resources, and other factors. In addition, as the Company is a party to ongoing litigation, it is at least reasonably possible that our estimates will change in the near term and the effect may be material. As of September 30, 2022 and December 31, 2021, the Company has no accrued losses for litigation. Pegasystems Inc. v. Appian Corp. & Business Process Management Inc. On July 3, 2019, the Company filed suit in Massachusetts federal court against Appian Corp. (“Appian”) and Business Process Management, Inc. (“BPM”) relating to a BPM “Market Report” that Appian had used to promote itself against the Company. Pegasystems Inc. v. Appian Corp. & Business Process Management Inc., No. 1:19-cv-11461 (D. Mass). On April 15, 2022, each of the parties filed motions for summary judgment with the court. On September 30, 2022, the court entered an order allowing in part and denying in part each party’s motion for summary judgment, thereby narrowing the potential issues for trial. On October 24, 2022, the court entered an order setting a trial date of January 3, 2023. The Company continues to believe the counterclaims brought by Appian against the Company are without merit, and the Company intends to vigorously pursue its claims against Appian and defend against the counterclaims brought against the Company in this matter. The Company is unable to reasonably estimate possible damages or a range of possible damages in this matter given the Company’s belief that the damages claimed by Appian fail to satisfy the required legal standard, the status of the proceeding, and due to the uncertainty as to how a jury may rule if this ultimately proceeds to trial. Appian Corp. v. Pegasystems Inc. & Youyong Zou As previously reported, the Company is a defendant in litigation brought by Appian in the Circuit Court of Fairfax County, Virginia (the “Court”) titled Appian Corp. v. Pegasystems Inc. & Youyong Zou, No. 2020-07216 (Fairfax Cty. Ct.). On May 9, 2022, the jury rendered its verdict finding that the Company had misappropriated one or more of Appian’s trade secrets, that the Company had violated the Virginia Computer Crimes Act, and that the trade secret misappropriation was willful and malicious. The jury awarded damages in the amount of $ 2,036,860,045 for trade secret misappropriation and $ 1.00 for the violation of the Virginia Computer Crimes Act. On September 15, 2022, the circuit court of Fairfax County entered judgment in the amount of $ 2,060,479,287 , consisting of the damages previously awarded by the jury plus attorneys’ fees and costs, and stating that the judgment is subject to post-judgment interest at a rate of 6.0 % per annum, from the date of the jury verdict (May 9, 2022) as to the amount of the jury verdict and from September 15, 2022 as to the amount of the award of attorneys’ fees and costs. On September 15, 2022, the Company filed a notice of appeal from the judgment. On September 29, 2022, the circuit court of Fairfax County approved a $ 25,000,000 letter of credit obtained by the Company to secure the judgment and entered an order suspending the judgment during the pendency of the Company’s appeal. This appeals process could potentially take years to complete. The Company continues to believe that it did not misappropriate any alleged trade secrets and that its sales of the Company’s products at issue were not caused by, or the result of, any alleged misappropriation of trade secrets. The Company is unable to reasonably estimate possible damages because of, among other things, uncertainty as to the outcome of appellate proceedings and/or any potential new trial resulting from the appellate proceedings. 19 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) City of Fort Lauderdale Police and Firefighters’ Retirement System, Individually and on Behalf of All Others Similarly Situated v. Pegasystems Inc., Alan Trefler, and Kenneth Stillwell On May 19, 2022, a lawsuit was filed against the Company, the Company’s chief executive officer and the Company’s chief operating and financial officer in the United States District Court for the Eastern District of Virginia Alexandria Division, captioned City of Fort Lauderdale Police and Firefighters’ Retirement System, Individually and on Behalf of All Others Similarly Situated v. Pegasystems Inc., Alan Trefler, and Kenneth Stillwell (Case 1:22-cv-00578-LMB-IDD). The complaint generally alleges, among other things, that the defendants violated Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and Rule 10b-5 promulgated thereunder and that the individual defendants violated Section 20(a) of the Exchange Act, in each case by allegedly making materially false and/or misleading statements, as well as allegedly failing to disclose material adverse facts about the Company’s business, operations, and prospects, which caused the Company’s securities to trade at artificially inflated prices. The complaint seeks unspecified damages on behalf of a class of purchasers of the Company’s securities between May 29, 2020 and May 9, 2022. The litigation has since been transferred to the United States District Court for the District of Massachusetts (Case 1:22-cv-11220-WGY), and lead plaintiff class representatives—Central Pennsylvania Teamsters Pension Fund - Defined Benefit Plan, Central Pennsylvania Teamsters Pension Fund - Retirement Income Plan 1987, and Construction Industry Laborers Pension Fund—have been appointed. On October 18, 2022, a consolidated amended complaint was filed that does not add any new parties or legal claims, is based upon the same general factual allegations as the original complaint, and now seeks unspecified damages on behalf of a class of purchasers of the Company’s securities between June 16, 2020 and May 9, 2022. The Company believes the claims brought against the defendants are without merit, and intends to vigorously defend against these claims. The Company is unable to reasonably estimate possible damages or a range of possible damages in this matter given the stage of the lawsuit, the Company’s belief that the claims are without merit, and there being no specified quantum of damages sought in the complaint. 20