QUALYS, INC. 10-K

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations   You should read the following discussion in conjunction with the section titled "Selected Consolidated Financial Data" and our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. You should carefully review and consider the information regarding our financial condition and results of operations set forth under Part I-Item 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations) in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 21, 2020, for an understanding of our results of operations and liquidity discussions and analysis comparing fiscal year 2019 to fiscal year 2018. In addition to historical information, this discussion contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially from our expectations, as discussed in "Forward-Looking Statements" in Part I of this Annual Report on Form 10-K. Factors that could cause such differences include, but are not limited to, those described in the section titled "Risk Factors" and elsewhere in this Annual Report on Form 10-K.   Overview   We are a pioneer and leading provider of a cloud-based platform delivering IT, security and compliance solutions that enable organizations to identify security risks to their information technology (IT) infrastructures, help protect their IT systems and applications from ever-evolving cyber-attacks and achieve compliance with internal policies and external regulations. Our cloud solutions address the growing security and compliance complexities and risks that are amplified by the dissolving boundaries between internal and external IT infrastructures and web environments, the rapid adoption of cloud computing, containers and serverless IT models, and the proliferation of geographically dispersed IT assets. Our integrated suite of security and compliance solutions delivered on our Qualys Cloud Platform enables our customers to identify and manage their IT assets, collect and analyze large amounts of IT security data, discover and prioritize vulnerabilities, recommend remediation actions and verify the implementation of such actions. Organizations use our integrated suite of solutions delivered on our Qualys Cloud Platform to cost-effectively obtain a unified view of their IT asset inventory as well as security and compliance posture across globally-distributed IT infrastructures as our solution offers a single platform for information technology, information security, application security, endpoint, developer security and cloud teams.   We were founded and incorporated in December 1999 with a vision of transforming the way organizations secure and protect their IT infrastructure and applications and initially launched our first cloud solution, Vulnerability Management (VM), in 2000. As VM gained acceptance, we introduced additional solutions to help customers manage increasing IT, security and compliance requirements. Today, the suite of solutions that we offer on our cloud platform and refer to as the Qualys Cloud Apps helps our customers protect a range of assets across on-premises, endpoints, cloud, containers, and mobile environments. These Cloud Apps address and include:     • IT Security: Vulnerability Management (VM), Vulnerability Management, Detection and Response (VMDR), Threat Protection (TP), Continuous Monitoring (CM), Patch Management (PM), Multi-Vector Endpoint Detection and Response (EDR), Indication of Compromise (IOC), Certificate Assessment (CRA);   • Compliance: Policy Compliance (PC), Security Configuration Assessment (SCA), PCI Compliance (PCI), File Integrity Monitoring (FIM), Security Assessment Questionnaire (SAQ), Out of-Band Configuration Assessment (OCA);   • Web Application Security: Web Application Scanning (WAS), Web Application Firewall (WAF);   • Asset Management: Global IT Asset Inventory (AI), CMDB Sync (SYN), Certificate Inventory (CRI); and,   • Cloud/Container Security: Cloud Inventory (CI), Cloud Security Assessment (CSA), Container Security (CS).   We provide our solutions through a software-as-a-service model, primarily with renewable annual subscriptions. These subscriptions require customers to pay a fee in order to access each of our cloud solutions. We generally invoice our customers for the entire subscription amount at the start of the subscription term, and the invoiced amounts are treated as deferred revenues and are recognized ratably over the term of each subscription. We continue to experience revenue growth from our existing customers as they renew and purchase additional subscriptions.   We market and sell our solutions to enterprises, government entities and small and medium-sized businesses across a broad range of industries, including education, financial services, government, healthcare, insurance, manufacturing, media, retail, technology and utilities. In 2020, 2019 and 2018, approximately 63%, 64% and 67%, respectively, of our revenues were derived from customers in the United States based on our customers billing address. We sell our solutions to enterprises and government entities primarily through our field sales force and to small and medium-sized businesses through our inside sales force. We generate a significant portion of sales through our channel partners, including managed service providers, value-added resellers and consulting firms in the United States and internationally.   40 Table of Contents   Impacts of COVID-19   In March 2020, the World Health Organization declared the outbreak of COVID-19 as a pandemic. As a result of COVID-19, we have modified certain aspects of our business, including restricting employee travel, requiring employees to work from home, and canceling certain events and meetings, among other modifications. We will continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state or local authorities or that we determine are in the best interests of our employees, customers, partners, suppliers and stockholders. COVID-19 has not had and is not expected to have a significant impact on our business in 2021. However, while we have not incurred significant disruptions from the COVID-19 outbreak, we are unable to accurately predict the full impact that COVID-19 will have due to numerous uncertainties, including the duration of the outbreak, actions that may be taken by governmental authorities and the impact to the business of our customers and partners. We will continue to evaluate the nature and extent of the impact to our business, financial position, results of operations and cash flows.   Key Components of Results of Operations   Revenues   We derive revenues from the sale of subscriptions to our security and compliance solutions, which are delivered on our cloud platform. Subscriptions to our solutions allow customers to access our cloud-based security and compliance solutions through a unified, web-based interface. Customers generally enter into one-year renewable subscriptions. The subscription fee entitles the customer to an unlimited number of scans for a specified number of devices or web applications and, if requested by a customer as part of their subscription, a specified number of physical or virtual scanner appliances. Our physical and virtual scanner appliances are requested by certain customers as part of their subscriptions in order to scan IT infrastructures within their firewalls and do not function without, and are not sold separately from, subscriptions for our solutions. In some limited cases, we also provide certain computer equipment used to extend our Qualys Cloud Platform into our customers' private cloud environment. Customers are required to return physical scanner appliances and computer equipment if they do not renew their subscriptions.   We typically invoice our customers for the entire subscription amount at the start of the subscription term. Invoiced amounts are reflected on our consolidated balance sheets as accounts receivable or as cash when collected, and as deferred revenues until earned and recognized ratably over the subscription period. Accordingly, deferred revenues represent the amount billed to customers that has not yet been earned or recognized as revenues, pursuant to subscriptions entered into in current and prior periods.   Cost of Revenues   Cost of revenues consists primarily of personnel expenses, comprised of salaries, benefits, amortization of capitalized internal-use software, performance-based compensation and stock-based compensation, for employees who operate our data centers and provide support services to our customers. Other expenses include depreciation of data center equipment and physical scanner appliances and computer hardware provided to certain customers as part of their subscriptions, expenses related to the use of third-party data centers, amortization of software and license fees, amortization of intangibles related to acquisitions, maintenance support, fees paid to contractors who supplement or support our operations center personnel and overhead allocations. We expect to continue to make capital investments to expand and support our data center operations, which will increase the cost of revenues in absolute dollars.   Operating Expenses   Research and Development   Research and development expenses consist primarily of personnel expenses, comprised of salaries, benefits, performance-based compensation and stock-based compensation, for our research and development teams. Other expenses include third-party contractor fees, software and license fees, amortization of intangibles related to acquisitions and overhead allocations.   41 Table of Contents   Sales and Marketing   Sales and marketing expenses consist primarily of personnel expenses, comprised of salaries, benefits, sales commissions, performance-based compensation and stock-based compensation for our worldwide sales and marketing teams. Other expenses include marketing and promotional events, lead-generation marketing programs, public relations, travel, software licenses and overhead allocations. Sales commissions related to new business and upsells are capitalized as an asset. We amortize the capitalized commission cost as a selling expense on a straight-line basis over a period of five years. We expense sales commissions related to contract renewals as incurred. Our new sales personnel are typically not immediately productive, and the resulting increase in sales and marketing expenses we incur when we add new personnel may not result in increased revenues if these new sales personnel fail to become productive. The timing of our hiring of sales personnel, or the participation in new marketing events or programs, and the rate at which these generate incremental revenues, may affect our future operating results. We expect to continue to significantly invest in additional sales personnel worldwide and also in more marketing programs to support new solutions on our platform, which will increase sales and marketing expenses in absolute dollars.   General and Administrative   General and administrative expenses consist primarily of personnel expenses, comprised of salaries, benefits, performance-based compensation and stock-based compensation for our executive, finance and accounting, IT, legal and human resources teams, as well as professional services, fees, software licenses and overhead allocations. We expect that general and administrative expenses will increase in absolute dollars, as we continue to add personnel and incur professional services to support our growth and compliance with legal requirements.   Other Income (Expense), Net   Our other income (expense), net consists primarily of interest and investment income from our short-term and long-term marketable securities; foreign exchange gains and losses, the majority of which result from fluctuations between the U.S. Dollar and the Euro, British Pound ("GBP") and Indian Rupee ("INR"); and gains and losses from disposal of property and equipment.   Provision for Income Taxes   We are subject to federal, state and foreign income taxes for jurisdictions in which we operate, and we use estimates in determining our provision for these income taxes and deferred tax assets. Earnings from our non-U.S. activities are subject to income taxes in the local countries at rates which were generally similar to the U.S. statutory tax rate.    Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the tax impact of timing differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period when the statutory rate change is enacted into law.   We assess the likelihood that deferred tax assets will be realized, and we recognize a valuation allowance if it is more likely than not that some portion of the deferred tax assets will not be recognized. This assessment requires judgment as to the likelihood and amounts of future taxable income.   42 Table of Contents   Results of Operations   The following table sets forth selected consolidated statements of operations data for each of the periods presented as a percentage of revenues:       Year Ended December 31,       2020     2019   Revenues     100 %     100 % Cost of revenues     22       22   Gross profit     78       78   Operating expenses:                 Research and development     20       21   Sales and marketing     19       22   General and administrative     12       13   Total operating expenses     51       56   Income from operations     27       22   Other income (expense), net     1       3   Income before income taxes     28       25   Provision for income taxes     3       3   Net income     25 %     22 %   Comparison of Years Ended December 31, 2020 and 2019   Revenues       Year Ended                       December 31,     Change       2020     2019     $     %       (in thousands, except percentages)   Revenues   $ 362,963     $ 321,607     $ 41,356       13 %   Revenues increased $41.4 million in 2020 compared to 2019 due to an increase in the subscriptions from existing customers and new customer subscriptions entered into in 2020. Revenues from customers existing at or prior to December 31, 2019 grew by $31.0 million to $352.6 million during 2020. Subscriptions from new customers added in 2020 contributed $10.4 million to the increase in revenues. Revenues from customers in the United States increased by $23.9 million, or 12%, from $206.6 million in 2019 to $230.4 million in 2020 and revenues from customers in foreign countries increased by $17.5 million, or 15%, from $115.1 million in 2019 to $132.5 million in 2020. We expect revenue growth from existing and new customers to continue. The growth in revenues reflects the continued demand for our solutions.   43 Table of Contents   Cost of Revenues       Year Ended                       December 31,     Change       2020     2019     $     %       (in thousands, except percentages)   Cost of revenues   $ 79,226     $ 69,517     $ 9,709       14 % Percentage of revenues     22 %     22 %                 Gross profit percentage     78 %     78 %                   Cost of revenues increased $9.7 million in 2020 compared to 2019. The increase was primarily due to an increase in personnel costs of $3.5 million driven by the headcount increase to support the growth of our business, an increase in licenses and software services of $1.9 million, an increase in data center costs of $1.8 million to meet growing demand, an increase in equipment repairs and maintenance costs of $1.2 million and a $1.3 million increase in depreciation of property and plant and allocation of increased leasing expenses to the cost of revenue related to our new office in India and data centers.    Research and Development Expenses       Year Ended                       December 31,     Change       2020     2019     $     %       (in thousands, except percentages)   Research and development   $ 72,548     $ 68,239     $ 4,309       6 % Percentage of revenues     20 %     21 %                   Research and development expenses increased $4.3 million in 2020 compared to 2019, primarily due to an increase in personnel expense of $3.2 million driven by additional employees hired to support the growth of our business, a $2.0 million increase in allocation of overhead costs to the research and development department mainly caused by an increase in leasing expenses for our new office in India, an increase in depreciation and amortization expense of $0.8 million and an increase in licenses and software services of $0.4 million. These increases were partially offset by a decrease in acquisition-related expense of $2.1 million.   Sales and Marketing Expenses       Year Ended                       December 31,     Change       2020     2019     $     %       (in thousands, except percentages)   Sales and marketing   $ 67,965     $ 70,833     $ (2,868 )     (4 )% Percentage of revenues     19 %     22 %                   Sales and marketing expenses decreased $2.9 million in 2020 compared to 2019, primarily due to decreases in trade show related costs of $4.5 million, travel related expenses of $3.0 million and other marketing related expenses of $0.8 million driven by the COVID-19 pandemic, partially offset by an increase in personnel costs of $4.7 million due to additional employees hired to support the growth of our business and a $0.7 million increase in commission expenses.   44 Table of Contents   General and Administrative Expenses       Year Ended                       December 31,     Change       2020     2019     $     %       (in thousands, except percentages)   General and administrative   $ 46,570     $ 40,765     $ 5,805       14 % Percentage of revenues     13 %     13 %                   General and administrative expenses increased $5.8 million in 2020 compared to 2019, primarily due to an increase in legal fees of $3.4 million due to legal and compliance matters and a $1.1 million increase in personnel costs due to additional employees hired to support the growth of our business and an increase in performance-based stock compensation of $1.8 million as a result of the modification of certain awards in June 2020 and a higher forecasted performance level, partially offset by a decrease in office supply expense of $0.5 million due to working from home during the COVID-19 pandemic.   Total Other Income (Expense), Net       Year Ended                       December 31,     Change       2020     2019     $     %       (in thousands, except percentages)   Total other income (expense), net   $ 5,383     $ 7,730     $ (2,347 )     (30 )% Percentage of revenues     1 %     2 %                   Total other income (expense), net, decreased $2.3 million in 2020 compared to 2019, primarily due to a decrease in interest income driven by lower yield.   Provision for (benefit from) Income Taxes       Year Ended                       December 31,     Change       2020     2019     $     %       (in thousands, except percentages)   Provision for income taxes   $ 10,465     $ 10,647     $ (182 )     (2 )% Percentage of revenues     3 %     3 %                   Our income tax expense decreased in 2020 compared to 2019 by $0.2 million primarily due to an increase in income tax benefit from excess stock-based compensation deductions offset by the increase in income before income taxes.   45 Table of Contents   Key Non-GAAP Metric   In addition to measures of financial performance presented in our consolidated financial statements, we monitor the non-GAAP key metric set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies.       Year Ended December 31,       2020     2019       (in thousands)   Adjusted EBITDA   $ 169,534     $ 138,346     Adjusted EBITDA   We monitor Adjusted EBITDA, a non-GAAP financial measure, to analyze our financial results and believe that it is useful to investors, as a supplement to U.S. GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance. We believe that Adjusted EBITDA helps illustrate underlying trends in our business that could otherwise be masked by the effect of the income or expenses that we exclude in Adjusted EBITDA. Furthermore, we use this measure to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that Adjusted EBITDA provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry.   Adjusted EBITDA should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with U.S. GAAP. We calculate Adjusted EBITDA as net income before (1) other (income) expense, net, which includes interest income, interest expense and other income and expense, (2) provision for (benefit from) income taxes, (3) depreciation of property and equipment, (4) amortization of intangible assets, (5) stock-based compensation and (6) non-recurring expenses that do not reflect ongoing costs of operating the business.   Adjusted EBITDA has limitations as an analytical tool, and should not be considered in isolation from or as a substitute for the measures presented in accordance with U.S. GAAP. Some of these limitations are:   • Adjusted EBITDA does not reflect certain cash and non-cash charges that are recurring;   • Adjusted EBITDA does not reflect income tax payments that reduce cash available to us;   • Adjusted EBITDA excludes depreciation of property and equipment and amortization of intangible assets, although these are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future; and   • Other companies, including companies in our industry, may calculate Adjusted EBITDA differently or not at all, which reduces its usefulness as a comparative measure.   Because of these limitations, Adjusted EBITDA should be considered alongside other financial performance measures, including revenues, net income, cash flows from operating activities and our financial results presented in accordance with U.S. GAAP.   The following unaudited table presents the reconciliation of net income to Adjusted EBITDA for the years ended December 31, 2020 and 2019.       Year Ended December 31,       2020     2019       (in thousands)   Net income   $ 91,572     $ 69,336   Depreciation and amortization of property and equipment     26,556       25,121   Amortization of intangible assets     6,289       6,080   Provision for income taxes     10,465       10,647   Stock-based compensation     40,035       34,892   Other income (expense), net     (5,383 )     (7,730 ) Adjusted EBITDA   $ 169,534     $ 138,346   Percentage of revenues     47 %     43 %   46 Table of Contents     Liquidity and Capital Resources     At December 31, 2020, our principal source of liquidity was cash, cash equivalents and marketable securities of $454.5 million, including $30.7 million of cash held outside of the United States. We do not anticipate that we will need funds generated from foreign operations to fund our domestic operations. However, if we repatriate these funds, we could be subject to foreign withholding taxes.     We generated positive cash flows from operations during the years ended December 31, 2020 and 2019. We believe our existing cash, cash equivalents, marketable securities and cash from operations will be sufficient to fund our operations for at least the next twel ve months. In 2021, we expect capital expenditures to be in a range of $30.0 million to $35.0 million.     Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing, type and extent of our spending on research and development efforts, international expansion and investment in data centers. We may also seek to invest in or acquire complementary businesses or technologies. While the COVID-19 pandemic has not had a material adverse financial impact on our operations to date, the future impact of the pandemic cannot be predicted with certainty and may increase our costs of capital and otherwise adversely affect our business, result of operations, financial condition and liquidity.   Cash Flows   The following summary of cash flows for the periods indicated has been derived from our consolidated financial statements included elsewhere in this report:       Year Ended December 31,       2020     2019       (in thousands)   Cash provided by operating activities   $ 180,086     $ 160,607   Cash used in investing activities     (80,932 )     (35,029 ) Cash used in financing activities     (112,581 )     (79,045 ) Net increase (decrease) in cash, cash equivalents and restricted cash   $ (13,427 )   $ 46,533     Cash Flows from Operating Activities   In 2020, cash provided by operating activities of $180.1 million was primarily due to $91.6 million of net income, as adjusted for non-cash items including stock-based compensation expense of $40.0 million, depreciation and amortization expense of $32.8 million, deferred income tax expense of $3.5 million, an increase in accrued liabilities of $5.1 million due to higher compensation related accrual as well as timing of payments and an increase in deferred revenues of $30.9 million due to our continued growth in sales. These increases were partially offset by a $22.6 million increase in accounts receivable due to higher billings.   In 2019, cash provided by operating activities of $160.6 million was primarily due to $69.3 million of net income, as adjusted by increases in non-cash items including stock-based compensation expense of $34.9 million, depreciation and amortization expense of $31.2 million, an increase in deferred income taxes of $7.1 million; and an increase in deferred revenues of $28.1 million due to our continued growth in sales. These increases were partially offset by $6.0 million of increased prepayments primarily for computer hardware maintenance fees; a $2.5 million increase in accounts receivable due to higher billings; and a $1.1 million decrease in accounts payable mainly due to timing of payments.   Cash Flows from Investing Activities   In 2020, cash used in investing activities of $80.9 million was primarily attributable to $49.8 million of cash used for purchases of marketable securities, net of sales and maturities, and $29.6 million of cash used for capital expenditures mainly related to computer equipment to support our growth and development, net of proceeds received from disposal of certain assets. Additionally, we paid $1.5 million in connection with our acquisition of the assets of Spell Security and payment of deferred consideration to Adya.    In 2019, cash used in investing activities of $35.0 million was primarily attributable to $27.6 million of cash used for capital expenditures, $4.1 million in aggregate payments made in connection with our acquisitions of Adya and holdback payments for our acquisitions in the prior years, net purchases of investments of $2.8 million, and $0.6 million for our purchase of an investment in a privately-held company. The $27.6 million increase in capital expenditures included leasehold improvements for a new office in India and computer hardware purchases to support our growth.   47 Table of Contents   Cash Flows from Financing Activities   In 2020, cash used in financing activities of $112.6 million was primarily attributable to $126.7 million of common stock repurchases and $20.2 million of payments related to net share settlement of equity awards, offset by $34.5 million of proceeds from the exercise of stock options.   In 2019, cash used in financing activities of $79.0 million was primarily attributable to $86.4 million of common stock repurchases and $15.7 million of payments related to net share settlement of equity awards, offset by $24.8 million of proceeds from the exercise of stock options.   Contractual Obligations   Our principal commitments consist of obligations under our outstanding leases for office space and third-party data centers. The following table summarizes our contractual cash obligations at December 31, 2020 and the effect such obligations are expected to have on our liquidity and cash flows in future periods:                Payment Due by Period   Contractual Obligations:   Total     Less Than 1 Year     1-3 Years     3-5 Years     More than 5 Years       (in thousands)           Operating lease obligations   $ 65,533     $ 14,186     $ 24,613     $ 16,417     $ 10,317   Purchase order obligations     43,236       20,131       13,452       9,653       —   Total   $ 108,769     $ 34,317     $ 38,065     $ 26,070     $ 10,317     Operating lease obligations primarily represent our obligations to make payments under the lease agreements for our facilities and data centers. During the year ended December 31, 2020, total payments for our operating lease obligations was $13.4 million.   Off-Balance Sheet Arrangements   During the periods presented, we did not have, nor do we currently have, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities.   Recent Accounting Pronouncements   See Note 1 to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form10-K for a discussion of recent accounting pronouncements.   Critical Accounting Policies and Estimates   Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions.   We believe that of our significant accounting policies, which are described in the notes to our consolidated financial statements, the following accounting policies involve the greatest degree of judgment and complexity and have the greatest potential impact on our consolidated financial statements. A critical accounting policy is one that is material to the presentation of our consolidated financial statements and requires us to make difficult, subjective or complex judgments for uncertain matters that could have a material effect on our financial condition and results of operations. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. For further information on all of our significant accounting policies, see Note 1 - The Company and Summary of Significant Accounting Policies in the accompanying notes to the consolidated financial statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K.   48 Table of Contents   Revenue Recognition   We derive revenues from subscriptions that require customers to pay a fee in order to access our cloud solutions. Contract period with customers generally ranges from less than a year to five years.  The subscription fee entitles the customer to an unlimited number of scans for a specified number of networked devices or web applications and, if requested by a customer as part of their subscription, a specified number of physical or virtual scanner appliances. Our physical and virtual scanner appliances are requested by certain customers as part of their subscriptions in order to scan IT infrastructures within their firewalls and do not function without, and are not sold separately from, subscriptions for our solutions. In some limited cases, we also provide certain computer equipment used to extend our Qualys Cloud Platform into our customers’ private cloud environment. Customers are required to return physical scanner appliances and computer equipment if they do not renew their subscriptions.    In accordance with ASC 606 Revenue from Contracts with Customers ("ASC 606"), revenue is recognized when control of the subscription service is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those services. Our subscription services are typically satisfied ratably over the subscription term as our cloud-based offerings are delivered to customers electronically and over time. In addition, we recognize revenues for certain limited scan arrangements on an as-used basis. We recognize revenue related to professional services based on time and materials or completion of milestones stated in the contracts. When physical equipment are provided to the customers as part of the subscription service contract, we apply the practical expedient allowed under ASC 842 Leases to combine lease and nonlease components as a combined component to be accounted for under ASC 606, as we determined that the software subscription is the predominant component of the combined components. Therefore, we recognize revenue for the physical equipment ratably over the related subscription period.    Incremental direct costs of obtaining a contract, which consist of sales commissions primarily for new business and upsells, are deferred and amortized over the estimated life of the customer relationship if renewals are expected and the renewal commission is not commensurate with the initial commission. We elected the practical expedient to expense commissions on renewals where the specific anticipated contract term amortization period is one year or less. We amortize the capitalized commission cost as a selling expense on a straight-line basis over a period of five years.   Income Taxes   We are subject to income taxes in the United States as well as other tax jurisdictions in which we conduct business. Earnings from our non-U.S. activities are subject to local income tax and may also be subject to U.S. income tax.   Income tax expense or benefit is recognized for the amount of taxes payable or refundable for the current year, and for deferred tax assets and liabilities for the tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We must make significant assumptions, judgments and estimates to determine our current provision for (benefit from) income taxes, our deferred tax assets and liabilities, and any valuation allowance to be recorded against our deferred tax assets. Our judgments, assumptions and estimates relating to the current provision for (benefit from) income taxes include the geographic mix and amount of income (loss), our interpretation of current tax laws, and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. Our judgments also include anticipating the tax positions we will record in the financial statements before actually preparing and filing the tax returns. Our estimates and assumptions may differ from the actual results as reflected in our income tax returns and we record the required adjustments when they are identified or resolved. Changes in our business, tax laws or our interpretation of tax laws, and developments in current and future tax audits, could significantly impact the amounts provided for income taxes in our results of operations, financial position, or cash flows.   Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to tax benefit carry-forwards and to differences between the financial statement amounts of assets and liabilities and their respective tax basis. We regularly review our deferred tax assets for recoverability and establish a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. To make this assessment, we take into account predictions of the amount and category of taxable income from available positive and negative evidence about these possible sources of taxable income. The weight given to the potential effect of negative and positive evidence is commensurate with the extent to which the strength of the evidence can be objectively verified.   Based on the analysis of positive and negative factors noted above, we believe it is more likely than not that our California deferred tax assets will not be realized because the income attributed to California is not expected to be sufficient to recognize these deferred tax assets. Accordingly, we continue to record a valuation allowance as of December 31, 2020 for our California deferred tax assets. If, in the future, we determine that these deferred tax assets are more likely than not to be realized, a release of all or part, of the related valuation allowance could result in an income tax benefit in the period such determination is made. W e do not have a valuation allowance against U.S. federal and certain other state deferred tax assets.   We recognize an income tax expense or benefit with respect to uncertain tax positions in our financial statements that we judge is more likely than not to be sustained solely on its technical merits in a tax audit, including resolution of any related appeals or litigation processes. To make this judgment, we must interpret complex and sometimes ambiguous tax laws, regulations and administrative practices. If an income tax position meets the more likely than not recognition threshold, then we must measure the amount of the tax benefit to be recognized by determining the largest amount of tax benefit that has a greater than a 50% likelihood of being realized upon effective settlement with a taxing authority that has full knowledge of all of the relevant facts. It is inherently difficult and subjective to estimate such amounts, as this requires us to determine the probability of various possible settlement outcomes. To determine if a tax position is effectively settled after a tax examination has been completed, we must also estimate the likelihood that another taxing authority could review the respective tax position. We must also determine when it is reasonably possible that the amount of unrecognized tax benefits will significantly increase or decrease in the 12 months after each fiscal year-end. These judgments are difficult because a taxing authority may change its behavior as a result of our disclosures in our financial statements. We must reevaluate our income tax positions on a quarterly basis to consider factors such as changes in facts or circumstances, changes in tax laws, effectively settled issues under audit, the potential for interest and penalties, and new audit activity. Such a change in recognition or measurement would result in recognition of a tax benefit or an additional charge to the tax provision.   49 Table of Contents   Stock-Based Compensation   We recognize the fair value of our employee stock options and restricted stock units over the requisite service period for those awards ultimately expected to vest. The fair value of each option is estimated on date of grant using the Black-Scholes-Merton option pricing model and the fair value of each restricted stock unit is based on the fair value of our stock on the date of grant. Forfeitures are estimated on the date of grant and revised if actual or expected forfeiture activity differs materially from original estimates. For performance-based non-qualified stock options and restricted stock units, we recognize compensation costs when it is probable that the performance conditions will be met. We assess these conditions on a quarterly basis.   Determining the appropriate fair value model and calculating the fair value of employee stock options requires the use of highly subjective assumptions, including the expected life of the stock option and stock price volatility. The assumptions used in calculating the fair value of employee stock options represent management’s best estimates, but the estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.   Fair Value Measurement   Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For certain of our financial instruments, including cash and certain cash equivalents, accounts receivable, accounts payable and accrued liabilities, the carrying amounts approximate their fair value due to the relatively short maturity of these balances.   We measure and report certain cash equivalents, marketable securities and derivative foreign currency forward contracts at fair value in accordance with the provisions of the authoritative accounting guidance that addresses fair value measurements. This guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:   Level 1 -  Valuations based on quoted prices in active markets for identical assets or liabilities.   Level 2  - Valuations based on other than quoted prices in active markets for identical assets and liabilities, including quoted prices for identical assets or liabilities in less active or inactive markets, quoted prices for similar assets or liabilities in active markets, or inputs other than quoted prices that are observable for substantially the full term of the assets or liabilities.   Level 3 -  Valuations based on inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability.   For further details, see Part II, Item 8 of this Annual Report on Form10-K Note 2, Fair Value of Financial Instruments.   Leases   We lease offices, our data center facilities and certain computer equipment under non-cancelable operating leases and finance leases. On January 1, 2019, we adopted ASC 842 Leases using the current period adjustment method with an effective date of January 1, 2019. For both operating and finance leases, we recognize a right-of-use asset, which represents our right to use the underlying asset for the lease term, and a lease liability, which represents the present value of our obligation to make payments arising over the lease term. Many of our leases include rental escalation clauses, renewal options and/or termination options that are factored into our determination of lease payments and lease terms when appropriate. The present value of the lease payments is calculated using the incremental borrowing rate of the underlying leases determined at lease commencement. As most of our leases do not provide a readily determinable implicit rate, we determine an incremental borrowing rate using a portfolio approach based on the rate of interest that the Company would have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term as the leases.    Where we are the lessee, we elect to account for non-lease components associated with our leases (e.g., common area maintenance costs) and lease components separately for substantially all of our asset classes, except for data centers, for which we elected to combine lease and non-lease components. For leases with a term of one year or less, we have elected not to record the right-of-use asset or liability.   50 Table of Contents