SERVICESOURCE INTERNATIONAL, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with our annual consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K.

This discussion contains "forward-looking statements" that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. These forward-looking statements include, but are not limited to, statements related to changes in market conditions that impact our ability to generate service revenue on behalf of our customers; errors in estimates as to the service revenue we can generate for our customers; our ability to attract new customers and retain existing customers; risks associated with material defects or errors in our software or the effect of data security breaches; our ability to adapt our solution to changes in the market or new competition; our ability to improve our customers' renewal rates, margins and profitability; our ability to increase our revenue and contribution margin over time from new and existing customers, including as a result of sales of our next-generation technology platform, Renew OnDemand, on a stand-alone subscription basis; our ability to implement Renew OnDemand; the potential effect of mergers and acquisitions on our customer base; business strategies and new sales initiatives; technology development; protection of our intellectual property; investment and financing plans; liquidity; our competitive position; the effects of competition; industry environment; and potential growth opportunities. Forward-looking statements are also often identified by the use of words such as, but not limited to, "anticipate," "believe," "can," "continue," "could," "estimate," "expect," "intend," "may," "plan," "project," "seek," "should," "target," "will," "would," and similar expressions or variations intended to identify forward-looking statements. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section of this Annual Report on Form 10-K titled "Risk Factors". Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview We are the global leader in recurring revenue management, partnering with technology and technology-enabled companies to optimize maintenance, support and subscription revenue streams, while also improving customer relationships and loyalty. We deliver these results via a cloud application with a suite of managed services through dedicated service teams, leveraging benchmarks and best practices derived from our rich database of service and renewal behavior. By integrating software, managed services and data, we provide end-to-end management and optimization of the service-contract renewals process, including data management, quoting, selling and recurring-revenue business intelligence.

Our business is built on our pay-for-performance model, whereby customers pay us a commission based on renewal sales that we generate on their behalf, enabling a success-driven, shared-risk partnership with our customers. We recently began to unbundle our renewal management software and offer as a Software-As-A-Service ("SaaS") solution to customers. We believe selling software subscription as a stand-alone SaaS offering will be an important part of our business over time.

As of December 31, 2012, we managed over 145 engagements across more than 70 customers, representing over $8 billion in service revenue opportunity under management.

We were formed in November 2002 as a limited liability company, and shortly thereafter we purchased certain assets of a business originally started by service sales representatives from a major technology company. Since then we have refined our business model, developed and expanded our service sales teams, and our suite of 34 -------------------------------------------------------------------------------- Table of Contents cloud based applications, and opened additional sales centers in the United States, Europe and Asia and a global sales operations center in Kuala Lumpur, Malaysia. We broadened our customer focus from technology companies to also include technology-enabled healthcare and life sciences and industrial systems companies. We have experienced rapid growth in our operations in recent periods, as indicated by the following: • Our revenue has increased from $205.5 million in 2011 to $243.7 million in 2012, representing an increase of 19%.

• Our engagements have grown from approximately 120 as of December 31, 2011 to over 145 as of December 31, 2012.

Over the past several quarters, we have invested a substantial portion of our research and development resources toward the development of Renew OnDemand, a cloud application purpose-built to maximize recurring revenues. Total spending on research and development, including amounts capitalized as internal-use software, were $11.9 million, $19.1 million and $25.4 million for the years ended December 31, 2010, 2011 and 2012, respectively.

We currently derive a small portion of our revenue from subscriptions to our legacy cloud applications. With the launch of Renew OnDemand, we have gone to market with two distinct offerings. First, our Renew OnDemand SaaS solution and its cloud applications. And second, a menu of services, including data services, enablement services, selling services and support services which customers can attach to their SaaS subscription. We believe our strategy of combing subscriptions to our cloud applications with a suite of managed services provides our customers with software and services needed to maximize renewals of subscriptions, maintenance and support contracts.

To date, a limited number of customers are using our Renew OnDemand platform to manage their recurring revenues. As a result, Renew OnDemand is largely unproven and we have little experience implementing it with customers. Accordingly, we intend to control the pace of customer deployments in the first half of 2013 to ensure the successful rollout of our cloud applications. As the year progresses, we expect most new engagements will have a Renew OnDemand commercial subscription relationship even for customers that continue to choose our full pay-for-performance offering.

As we move to an unbundled solution of software and services, we anticipate significant investments in implementation resources as well as support and training functions, all of which will adversely impact our gross profit in the near term. We also expect to incur additional expenses as a result of running dual technology platforms for the next several quarters as we move toward broad adoption of Renew OnDemand while also maintaining our legacy technology platform. In addition, we anticipate our our total spending on research and development will increase in absolute dollars in 2013 relative to 2012 as we invest in our suite of cloud application.

Key Business Metrics In assessing the performance of our business, we consider a variety of business metrics in addition to the financial metrics discussed below under, "Basis of Presentation." These key metrics include service revenue opportunity under management and number of engagements.

Service Revenue Opportunity Under Management. At December 31, 2012, we estimated our opportunity under management to be over $8 billion. Service revenue opportunity under management ("opportunity under management") is a forward-looking metric and is our estimate, as of a given date, of the value of all end customer service contracts that we will have the opportunity to sell on behalf of our customers over the subsequent twelve-month period. Opportunity under management is not a measure of our expected revenue. In addition, opportunity under management reflects our estimate for a forward twelve-month period and should not be used to estimate our opportunity for any particular quarter within that period. The value of end customer 35-------------------------------------------------------------------------------- Table of Contents contracts actually delivered during a twelve-month period should not be expected to occur in even quarterly increments due to seasonality and other factors impacting our customers and their end customers.

We estimate the value of such end customer contracts based on a combination of factors, including the value of end customer contracts made available to us by customers in past periods, the minimum value of end customer contracts that our customers are required to give us the opportunity to sell pursuant to the terms of their contracts with us, periodic internal business reviews of our expectations as to the value of end customer contracts that will be made available to us by customers, the value of end customer contracts included in the SPA and collaborative discussions with our customers assessing their expectations as to the value of service contracts that they will make available to us for sale. While the minimum value of end customer contracts that our customers are required to give us represents a portion of our estimated opportunity under management, a significant portion of the opportunity under management is estimated based on the other factors described above. As our experience with our business, our customers and their contracts has grown, we have continually refined the process, improved the assumptions and expanded the data related to our calculation of opportunity under management.

When estimating service revenue opportunity under management, we must, to a large degree, rely on the assumptions described above, which may prove incorrect. These assumptions are inherently subject to significant business and economic uncertainties and contingencies, many of which are beyond our control.

Our estimates therefore may prove inaccurate, causing the actual value of end customer contracts delivered to us in a given twelve-month period to differ from our estimate of opportunity under management. These factors include: • the extent to which customers deliver a greater or lesser value of end customer contracts than may be required or otherwise expected; • roll-overs of unsold service contract renewals from prior periods to the current period or future periods; • changes in the pricing or terms of service contracts offered by our customers; • increases or decreases in the end customer base of our customers; • the extent to which the renewal rates we achieve on behalf of a customer early in an engagement affect the amount of opportunity that the customer makes available to us later in the engagement; • customer cancellations of their contracts with us; and • changes in our customers' businesses, sales organizations, management, sales processes or priorities.

Our revenue also depends on our close rates and commissions. Our close rate is the percentage of opportunity under management that we renew on behalf of our customers. Our commission rate is an agreed-upon percentage of the renewal value of end customer contracts that we sell on behalf of our customers.

Our close rate is impacted principally by our ability to successfully sell service contracts on behalf of our customers. Other factors impacting our close rate include: the manner in which our customers price their service contracts for sale to their end customers; the stage of life-cycle associated with the products and underlying technologies covered by the service contracts offered to the end customer; the extent to which our customers or their competitors introduce new products or underlying technologies; the nature, size and age of the service contracts; and the extent to which we have managed the renewals process for similar products and underlying technologies in the past.

In determining commission rates for an individual engagement, various factors, including our close rates, as described above, are evaluated. These factors include: historical, industry-specific and customer-specific renewal rates for similar service contracts; the magnitude of the opportunity under management in a particular engagement; the number of end customers associated with these opportunities; and the opportunity to receive additional performance commissions when we exceed certain renewal levels. We endeavor to set our commission rates at levels commensurate with these factors and other factors that may be relevant to a particular engagement.

36 -------------------------------------------------------------------------------- Table of Contents Accordingly, our commission rates vary, often significantly, from engagement to engagement. In addition, we sometimes agree to lower commission rates for engagements with significant opportunity under management.

Number of Engagements. We track the number of engagements we have with our customers. We often have multiple engagements with a single customer, particularly where we manage the sales of service renewals relating to different product lines, technologies, types of contracts or geographies for the customer.

When the set of renewals we manage on behalf of a customer is associated with a separate customer contract or a distinct product set, type of end customer contract or geography and therefore requires us to assign a service sales team to manage the renewals, we designate the set of renewals, and associated revenues and costs to us as a unique engagement. For example, we may have one engagement consisting of a service sales team selling maintenance contract renewals of a particular product for a customer in the United States and another engagement consisting of a sales team selling warranty contract renewals of a different product for the same customer in Europe. These would count as two engagements. We had approximately 145, 120 and 100 engagements as of December 31, 2012, 2011 and 2010, respectively.

Factors Affecting our Performance Sales Cycle. We sell our integrated solution through our sales organization. At the beginning of the sales process, our quota-carrying sales representatives contact prospective customers and educate them about our offerings. Educating prospective customers about the benefits of our solution can take time, as many of these prospects have not historically relied upon integrated solutions like ours for service revenue management, nor have they typically put out a formal request for proposal or otherwise made a decision to focus on this area. As part of our sales process, we utilize our solutions design team to perform a Service Performance Analysis ("SPA") of our prospect's service revenue. The SPA includes an analysis of best practices and benchmarks the prospect's service revenue against industry peers. Through the SPA process, which typically takes several weeks, we are able to assess the characteristics and size of the prospect's service revenue, identify potential areas of performance improvement, and formulate our proposal for managing the prospect's service revenue. The length of our sales cycle for a new customer, inclusive of the SPA process and measured from our first formal discussion with the customer until execution of a new customer contract, is typically longer than six months and has increased in recent periods.

We generally contract with new customers to manage a specified portion of their service revenue opportunity, such as the opportunity associated with a particular product line or technology, contract type or geography. We negotiate the engagement-specific terms of our customer contracts, including commission rates, based on the output of the SPA, including the areas identified for improvement. Once we demonstrate success to a customer with respect to the opportunity under contract, we seek to expand the scope of our engagement to include other opportunities with the customer. For some customers, we manage all or substantially all of their service contract renewals.

Implementation Cycle. After entering into an engagement with a new customer, and to a lesser extent after adding an engagement with an existing customer, we incur sales and marketing expenses related to the commissions owed to our sales personnel. The commissions are based on the estimated total contract value, with a material portion of the commission expensed upfront with the remaining portion expensed over a period of eight to fourteen months. We also make upfront investments in technology and personnel to support the engagement. These expenses are typically incurred one to three months before we begin generating sales and recognizing revenue. Accordingly, in a given quarter, an increase in new customers, and, to a lesser extent, an increase in engagements with existing customers, or a significant increase in the contract value associated with such new customers and engagements, will negatively impact our gross margin and operating margins until we begin to achieve anticipated sales levels associated with the new engagements, which is typically two-to-three quarters after we begin selling contracts on behalf of our customers.

Although we expect new customer engagements to contribute to our operating profitability over time, in the initial periods of a customer relationship, the near term impact on our profitability can be negatively impacted by 37-------------------------------------------------------------------------------- Table of Contents slower-than anticipated growth in revenues for these engagements as well as the impact of the upfront costs we incur, the lower initial level of associated service sales team productivity and lack of mature data and technology integration with the customer. As a result, an increase in the mix of new customers as a percentage of total customers may initially have a negative impact on our operating results. Similarly, a decline in the ratio of new customers to total customers may positively impact our operating results.

Contract Terms. Substantially all of our revenue comes from our pay-for-performance model. Under our pay-for-performance model, we earn commissions based on the value of service contracts we sell on behalf of our customers. In some cases, we earn additional performance-based commissions for exceeding pre-determined service renewal targets.

Since 2009, our new customer contracts have typically had a term of approximately 36 months, although we sometimes have contract terms of up to 60 months. Our contracts generally require our customers to deliver a minimum value of qualifying service revenue contracts for us to renew on their behalf during a specified period. To the extent that our customers do not meet their minimum contractual commitments over a specified period, they may be subject to fees for the shortfall. Our customer contracts are cancelable on relatively short notice, subject in most cases to the payment of an early termination fee by the customer. The amount of this fee is based on the length of the remaining term and value of the contract.

We invoice our customers on a monthly basis based on commissions we earn during the prior month, and with respect to performance-based commissions, on a quarterly basis based on our overall performance during the prior quarter.

Amounts invoiced to our customers are recognized as revenue in the period in which our services are performed or, in the case of performance commissions, when the performance condition is determinable. Because the invoicing for our services generally coincides with or immediately follows the sale of service contracts on behalf of our customers, we do not generate or report a significant deferred revenue balance. However, the combination of minimum contractual commitments, our success in generating improved renewal rates for our customers, our customers' historical renewal rates and the performance improvement potential identified by our SPA process, provides us with revenue visibility.

M&A Activity. Our customers, particularly those in the technology sector, participate in an active environment for mergers and acquisitions. Large technology companies have maintained active acquisition programs to increase the breadth and depth of their product and service offerings and small and mid-sized companies have combined to better compete with large technology companies. A number of our customers have merged, purchased other companies or been acquired by other companies. We expect merger and acquisition activity to continue to occur in the future.

The impact of these transactions on our business can vary. Acquisitions of other companies by our customers can provide us with the opportunity to pursue additional business to the extent the acquired company is not already one of our customers. Similarly, when a customer is acquired, we may be able to use our relationship with the acquired company to build a relationship with the acquirer. In some cases we have been able to maintain our relationship with an acquired customer even where the acquiring company handles its other service contract renewals through internal resources. In other cases, however, acquirers have elected to terminate or not renew our contract with the acquired company.

For example, Oracle terminated our contracts with Sun Microsystems effective as of September 30, 2010 and had previously terminated our contract with another customer, BEA Systems, in April 2008.

Economic Conditions and Seasonality. An improving economic outlook generally has a positive, but mixed, impact on our business. As with most businesses, improved economic conditions can lead to increased end customer demand and sales. In particular, within the technology sector, we believe that the recent economic downturn led many companies to cut their expenses by choosing to let their existing maintenance, support and subscription agreements lapse. An improving economy may have the opposite effect.

However, an improving economy may also cause companies to purchase new hardware, software and other technology products, which we generally do not sell on behalf of our customers, instead of purchasing 38-------------------------------------------------------------------------------- Table of Contents maintenance, support and subscription services for existing products. To the extent this occurs, it would have a negative impact on our opportunities in the near term that would partially offset the benefits of an improving economy.

We believe the current uncertainty in the economy, combined with shifting market forces toward subscription-based models, is impacting a number of our customers and prospective customers, particularly in the traditional enterprise software and hardware segments. These forces have placed pressure on end customer demand for their renewal contracts and also have led to some slower decision making in general. This economic and industry environment has adversely affected the conversion rates for end customers and contracts. To the extent these conditions continue they will impact our future revenues.

Certain new engagements we entered into in the fourth quarter of 2011 and during 2012 and have not yet fully ramped-up to performance levels we anticipate achieving. As a result, our revenues have not reflected, and are not expected in the first half of 2013 to reflect, the full revenue and operating margin potential from these customers. In addition to the uncertainty in the macroeconomic environment, we experience a seasonal variance in our revenue typically for the third quarter of the year as a result of lower or flat renewal volume corresponding to the timing of our customers' product sales. The impact of this seasonal fluctuation can be amplified if the economy as a whole is experiencing disruption or uncertainty, leading to deferral of some renewal decisions.

Adoption of "Software-as-a-Service" Solutions. Within the software industry, there is a growing trend toward providing software to customers using a software-as-a-service ("SaaS") model. Under this model, SaaS companies provide access to software applications to customers on a remote basis, and provide their customers with a subscription to use the software, rather than licensing software to their customers. SaaS companies face a distinct set of challenges with respect to customer renewals, given the potentially lower switching costs for customers utilizing their solutions, and are more reliant on renewals for their long-term revenues than traditional software companies. Given the strategic importance of renewals to their model, SaaS companies may be less inclined than traditional software companies to rely on third-party solutions such as ours to manage the sale of renewals of subscription contracts. We have tailored our solution to address the needs of SaaS companies in this area and expect to continue to develop and enhance our solution as this market grows, especially with our Renew OnDemand application suite.

In connection with our purpose-built SaaS offering to manage and maximize recurring revenue, we intend to significantly increase our investment in our customer support, training and professional services organizations to support deployments of Renew OnDemand. We anticipate that the cost of providing professional services, support and training will be significant and that our gross profit will be adversely affected as we build out these functions.

Basis of Presentation Net Revenue Substantially all of our net revenue is attributable to commissions we earn from the sale of renewals of maintenance, support and subscription agreements on behalf of our customers. We generally invoice our customers for our services in arrears on a monthly basis for sales commissions, and on a quarterly basis for certain performance sales commissions; accordingly, we typically have no deferred revenue related to these services. We do not set the price, terms or scope of services in the service contracts with end customers and do not have any obligations related to the underlying service contracts between our customers and their end customers.

We also earn revenue from the sale of subscriptions to our cloud based applications. To date, subscription revenue has been insignificant. However, we expect revenues generated from subscriptions to Renew OnDemand to increase in 2013. Subscription fees are accounted for separately from commissions and they are billed on either a monthly or quarterly basis in advance and revenue is recognized ratably over the related subscription term.

39-------------------------------------------------------------------------------- Table of Contents We have generated a significant portion of our revenue from a limited number of customers. For the years ended December 31, 2012, 2011 and 2010, our top ten customers in each period accounted for 50%, 47%, and 54% of our net revenue, respectively. One customer accounted for more than 10% of our revenues in 2012, 2011 and 2010 and another customer represented more than 10% of our revenues in 2010.

Our business is geographically diversified. During 2012, 62% of our net revenue was earned in North America and Latin America ("NALA"), 27% in Europe, Middle East and Africa ("EMEA") and 11% in Asia Pacific-Japan ("APJ"). Net revenue for a particular geography generally reflects commissions earned from sales of service contracts managed from our sales centers in that geography.

Predominantly all of the service contracts sold and managed by our sales centers relate to end customers located in the same geography.

Cost of Revenue and Gross Profit Our cost of revenue expenses include compensation, technology costs, including those related to the delivery of our cloud-based solutions, and allocated overhead costs. Compensation includes salary, bonus, benefits and stock-based compensation for our dedicated service sales teams. Our allocated overhead includes costs for facilities, information technology and depreciation, including amortization of internal-use software associated with our service revenue technology platform and cloud applications. Allocated costs for facilities consist of rent, maintenance and compensation of personnel in our facilities departments. Our allocated costs for information technology include costs associated with third-party data centers where we maintain our data servers, compensation of our information technology personnel and the cost of support and maintenance contracts associated with computer hardware and software. To the extent our customer base or opportunity under management expands, we may need to hire additional service sales personnel and invest in infrastructure to support such growth. We currently expect that our cost of revenue will fluctuate significantly and may increase on an absolute basis and as a percentage of revenue in the near term, including for the reasons discussed above under, "-Factors Affecting Our Performance-Implementation Cycle" and as a result of our near term plans to run dual technology platforms for several quarters as we commence the launch of Renew OnDemand while maintaining our existing technology platform.

Operating Expenses Sales and Marketing. Sales and marketing expenses are the largest component of our operating expenses and consist primarily of compensation and sales commissions for our sales and marketing staff, allocated expenses and marketing programs and events. We sell our solutions through our global sales organization, which is organized across three geographic regions: NALA, EMEA and APJ. Our commission plans provide that payment of commissions to our sales representatives is contingent on their continued employment, and we recognize expense over a period that is generally between twelve and fourteen months following the execution of the applicable contract. We currently expect sales and marketing expenses to increase on an absolute basis and as a percentage of revenue in the near term based on commissions earned on customer contracts entered into in prior periods, as well as continued investments in sales and marketing personnel and programs as we expand our business domestically and internationally and pursue new sales initiatives.

Research and Development. Research and development expenses consist primarily of compensation, allocated costs and the cost of third-party service providers. We focus our research and development efforts on developing new products, including Renew OnDemand, our next-generation technology platform, and adding new features to our existing technology platform. In connection with the development and enhancements of our SaaS applications, we capitalize certain expenditures related to the development and enhancement of internal-use software related to our technology platform. We expect research and development spending to increase on an absolute basis and as a percentage of revenue in the near term as we continue to invest in enhancement to our Renew OnDemand platform and our expectation that future capitalization of internal-use software costs will be insignificant.

General and Administrative. General and administrative expenses consist primarily of compensation for our executive, human resources, finance and legal functions, and related expenses for professional fees for 40-------------------------------------------------------------------------------- Table of Contents accounting, tax and legal services, as well as allocated expenses. We expect that our general and administrative expenses will increase on an absolute basis to support our anticipated growth.

Other Income (Expense), Net Other income (expense) consists primarily of interest expense associated with borrowings under our credit facility, foreign exchange transaction gains and losses and interest income.

Income Tax Provision (Benefit) We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries' assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.

We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. To the extent that the assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.

For a description of our accounting practices relating to income taxes, see "-Critical Accounting Policies and Estimates-Income Taxes" below.

41-------------------------------------------------------------------------------- Table of Contents Results of Operations The table below sets forth our consolidated results of operations for the periods presented. The period-to-period comparison of financial results presented below is not necessarily indicative of financial results to be achieved in future periods.

Years Ended December 31, 2012 2011 2010 (in thousands) Consolidated statement of operations data: Net revenue $ 243,703 $ 205,501 $ 152,935 Cost of revenue 136,321 113,406 90,048 Gross profit 107,382 92,095 62,887 Operating expenses: Sales and marketing 56,925 48,520 35,119 Research and development 19,255 13,073 7,188 General and administrative 41,135 33,647 19,378 Total operating expenses 117,315 95,240 61,685 Income (loss) from operations (9,933 ) (3,145 ) 1,202 Other expense, net (774 ) (1,127 ) (1,622 ) Loss before provision for income taxes (10,707 ) (4,272 ) (420 ) Income tax provision (benefit) 32,107 (19,383 ) 2,147 Net income (loss) $ (42,814 ) $ 15,111 $ (2,567 ) Includes stock-based compensation of: Cost of revenue $ 2,772 $ 1,877 $ 1,126 Sales and marketing 8,146 4,456 2,993 Research and development 1,880 1,167 803 General and administrative 8,077 4,099 3,167 Total $ 20,875 $ 11,599 $ 8,089 The following table sets forth our operating results as a percentage of net revenue: Years Ended December 31, 2012 2011 2010 (as a % of net revenue) Net revenue 100 % 100 % 100 % Cost of revenue 56 % 55 % 59 % Gross profit 44 % 45 % 41 % Operating expenses: Sales and marketing 23 % 24 % 23 % Research and development 8 % 6 % 5 % General and administrative 17 % 16 % 12 % Total operating expenses 48 % 46 % 40 % Income (loss) from operations (4 )% (1 )% 1 % 42 -------------------------------------------------------------------------------- Table of Contents Years Ended-December 31, 2012 and 2011 Net Revenue Years Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue Change Change (in thousands) Net revenue by geography: NALA $ 150,041 62 % $ 127,430 62 % $ 22,611 18 % EMEA 66,902 27 % 58,344 28 % 8,558 15 % APJ 26,760 11 % 19,727 10 % 7,033 36 % Total net revenue $ 243,703 100 % $ 205,501 100 % $ 38,202 19 % The 19% increase in net revenue in 2012 reflects an increase in the number of engagements from 120 at December 31, 2011 to over 145 at December 31, 2012 as well as an increase in the value of service contracts sold on behalf of our customers. Our revenue performance was driven by a combination of growth in opportunity from new and existing customers, as well as strong performance across all of our service sales centers around the world in closing service revenue renewals. The increase in number of customer engagements resulted from expansion of customer engagements with certain existing customers due to the success of our solution with these customers as well as new customer acquisitions due to our investments in our sales organization. These increases were partially offset by a few customers in NALA and APJ where the scope of our services was reduced as well as the impact of customer terminations in EMEA in the last half of 2011. The increase in net revenue reflects revenue growth in all geographies, particularly NALA and APJ, due to an increase in the number and value of service contracts sold on behalf of our customers and the ramp of new engagements entered into in 2011.

Cost of Revenue and Gross Profit Years Ended December 31, % 2012 2011 Change Change (in thousands) Cost of revenue $ 136,321 $ 113,406 $ 22,915 20 % Includes stock-based compensation of: 2,772 1,877 895 48 % Gross profit 107,382 92,095 15,287 17 % Gross profit percentage 44 % 45 % (1 )% The 20% increase in our cost of revenue in 2012 reflected an increase in the number of service sales and sales operational personnel, primarily in APJ, resulting in a $16.6 million increase in compensation and temporary labor, a $5.4 million increase in allocated costs for facilities, including incremental facility costs related to an expansion of an existing facility, and greater costs for information technology and depreciation. The decrease in our gross profit was driven primarily by the slower ramp of new customers added in the last half of 2011 and during 2012, technology costs associated with hosting our cloud applications and lower margins from professional service engagements associated with the deployment of our cloud applications. For the next several quarters, we expect that our spending will reflect increased amounts to support our legacy service revenue platform in addition to our Renew OnDemand application suite as well as increased spending on customer support and training to support future deployments of our cloud applications.

43-------------------------------------------------------------------------------- Table of Contents Operating Expenses Years Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue Change Change (in thousands) Operating expenses: Sales and marketing $ 56,925 23 % $ 48,520 24 % $ 8,405 17 % Research and development 19,255 8 % 13,073 6 % 6,182 47 % General and administrative 41,135 17 % 33,647 16 % 7,488 22 % Total operating expenses $ 117,315 48 % $ 95,240 46 % $ 22,075 23 % Includes stock-based compensation of: Sales and marketing $ 8,146 $ 4,456 $ 3,690 Research and development 1,880 1,167 713 General and administrative 8,077 4,099 3,978 Total $ 18,103 $ 9,722 $ 8,381 Sales and marketing expenses The 17% increase in sales and marketing expenses in 2012 reflected an increase in the number of sales and marketing personnel, primarily in NALA, resulting in a $4.8 million increase in compensation. The increase also resulted from a $1.7 million increase in marketing program expenses as a result of additional investments in brand development to heighten awareness and to maximize the strength of our brand and an increase in costs for facilities and IT of $1.1 million associated with higher headcount.

Research and development expenses The increase in research and development expense in 2012 reflected an increase in the number of research and development personnel in NALA, resulting in a $1.8 million increase in compensation, a $3.6 million increase in outside consulting services related to contract research and development services and a $0.5 million increase in facilities and IT costs. The increase is a result of our continued investment in the development of additional cloud based applications to enable greater operational efficiencies and enhanced functionality for our customers. The increase was partially offset by capitalization of $6.2 million of internal labor and third party costs for development of internal-use software in 2012 compared to $6.0 million of capitalized costs in 2011. We expect research and development expenditures to increase in both absolute dollars and as a percentage of net revenues as we continue to enhance Renew OnDemand and our expectations that there will be an insignificant amount of capitalized costs in 2013.

General and administrative expenses The 23% increase in general and administrative expenses in 2012 reflected a $7.5 million increase in compensation due to an increase in headcount in the general and administrative functions across all geographic segments. We anticipate increased spending for general and administrative functions to support the overall growth anticipated in our operations.

44-------------------------------------------------------------------------------- Table of Contents Other Expense, Net Years Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue Change Change (in thousands) Other expense, net $ 774 0 % $ 1,127 1 % $ (353 ) (31 )% The decrease in other expense in 2012 compared to 2011 resulted from a $0.4 million decrease in interest expense and the write-off of costs associated with our borrowings due to the repayment of outstanding balances on our term loan and borrowings under our revolving credit facility in March 2011, partially offset by a $0.1 million increase in interest income in 2012 from our short-term investments.

Income Tax Provision Years Ended December 31, % 2012 2011 Change Change (in thousands) Income tax provision (benefit) $ 32,107 $ (19,383 ) $ 51,490 * * Not meaningful.

During the second quarter of 2012, a valuation allowance against our U.S.

deferred tax assets was recorded in the amount of $31.8 million as the cumulative losses for the most recent three years, as well as the U.S. losses in the first half of 2012, represented significant negative evidence for us to conclude that a valuation allowance was required. Accordingly, the computation of the effective tax rate does not include U.S. losses, nor does it include losses incurred by our Singapore subsidiary, which are offset by a full valuation allowance. The 2012 tax provisions also reflects the reversal of prior quarter deferred tax benefits, plus tax expense in jurisdictions where we report taxable profits. In 2011, we recorded a one-time non-cash tax benefit of $20.7 million as a result of recognition of deferred tax assets resulting from our election to be subject to taxation as a corporation.

Years Ended-December 31, 2011 and 2010 Net Revenue Years Ended December 31, 2011 2010 % of Net % of Net % Amount Revenue Amount Revenue Change Change (in thousands) Net revenue by geography: NALA $ 127,430 62 % $ 102,411 67 % $ 25,019 24 % EMEA 58,344 28 % 43,069 28 % 15,275 35 % APJ 19,727 10 % 7,455 5 % 12,272 165 % Total net revenue $ 205,501 100 % $ 152,935 100 % $ 52,566 34 % * Not meaningful.

The 34% increase in net revenue in 2011 reflects an increase in the number of engagements and the value of service contracts sold on behalf of our customers.

The number of customer engagements increased from approximately 100 as of December 31, 2010 to over 120 as of December 31, 2011. International revenue increased 55% during 2011 as compared to 2010 with this growth supported by strong performance in our foreign service sales centers around the world in closing service revenue renewals reflecting the strong demand we see for our solution internationally.

45 -------------------------------------------------------------------------------- Table of Contents Cost of Revenue and Gross Profit Years Ended December 31, % 2011 2010 Change Change (in thousands) Cost of revenue $ 113,406 $ 90,048 $ 23,358 26 % Includes stock-based compensation of: 1,877 1,126 751 67 % Gross profit 92,095 62,887 29,208 46 % Gross profit percentage 45 % 41 % 4 % The 26% increase in our cost of revenue in 2011 reflected an increase in the number of service sales personnel, primarily in APJ, resulting in a $18.1 million increase in compensation, a $2.9 million increase in costs for facilities, including incremental facility costs related to an expansion of an existing facility, and greater costs for information technology and depreciation and a $2.1 million increase in temporary labor to ramp up our new engagements.

The improvement in our gross profit was driven primarily by the improved revenue performance we saw across all of our service sales centers in 2011 and increasing use of our applications to drive automation and operating scale across the Company as well as the ramp of new engagements. Gross margins for 2011 and 2010 were favorably impacted by one-time events including $1.8 million in settlement fees and $3.8 million in contract termination fees, respectively, both of which had no direct costs.

Operating Expenses Years Ended December 31, 2011 2010 % of Net % of Net % Amount Revenue Amount Revenue Change Change (in thousands) Operating expenses: Sales and marketing $ 48,520 24 % $ 35,119 23 % $ 13,401 38 % Research and development 13,073 6 % 7,188 5 % 5,885 82 % General and administrative 33,647 16 % 19,378 12 % 14,269 74 % Total operating expenses $ 95,240 46 % $ 61,685 40 % $ 33,555 54 % Includes stock-based compensation of: Sales and marketing $ 4,456 $ 2,993 $ 1,463 Research and development 1,167 803 364 General and administrative 4,099 3,167 932 Total $ 9,722 $ 6,963 $ 2,759 Sales and marketing expenses The 38% increase in sales and marketing expenses in 2012 reflected an increase in the number of sales and marketing personnel, primarily in APJ and EMEA, resulting in a $6.7 million increase in compensation. The increase also resulted from a $3.3 million increase in marketing and consulting expenses as a result of additional investments in brand development to heighten awareness and to maximize the strength of our brand, and an increase in costs for facilities and IT of $1.5 million.

Research and development expenses The increase in research and development expense in 2011 reflected an increase in the number of research and development personnel in NALA, resulting in a $4.5 million increase in compensation, a $1.8 million 46-------------------------------------------------------------------------------- Table of Contents increase in outside consulting services related to contract research and development services and a $1.4 million increase in facilities and IT costs. The increase is a result of our continued investment in the development of additional cloud based applications to enable greater operational efficiencies and enhanced functionality for our customers. The increase was partially offset by capitalization of $5.6 million of internal labor and third party costs for development of internal-use software in 2011 compared to $3.8 million of capitalized costs in 2010.

General and administrative expenses The 74% increase in general and administrative expense in 2011 reflected a $10.3 million increase in compensation due to an increase in headcount in the general and administrative functions across all geographic segments and a $2.2 million increase in professional fees related to expenses incurred in connection with our initial public offering and follow-on offering and incremental fees related to being a public company.

Other Expense, Net Years Ended December 31, 2011 2010 % of Net % of Net % Amount Revenue Amount Revenue Change Change (in thousands) Other expense, net $ 1,127 1 % $ 1,622 1 % $ (495 ) (31 )% The decrease in other expense in 2011 compared to 2010 resulted from a $0.7 million decrease in interest expense in 2011 due to the retirement of our term loan in March 2011, partially offset by a net increase in losses on foreign exchange transactions primarily in APJ, combined with the strengthening of the US dollar.

Income Tax Provision (Benefit) Years Ended December 31, % 2011 2010 Change Change (in thousands) Income tax provision (benefit) $ (19,383 ) $ 2,147 $ (21,530 ) * * Not meaningful.

In 2011, we recorded a one-time non-cash tax benefit of $20.7 million as a result of recognition of deferred tax assets resulting from our election to be subject to taxation as a corporation. The computation of the effective tax rate does not include losses incurred prior to March 1, 2011 when we became subject to taxation as a corporation. Pretax earnings for 2011, excluding LLC losses incurred prior to March 1, 2011, were approximately $50,000, which would result in an effective tax rate that is not meaningful for comparison purposes. We would have recognized a larger tax benefit in 2011 were it not for projected losses in a foreign subsidiary for which no tax benefit was recognized, and nondeductible IPO and secondary offering expenses incurred.

Liquidity and Capital Resources At December 31, 2012, we had cash, cash equivalents and short-term investments of $109.4 million, which primarily consisted of money market mutual funds, corporate bonds and U.S. government obligations held by well-capitalized financial institutions. Our primary operating cash requirements include the payment of compensation and related costs, working capital requirements related to accounts receivable and accounts payable, as well as costs for our facilities and information technology infrastructure. Historically, we have financed our operations principally from cash provided by our operating activities, proceeds from stock offerings and the exercise of stock options, and to a lesser extent, from borrowings under various credit facilities, with no 47-------------------------------------------------------------------------------- Table of Contents such borrowings in 2012. We believe our existing cash and cash equivalents and short-term investments and our currently available credit facility will be sufficient to meet our working capital and capital expenditure needs for at least the next twelve months.

Credit Facility On June 29, 2012, we terminated a revolving credit facility scheduled to expire in February 2013. The credit facility provided for a $20.0 million line of credit. At the time of termination, no borrowings other than a letter of credit in the face amount of $850,000 were outstanding under the credit facility.

On July 5, 2012, we entered into a new three-year credit agreement (the "Credit Agreement"). The Credit Agreement provides for a secured revolving line of credit based on eligible accounts receivable in an amount up to $25.0 million on and before July 5, 2013 and up to $30.0 million thereafter, in each case with a $2.0 million letter of credit sublimit. Proceeds available under the Credit Agreement may be used for working capital and other general corporate purposes.

We have the option to prepay the loans under the Credit Agreement in whole or in part at any time without premium or penalty. We also have the option to terminate the commitments under the Credit Agreement in whole at any time, and may reduce the commitments by up to $10.0 million between July 1, 2013 and June 30, 2014.

The loans under the Credit Agreement bear interest, at our option, at a base rate determined in accordance with the Credit Agreement, minus 0.50%, or at a LIBOR rate plus 2.00%. Principal, together with all accrued and unpaid interest, is due and payable on July 5, 2015, the maturity date. We are also obligated to pay a quarterly commitment fee, payable in arrears, based on the available commitments.

The Credit Agreement contains customary affirmative and negative covenants, as well as financial covenants. Affirmative covenants include, among others, delivery of financial statements, compliance certificates and notices of specified events, maintenance of properties and insurance, preservation of existence, and compliance with applicable laws and regulations. Negative covenants include, among others, limitations on the ability of us and our subsidiaries to grant liens, incur indebtedness, engage in mergers, consolidations and sales of assets and engage in affiliate transactions. The Credit Agreement requires us to maintain a maximum leverage ratio and a minimum liquidity amount, each as defined in the Credit Agreement.

The Credit Agreement also contains customary events of default including, among other things, payment defaults, breaches of covenants or representations and warranties, cross-defaults with certain other indebtedness, bankruptcy and insolvency events and change in control of the Company, subject to grace periods in certain instances. Upon an event of default, the lender may declare the outstanding obligations of the Company under the Credit Agreement to be immediately due and payable and exercise other rights and remedies provided for under the Credit Agreement.

Our obligations under the Credit Agreement are guaranteed by our subsidiary, ServiceSource Delaware, Inc., and are collateralized by substantially all of our assets and our subsidiary's assets.

48-------------------------------------------------------------------------------- Table of Contents Summary Cash Flows The following table sets forth a summary of our cash flows for the periods indicated: Years Ended December 31, 2012 2011 2010 (in thousands)Net cash (used in) provided by operating activities $ 10,502 $ (11,231 ) $ 22,630 Net cash used in investing activities (10,889 ) (57,542 ) (9,170 ) Net cash provided by (used in) financing activities 11,092 112,181 (4,139 ) Net increase in cash and cash equivalents, net of impact of exchange charges on cash $ 10,585 $ 43,331 $ 9,483 Operating Activities In 2012, net cash provided by operating activities was $10.5 million. Our net loss during the period was $42.8 million, which was impacted by a non-cash valuation allowance of $33.1 million for a substantial portion of our deferred tax assets and adjusted by non-cash charges of $10.0 million for depreciation and amortization and $20.9 million for stock-based compensation. Cash provided for operations resulted from changes in our working capital, including a $7.5 million increase in other accrued liabilities and a $3.8 million decrease in prepaid balances. Uses of cash were related to an $11.2 million increase in accounts receivable, a $6.2 million decrease in accrued compensation and benefits and a $2.5 million decrease in accounts payable.

In 2011, net cash used in operating activities was $11.2 million. Our net income during the period was $15.1 million which reflected a one-time non-cash tax benefit of $20.7 million as a result of recognition of deferred tax assets resulting from our election to be subject to taxation as a corporation. The net income was adjusted by non-cash charges of $9.4 million for depreciation and amortization and $11.6 million for stock-based compensation. Cash used for operations during 2011 principally resulted from $18.1 million in payments to Oracle/Sun and the related settlement of accrued payables owed to Oracle/Sun and amounts owed to us by Oracle/Sun. Additional uses of cash were related to a $1.4 million increase in prepaid expenses and other assets and a $5.0 million increase in accounts receivable. Sources of cash resulted from changes in our working capital, including a $6.9 million increase in accrued compensation and benefits, a $2.2 million increase in accounts payable, a $2.0 million increase in other accrued liabilities and a $1.8 million increase in accrued taxes.

In 2010, cash inflows from our operating activities were $22.6 million. Our net loss during the period was $2.6 million, adjusted by non-cash charges of $6.1 million for depreciation and amortization and $8.1 million for stock-based compensation. Additional sources of net cash inflows were from changes in our working capital, including a $23.6 million increase in accrued payables to customers, consisting of amounts owed to Oracle from end customers with respect to our Sun Microsystems engagements that terminated effective September 30, 2010, a $5.2 million increase in other accrued liabilities and a $3.9 million increase in accrued compensation and benefits, partially offset by a $21.2 million increase in accounts receivable.

Investing Activities In 2012 cash used for investing activities related to purchases of property and equipment totaled $20.0 million, including costs capitalized for development of internal-use software and leasehold improvements associated with our offices, partially offset by net proceeds from sales and maturities of short-term of investments $9.5 million.

In 2011 net cash used in investing activities was $57.5 million. During 2011, a portion of our proceeds from our public stock offering was used to purchase short-term investments. Our other investing activities consisted of purchases of property and equipment and costs related to capitalizing internal-use software.

We expect to increase our purchases of property and equipment in future periods as we continue to invest in the infrastructure 49-------------------------------------------------------------------------------- Table of Contents needed to operate our global service sales centers for an increasing customer and engagement base. In 2011, cash used in investing activities was principally for the purchases of short-term investments, net of sales and maturities, of $43.5 million and to a lesser extent, for purchase of property and equipment of $14.0 million, including costs capitalized for development of internal-use software.

In 2010, net cash used in investing activities was $9.2 million, and related to the purchase of property and equipment, including costs capitalized for the development of internal-use software.

Financing Activities Cash provided by financing activities was $11.0 million during 2012 and principally resulted from proceeds of $10.4 million from the exercise of common stock options and the purchase of common stock under our employee stock purchase plan.

Cash provided by financing activities was $112.2 million during 2011 and comprised primarily of proceeds from our IPO, net of issuance costs, of $87.7 million and proceeds from our follow-on offering, net of issuance costs of $23.0 million. In addition we received proceeds of $15.0 million from the exercise of common stock options and the purchase of common stock under our employee stock purchase plan, partially offset by $16.3 million in net payments to pay off our term loan and for payment under capital lease obligations.

In 2010 cash used in financing activities was $4.1 million, primarily resulting from principal payments on our term loan.

Off-Balance Sheet Arrangements We do not have any relationships with other entities or financial partnerships, such as entities often referred to as structured finance or special-purpose entities, which have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Contractual Obligations and Commitments Our principal commitments consist of obligations under operating leases for office space and computer equipment. At December 31, 2012, the future minimum payments under these commitments were as follows (in thousands): Less than 1 More than 5 Total year 1-3 years 3-5 years yearsObligations under capital leases $ 964 $ 326 $ 417 $ 221 $ - Operating lease obligations 41,136 8,318 16,332 10,642 5,844 $ 42,100 $ 8,644 $ 16,749 $ 10,863 $ 5,844 The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding, which specify significant terms, including payment terms, related services and the approximate timing of the transaction. Obligations under contracts that we can cancel without a significant penalty are not included in the table above.

Critical Accounting Policies and Estimates Revenue Recognition Our revenue is derived primarily from recurring revenue management. Other revenues, which have not been significant, include subscriptions to our cloud applications and professional services.

50-------------------------------------------------------------------------------- Table of Contents Revenue from recurring revenue management consists of fees earned from the sales of services contracts on behalf of our customers or assisting our customers in their sales process. Our contract obligations include administering and managing the sales and/or renewal process for our customer's service contracts, providing adequately trained staff, reporting, and holding periodic business reviews with our customers. Under our contracts, customers are obligated to provide us with a detailed listing of sales prospects, access to their databases or management systems, and sales and marketing materials. Our fees are generally calculated as a fixed percentage of the overall sales value associated with the successful renewal of service contracts sold on behalf of our customers. In addition, many of our customer contracts include performance-based fees determined by the achievement of specified performance metrics. Our recurring revenue management contracts typically entitle us to additional fees and adjustments resulting from instances where our customers fail to provide us with a specified minimum value of contract renewals or they fail to provide contract renewal data within the time frames specified in our contract. We also receive fees in the event a customer cancels a contract without cause prior to its terminations date.

Revenue is recognized when persuasive evidence of an arrangement exists, services have been provided, the sales price is fixed or determinable and collectability is reasonably assured from customers and we have no significant or unfulfilled obligations. Customer contracts are used to determine the existence of an arrangement. Our contracts are generally cancellable by our customers for convenience, subject to termination fees, or can be cancelled by our customers without a termination fee if we fail to achieve certain performance levels. Recurring revenue management services are deemed delivered when our customers accept purchased orders from their end customers and we have no significant remaining obligations. Our fees from recurring revenue management services are recognized on a net basis since we act as an agent on behalf of our customers. We do not perform the underlying services, determine pricing, terms or scope of services to our customer's end users. Performance incentive fees and early termination fees are recorded in the period when the performance criteria have been met. Subscription revenue is recognized ratably over the contract term, commencing when our cloud applications are made available to our customers. Professional services are deemed delivered and revenue recognized when project milestones have been achieved and accepted by the customer.

We have entered into a limited number of multiple element arrangements wherein our customers utilize a combination of recurring revenue management services, subscriptions to our cloud applications and professional services. We separate deliverables at the inception of the arrangement as if each deliverable has stand-alone value to our customer. Arrangement consideration is allocated based on the relative selling prices of each deliverable. However, substantially all fees earned from our recurring revenue management services are contingent in nature as the commissions we earn are based on our performance against the specific terms of each contract. Therefore, contingent fees from revenue management services are excluded from the allocation of relative selling prices at inception of our multiple element arrangements.

Selling prices for each deliverable is determined based on the selling price hierarchy of vendor-specific objective evidence (VSOE), third-party evidence (TPE), and best estimated selling price (BESP). We have not been able to establish VSOE for our deliverables due to the customer-specific nature of our products and services. Also, we have not been able to reliably determine the stand-alone selling prices of competitor's products and services, and as a result, we cannot rely on TPE for our deliverables. Therefore, we utilize estimates of BESP to determine the selling prices of our deliverables. BESP is determined through consultation with management, taking into consideration our marketing and pricing strategies. As these strategies evolve, we may modify our pricing practices in the future, which could result in changes in the estimates used to estimate BESP which could change the allocation of revenue for our multiple element arrangements.

Stock-Based Compensation We measure and recognize compensation expense for share-based payment awards made to our employees and directors, including employee stock options and restricted stock units, based on the grant-date fair values of the awards.

51-------------------------------------------------------------------------------- Table of Contents We estimate the fair value of stock options granted using the Black-Scholes option-pricing model. This model requires us to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will retain vested stock options before exercising them, the estimated volatility of our common stock price using historical volatility and the number of options that will be forfeited prior to vesting. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of share-based compensation and consequently, the related amount recognized in our consolidated statements of operations.

The compensation expense of restricted stock units and performance based restricted stock awards is determined using the fair value of our common stock on the date of grant, and the expense is recognized on a straight-line basis over the vesting period.

Capitalized Internal-Use Software Our software development costs relate to the research, development, enhancement, and maintenance of our technology platforms, Atlas and Renew OnDemand. Software development costs include employee salaries, benefits and third-party contractor fees. Research and development costs, relating principally to the design and development of new products prior to the application development stage and the routine enhancement, and maintenance of existing products, are expensed as incurred.

We capitalize certain internal and external costs related to the development and enhancement of our internal-use software when we enter the application development stage and until software is substantially complete and is ready for its intended use. These capitalized costs include direct external costs of services utilized in developing or obtaining internal-use software, compensation and related expenses of employees who are directly associated with, and who devote substantive time to, internal-use software projects. Capitalization of these costs ceases once the project is substantially complete and the software is ready for its intended use. The related costs are amortized over estimated useful lives ranging from 24 to 60 months. Capitalized internal-use software development costs for projects not yet complete are included as construction in progress. We initiate our review of potential impairment whenever events or changes in circumstances indicate that the carrying amount of the capitalized internal-use software may not be recoverable. Recoverability of assets is assessed by a comparison of the carrying amount of an asset to the expected future undiscounted cash flows expected to be generated by the asset. If it is determined that the carrying value of the internal-use software is not recoverable, an impairment loss is recorded in the amount by which the carrying amount of the asset exceeds the fair value of the asset. There were no impairments to internal-use software in 2012, 2011 or 2010.

Income Taxes We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries' assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in those jurisdictions where the deferred tax assets are located. We consider future growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate, historical earnings, taxable income in prior years, if carryback is permitted under the law and prudent and feasible tax planning 52 -------------------------------------------------------------------------------- Table of Contents strategies in determining the need for a valuation allowance. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets valuation allowance would be charged to earnings in the period in which we make such a determination, or goodwill would be adjusted at our final determination of the valuation allowance related to an acquisition within the measurement period. If we later determine that it is more likely than not that the net deferred tax assets would be realized, we would reverse the applicable portion of the previously provided valuation allowance as an adjustment to earnings at such time.

We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. To the extent that the assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.

Recent Accounting Pronouncements See "Note 2. Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data for a full description of recent accounting pronouncements including the respective expected dates of adoption and effects on Consolidated Balance Sheets and Consolidated Statements of Operations.

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