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TMCNet:  IMPERVA INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[February 28, 2014]

IMPERVA INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our "Selected Consolidated Financial Data" and consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K. This Annual Report on Form 10-K contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These statements are often identified by the use of words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate," or "continue," and similar expressions or variations. 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 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 herein, and those discussed in the section titled "Risk Factors," set forth in Item 1A of this Annual Report on Form 10-K and in our other SEC filings. You should review these risk factors for a more complete understanding of the risks associated with an investment in our securities. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.


Overview We are pioneering the third pillar of enterprise security, data center security, by directly protecting high-value applications and data assets in physical and virtual data centers. Built specifically for modern threats, our comprehensive suite of data center security offerings is designed to provide the visibility and control needed to neutralize attacks, theft and fraud from inside and outside the organization, mitigate risk, and streamline compliance. Our SecureSphere platform provides database, file and web application security across various physical and virtual systems in data centers, including traditional on-premise data centers as well as private, public and hybrid cloud computing environments. In addition, our cloud offerings are designed to protect against the unique threats created as enterprises increasingly shift to deploying their applications and storing their data in the cloud to take advantage of the flexibility and cost-efficiency offered by cloud-based solutions.

We believe that data center security is the third pillar of enterprise security because it fills the gaps between the first pillar of security, endpoint security, which blocks threats targeting devices, and the second pillar of security, network security, which blocks threats trying to access the network.

Our unique suite of offerings protects the high-value applications and data assets that endpoint and network solutions are not designed to protect, whether the applications and data reside within our customers' data center or the cloud.

Organizations are facing numerous challenges in providing the visibility and control required to protect high-value applications and data assets from attack, theft and fraud. Attacks, whether perpetrated by sophisticated hackers or malicious insiders, continue to increase in sophistication, scale and frequency, and organizations must comply with increasingly complex regulatory standards enacted to protect high-value applications and data. Adoption of new technologies and architectures, such as mobile applications, modern web applications and big data, increases the complexity of, and open access to, the data center; thereby exposing critical data assets to new vulnerabilities. The increased adoption of cloud delivery models and virtualization technologies is also forcing applications to operate outside of the traditional security model.

We believe that these challenges are driving the need for a comprehensive data center security solution to protect high-value applications and data assets in the data center.

We were incorporated as a Delaware corporation in 2002 with the vision of protecting high-value applications and data assets within the enterprise. Since that time we have been investing in our data center security solutions to meet the rapidly evolving demands of customers. We shipped our initial web application security and data security products in 2002; in 2006, we expanded our database security product to include compliance features. In 2010, we launched our file security offering. In addition, in 2010, we launched our cloud-based initiatives with ThreatRadar and, in 2011, we introduced our cloud-based offering for mid-market enterprises and small and medium-sized businesses ("SMB") that we provide through Incapsula, Inc., our majority owned 33 -------------------------------------------------------------------------------- Table of Contents subsidiary. In January 2014, we acquired certain assets and liabilities of Tomium Software, LLC to accelerate our mainframe data security solutions. In February 2014, we acquired SkyFence Networks Ltd. to further our Software as a Service (SaaS) delivery models for internally facing corporate applications and agreed to acquire the remaining portion of Incapsula that we did not already own in order to more fully integrate their operations with ours.

Our research and development efforts are focused primarily on improving and enhancing our existing data center security solutions and services, as well as developing new products and services and conducting advanced security research.

We conduct our research and development activities in Israel, and we believe this provides us with access to some of the best engineering talent in the security industry. As of December 31, 2013, we had 183 employees dedicated to research and development, including our advanced security research group, the Application Defense Center ("ADC"). Our research and development expense was $27.6 million, $20.6 million and $17.6 million for the years ended December 31, 2013, 2012 and 2011, respectively.

We derive our revenue from sales and licenses of our products and sales of our services. Products and license revenue is generated primarily from sales of perpetual software licenses installed on hardware appliances or virtual appliances for our SecureSphere Business Security Suite. Services revenue consists of maintenance and support, professional services and training and subscriptions. A majority of our revenue is derived from customers in the Americas region. In 2013, 61% of our total revenue was generated from the Americas, 24% from Europe, Middle East and Africa ("EMEA") and 15% from Asia Pacific ("APAC").

We market and sell our products through a hybrid sales model, which combines a direct touch sales organization and an overlay channel sales team that actively assist our extensive network of channel partners throughout the sales process.

We also provide our channel partners with marketing assistance, technical training and support. We primarily sell our products and services through our channel partners, including distributors and resellers, which sell to end-user customers, who we refer to in this Annual Report on Form 10-K as our customers.

We have a network of over 300 channel partners worldwide, including both resellers and distributors. In 2013, our channel partners originated over 40%, and fulfilled almost 85%, of our sales. We work with many of the world's leading security value-added resellers, and our partners include some of the largest hosting companies for cloud-based deployments.

As of December 31, 2013, we had over 3,000 customers in more than 75 countries.

In addition, our solutions are used to protect thousands of organizations through cloud-based deployments with our Software-as-a-Service ("SaaS") customers and our managed security service provider ("MSSP") and hosting partners. Our customers include eight of the top ten telecommunications companies, five of the top ten commercial banks in the United States, three of the top five global consumer financial services firms, four of the top five global computer hardware companies, over 250 government agencies around the world and more than 350 Global 2000 companies.

Our net revenue has increased in each of the last three years, growing from $78.3 million in 2011 to $137.8 million in 2013. We have incurred net losses attributable to our stockholders of $25.2 million, $7.4 million and $10.3 million in 2013, 2012 and 2011, respectively. As of December 31, 2013, we had an accumulated deficit of $98.7 million.

Opportunities, Challenges and Risks We believe that the growth of our business and our future success are dependent upon many factors, including our ability to maintain our technology leadership, improve our sales and marketing, address the needs of smaller enterprises and compete effectively in the marketplace for data center security solutions. While each of these areas presents significant opportunities for us, they also pose important challenges and risks that we must successfully address in order to sustain the growth of our business and improve our results of operations.

Maintain Technology Leadership. As a result of the rise in sophisticated attacks by hackers and malicious insiders, the difficulty in complying with regulations governing business data and the growing complexity of, and open access to, data centers, we believe that enterprises are struggling to provide visibility and control over high-value business applications and data assets that they need to protect. In addition, organizations are increasingly taking advantage of cloud-based services and virtualization technologies, and these new technologies and architectures are increasing the complexity of, and accessibility to, the data center. We believe these challenges are driving the need for a new protection layer positioned closely around the applications and data assets in the data center. We expect that as enterprises recognize the growing risk to high-value business data and the need to comply with increasing regulatory compliance mandates, their spending will increase on solutions designed to control and protect such data. We believe that traditional security and compliance products do not address the evolving needs of enterprises or do not do so adequately, and that this presents us with a large market opportunity. To capitalize on this opportunity, we have introduced and expect that in the future we will need to continue to introduce innovations to our broad business security solutions, including solutions to address data center security opportunities that arise as enterprises pursue cloud computing initiatives. We cannot assure you that our products will achieve widespread market acceptance or that we will properly anticipate future customer needs. Moreover, if our products do not satisfy evolving customer requirements, we will not capture the increase in spending that we expect will result from enterprises seeking to secure data across various systems in the data center.

34-------------------------------------------------------------------------------- Table of Contents Invest in Sales and Marketing. In order to capitalize on the anticipated increase in spending in the data center security market, we will need to continue to invest significant resources to further strengthen our existing relationships with channel partners, extend our global network by adding new channel partners and grow our sales and marketing team. Any investments that we make in our sales and marketing will occur in advance of our experiencing any benefits from such investments, and so it may be difficult for us to determine if we are efficiently allocating our resources in this area. We cannot assure you that the investments that we intend to make to strengthen our sales and marketing efforts will enable us to capitalize on the expected increase in spending in the data center security market or result in an increase in revenue or an improvement in our results of operations.

Address Needs of Smaller Enterprises. As market awareness of the benefits of a comprehensive data center security solution increases, we believe there is a significant opportunity to provide data center security solutions to smaller enterprises as they confront increasing security threats and compliance mandates. To capitalize on this opportunity, we intend to increase our business with mid-market enterprises and SMBs by expanding our cloud-based service offerings and our distribution channel. We have made, and may in the future continue to make, significant investments in our cloud-based security products to address the business security needs of mid-market enterprises and SMBs. If our cloud-based security products, which are relatively new, fail to gain broad acceptance with mid-market enterprises and SMBs, our revenue growth, results of operations and competitive position in our industry could suffer.

Compete Effectively. We operate in an intensely competitive market that has witnessed significant consolidation in recent years with large companies acquiring many of our competitors. We track our success rate in competitive sales opportunities against certain competitors, some of which generate higher revenues and have greater market capitalizations than we do, and many of which are more established or have greater name recognition within our industry. Based upon our internal tracking of the results of such competitive sales opportunities, we believe that we have historically competed favorably against our larger competitors, and that we have a proven track record of successfully competing against such larger competitors. Nonetheless, some of our larger competitors have numerous advantages, including, but not limited to, greater financial resources, broader product offerings and more established relationships with channel partners and customers. If we are unable to compete effectively for a share of the business security market, our business, results of operations and financial condition could be materially and adversely affected.

To date, we have incurred, and continue to incur, losses from operations and net losses. However, we believe that our existing cash, cash equivalents and short-term investments will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Further, we expect that, if we successfully execute our business plan and strategy, our loss from operations and our net losses will decline, and that we will reach profitability. Should we need additional cash in the future, we may utilize existing lines of credit, enter into additional lines of credit or raise funds through the sale of equity securities.

Key Metrics of Our Business We monitor the key financial metrics discussed below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies.

Net Revenue. We measure our net revenue to assess the acceptance of our products from our customers, our growth in the markets we serve and to help us establish our strategic and operating plans for future periods. We discuss the components of our net revenue in "-Financial Overview- Net Revenue" below.

Gross Margin. We monitor our gross margin to assess the impact on our current and forecasted financial results from any changes to the pricing and mix of products we are selling to our customers.

Loss from Operations. We track our loss from operations to assess how effectively we are planning and monitoring our operations as well as controlling our operational costs, which are primarily driven by headcount.

Cash, Cash Equivalents and Short-term Investments. We evaluate the level of our cash, cash equivalents and short-term investments to ensure we have sufficient liquidity to fund our operations, including the development of future products and product enhancements and the expansion into new sales channels and territories.

Number of Customers. We believe our customer count is a key indicator of our market penetration, the productivity of our sales organization and the value that our products bring to our customer base. We also believe our existing customers represent significant future revenue opportunities for us.

We discuss for the periods presented revenue, gross margin, the components of loss from operations and number of customers further below under "-Segments" and "-Results of Operations", as applicable, and we discuss our cash and cash equivalents under "-Liquidity and Capital Resources." 35-------------------------------------------------------------------------------- Table of Contents We also believe that deferred revenue and cash flow from operations are key financial metrics for our business. The components of deferred revenue and cash flow from operations, as well as our rationale for monitoring these metrics, are discussed immediately below this table: Years ended (or as of December 31) 2013 2012 2011 (in thousands, except number of customers and percentages) Net revenue $ 137,759 $ 104,235 $ 78,302 Gross margin 78.4 % 79.0 % 79.3 % Loss from operations $ (25,429 ) $ (7,104 ) $ (10,006 ) Total deferred revenue $ 63,052 $ 46,291 $ 32,925 Cash, cash equivalents and short-term investments $ 115,085 $ 102,327 $ 97,612 Net cash provided by (used in) operations $ 9,797 $ 4,467 $ (6,537 ) Number of customers 3,011 2,293 1,740 Deferred Revenue Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unamortized portion of services revenue from maintenance and support, and subscription contracts. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods. We also assess the increase in our deferred revenue balance plus revenue we recognized in a particular period as a measure of our sales activity for that period. While the change in our deferred revenue and revenue recognized in a given period comprise the majority of our sales activity during that period, they do not constitute the entire sales activity during the period. Our total sales activity also includes sales of products and services for which we have not yet met the criteria to recognize revenue or add such amounts to our deferred revenue balance. Revenue and deferred revenue from these transactions is recognized or recorded in future periods when we have met the required criteria. We discuss for the periods presented deferred revenue further below under "-Results of Operations." Net Cash Used in Operations We monitor cash flow from operations as a measure of our overall business performance. Our cash flow from operations is driven primarily by sales of our products and licenses and, to a lesser extent, from up-front payments from customers under maintenance and support contracts. Our primary uses of cash in operating activities are for personnel-related expenditures, costs of acquiring the hardware used for our appliances, marketing and promotional expenses and costs related to our facilities. Monitoring cash flow from operations enables us to analyze our financial performance without the non-cash effects of certain items such as depreciation and amortization and stock-based compensation expenses, thereby allowing us to better understand and manage the cash needs of our business.

Segments For financial reporting purposes, we operate as two reportable business segments: (i) Imperva, which is comprised of our financial position and results of operations and those of our wholly-owned subsidiaries; and (ii) Incapsula, which is comprised entirely of the financial position and results of operations of our majority-owned subsidiary. Our Incapsula segment commenced operations in November 2009 and has not generated significant revenue since inception. In discussing our results of operations, we have provided a consolidated discussion and analysis of the revenues from our two segments and, where significant, provided a separate discussion and analysis of the operating expenses of our two segments. See Note 13 of "Notes to Consolidated Financial Statements" for a discussion of our financial information by segment.

Financial Overview Net Revenue We derive our revenue from sales and licenses of our products and sales of our services. As discussed further in "-Critical Accounting Policies and Estimates-Revenue Recognition" below, revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable and collection is probable.

36-------------------------------------------------------------------------------- Table of Contents Our net revenue is comprised of the following: • Products and License Revenue-Product and license revenue is generated from sales of perpetual software licenses installed on hardware appliances or virtual appliances for our SecureSphere Business Security Suite. Our SecureSphere Business Security Suite consists of database security, file security and web application security. We offer multiple hardware appliance versions that accompany our software, each with different throughput capacities. Perpetual software license revenue is generated from sales of our appliances, licenses for additional users and add-on software modules. We also generate a small amount of hardware revenue from sales of spares or replacement appliances, demonstration units and accessories.

• Services Revenue-Services revenue consists of maintenance and support, professional services and training and subscriptions. Maintenance and support revenue is generated from support services that are bundled with appliances and add-on software modules. There are three levels of maintenance and support-Standard, Enhanced and Premium-and these are offered through agreements for one to five-year terms. Maintenance and support includes major and minor when-and-if available software updates; customer care, which includes our designated support engineer and Imperva resident engineer programs; content updates from our advanced security research group, the ADC, and hardware replacement. Subscription revenue is generated from sales of our cloud-based services. Professional services revenue consists of fees we earn related to implementation and consulting services we provide our customers. Training services revenue consists of fees we earn related to training customers and partners on the use of our products. We expect that the services revenue from maintenance and support contracts will continue to grow along with the increase in the size of our installed base.

A majority of our products and services are sold to customers in the Americas, primarily in the U.S., however, a significant portion of our revenue is generated from international sales. See Note 13 of "Notes to Consolidated Financial Statements" for a discussion of our financial information by geographic region. Our revenue by geographic region is as follows (in thousands): Years Ended December 31, 2013 2012 2011 Americas $ 83,736 $ 61,588 $ 47,851 EMEA 33,183 24,958 18,464 APAC 20,840 17,689 11,987 Total net revenue $ 137,759 $ 104,235 $ 78,302 Cost of Revenue Our total cost of revenue is comprised of the following: • Cost of Products and License Revenue-Cost of products and license revenue is comprised primarily of third-party hardware costs and royalty fees. Our cost of products and license revenue also includes personnel costs related to our operations team, shipping costs and write-offs for excess and obsolete inventory.

• Cost of Services Revenue-Cost of services revenue is primarily comprised of personnel costs of our technical support team, our professional consulting services and training teams and our Security Operations Center ("SOC") team. Cost of services revenue also includes facilities costs, subscription fees and depreciation. We expect that our cost of services revenue will increase in absolute dollars as we increase our headcount.

Operating Expenses Our operating expenses consist of research and development, sales and marketing and general and administrative expenses. Personnel costs are the most significant component of our operating expenses and consist of wages, benefits and bonuses and, with regard to the sales and marketing expense, sales commissions. Personnel costs also include stock-based compensation. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business.

Research and Development Our research and development is focused on maintaining and improving our existing products and on new product development. A majority of our research and development expenses are comprised of personnel costs and, to a lesser extent, facility costs, hardware prototype costs, laboratory expenses and depreciation.

We expense research and development costs as incurred. We expect our research and development expenses to increase in absolute dollars as we continue to enhance our existing products and develop new products and services that address the emerging market for business security and regulatory compliance.

37-------------------------------------------------------------------------------- Table of Contents Sales and Marketing Sales and marketing expense is the largest component of our operating expenses and consists primarily of personnel costs, including commissions and travel expenses. Sales and marketing expenses also include costs related to marketing and promotional activities, third-party referral fees and, to a lesser extent, facilities costs and depreciation. We expect our sales and marketing expenses to increase in absolute dollars as we expand our sales and marketing efforts worldwide.

General and Administrative General and administrative expense consists primarily of personnel costs, including stock-based compensation, as well as professional fees, facilities costs and depreciation. General and administrative personnel costs include our executive, finance, purchasing, order entry, human resources, information technology and legal functions. Our professional fees consist primarily of accounting, external legal, information technology and other consulting costs.

Other Income (Expense), net Other income (expense), net is comprised of the following items: • Interest Income-Interest income consists of interest earned on our cash, cash equivalents and short-term investments. We expect interest income will vary each reporting period depending on our average investment balances during the period and market interest rates.

• Interest Expense-Interest expense consists of interest accrued or paid on debt obligations.

• Foreign Currency Forward Contract Gains (Losses)-Foreign currency forward contract gains and losses pertain to the ineffective portion of derivative instruments designated as hedges and changes in fair value of derivatives not designated as hedges that we have entered into primarily to manage our exposure to the variability in expected future expenses resulting from changes in foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes. We expect our foreign currency forward contract gains (losses) to continue to fluctuate in the future due to changes in foreign currency exchange rates for derivatives not designated as hedges.

• Foreign Currency Exchange Gains (Losses)-Foreign currency exchange gains and losses relate to transactions denominated in currencies other than the U.S. Dollar.

• Warrant Liability Gain (Losses)-Our outstanding convertible preferred stock warrants were classified as a liability on our consolidated balance sheets and, as such, were remeasured to fair value at each balance sheet date with the corresponding gain or loss from the adjustment recorded as other income (expense), net. Following the completion of our initial public offering in November 2011, outstanding warrants were automatically converted into warrants to purchase common stock and, upon such conversion, were no longer classified as a liability on our consolidated balance sheet.

Provision for Income Taxes We operate in several income tax jurisdictions and are subject to income taxes in each country or jurisdiction in which we conduct business including the United States and Israel. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax if such earnings are distributed to the U.S. To date, we have incurred net losses and have recorded insignificant U.S. federal income tax expense. Our income tax expense to date relates primarily to foreign income taxes, mainly from our Israeli and United Kingdom activities, and to a lesser extent, state income taxes.

38-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table is a summary of our consolidated statements of operations in dollars and as a percentage of our total net revenue. We have derived the data for the years ended December 31, 2013, 2012 and 2011 from our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

Years Ended December 31, 2013 2012 2011 % of Net % of Net % of Net Amount Revenue Amount Revenue Amount Revenue (dollars in thousands) Statement of Operations Data: Net revenue: Products and license $ 72,153 52.4 $ 59,490 57.1 $ 47,600 60.8 Services: Maintenance and support 44,353 32.2 33,647 32.3 24,497 31.3 Professional services and training 9,890 7.2 6,428 6.1 4,730 6.0 Subscriptions 11,363 8.2 4,670 4.5 1,475 1.9 Total services 65,606 47.6 44,745 42.9 30,702 39.2 Total net revenue 137,759 100.0 104,235 100.0 78,302 100.0 Cost of revenue: Products and license 8,756 6.4 8,530 8.2 6,711 8.6 Services 20,940 15.2 13,374 12.8 9,510 12.1 Total cost of revenue 29,696 21.6 21,904 21.0 16,221 20.7 Gross profit 108,063 78.4 82,331 79.0 62,081 79.3 Operating expenses: Research and development 27,556 20.0 20,555 19.7 17,598 22.5 Sales and marketing 81,500 59.2 53,509 51.3 42,682 54.5 General and administrative 24,436 17.7 15,371 14.8 11,807 15.1 Total operating expenses 133,492 96.9 89,435 85.8 72,087 92.1 Loss from operations (25,429 ) (18.5 ) (7,104 ) (6.8 ) (10,006 ) (12.8 ) Other income (expense), net (125 ) (0.1 ) (243 ) (0.2 ) (190 ) (0.2 ) Loss before provision for income taxes (25,554 ) (18.6 ) (7,347 ) (7.0 ) (10,196 ) (13.0 ) Provision for income taxes 777 0.6 545 0.5 662 0.8 Net loss (26,331 ) (19.2 ) (7,892 ) (7.5 ) (10,858 ) (13.8 ) Loss attributable to noncontrolling interest 1,153 0.8 505 0.5 589 0.8 Net loss attributable to Imperva, Inc. stockholders $ (25,178 ) (18.4 ) $ (7,387 ) (7.0 ) $ (10,269 ) (13.0 ) 39 -------------------------------------------------------------------------------- Table of Contents Comparison of the Years Ended December 31, 2013 and 2012 Net Revenue Years ended December 31, 2013 2012 Change % of Net % of Net Amount Revenue Amount Revenue Amount % (dollars in thousands) Net revenue: Products and license $ 72,153 52.4 $ 59,490 57.1 $ 12,663 21.3 % Services: Maintenance and support 44,353 32.2 33,647 32.3 10,706 31.8 % Professional services and training 9,890 7.2 6,428 6.1 3,462 53.9 % Subscriptions 11,363 8.2 4,670 4.5 6,693 143.3 % Total Services 65,606 47.6 44,745 42.9 20,861 46.6 % Total net revenue $ 137,759 100.0 $ 104,235 100.0 $ 33,524 32.2 % Americas $ 83,736 60.8 $ 61,588 59.1 $ 22,148 36.0 % EMEA 33,183 24.1 24,958 23.9 8,225 33.0 % APAC 20,840 15.1 17,689 17 3,151 17.8 % Total net revenue $ 137,759 100.0 $ 104,235 100.0 $ 33,524 32.2 % Our net revenue increased by $33.5 million, or 32.2%, to $137.8 million during the year ended December 31, 2013 from $104.2 million during the year ended December 31, 2012 due to growth in products and license revenue and services revenue. This revenue growth reflects the increasing demand for our product and service offerings consistent with our business plan and expectations for growth.

The Americas region contributed the largest portion with a $22.1 million increase, or approximately a 36.0% change over the same period in 2012. In addition, an increase in our international sales personnel resulted in increases in revenue in EMEA and APAC of $8.2 million and $3.2 million, or approximately a 33.0% and 17.8% change, respectively, over the same period in 2012.

Products and license revenue increased by $12.7 million, or 21.3%, to $72.2 million during the year ended December 31, 2013 from $59.5 million during the year ended December 31, 2012. The change in product and license revenue was driven by a significant increase in product sales, primarily in the Americas region in the year ended December 31, 2013 compared to the year ended December 31, 2012. This increase was due to increased sales volume of our products.

Services revenue increased by $20.9 million, or 46.6%, to $65.6 million during the year ended December 31, 2013 from $44.7 million during the year ended December 31, 2012. During the year ended December 31, 2013, our services revenue was comprised of $44.4 million of maintenance and support, $9.9 million of professional services and training and $11.4 million of subscriptions. The change in services revenue in the year ended December 31, 2013 from the year ended December 31, 2012 was primarily due to an increase of $10.7 million in maintenance and support revenue resulting from our larger installed base, $6.7 million in subscriptions revenue from our cloud-based security services, including our Incapsula offering, and $3.5 million in professional services and training revenues due primarily to an increase in the number of implementation projects.

40 -------------------------------------------------------------------------------- Table of Contents Gross Profit Years Ended December 31, 2013 2012 Gross Gross Amount Margin Amount Margin % Change (dollars in thousands) Products and license gross profit $ 63,397 87.9 % $ 50,960 85.7 % 2.2 Services gross profit 44,666 68.1 % 31,371 70.1 % (2.0 ) Total gross profit $ 108,063 78.4 % $ 82,331 79.0 % (0.6 ) Total gross margin decreased 0.6 percentage points from 79.0% during the year ended December 31, 2012 to 78.4% during the year ended December 31, 2013 primarily due to a decrease in services gross margin of 2.0 percentage points in the year ended December 31, 2013 compared to the same period in 2012. In addition there was an increased proportion of services revenue to total revenue during the year ended December 31, 2013 as compared to the 2012 period. The decrease in services gross margin was primarily due to higher use of outside contractors, which tend to be more costly that our internal service personnel, in order to support the growth in services revenue for the year ended December 31, 2013. Products and license gross margins increased by 2.2 percentage points to 87.9% for the year ended December 31, 2013 as compared to 85.7% for the year ended December 31, 2012. The increase was mostly due to an increase in the proportion of virtual appliance sales in the year ended December 31, 2013 as compared to the 2012 period. Virtual appliance sales tend to have higher gross margin percentages than physical appliances.

Operating Expenses Years Ended December 31, 2013 2012 Change % of Net % of Net Amount Revenue Amount Revenue Amount % (dollars in thousands) Operating expenses: Research and development $ 27,556 20.0 $ 20,555 19.7 $ 7,001 34.1 Sales and marketing 81,500 59.2 53,509 51.3 27,991 52.3 General and administrative 24,436 17.7 15,371 14.8 9,065 59.0 Total operating expenses $ 133,492 96.9 $ 89,435 85.8 $ 44,057 49.3 Results above include stock-based compensation expense of: Years ended December 31, 2013 2012 Change (dollars in thousands) Research and development $ 3,660 $ 1,227 $ 2,433 Sales and marketing 8,537 2,543 5,994 General and administrative 8,857 1,729 7,128 $ 21,054 $ 5,499 $ 15,555 Research and development expenses increased by $7.0 million, or 34.1%, to $27.6 million during the year ended December 31, 2013 from $20.6 million during the year ended December 31, 2012. The change was primarily attributable to an increase of $4.8 million in personnel costs, including stock-based compensation, due to additional research and development personnel being hired to support our ongoing product development efforts, and an increase of $1.4 million in Incapsula research and development costs, including stock-based compensation. In addition, facility and depreciation expenses increased by $0.6 million.

Sales and marketing expenses increased by $28.0 million, or 52.3%, to $81.5 million during the year ended December 31, 2013 from $53.5 million during the year ended December 31, 2012. The change was due to an increase of $21.1 million in personnel costs, including stock-based compensation due to increased headcount in all regions in an effort to help drive our overall revenue growth, and contractor costs, $2.0 million in travel expenses, and an increase in trade show, corporate marketing and seminar costs totaling $0.7 million. In addition, Incapsula marketing expenses increased by $2.5 million, including stock-based compensation, and facility expenses increased $0.9 million.

41 -------------------------------------------------------------------------------- Table of Contents General and administrative expenses increased by $9.1 million, or 59.0%, to $24.4 million during the year ended December 31, 2013 from $15.4 million during the year ended December 31, 2012. The change was primarily due to an increase of $8.4 million in personnel costs, including stock-based compensation, primarily related to stock-based awards issued to Incapsula employees for retention purposes which will not recur in future periods, and increased headcount to support the growth and operations of our business. In addition, facility expenses increased by $0.5 million.

Loss from Operations Years ended December 31, 2013 2012 Change % Change (dollars in thousands) $ (25,429 ) $ (7,104 ) $ (18,325 ) -258.0 % Our loss from operations increased by $18.3 million, or 258.0%, from $7.1 million during the year ended December 31, 2012 to $25.4 million during the year ended December 31, 2013. Total operating expenses increased by $44.1 million for the year ended December 31, 2013 when compared to the prior year principally due to increases in personnel costs, including stock-based compensation expense, to support the increased scope and global reach of our business. The increase in operating expenses was comprised of increased sales and marketing costs of $28.0 million to expand our global sales efforts, and increased general and administrative costs of $9.1 million primarily related to stock-based compensation for performance based restricted stock units with multiple performance and a market condition granted to Incapsula employees as part of a retention plan, and increased headcount to support the growth and operations of our business In addition, we had increased research and development costs of $7.0 million primarily from hiring to support our ongoing product development efforts. This increase in operating expenses was partially offset by an increase in our gross profit of $25.7 million during the year ended December 31, 2013 due to higher net revenues.

Other Income (Expense), Net Years ended December 31, Change 2013 2012 Amount % (dollars in thousands) $ (125 ) $ (243 ) $ 118 48.6 % Other income (expense), net, increased approximately $0.1 million, or 48.6% during the year ended December 31, 2013 as compared to 2012. The change was primarily due to a decrease of $0.1 million in foreign currency exchange losses, net.

42 -------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes 2013 2012 Amount % (dollars in thousands) Provision for income taxes $ 777 $ 545 $ 232 42.6 % Effective tax rate -3.0 % -7.4 % The provision for income taxes for the years ended December 31, 2013 and 2012 was comprised primarily of foreign and state income taxes. The increase in the provision for income taxes in the year ended December 31, 2013 compared with the year ended December 31, 2012 was primarily attributable to an increase in state income tax.

Deferred Revenue As of December 31, Change 2013 2012 Amount % (dollars in thousands) Total deferred revenue $ 63,052 $ 46,291 $ 16,761 36.2 % Deferred revenue increased by $16.8 million, or 36.2%, to $63.1 million as of December 31, 2011 from $46.3 million as of December 31, 2012. The growth in our deferred revenue was primarily attributable to an increase in our installed base of products and licenses worldwide and resulting renewals of maintenance and support agreements, as well as new sales of subscription and maintenance and support agreements.

Number of Customers As of December 31, Change 2013 2012 Amount % Number of customers 3,011 2,293 718 31.3 % Our number of customers increased by 718, or 31.3%, to 3,011 as of December 31, 2013 from 2,293 as of December 31, 2012. Our growth in customer count was driven by increasing market acceptance of our products as well as an increase in our global sales and services and support organizations from 238 people as of December 31, 2012 to 296 as of December 31, 2013. The growth in our sales and service and support organizations was consistent with our plans to continue expanding our global sales and support coverage, in particular our channel partner sales and support teams. The increases in our sales and support organizations allowed us to target new customers while continuing to support existing customers across all of our geographies.

43-------------------------------------------------------------------------------- Table of Contents Comparison of the Years Ended December 31, 2012 and 2011 Net Revenue Years ended December 31, 2012 2011 Change % of Net % of Net Amount Revenue Amount Revenue Amount % (dollars in thousands) Net revenue: Products and license $ 59,490 57.1 $ 47,600 60.8 $ 11,890 25.0 % Services: Maintenance and Support 33,647 32.3 24,497 31.3 9,150 37.4 % Professional Services and training 6,428 6.1 4,730 6.0 1,698 35.9 % Subscriptions 4,670 4.5 1,475 1.9 3,195 216.6 % Total Services 44,745 42.9 30,702 39.2 14,043 45.7 % Total net revenue $ 104,235 100.0 $ 78,302 100.0 $ 25,933 33.1 % Americas $ 61,588 59.1 $ 47,851 61.1 $ 13,737 28.7 % EMEA 24,958 23.9 18,464 23.6 6,494 35.2 % APAC 17,689 17.0 11,987 15.3 5,702 47.6 % Total net revenue $ 104,235 100.0 $ 78,302 100.0 $ 25,933 33.1 % Our net revenue increased by $25.9 million, or 33.1%, to $104.2 million during the year ended December 31, 2012 from $78.3 million during the year ended December 31, 2011 due to growth in products and license revenue and services revenue. This revenue growth reflects the increasing demand for our product and service offerings consistent with our business plan and expectations for growth.

The Americas region contributed the largest portion of this growth with a $13.7 million increase, or approximately a 28.7% change over the same period in 2011. In addition, an increase in our international sales personnel resulted in increases in revenue in EMEA and APAC of $6.5 million and $5.7 million, or approximately a 35.2% and 47.6% change, respectively, over the same period in 2011.

Products and license revenue increased by $11.9 million, or 25.0%, to $59.5 million during the year ended December 31, 2012 from $47.6 million during the year ended December 31, 2011. The change in product and license revenue was driven by a significant increase in product sales, primarily in the Americas region in the year ended December 31, 2012 compared to the year ended December 31, 2011. This increase was due to increased sales volume of our products.

Services revenue increased by $14.0 million, or 45.7%, to $44.7 million during the year ended December 31, 2012 from $30.7 million during the year ended December 31, 2011. During the year ended December 31, 2012, our services revenue was comprised of $33.6 million of maintenance and support, $6.4 million of professional services and training and $4.7 million of subscriptions. The change in services revenue in the year ended December 31, 2012 from the year ended December 31, 2011 was primarily due to an increase of $9.2 million in maintenance and support revenue resulting from our larger installed base, $3.2 million in subscriptions revenue from our cloud-based services including ThreatRadar, which was launched in the first quarter of 2010, and $1.7 million in professional services and training revenues due primarily to an increase in the number of implementation projects.

Gross Profit Years Ended December 31, 2012 2011 Gross Gross Amount Margin Amount Margin % Change (dollars in thousands) Products and license gross profit $ 50,960 85.7 % $ 40,889 85.9 % (0.2 ) Services gross profit 31,371 70.1 % 21,192 69.0 % 1.1 Total gross profit $ 82,331 79.0 % $ 62,081 79.3 % (0.3 ) 44 -------------------------------------------------------------------------------- Table of Contents Total gross margin decreased 0.3 percentage points from 79.3% during the year ended December 31, 2011 to 79.0% during the year ended December 31, 2012 primarily due to a decrease in products and license gross margin of 0.2 percentage points in the year ended December 31, 2012 compared to the same period in 2011. The decrease in products and license gross margin was primarily due to an increase in third party licensing fees for certain products and licenses during the year ended December 31, 2012. The 1.1 percentage point increase in services gross margin was mostly due to higher maintenance and subscriptions revenue which better leveraged the internal cost structure to support these services.

Operating Expenses Years Ended December 31, 2012 2011 Change % of Net % of Net Amount Revenue Amount Revenue Amount % (dollars in thousands) Operating expenses: Research and development $ 20,555 19.7 $ 17,598 22.5 $ 2,957 16.8 Sales and marketing 53,509 51.4 42,682 54.5 10,827 25.4 General and administrative 15,371 14.7 11,807 15.1 3,564 30.2 Total operating expenses $ 89,435 85.8 $ 72,087 92.1 $ 17,348 24.1 Results above include stock-based compensation expense of: Years Ended December 31, 2012 2011 Change (dollars in thousands) Research and development $ 1,227 $ 130 $ 1,097 Sales and marketing 2,543 412 2,131 General and administrative 1,729 1,067 662 $ 5,499 $ 1,609 $ 3,890 Research and development expenses increased by $3.0 million, or 16.8%, to $20.6 million during the year ended December 31, 2012 from $17.6 million during the year ended December 31, 2011. The change was primarily attributable to an increase of $2.3 million in personnel costs due to additional research and development personnel being hired to support our ongoing product development efforts. In addition, facility and depreciation expenses increased by $0.5 million.

Sales and marketing expenses increased by $10.8 million, or 25.4%, to $53.5 million during the year ended December 31, 2012 from $42.7 million during the year ended December 31, 2011. The change was due to an increase of $7.3 million in personnel costs due to increased headcount in all regions in an effort to help drive our overall revenue growth, $1.6 million in travel expenses, $1.4 million in promotional and other sales and marketing related expenses, and $0.4 million in Incapsula marketing expenses.

General and administrative expenses increased by $3.6 million, or 30.2%, to $15.4 million during the year ended December 31, 2012 from $11.8 million during the year ended December 31, 2011. The change was primarily due to an increase of $2.2 million in professional fees associated with public company costs, such as accounting and legal fees and directors and officers insurance. Additionally, there was an increase of $1.2 million in personnel costs, including stock-based compensation, related to increased headcount to support the growth and operations of our business and to support operating as a public company.

Loss from Operations Years Ended December 31, % 2012 2011 Change Change (dollars in thousands) $ (7,104 ) $ (10,006 ) $ 2,902 29.0 % 45 -------------------------------------------------------------------------------- Table of Contents Our loss from operations decreased by $2.9 million, or 29.0%, from $10.0 million during the year ended December 31, 2011 to $7.1 million during the year ended December 31, 2012. Our gross profit increased by $20.2 million during the year ended December 31, 2012 due to higher net revenues. This gross profit increase was partially offset by increased sales and marketing costs of $10.8 million to expand our global sales efforts, increased general and administrative costs of $3.6 million primarily related to professional fees associated with being a public company, such as accounting and legal fees and directors and officers insurance, and personnel costs related to the increased global scope and operations of our business. In addition, we had increased research and development personnel costs of $3.0 million from hiring to support our ongoing product development efforts. The increase in operating expenses during the year ended December 31, 2012 was due to the aforementioned headcount increases to support the increase in scope and global reach of our business and additional costs to operate as a public company.

Other Income (Expense), Net Years Ended December 31, Change 2012 2011 Amount % (dollars in thousands) $ (243 ) $ (190 ) $ (53 ) -27.9 % Other income (expense), net, decreased approximately $0.1 million, or 27.9% during the year ended December 31, 2012 as compared to 2011. The change was primarily due to an increase of $0.7 million in foreign currency exchange losses, net, an increase of $0.4 million in interest income and a decrease in convertible preferred stock warrant losses of $0.2 million in the year ended December 31, 2012.

Provision for Income Taxes Years Ended December 31, Change 2012 2011 Amount % (dollars in thousands) Provision for income taxes $ 545 $ 662 $ (117 ) -17.7 % Effective tax rate -7.4 % -6.5 % The provision for income taxes for the year ended December 31, 2012 and 2011 were comprised primarily of foreign income taxes. The decrease in the provision for income taxes in the year ended December 31, 2012 compared with the year ended December 31, 2011 was primarily attributable to a reduction in the valuation allowance against certain U.S. federal deferred income tax assets.

Deferred Revenue As of December 31, Change 2012 2011 Amount % (dollars in thousands) Total deferred revenue $ 46,291 $ 32,925 $ 13,366 40.6 % Deferred revenue increased by $13.4 million, or 40.6%, to $46.3 million as of December 31, 2012 from $32.9 million as of December 31, 2011. The growth in our deferred revenue was primarily attributable to an increase in our installed base of products and licenses worldwide and resulting renewals of maintenance and support agreements, as well as new sales of subscription and maintenance and support agreements.

Number of Customers As of December 31, Change 2012 2011 Amount % Number of customers 2,293 1,740 553 31.8 % Our number of customers increased by 553, or 31.8%, to 2,293 as of December 31, 2012 from 1,740 as of December 31, 2011. Our growth in customer count was driven by increasing market acceptance of our products as well as an increase in our global sales and services and support organizations from 181 people as of December 31, 2011 to 238 as of December 31, 2012. The growth in our sales and service and support organizations was consistent with our plans to continue expanding our global sales and support coverage, in particular our channel partner sales and support teams. The increases in our sales and support organizations allowed us to target new customers while continuing to support existing customers across all of our geographies.

46-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources To date, we have satisfied our capital and liquidity needs through sales of our products and services, our initial public offering of common stock, and private placements of convertible preferred stock. We have incurred significant losses as we continue to expand our business. Our cash flow from operating activities will continue to be affected principally by the extent to which our revenue exceeds or does not exceed any increase in spending on personnel to support the growth of our business. Our largest source of operating cash flow is cash collections from our customers.

Capital Resources As of December 31, 2013, we had $115.1 million of cash, cash equivalents and short-term investments, $2.5 million of which is held outside of the United States and not presently available to fund domestic operations and obligations.

If we were to repatriate cash held outside of the United States, we could be subject to U.S. income taxes on such amounts, less any previously paid foreign income taxes. Our cash, cash equivalents and short-term investments have increased from $17.7 million as of December 31, 2010 to $115.1 million as of December 31, 2013. This increase is primarily the result of our initial public offering of common stock in November 2011 in which we raised $86.2 million, after deducting underwriters' discounts and offering expenses. This amount was partially offset by our losses from operations as we continued to fund our investments in growth, including the development of future products and product enhancements, and expanded into new sales channels and geographies. In addition, during the first quarter of 2014, we increased our use of cash through the acquisitions of SkyFence Networks, Ltd. and certain assets of Tomium Software, LLC which included cash consideration totaling approximately $20.9 million. We believe our existing cash, cash equivalents and short-term investments will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including, among other things, market acceptance of our products, the cost of our research and development activities, the acquisition of other businesses and overall economic conditions.

As of December 31, 2013, we had no amounts outstanding under our credit facility agreement with a financial institution. The credit facility agreement, as amended, provides for borrowing capacity up to $6.0 million and contains a minimum cash and cash equivalents balance covenant of $3.0 million. The credit facility expires on May 1, 2014. As of December 31, 2013, we were compliant with the covenant under the credit facility.

Cash Flows The following summary of our cash flows for the periods indicated has been derived from our consolidated financial statements which are included elsewhere in this Annual Report on Form 10-K: Years ended December 31, 2013 2012 2011 (dollars in thousands Net cash provided by (used in) operating activities $ 9,797 $ 4,467 $ (6,537 ) Net cash provided by (used in) investing activities 1,597 (45,574 ) (1,642 ) Net cash provided by financing activities $ 6,316 $ 4,230 $ 87,856 Cash Flows from Operating Activities We have historically experienced negative cash flow from operations as we have continued to expand our business although we did generate $9.8 million and $4.5 million in cash flow from operations during the years ended December 31, 2013 and 2012, respectively. Our largest uses of cash from operating activities are for employee related expenditures. Our primary source of cash flow from operating activities is cash receipts from customers. Our cash flow from operations will continue to be affected principally by the extent to which we grow our revenues and increase our headcount, primarily in our sales and marketing and research and development functions, in order to grow our business.

Net cash provided by operating activities of $9.8 million for the year ended December 31, 2013 reflected a net loss of $26.3 million, adjusted for non-cash charges of $25.8 million, as well as a net change of $10.4 million in our net operating assets and liabilities. The net change in our operating assets and liabilities was primarily the result of a $16.8 million increase in our deferred revenue, which represents unearned amounts billed to our customers, resulting from our larger installed base combined with strong maintenance and support renewal rates from our existing customers, in addition to an increase of $3.7 million in accrued compensation and benefits. This change was partially offset by an increase in accounts receivable of $8.9 million and a decrease in prepaid expenses and other assets of $1.2 million.

Net cash provided by operating activities of $4.5 million for the year ended December 31, 2012 reflected a net loss of $7.9 million, adjusted for non-cash charges of $8.3 million, as well as a net change of $4.1 million in our net operating assets and 47 -------------------------------------------------------------------------------- Table of Contents liabilities. The net change in our operating assets and liabilities was primarily the result of a $13.4 million increase in our deferred revenue, which represents unearned amounts billed to our customers, resulting from our larger installed base combined with strong maintenance and support renewal rates from our existing customers. This change was partially offset by an increase in accounts receivable of $9.8 million.

Net cash used in operating activities of $6.5 million for the year ended December 31, 2011 reflected a net loss of $10.9 million, partially offset by non-cash charges of $3.5 million, as well as a net change of $0.8 million in our net operating assets and liabilities. The net change in our operating assets and liabilities was the result of an increase in accounts receivable of $12.6 million partially offset by an $11.7 million increase in our deferred revenue, which represents unearned amounts billed to our customers, resulting from our larger installed base combined with strong maintenance and support renewal rates from our existing customers.

Cash Flows from Investing Activities Our investing activities consist primarily of expenditures to purchase property and equipment and purchases and sales of investments. During the year ended December 31, 2013, cash provided by investing activities was $1.6 million, primarily as a result of $42.2 million in proceeds from maturities of short-term investment activities partially offset by $2.6 million in net purchases of property and equipment and $38.0 million in purchases of short-term investments.

During the year ended December 31, 2012, cash used in investing activities was $45.6 million, primarily as a result of $41.9 in net purchases of short-term investments in addition to $3.3 million in net purchases of property and equipment.

During the year ended December 31, 2011, cash used in investing activities was $1.6 million, primarily as a result of $1.5 million in capital expenditures.

Cash Flows from Financing Activities Net cash provided by financing activities was $6.3 million for the year ended December 31, 2013 as a result of proceeds from the issuance of common stock, net of repurchases.

Net cash provided by financing activities was $4.2 million for the year ended December 31, 2012 as a result of proceeds from the issuance of common stock.

Net cash provided by financing activities was $87.9 million for the year ended December 31, 2011 which primarily resulted from the $86.2 million of net proceeds of our November 2011 initial public offering of common stock, after deducting underwriters' discounts and offering expenses, issuance of shares of restricted common stock of $1.0 million, proceeds from the exercise of stock options of $0.7 million and proceeds from the sale of common stock of $0.5 million. These amounts were partially offset by net repayments on our revolving credit facility of $0.5 million.

For a description of our issuance of restricted stock and transactions with Incapsula, see "Certain Relationships and Related Person Transactions." Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in conformity with U.S.

generally accepted accounting principles ("GAAP") and include our accounts and the accounts of our wholly-owned subsidiaries and Incapsula, our majority owned subsidiary. The preparation of our consolidated financial statements requires our management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the applicable periods. Management bases its estimates, assumptions and judgments on historical experience and on various other factors that they believe to be reasonable under the circumstances.

Different assumptions and judgments would change the estimates used in the preparation of our consolidated financial statements, which, in turn, could change the results from those reported. Our management evaluates its estimates, assumptions and judgments on an ongoing basis.

The critical accounting policies requiring estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are described below.

Revenue Recognition Our management must make significant judgments and estimates to determine revenue to be recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management makes different judgments or utilizes different estimates.

We derive revenue from two sources: (i) products and license revenue, which includes hardware and perpetual software license revenue and (ii) services revenue, which includes maintenance, professional services, training and subscription arrangements.

48 -------------------------------------------------------------------------------- Table of Contents Substantially all of product and license sales have been sold in combination with maintenance services. Revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery or performance has occurred; the sales price is fixed or determinable; and collection is reasonably assured.

We define each of the four criteria above as follows: • Persuasive evidence of an arrangement exists. Evidence of an arrangement consists of a purchase order issued pursuant to the terms and conditions of a distributor or value-added reseller agreement and, in limited cases, an end user agreement and/or purchase order.

• Delivery or performance has occurred. We use shipping and related documents, or written evidence of customer acceptance, when applicable, to verify delivery or performance. We recognize product revenue upon transfer of title and risk of loss, which primarily is upon shipment to value-added resellers, distributors or end users. In most instances, we do not have significant obligations for future performance, such as customer acceptance provisions, rights of return or pricing credits, associated with our sales. In instances where final acceptance of the product or service is specified by the customer, revenue is deferred until all acceptance criteria have been met.

• The sales price is fixed or determinable. We assess whether the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment. Standard payment terms to customers range from 30 to 90 days. In the event payment terms are provided that differ from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.

• Collection is reasonably assured. We assess probability of collection on a customer-by-customer basis. Our customers are subjected to a credit review process that evaluates their financial condition and ability to pay for products and services. If we conclude that collection is not reasonably assured based upon an initial review, we do not recognize revenue until payment is received.

Maintenance and subscription revenue includes arrangements for software maintenance and technical support for our products and subscription services revenue primarily related to our cloud-based services. The terms of our subscription service arrangements do not provide customers the right to take possession of the related software. Maintenance is offered under renewable, fee-based contracts, which include technical support, hardware repair and replacement parts, bug fixes, patches and unspecified upgrades on a when-and-if-available basis. Maintenance and subscription revenue is initially deferred and recognized ratably over the life of the contract, with the related expenses recognized as incurred. Maintenance and subscription contracts usually have a term of one to five years. Unearned maintenance and subscription revenue is included in deferred revenue.

Professional service revenue primarily consists of the fees we earn related to installation and consulting services. We recognize revenue from professional services upon delivery or completion of performance. Professional service arrangements are typically short term in nature and are largely completed within 90 days from the start of service.

Training services are recognized upon delivery of the training.

Multiple Element Arrangements In October 2009, the Financial Accounting Standards Board ("FASB") amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product's essential functionality. In addition, the FASB amended the accounting standards for multiple element revenue arrangements not within the scope of industry-specific software revenue recognition guidance to: • Provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated, and how the arrangement consideration should be allocated to the separate elements; • Implement a price hierarchy, where the selling price for an element is based on vendor-specific objective evidence ("VSOE"), if available; third-party evidence ("TPE"), if available and VSOE is not available; or the best estimate of selling price ("BESP"), if neither VSOE nor TPE is available; and • Eliminate the use of the residual method and require an entity to allocate arrangement consideration using the relative selling price method.

This guidance did not change the units of accounting for our revenue transactions. Our non-software products and services qualify as separate units of accounting because they have value to the customer on a stand-alone basis and our revenue arrangements do not include a general right of return for delivered products. Most of our products are hardware appliances containing software components that function together to provide the essential functionality of the product. Therefore, our hardware appliances are considered non-software deliverables and have been removed from the industry-specific software revenue recognition guidance.

49 -------------------------------------------------------------------------------- Table of Contents Our product revenue also includes revenue from the sale of stand-alone software products. Stand-alone software may operate on our hardware appliance, but is not considered essential to the functionality of the hardware and continues to be subject to the industry-specific software revenue recognition guidance, which remains unchanged.

Certain of our stand-alone software when sold with hardware appliances is considered essential to the functionality and as a result is no longer accounted for under industry-specific software revenue recognition guidance; however, this same software when sold separately is accounted for under the industry-specific software revenue recognition guidance. Additionally, we provide unspecified software upgrades for our products, on a when-and-if available basis, through maintenance and support contracts. To the extent that the software being supported is not considered essential to the functionality of the hardware, these support arrangements would continue to be subject to the industry specific software revenue recognition guidance.

For stand-alone software sales after December 31, 2009 and for all transactions entered into prior to January 1, 2010, we recognize revenue based on software revenue recognition guidance. Under the software revenue recognition guidance, we use the residual method to recognize revenue when a product agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. In the majority of our contracts, the only element that remains undelivered at the time of delivery of the product is maintenance and support services. Under the residual method, VSOE of the fair value of the undelivered elements is deferred and the remaining portion of the contract fee is recognized as product revenue. If evidence of VSOE of the fair value of one or more undelivered elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established.

For all other transactions originating or materially modified after December 31, 2009, we recognize revenue in accordance with the amended accounting guidance.

For certain arrangements with multiple deliverables, we allocate the arrangement fee to the non-software element based upon the relative selling price of such element and, if software and software-related (e.g., maintenance and support for the software element) elements are also included in the arrangement, we allocate the arrangement fee to each of those software and software-related elements as a group. After such allocations are made, the amount of the arrangement fee allocated to the software and software-related elements is accounted for using the residual method. When applying the relative selling price method, we determine the selling price for each element using VSOE of selling price, if it exists, or if not, TPE of selling price, if it exists. If neither VSOE nor TPE of selling price exist for an element, we use our BESP for that element. The revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for that element. We limit the amount of revenue recognized for delivered elements to the amount that is not contingent on the future delivery of products or services, or subject to our future performance obligation.

Consistent with our methodology under previous accounting guidance, VSOE of fair value for elements of an arrangement is based upon the normal pricing and discounting practices for those services when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for a service fall within a reasonably narrow pricing range, evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range. In addition, we consider major service groups and geographies in determining VSOE.

We have not been able to determine TPE for our products or services. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from that of our peers and our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained.

Furthermore, we are unable to reliably determine what similar competitor products' selling prices are on a stand-alone basis.

When we are unable to establish the selling price of our non-software deliverables using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP for the purposes of allocating the arrangement by reviewing external and internal market factors including, but not limited to, pricing practices including discounting, the geographies in which we offer our products and services, the type of customer (i.e., distributor, value added reseller or direct end user) and competition. Additionally, we consider historical transactions, including transactions whereby the deliverable was sold on a stand-alone basis. The determination of BESP is made through consultation with and approval by our management. Selling prices are analyzed on a quarterly basis to identify if we have experienced significant changes in our selling prices.

For our non-software deliverables we allocate the arrangement consideration based on the relative selling price of the deliverables. For our hardware appliances we use BESP as the selling price as we have no history of selling our hardware appliances separately. For our maintenance and support and professional services and training, we primarily use VSOE as the selling price and when we are unable to establish selling price using VSOE, we used BESP.

50-------------------------------------------------------------------------------- Table of Contents Stock-Based Compensation We recognize compensation costs related to stock option, employee stock purchase plan, restricted stock unit, or RSU, and shares of restricted stock grants to employees based on the estimated fair value of the awards on the date of grant, net of estimated forfeitures. For stock option and employee stock purchase plan grants, we estimate the grant date fair value, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The fair value of RSUs is determined using the closing price of the Company's stock on the date of grant. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards.

For performance based RSUs granted to Incapsula employees which have multiple performance and a market condition we used a Monte Carlo simulation model to determine fair value of such awards. The key inputs used to determine the fair value of the awards were our stock price on the date of grant, the expected volatility, the risk free interest rate and a revenue forecast. We update the estimated expense, net of forfeitures, at the end of each reporting period.

Based on forecasted 2014 revenue until the actual 2014 revenue performance becomes known, the expense is recognized on an accelerated basis over the requisite service period, generally the vesting period of the respective awards.

The fair value of the option and employee stock purchase plan awards during 2013, 2012 and 2011 were calculated using the Black-Scholes option pricing model with the following weighted-average assumptions: Years ended December 31, 2013 2012 2011 Option grants: Expected dividend rate 0 % 0 % 0 % Risk-free interest rate 1.2 % 1.0 % 1.7 % Expected term (in years) 6.1 6.0 5.4 Expected volatility 46 % 48 % 49 % ESPP grants: Dividend rate 0 % 0 % - Risk-free interest rate 0.1 % 0.1 % - Expected term (in years) 0.5 0.5 - Expected volatility 27 % 39 % - The Black-Scholes options pricing model requires the use of highly subjective and complex assumptions which determine the fair value of share-based awards, including the grant's expected term and the price volatility of the underlying stock. These assumptions include: Expected Term. The expected term represents the period over which the stock-based awards are expected to be outstanding. For option grants that are considered to be "plain vanilla," we used the simplified method to determine the expected term as set forth in the guidance provided by the U.S. Securities and Exchange Commission. The simplified method calculates the expected term as the average of the time-to-vesting and the contractual life of the options. For option grants that are not considered "plain vanilla," the expected term is based on historical option exercise behavior and post-vesting cancellations of options by employees. For ESPP grants, the expected term is based on the length of the offering period, which is six months.

Risk-Free Interest Rate. The risk-free interest rate is based on the U.S.

Treasury yield in effect at the time of grant for zero coupon U.S. Treasury notes with maturities approximately equal to each award's expected term.

Expected Volatility. Since we do not have a sufficient trading history of our common stock, the expected volatility was derived from the average historic volatilities of several unrelated public companies within our industry that we considered to be comparable to our business over a period equivalent to the expected term of the stock option grants and the offering period for ESPP grants.

Expected Dividend. The expected dividend was assumed to be zero as we have never paid dividends and have no current plans to do so.

In addition to assumptions used in the Black-Scholes option pricing model, we must also estimate a forfeiture rate to calculate the stock-based compensation for expense related to our awards. Our forfeiture rate is based on an analysis of our actual forfeitures. We will continue to evaluate the appropriateness of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover and other factors. Quarterly changes in the estimated forfeiture rate can have a significant impact on our stock-based compensation expense as the cumulative effect of adjusting the rate is recognized in the period the forfeiture estimate is changed. If a revised forfeiture rate is higher than the previously estimated forfeiture rate, an adjustment is made that will result in a decrease to the stock-based compensation expense recognized in the financial statements. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, an adjustment is made that will result in an increase to the stock-based compensation expense recognized in the financial statements.

51-------------------------------------------------------------------------------- Table of Contents We will continue to use judgment in evaluating the expected term, expected volatility and forfeiture rate related to our own stock-based compensation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may have refinements to the estimates of our expected volatility, expected terms and forfeiture rates, which could materially impact our future stock-based compensation expense.

Long-Lived Assets Property and equipment are stated at cost less accumulated depreciation on our consolidated balance sheets. Depreciation on property and equipment is calculated using the straight-line method over the estimated useful lives of the assets. We make estimates of the useful life of our property and equipment in order to determine depreciation expense to be recorded each reporting period based on similar assets purchased in the past and our historical experience with such similar assets, or asset group, as well as anticipated technological or market changes. The estimated useful life of our property and equipment directly impacts the timing of when our depreciation expense is recognized. There is significant judgment involved with estimating the useful lives of our property and equipment, and a change in the estimates of such useful lives could cause our depreciation expense in future periods to increase significantly.

We assess impairment of our property and equipment whenever events or changes in circumstances indicate that the carrying amount of the asset is impaired or the estimated useful lives are no longer appropriate. Circumstances such as changes in technology or in the way an asset is being used may trigger an impairment review. If indicators of impairment exist and the undiscounted projected cash flow associated with such assets are less than the carrying amount of the asset, an impairment loss is recorded to write the asset down to their estimated fair values. Fair value is estimated based on discounted future cash flow. We have not recognized an impairment charge on our property and equipment in our consolidated statement of operations during 2013, 2012 and 2011.

Income Taxes We make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, tax benefits and deductions and in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. Significant changes to these estimates may result in an increase or decrease to our tax provision in the subsequent period when such a change in estimate occurs.

We use the liability method for accounting of deferred income taxes, which requires recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income.

Estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred income tax assets, which arise from temporary differences and carry-forwards. Deferred income tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We regularly assess the likelihood that our deferred income tax assets will be realized. To the extent that we believe any amounts are not more likely than not to be realized, we record a valuation allowance to reduce our deferred income tax assets. In the event we determine that all or part of the net deferred tax assets are not realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if we subsequently realize deferred income tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in an adjustment to earnings in the period such determination is made.

In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize and measure potential liabilities based upon a more likely than not criteria. Based upon these criteria, we estimate whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities may result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If our estimate of tax liabilities is less than the amount ultimately assessed, a further charge to expense would result.

Significant judgment is required in determining any valuation allowance recorded against deferred income tax assets. In assessing the need for a valuation allowance, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred income tax assets that could be realized, we will adjust our valuation allowance with a corresponding effect to the provision for income taxes in the period in which such determination is made.

Significant judgment is also required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe our reserves for uncertain tax positions are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different from the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the effect of reserves for uncertain tax positions and any changes to the reserves that are considered appropriate, as well as the related net interest and penalties, if applicable.

52 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following summarizes our contractual obligations as of December 31, 2013: Contractual Obligations: 2014 2015 2016 2017 2018 Total (in thousands) Operating lease obligations 1 $ 4,693 $ 2,338 $ 2,390 $ 1,917 $ 272 $ 11,610 Severance Pay Fund 2 - - - - - 4,385 Purchase commitments 3 3,179 - - - - 3,179 $ 7,872 $ 2,338 $ 2,390 $ 1,917 $ 272 $ 19,174 1 Operating lease agreements represent our obligations to make payments under our non-cancelable lease agreements for our facilities. During the year ended December 31, 2013, we made regular lease payments of $3.0 million under the operating lease agreements.

2 Our consolidated balance sheet as of December 31, 2013 includes $4.4 million of non-current liabilities for our Israeli severance pay fund. The specific timing of any cash payments relating to this obligation cannot be projected with reasonable certainty and, therefore, no amounts for this obligation are included in the annual columns of the table set forth above.

3 Purchase commitments are contractual obligations to purchase hardware appliances and related component parts from our vendors in advance of anticipated sales.

Off-Balance Sheet Arrangements Through December 31, 2013, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Recent Accounting Pronouncements From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board ("FASB") or other standard setting bodies that are adopted by us as of the specified effective date. Unless otherwise discussed, we believe that the impact of recently issued standards that are not yet effective will not have a material impact on our financial position or results of operations upon adoption.

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