The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. As discussed in the section titled "Forward Looking Statements," the following discussion and analysis 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. Factors that could cause or contribute to these differences include, but are not limited to, those identified below and those discussed in the section titled "Risk Factors" in Part I, Item 1A of this Annual Report on Form 10-K.
A discussion regarding our financial condition and results of operations for 2020 compared to 2019 and for 2019 compared to 2018 is presented below.
Overview Datto is the leading provider of cloud-based software and technology solutions purpose-built for delivery through the managed service provider, or MSP, channel to small and medium businesses, or SMBs. We enable our more than 17,000 MSP partners to manage and grow their businesses serving the SMB information technology, or SMB IT, market. Our platform combines mission-critical cloud-based software, technologies and security solutions that MSPs sell to SMBs, business management software to help MSPs scale their own businesses, and marketing tools, content, training and industry-leading events that cultivate an empowered and highly engaged MSP partner community. MSPs represent the future of IT management for SMBs. Digital transformation is driving SMB adoption of modern software and technology, while regulatory and data protection requirements and proliferating security threats are increasing the complexity and risk of IT for SMBs. These trends have created an inflection point in SMB outsourcing to MSPs for IT management. MSPs are equipped with the IT resources and expertise SMBs lack, providing a single source to meet all of an SMB's IT needs. MSPs are trusted to select, procure, implement and manage software and technology stacks that support their SMB customers' business needs. The number of MSPs continues to grow, with approximately 125,000 MSPs providing this critical function to millions of SMBs worldwide today. We are committed to the success of MSPs. It is the foundation of our strategy and culture. We empower our MSP partner channel, creating enormous sales and support leverage for us to efficiently address the large, but fragmented, SMB IT market. Our MSP-centric platform enables our partners to generate recurring revenue through the sale of our solutions to SMBs and to scale and effectively manage their own businesses. Our relationships are directly with our MSP partners. We are the leading pure-play vendor serving the MSP market, and believe our MSP-centric approach is highly differentiating as it aligns our mutual incentives, creates a motivated and engaged sales channel and reinforces our position as an integral component of our MSP partners' businesses. Our cloud-based platform provides Unified Continuity, Networking and Business Management software solutions. Our Unified Continuity offerings ensure the ongoing availability and security of mission-critical IT systems for SMBs on-premise, in private clouds and in the public cloud. Datto's business continuity and disaster recovery, or BCDR, software, enables rapid restoration of an SMB's full IT environment. Datto's SaaS Protection is a reliable, automated and secure backup and restoration product for data stored on cloud applications such as Microsoft 365 and Google Workspace. Datto Networking constitutes a suite of MSP-centric networking solutions sold through our MSP partners to easily deliver networking as a managed service. These solutions are simple for MSPs to deploy, configure and manage across their SMB customers through a single portal. Our Business Management software provides critical operational tools to MSPs for efficient workflow management and delivery of end-to-end managed services. Our platform also includes a host of business development tools, training and content to help MSPs address the challenges of marketing and selling to SMB customers. Datto was founded in 2007. From the very start, we have been creators of technology solutions for SMBs, typically only available to enterprises at the time, and recognized the power of the MSP channel. We have designed our strategy, culture and technology solutions to drive the success of our MSP partners. We have developed our platform and expanded our solutions to meet the evolving needs of MSPs, and we continually invest in cultivating the MSP community. Our Business Model We are committed to the success of MSPs. It is the foundation of our strategy and culture. Our cloud-based solutions are purpose-built to address the needs of MSPs and to enable the end-to-end delivery of managed services to their SMB customers. We believe our MSP-centric approach is highly differentiating because it aligns our mutual incentives, creates a motivated and engaged sales channel and ensures we become an integral component of our MSP partners' businesses. We empower our MSP partner channel, creating 60 -------------------------------------------------------------------------------- Table o f Contents enormous sales and support leverage for us to efficiently address the large, but fragmented, SMB IT market. We do not market or sell to SMBs directly to avoid competing with our MSP partners, and instead, invest in helping MSPs thrive. We generate substantially all our revenue from the sale of subscriptions to our cloud-based solutions and recognize revenue ratably over the subscription term. These contracts typically begin with a 1-year or 3-year term and auto-renew on a monthly or annual basis thereafter. For certain offerings, we enable our ongoing subscription services with an up-front sale of equipment or professional services that we recognize at the time of delivery and performance. The majority of our partners pay on a monthly basis, regardless of term length, with some opting to make quarterly, annual or multi-year prepayments. Unified Continuity subscriptions are priced based on service tier, which is determined by data storage capacity and data retention period for our BCDR products, or by number of Microsoft 365 or Google Workspace employee accounts at the SMB domains that our MSP partners protect and data retention period for SaaS Protection offerings. Networking subscriptions are priced based on the volume and type of networking devices ordered. Business Management subscriptions are priced based on the number of employees at an MSP that are able to utilize our PSA product, or per endpoint device at the SMB for our RMM software. All of our contracts give us the right to increase prices at our discretion, although we have exercised this right infrequently. We employ a highly efficient land-and-expand sales strategy facilitated by offering products that are reliable, easy to adopt and that drive recurring revenue growth and margin efficiency for our MSP partners. We sell our solutions to MSPs primarily through our sales team, leveraging the reach of our MSP partners and providing them with self-service options to upgrade service tiers, add volume and purchase additional solutions. Our MSP partners often significantly increase usage from their initial purchase and expand their usage to other products on our platform. We also provide access to business development tools and content to help MSPs address the challenges of marketing and selling to SMB customers. We grow alongside our MSP partners as they deploy our solutions across their existing SMB customers, add new customers and upgrade service tiers. As ofDecember 31, 2020 , our ARR was$542.8 million and our revenue for the year endedDecember 31, 2020 was$518.8 million , of which approximately 94% was recurring subscription revenue. For the year endedDecember 31, 2020 , our net income was$22.5 million and our Adjusted EBITDA was$150.5 million . As ofDecember 31, 2019 , our ARR was$474.8 million and our revenue for the year endedDecember 31, 2019 , was$458.8 million , of which approximately 90% was recurring subscription revenue. For the year endedDecember 31, 2019 , our net loss was$31.2 million and our Adjusted EBITDA was$84.6 million . Refer to our discussion of ARR in Key Performance Metrics and Adjusted EBITDA in Non-GAAP Financial Measures. Impact of COVID-19 While we have not incurred significant disruptions thus far from the COVID-19 pandemic, we are unable to accurately predict the extent of the impact on our business because of numerous uncertainties, including but not limited to, the severity of the disease, the duration of the outbreak, the reoccurrence or emergence of variants of the virus, the effectiveness and speed of vaccinations, actions taken by government authorities, the impact on our customers and suppliers, and other factors. Specifically, we may experience impacts from customers deferring purchasing and activation decisions, reducing expenses and requesting extended payment terms or relief from payments. The effect of the COVID-19 pandemic will not be fully reflected in our results of operations and overall financial performance until future periods. In addition, our consolidated financial statements reflect estimates and assumptions made by management that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates and assumptions reflected in our consolidated financial statements include, but are not limited to, establishing allowances for doubtful accounts, assessing the recoverability of prepaid assets, including trade shows and other marketing events impacted by the pandemic, determining useful lives for finite-lived assets, assessing the recoverability of long-lived assets, determining the fair value of assets acquired and liabilities assumed in business combinations, accounting for income taxes and related valuation allowances against deferred tax assets, valuing stock-based awards, recognizing revenue and the estimate for sales returns and upgrades, determining the amortization period for capitalized commissions and assessing the accounting treatment for commitments and contingencies. Management evaluates these estimates and assumptions on an ongoing basis and makes estimates based on historical experience and various other considerations that are believed to be reasonable. Actual results may differ from those estimates, including as a result of the COVID-19 pandemic. We will continue to evaluate the nature and extent of the impact of the pandemic on our business and our consolidated results of operations and financial condition. Key Factors Affecting Our Performance Addition of New MSPs Our ability to attract new partners will depend on a number of factors, including the effectiveness of our pricing and products, offerings of our competitors, the effectiveness of our marketing efforts, and the growth of the MSP market. We believe there is 61 -------------------------------------------------------------------------------- Table o f Contents substantial opportunity to increase our penetration among MSPs. We intend to drive new partner acquisition by continuing to invest significantly in sales and marketing to identify and engage prospective partners and to extend the awareness of our brand as a trusted partner to the MSP community. We believe our singular dedication to the MSP channel and our solutions that are purpose-built to meet the needs of MSPs differentiates us in the marketplace. We intend to continue to grow the number of sales representatives to qualify and close new partner opportunities. In addition, we intend to continue investing in marketing programs, events and content to drive brand awareness, generate leads and cultivate the broader MSP ecosystem. As ofDecember 31, 2020 , we had approximately 17,000 MSP partners, a net increase of approximately 400 sinceDecember 31, 2019 and 2,600 sinceDecember 31, 2018 . During the fourth quarter of 2020, the number of MSP partners declined, reflecting the churn of certain smaller MSPs resulting in part from the ongoing impacts of the COVID-19 pandemic and related payment issues. Sales Expansion Within Our Existing Partner Base Our ability to expand sales within our existing partner base will depend on a number of factors, including their satisfaction with our solutions and support, competition, the effectiveness of the business development tools we provide to our partners and the ability of our partners to grow their sales. Our large base of partners represents a significant opportunity for further sales expansion. Once an MSP has become our partner, we aim to grow alongside them as they increase penetration of our solutions across their existing SMB partner base, attract additional SMB customers, upgrade service tiers and adopt additional Datto solutions. We have a strong track record of growth from our existing base as evidenced by our history of partner cohort expansion and our dollar-based net retention rate, which was 111% and 119% as ofDecember 31, 2020 and 2019, respectively. We intend to continue to invest in MSP self-service procurement tools to further enable a frictionless purchasing process, grow the number of sales representatives to facilitate increased partner adoption of our solutions and invest in enabling our partners' sales teams through our marketing automation platform, programs, content, training and certifications for MSPs. As ofDecember 31, 2020 , over 1,100 of our MSP partners contributed ARR of$100,000 or more, up from 950 as ofDecember 31, 2019 and 700 as ofDecember 31, 2018 . Innovation and Introduction of New Platform Solutions Our continued growth is dependent upon our ability to sustain innovation in order to maintain a competitive advantage. We recognize that the pace of technological innovation is accelerating and that we need to continue to innovate to maintain our product differentiation. We continually invest in improving our existing solutions and creating new mission-critical solutions to anticipate the evolving IT demands of MSPs and their SMB customers. In addition, we intend to evaluate strategic investments in businesses and technologies to drive product and market expansion. For example, inJuly 2020 we acquired Gluh Pty. Ltd., anAustralia -based company which offers a real-time quoting platform that enables MSPs to simplify the procurement of IT products and services for their end customers. Expansion of Our International Footprint Our international growth in any region will depend on our ability to effectively implement our business processes and go-to-market strategy, our ability to adapt to market or cultural differences, the competitive landscape, the maturity and growth trajectory of the MSP market and our brand awareness and perception. We believe there is significant opportunity to expand internationally. For both 2020 and 2019, our international revenue was approximately 27% of our total revenue. We intend to continue to make significant investments in international markets, particularly in EMEA and APAC. This may include investing in additional sales and marketing personnel, localizing product offerings and marketing content, and adding new data-center or office locations. Although these investments may adversely affect our operating results in the near term, we believe they will contribute to our long-term growth. Key Performance Metrics In addition to our GAAP financial information, we review a number of operating and financial metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans and make strategic decisions.MSP Partners The number of MSP partners represents the number of MSPs with active subscriptions as of the end of the period. We use this number to assess our ability to attract and retain MSP partners and thereby grow our business. As ofDecember 31, 2020 , we had over 17,000 MSP partners, a net increase of approximately 400 sinceDecember 31, 2019 and 2,600 sinceDecember 31, 2018 . Net changes in the number of our MSP partners are a result of the total new partners added during a period, largely based on our sales and marketing efforts, and the churn or reduction of existing partners during the period, which can be affected by the broader economic environment and factors such as the effects of COVID-19 on our partners' SMB end customers. As a result of our land-and-expand model, our revenue growth is driven principally by additional revenue from existing MSP partners. We view new MSP partner additions as a leading indicator of the health of the business, but the additions do not immediately drive material revenue growth in our reported results of 62 -------------------------------------------------------------------------------- Table o f Contents operations. During the fourth quarter of 2020, the number of MSP partners declined, reflecting the churn of certain smaller MSPs resulting in part from the ongoing impacts of the COVID-19 pandemic and related payment issues. Annual Run-Rate Revenue We define annual run-rate revenue, or ARR, as the annualized value of all subscription agreements as of the end of a period. We calculate ARR by multiplying the monthly run-rate revenue for the last month of a period by 12. Monthly run-rate revenue is calculated by aggregating monthly subscription values during the final month of the reporting period from both long-term and month-to-month subscriptions. ARR only includes the annualized value of subscription contracts and excludes any one-time revenue for devices or professional services. ARR mitigates fluctuations resulting from seasonality and contract term. ARR does not have any standardized meaning and is therefore unlikely to be comparable to similarly titled measures presented by other companies. ARR should be viewed independently of revenue and deferred revenue and is not intended to be combined with or to replace either of those items. ARR is not a forecast and the active contracts at the date used in calculating ARR may or may not be extended or renewed by our MSP partners. The table below sets forth our ARR as ofDecember 31, 2020 , 2019 and 2018: As of December 31, (in millions) 2020 2019 2018 ARR$ 542.8 $ 474.8 $ 379.2 ARR includes run-rate revenue values from month-to-month subscription contracts. For the year endedDecember 31, 2020 , approximately 39% of our total revenue and 42% of our subscription revenue was derived from month-to-month contracts. For the year endedDecember 31, 2019 , approximately 31% of our total revenue and 35% of our subscription revenue was derived from month-to-month contracts. The increase in percent of total revenue and subscription revenue from month-to-month contracts primarily resulted from adding fewer long-term contracts during the COVID-19 pandemic compared to the prior year period, while other existing contracts completed their initial term and rolled to month-to-month contracts thereafter. Our dollar-based gross retention rate as of bothDecember 31, 2020 and 2019, was approximately 88%. Our dollar-based gross retention rate reflects ARR losses from subscription cancellations, reductions in service levels or seat counts and non-renewals, and does not reflect any ARR expansion. We calculate our dollar-based gross retention rate as of the period end by starting with the ARR from the last day of the period one year prior, or Prior Period ARR. We then deduct from the Prior Period ARR any (i) ARR attrition from MSP partners who are no longer partners as of the last day of the period, and (ii) ARR compression from MSP partners whose subscriptions are at a lower value as of the last day of the period, or Remaining ARR. We then divide the Remaining ARR by the Prior Period ARR to arrive at our dollar-based gross retention rate, which is the percentage of ARR from all MSP partners as of the year prior that is not lost to partner churn or subscription compression. Given the meaningful percentage of our subscription revenue derived from month-to-month contracts, the approximately 88% dollar-based gross retention rate demonstrates that a large majority of our MSP partners continue to renew their subscription contracts, whether on a month-to-month or longer term basis. Based on our experience, we do not believe month-to-month contracts experience significantly higher attrition than longer-term subscription contracts. Dollar-Based Net Retention Rate To evaluate the efficacy of our land-and-expand business model, we examine the rate at which our partners increase their subscriptions for our solutions which result in changes to ARR. Our dollar-based net retention rate measures our ability to increase ARR across our existing partner base through expanded use of our platform, offset by MSP partners whose subscription contracts with us are not renewed or are renewed at a lower amount. We calculate our dollar-based net retention rate as of the end of a reporting period as a quotient of the following: •Denominator: ARR as of the last day of the prior year comparative reporting period. •Numerator: ARR as of the last day of the current reporting period from partners with associated ARR as of the last day of the prior year comparative reporting period. The quotient obtained from this calculation is our dollar-based net retention rate. We believe our ability to grow alongside our MSP partners as they deploy our solutions to more SMBs, and to cross-sell additional solutions, will continue to support our high dollar-based net retention rate. As ofDecember 31, 2020 and 2019, our dollar-based net retention rate was 111% and 119%, respectively. Because existing MSP partners drive the vast majority of our revenue growth in any given year, we believe our revenue growth is strongly correlated to our dollar-based net retention rate. 63
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Components of Results of Operations
Revenue
We generate revenue primarily from fees received for subscriptions to our products and services, and also from the sale of BCDR and Networking devices and professional services associated with our Business Management offerings.
Subscription. We derive revenue primarily from cloud-based software and technology solutions sold on a recurring subscription basis. Subscription revenue is recognized ratably over the subscription term after all revenue recognition criteria have been met. We generally invoice subscription agreements monthly in advance over the subscription period or monthly in arrears based on usage. Subscription revenue for our Unified Continuity and Networking solutions grows as the end-customers, managed by our MSP partners, add new subscription products, upgrade the service tier of their existing subscription products or increase the usage of their subscription products. Revenue from our Business Management solutions increases with the addition of employees of our MSP partners who require seat licenses, the proliferation of end-user devices managed by those MSPs and the expansion of products used by those MSPs to manage their SMB customers' IT infrastructures. Device. Our device revenue is derived from the sale of devices in conjunction with subscription solutions. Device revenue includes the sale of BCDR and Networking devices which enable us to deliver our BCDR and Networking services to our MSP partners under a recurring subscription model. Revenue from devices in our Unified Continuity solution primarily consists of the sale of our proprietary data storage devices. Revenue from devices in our Networking solution primarily consists of the sale of wireless access points, switches, edge routers and managed power. We recognize revenue at a point in time when control of the device has transferred to the MSP. Revenue from devices does not contribute significantly to overall revenue related to our Unified Continuity solutions. Professional services and other. We derive revenue from professional services associated with our Business Management offerings. These implementation and consulting services include configuration, database merging and data migration. Our professional services are generally priced on a time and materials basis and invoiced monthly with revenue recognized as the services are performed and we frequently discount our services to drive adoption of our business management offerings. Cost of revenue Subscription. Subscription cost of revenue consists of costs directly related to our subscription services, including personnel costs related to operating our data centers and customer support operations, hosting and data center related costs, third-party software licenses and allocated facilities and overhead costs associated with delivering these services. Device. Device cost of revenue consists of hardware, manufacturing, shipping and logistics, personnel costs and allocated facilities and overhead costs associated with delivering our devices. Our Unified Continuity products rely on a mix of off-the-shelf hardware and custom designed hardware. Our Networking devices generally consist of off-the-shelf hardware, although some of our devices feature a unique industrial design. Professional services and other. Professional services and other cost of revenue consists primarily of personnel costs and allocated facilities and overhead associated with delivering implementation and consulting services. Our professional services implementations aim to ensure higher software utilization, greater upsell opportunity and lower churn over time. Depreciation and amortization. Depreciation and amortization cost of revenue consists of depreciation of our Datto Cloud infrastructure and amortization of our acquired technology intangible assets. Gross profit and gross margin Gross profit, or revenue less cost of revenue, has been, and will continue to be, affected by various factors, including revenue fluctuations, the mix of revenue and the timing and amount of investments to expand our Datto Cloud infrastructure. Operating expenses Our operating expenses consist of sales and marketing, research and development and general and administrative expenses as well as depreciation and amortization of internally developed software, and amortization of acquired intangible assets. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, sales commissions, payroll taxes and stock-based compensation expense. Other significant components of operating expenses include events and travel, professional fees, allocated facilities and overhead costs, general marketing and promotion costs, payment processing fees and bad debt expense. 64 -------------------------------------------------------------------------------- Table o f Contents Sales and marketing Sales and marketing expenses consist primarily of personnel costs, costs for events and travel, costs of marketing and promotional activities, payment processing fees and allocated facilities and overhead costs. Sales and marketing expenses may fluctuate as a percentage of our revenue from period to period because of the timing and extent of marketing activities, trade shows, and events including DattoCon and DattoCon EMEA, as well as the timing of amortization of sales commissions and stock-based compensation expense. Research and development Research and development expenses consist primarily of personnel costs, third-party professional fees and allocated facilities and overhead costs. Research and development expense may fluctuate as a percentage of our revenue from period to period because of the timing and extent of our investments in research and development activities, as well as the timing of stock-based compensation expense. General and administrative General and administrative expenses consist primarily of personnel costs across the corporate functions of executive, finance, human resources, information technology, internal operations and legal, as well as third-party professional fees, bad debt expense, travel and allocated costs for facilities. Following the completion of our IPO we began incurring additional general and administrative expenses as a result of operating as a public company, including increased expenses for insurance, costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of theSEC , investor relations and professional services expenses, and increased stock-based compensation expense. Depreciation and amortization Depreciation and amortization expenses in operating expenses consist of amortization of tradenames and partner relationship intangibles as well as depreciation of other property and equipment such as leasehold improvements, furniture and fixtures, and computer equipment as well as amortization of internally developed software. Other expense Interest expense Interest expense consists primarily of interest payments on outstanding borrowings under our credit facilities. In conjunction with our IPO, we repaid all amounts outstanding under our 2019 Credit Agreement. We also entered into the 2020 Credit Agreement, which provides a$200.0 million revolving credit facility. No amounts were drawn under the 2020 Credit Agreement. See "Liquidity and Capital Resources-Credit Facilities" for additional details. Other (income) expense Other (income) expense primarily consists of the net exchange (gains) or losses on foreign currency transactions and (gains) or losses on the disposal of assets. Loss on extinguishment of debt Loss on extinguishment of debt reflects the loss incurred in conjunction with the termination of our credit facilities in both 2020 and 2019. See "Liquidity and Capital Resources-Credit Facilities" for additional details. (Benefit from) provision for income tax (Benefit from) provision for income tax consists primarily of income taxes related toU.S. federal and state income taxes and income taxes in foreign jurisdictions in which we conduct business. Stock-Based Compensation Stock-based compensation expense is recorded based upon the functional role of the holder. Stock-based compensation expense for awards which contained only a time-based vesting condition was recorded in all periods presented. However, stock-based compensation expense for awards which contained both a time-based and a performance-based vesting condition, which was the closing of an IPO, commenced during the fourth quarter of 2020 as a result of our IPO. 65
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Results of Operations The following table sets forth our consolidated statements of operations data for the period indicated: Year Ended December 31, 2020 2019 2018 (in thousands) Revenue: Subscription$ 485,326 $ 412,167 $ 333,397 Device 30,202 44,052 50,514 Professional services and other 3,257 2,533 3,444 Total revenue 518,785 458,752 387,355 Cost of revenue: Subscription(1) 84,463 82,066 72,498 Device(1) 37,607 53,933 50,813 Professional services and other(1) 6,244 5,563
3,637
Depreciation and amortization 21,890 15,745 12,923 Total cost of revenue 150,204 157,307 139,871 Gross profit 368,581 301,445 247,484 Operating expenses: Sales and marketing(1) 115,790 110,441 98,183 Research and development(1) 78,932 60,459 54,017 General and administrative(1) 85,668 73,903
57,913
Depreciation and amortization 27,223 27,417 28,953 Total operating expenses 307,613 272,220 239,066 Income from operations 60,968 29,225 8,418 Other expense: Interest expense 25,348 43,437 55,380 Loss on extinguishment of debt 8,488 19,231 - Other (income) expense, net (3,428) 256 802 Total other expense 30,408 62,924 56,182 Income (loss) before income taxes 30,560 (33,699)
(47,764)
(Provision for) benefit from income tax (8,062) 2,511 10,041 Net income (loss)$ 22,498 $ (31,188) $ (37,723)
(1)Includes stock-based compensation expense as follows:
Year Ended December 31, 2020 2019 2018 (in thousands) Cost of revenue-subscription$ 4,092 $ 98 $ 140 Cost of revenue-device 203 - - Cost of revenue-professional services and other 418 - - Selling and marketing 6,614 2,946 764 Research and development 13,590 3,510 1,020 General and administrative 8,543 5,661 2,211 Total stock-based compensation expense$ 33,460 $ 12,215 $ 4,135 66
-------------------------------------------------------------------------------- Table o f Contents The following table sets forth our consolidated statements of operations data expressed as a percentage of total revenue for the period indicated: Year Ended December 31, 2020 2019 2018 Revenue: Subscription 93.6 % 89.8 % 86.1 % Device 5.8 % 9.6 % 13.0 % Professional services and other 0.6 % 0.6 % 0.9 % Total revenue 100.0 % 100.0 % 100.0 % Cost of revenue: Subscription 16.3 % 17.9 % 18.7 % Device 7.2 % 11.8 % 13.1 % Professional services and other 1.2 % 1.2 % 0.9 % Depreciation and amortization 4.2 % 3.4 % 3.3 % Total cost of revenue 29.0 % 34.3 % 36.1 % Gross profit 71.0 % 65.7 % 63.9 % Operating expenses: Sales and marketing 22.3 % 24.1 % 25.3 % Research and development 15.2 % 13.2 % 13.9 % General and administrative 16.5 % 16.1 % 15.0 % Depreciation and amortization 5.2 % 5.9 % 7.5 % Total operating expenses 59.3 % 59.3 % 61.7 % Income from operations 11.8 % 6.4 % 2.2 % Other expense: Interest expense 4.9 % 9.4 % 14.3 % Loss on extinguishment of debt 1.6 % 4.2 % - % Other (income) expense, net (0.7) % 0.1 % 0.2 % Total other expense 5.9 % 13.7 % 14.5 % Income (loss) before income taxes 5.9 % (7.3) % (12.3) % (Provision for) benefit from income tax (1.6) % 0.5 % 2.6 % Net income (loss) 4.3 % (6.8) % (9.7) % Comparison of the Years Ended December 31, 2020 and 2019 Revenue Year Ended December 31, 2020 2019 $ Change % Change (in thousands) Revenue: Subscription$ 485,326 $ 412,167 $ 73,159 17.7 % Device 30,202 44,052 (13,850) (31.4) % Professional services and other 3,257 2,533 724 28.6 % Total revenue$ 518,785 $ 458,752 $ 60,033 13.1 % Subscription Subscription revenue increased$73.2 million , or 17.7%, for 2020 compared to 2019. The increase in subscription revenue was driven by increased sales across all of our Unified Continuity, Business Management and Networking cloud-based offerings. Recurring subscription revenue accounted for 94% of total revenue for 2020 compared to 90% for 2019. Device Device revenue decreased$13.9 million , or 31.4%, for 2020 compared to 2019. This decrease was primarily attributable to a lower volume of devices sold, partly as a result of the impact of the COVID-19 pandemic, which resulted in a lower volume of new subscriptions and thus a lower volume of BCDR and networking devices, as well as an impact of approximately$1.8 million from our shift in early 2019 from selling a broader range of networking devices on a one-time basis to packaging networking devices with cloud-based management software and services with lower upfront costs and a recurring subscription. 67 -------------------------------------------------------------------------------- Table o f Contents Professional services and other Professional services and other revenue increased$0.7 million , or 28.6%, for 2020 compared to 2019, primarily as a result of additional implementations of our cloud-based Business Management offerings. Cost of Revenue Year Ended December 31, 2020 2019 $ Change % Change (in thousands) Cost of revenue: Subscription$ 84,463 $ 82,066 $ 2,397 2.9 % Device 37,607 53,933 (16,326) (30.3) % Professional services and other 6,244 5,563 681 12.2 % Depreciation and amortization 21,890 15,745 6,145 39.0 % Total cost of revenue$ 150,204 $ 157,307 $ (7,103) (4.5) % Subscription Subscription cost of revenue increased$2.4 million , or 2.9%, for 2020 compared to 2019. The increase was primarily driven by additional costs to support the growth of our subscription offerings, including increased personnel costs, including significantly higher stock-based compensation expense as a result of our IPO, partially offset by increased efficiencies in the costs to provide our Unified Continuity solutions. Restructuring costs of$0.5 million related to our reduction in workforce were recorded in 2020. Subscription cost of revenue reflects stock-based compensation expense of$4.1 million and$0.1 million for 2020 and 2019, respectively. Device Device cost of revenue decreased$16.3 million , or 30.3% for 2020 compared to 2019, primarily driven by the lower volume of devices sold in 2020, partly as a result of the impact of the COVID-19 pandemic, which resulted in a lower volume of new subscriptions and thus a lower volume of BCDR and networking devices. In addition, the decrease was driven by greater inventory write offs in 2019 and the impact of approximately$1.1 million from our shift in early 2019 from selling a broader range of networking devices on a one-time basis to packaging networking devices with cloud-based management software and services with lower upfront costs and a recurring subscription. Device cost of revenue reflects stock-based compensation expense of$0.2 million during 2020. There was no stock-based compensation expense recorded in 2019.
Professional services and other
Professional services and other cost of revenue increased$0.7 million , or 12.2% for 2020 compared to 2019, driven by growth in employee and related costs in our professional services organization, including stock-based compensation expense as a result of our IPO. Restructuring costs of$0.1 million related to our reduction in workforce were recorded in 2020. Professional services and other cost of revenue reflects stock-based compensation expense of$0.4 million during 2020. There was no stock-based compensation expense recorded in 2019.
Depreciation and amortization
Depreciation and amortization related to cost of revenue increased$6.1 million for 2020 compared to 2019. The increase was attributable primarily to higher depreciation expense in 2020 associated with the continued capital expenditures for our Datto Cloud infrastructure to support the growth in subscriptions. Depreciation expense was$16.9 million and$11.0 million in 2020 and 2019, respectively, and amortization of intangible assets was$5.0 million and$4.7 million in 2020 and 2019, respectively. 68 --------------------------------------------------------------------------------
Table o f Contents Gross Profit and Gross Margin Year Ended December 31, 2020 2019 $ Change % Change (in thousands) Gross profit: Subscription$ 400,863 $ 330,101 $ 70,762 21.4 % Device (7,405) (9,881) 2,476 (25.1) % Professional services and other (2,987) (3,030) 43 (1.4) % Depreciation and amortization (21,890) (15,745) (6,145) 39.0 % Total gross profit$ 368,581 $ 301,445 $ 67,136 22.3 % Gross margin: Subscription 82.6 % 80.1 % Device (24.5) % (22.4) % Professional services and other (91.7) % (119.6) % Total gross margin 71.0 % 65.7 % Our gross profit increased$67.1 million , or 22.3%, and our gross margin increased by 534 basis points for 2020 as compared to 2019, driven by growth in subscription revenue and to a lesser extent by the reduction in device cost of revenue, partially offset by higher depreciation and amortization expense associated with our ongoing data center expansions, higher stock-based compensation expense of$4.6 million and$0.6 million of restructuring costs related to our reduction in workforce. Operating Expenses Year Ended December 31, 2020 2019 $ Change % Change (in thousands) Operating expenses: Sales and marketing$ 115,790 $ 110,441 $ 5,349 4.8 % Research and development 78,932 60,459 18,473 30.6 % General and administrative 85,668 73,903 11,765 15.9 % Depreciation and amortization 27,223 27,417 (194) (0.7) % Total operating expenses$ 307,613 $ 272,220 $ 35,393 13.0 % As a percentage of total revenue Sales and marketing 22.3 % 24.1 % Research and development 15.2 % 13.2 % General and administrative 16.5 % 16.1 % Sales and marketing Sales and marketing expense increased$5.3 million , or 4.8%, for 2020 compared to 2019, driven by increased personnel costs, including increased stock-based compensation expense of$3.7 million as a result of our IPO and costs related to our workforce reduction of$1.9 million , and higher payment processing fees resulting from higher revenues. The increases were partially offset by lower marketing, travel and events costs resulting from the COVID-19 pandemic, including the cancellation of DattoCon and DattoCon EMEA in 2020. Sales and marketing expense included$6.6 million and$2.9 million of stock-based compensation expense for 2020 and 2019, respectively. Research and development Research and development expense increased$18.5 million , or 30.6%, for 2020 compared to 2019, primarily driven by increases in personnel costs, including increased stock-based compensation expense of$10.1 million as a result of our IPO and costs related to our workforce reduction of$0.9 million , partially offset by lower travel costs resulting from the COVID-19 pandemic. Research and development expense included$13.6 million and$3.5 million of stock-based compensation expense for 2020 and 2019, respectively. General and administrative General and administrative expense increased$11.8 million , or 15.9%, for 2020 compared to 2019, driven primarily by increased personnel costs, including increased stock-based compensation expense of$2.9 million as a result of our IPO and costs related to our 69 -------------------------------------------------------------------------------- Table o f Contents workforce reduction of$0.4 million , increased public company insurance costs, transaction related and other costs, comprised of$2.2 million related to public company readiness and acquisition costs, and$1.0 million of expense resulting from the decision to discontinue development of a back-office system. The increased costs were partially offset by lower travel and other costs resulting from the COVID-19 pandemic. General and administrative expense included$8.5 million and$5.7 million of stock-based compensation expense for 2020 and 2019, respectively. Depreciation and amortization Depreciation and amortization expense related to operating expenses for 2020 was consistent with 2019. Amortization of intangible assets was$17.7 million and$17.9 million in 2020 and 2019, respectively, and depreciation expense was$9.5 million for both 2020 and 2019. Other Expenses Interest expense Interest expense of$25.3 million reflects a decrease of$18.1 million , or 41.6%, for 2020 compared to 2019, primarily as a result of lower interest rates in 2020 and the repayment of all outstanding debt with the proceeds from our IPO in October, partially offset by increased borrowings under our revolving credit facility during the first quarter of 2020 in order to strengthen our cash position and maintain flexibility given the unprecedented circumstances of the COVID-19 pandemic. In conjunction with the IPO, we terminated our 2019 Credit Agreement and entered into the 2020 Credit Agreement. No amounts were drawn under the 2020 Credit Agreement and we have no outstanding debt as ofDecember 31, 2020 . Loss on extinguishment of debt A loss on extinguishment of debt of$8.5 million was recorded in 2020 as a result of our debt refinancing which took place in conjunction with our IPO. A loss on extinguishment of debt of$19.2 million was recorded in 2019 as a result of our debt refinancing inApril 2019 . Other (income) expense, net Other (income) expense, net primarily relates to the impact of net exchange gains or losses on foreign currency balances, principally related to intercompany balances denominated in foreign currencies.
(Provision for) benefit from income tax
We recorded a provision for income tax of$8.1 million for 2020, as we generated taxable income, as compared to a benefit from income tax of$2.5 million in 2019, as we generated a taxable loss. The effective tax rate for 2020 compared to 2019 was 26.4% and 7.5%, respectively. The effective tax rate increased primarily as a result of generating taxable income in 2020, as the realizability of certain taxable losses was limited in 2019. 70
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Table o f Contents Comparison of the Years Ended December 31, 2019 and 2018 Revenue Year Ended December 31, 2019 2018 $ Change % Change (in thousands) Revenue: Subscription$ 412,167 $ 333,397 $ 78,770 23.6 % Device 44,052 50,514 (6,462) (12.8) % Professional services and other 2,533 3,444 (911) (26.5) % Total revenue$ 458,752 $ 387,355 $ 71,397 18.4 % Subscription Subscription revenue increased$78.8 million , or 23.6% for 2019 compared to 2018. The increase in subscription revenue was primarily driven by increased sales of our Unified Continuity and Business Management cloud-based offerings, as well as increased sales of SaaS offerings related to our Networking devices.
Device
Device revenue decreased$6.5 million , or 12.8% for 2019 compared to 2018. This decrease was primarily attributable to our shift from selling networking devices on a one-time basis at a substantial upfront cost to packaging networking devices with cloud-based management software and services with lower upfront costs and a recurring subscription.
Professional services and other
Professional services and other revenue decreased$0.9 million , or 26.5% for 2019 compared to 2018, primarily as a result of offering increased discounts on our professional services to encourage the adoption (and subsequent renewal) of our cloud-based Business Management offerings. Cost of Revenue Year Ended December 31, 2019 2018 $ Change % Change (in thousands) Cost of revenue: Subscription$ 82,066 $ 72,498 $ 9,568 13.2 % Device 53,933 50,813 3,120 6.1 % Professional services and other 5,563 3,637 1,926 53.0 % Depreciation and amortization 15,745 12,923 2,822 21.8 % Total cost of revenue$ 157,307 $ 139,871 $ 17,436 12.5 % Subscription Subscription cost of revenue increased$9.6 million , or 13.2%, for 2019 compared to 2018. The increase was primarily driven by additional costs to support the growth of our SaaS subscription offerings, including increased staffing levels and increased hosting and data center costs for our Datto Cloud infrastructure.
Device
Device cost of revenue increased
Professional services and other
Professional services and other cost of revenue increased$1.9 million , or 53.0% for 2019 compared to 2018, driven by growth in employee and related costs in our professional services organization to help ensure that MSP partners successfully deploy and adopt our Business Management cloud-based offerings. 71
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Depreciation and amortization
Depreciation and amortization related to cost of revenue increased$2.8 million for 2019 compared to 2018. The increase was attributable primarily to additional capital expenditures for our Datto Cloud infrastructure to support the growth in subscriptions. Gross Profit and Gross Margin Year Ended December 31, 2019 2018 $ Change % Change (in thousands) Gross profit: Subscription$ 330,101 $ 260,899 $ 69,202 26.5 % Device (9,881) (299) (9,582) NM Professional services and other (3,030) (193) (2,837) NM Depreciation and amortization (15,745) (12,923) (2,822) 21.8 % Total gross profit$ 301,445 $ 247,484 $ 53,961 21.8 % Gross margin: Subscription 80.1 % 78.3 % Device (22.4) % (0.6) % Professional services and other (119.6) % (5.6) % Total gross margin 65.7 % 63.9 %
NM - percentage change is not meaningful
Our gross profit increased$54.0 million , or 21.8%, and our gross margin increased by 180 basis points for 2019 compared to 2018, driven by growth in subscription revenue. Gross profit for device and professional services and other decreased from 2018 primarily as a result of discounts offered in conjunction with our strategy to decrease the upfront price paid for our devices in order to secure recurring subscriptions and the investment in our professional services organization. Operating Expenses Year Ended December 31, 2019 2018 $ Change % Change (in thousands) Operating expenses: Sales and marketing$ 110,441 $ 98,183 $ 12,258 12.5 % Research and development 60,459 54,017 6,442 11.9 % General and administrative 73,903 57,913 15,990 27.6 % Depreciation and amortization 27,417 28,953 (1,536) (5.3) % Total operating expenses$ 272,220 $ 239,066 $ 33,154 13.9 % As a percentage of total revenue Sales and marketing 24.1 % 25.3 % Research and development 13.2 % 13.9 % General and administrative 16.1 % 15.0 % Sales and marketing Sales and marketing expense increased$12.3 million , or 12.5%, for 2019 compared to 2018, driven by an increase in employee and related costs resulting from additional staffing and increased commissions as a result of the increase in revenue, as well as an increase in payment processing fees related to higher sales volume. These increases were partially offset by modestly lower advertising and promotion expenses. Sales and marketing expense included$2.9 million and$0.8 million of stock-based compensation expense for 2019 compared to 2018, respectively. 72 -------------------------------------------------------------------------------- Table o f Contents Research and development Research and development expense increased$6.4 million , or 11.9%, for 2019 compared to 2018, primarily as a result of an increase in employee and related costs because of increased staffing levels. Research and development expense included$3.5 million and$1.0 million of stock-based compensation expense for 2019 compared to 2018, respectively. General and administrative General and administrative expense increased$16.0 million , or 27.6%, for 2019 compared to 2018, driven primarily by an increase in professional fees and expenses for billing and financial systems to improve our internal processes, as well as an increase in employee and related costs resulting from increased staffing levels. These expenses were primarily related to our preparations to become a public company. In addition, we incurred an additional$4.0 million of bad debt expense as a result of billing system conversion issues experienced in 2019 which contributed to collection challenges. General and administrative expense included$5.7 million and$2.2 million of stock-based compensation expense for 2019 compared to 2018, respectively. Depreciation and amortization Depreciation and amortization expense related to operating expenses decreased$1.5 million for 2019 compared to 2018. This decrease was primarily driven by the end of the useful life of an acquired intangible asset, partially offset by an increase in depreciation for leasehold improvements and additions of computer equipment to support increased staffing levels. Other Expenses Interest expense Interest expense decreased$11.9 million , or 21.6%, for 2019 compared to 2018, primarily as a result of the lower interest rate from our debt refinancing inApril 2019 . Loss on extinguishment of debt A loss on extinguishment of debt of$19.2 million was recorded in conjunction with our debt refinancing inApril 2019 , which included a prepayment penalty of$10.4 million and the write-off of deferred financing costs of$8.8 million . Other expense (income), net Other expense, net decreased$0.5 million primarily because of net exchange (gains) or losses on foreign currency transactions and decreased losses on the disposal of assets. Non-GAAP Financial Measures In addition to our results determined in accordance with GAAP, we believe the non-GAAP measures of Non-GAAP Gross Profit, Non-GAAP Income from Operations, Non-GAAP Net Income and Adjusted EBITDA are useful in evaluating our operating performance. We believe that non-GAAP financial information may be helpful to investors because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only and should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly titled non-GAAP measures used by other companies. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures. Non-GAAP Gross Profit Non-GAAP Gross Profit is a supplemental measure of operating performance that is not prepared in accordance with GAAP and that does not represent, and should not be considered as, an alternative to gross profit, as determined in accordance with GAAP. We define Non-GAAP Gross Profit as gross profit, adjusted for amortization of acquired intangible assets, stock-based compensation expense, and restructuring expense. We use Non-GAAP Gross Profit to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans. We believe Non-GAAP Gross Profit is a useful measure to us and to our investors to assist in evaluating our core operating performance because it provides consistency and direct comparability with our past financial performance and between fiscal periods, as the metric eliminates the effects of variability of stock-based compensation expense and amortization of acquired technology intangible assets, which are non-cash expenses that may fluctuate for reasons unrelated to overall operating performance, as well as restructuring expense, which is infrequent in nature. While the amortization expense of 73 -------------------------------------------------------------------------------- Table o f Contents acquired technology intangible assets is excluded from Non-GAAP Gross Profit, the revenue related to acquired technology intangible assets is reflected in Non-GAAP Gross Profit as these assets contribute to our revenue generation. Non-GAAP Gross Profit has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Non-GAAP Gross Profit should not be considered as a replacement for gross profit, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Our presentation of Non-GAAP Gross Profit should not be construed to imply that our future results will be unaffected by the types of items excluded from the calculation of Non-GAAP Gross Profit. Non-GAAP Gross Profit is not a presentation made in accordance with GAAP and the use of the term may vary from other companies. A reconciliation of Non-GAAP Gross Profit to gross profit, the most directly comparable GAAP measure, is as follows: Year Ended December 31, 2020 2019 2018 (in thousands) Gross profit$ 368,581 $ 301,445 $ 247,484 Amortization of acquired intangible assets 5,023 4,700
4,994
Stock-based compensation expense 4,713 98 140 Restructuring expense(1) 601 - - Non-GAAP Gross Profit$ 378,918 $ 306,243 $ 252,618 (1) Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19 pandemic. Approximately$0.6 million of restructuring expense was recorded within cost of revenue for 2020. Non-GAAP Income from Operations Non-GAAP Income from Operations is a supplemental measure of operating performance that is not prepared in accordance with GAAP and that does not represent, and should not be considered as, an alternative to income from operations as determined in accordance with GAAP. We define Non-GAAP Income from Operations as income from operations, adjusted for amortization of acquired intangible assets, stock-based compensation, restructuring expense and transaction related and other expense. We use Non-GAAP Income from Operations to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans. We believe that Non-GAAP Income from Operations facilitates comparison of our operating performance on a consistent basis between periods, and when viewed in combination with our results prepared in accordance with GAAP, helps provide a broader picture of factors and trends affecting our results of operations. While the amortization expense of acquired technology,partner relationships and tradenames is excluded from Non-GAAP Income from Operations, the revenue related to acquired technology, partner relationships and tradenames is reflected in Non-GAAP Income from Operations as these assets contribute to our revenue generation. Non-GAAP Income from Operations has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Non-GAAP Income from Operations should not be considered as a replacement for operating income, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Our presentation of Non-GAAP Income from Operations should not be construed to imply that our future results will be unaffected by the types of items excluded from the calculation of Non-GAAP Income from Operations. Non-GAAP Income from Operations is not a presentation made in accordance with GAAP and the use of the term may vary from other companies. 74 -------------------------------------------------------------------------------- Table o f Contents A reconciliation of Non-GAAP Income from Operations to income from operations, the most directly comparable GAAP measure, is as follows: Year Ended December 31, 2020 2019 2018 (in thousands) Income from operations$ 60,968 $ 29,225 $ 8,418
Amortization of acquired intangible assets 22,679 22,600 25,481 Stock-based compensation expense
33,460 12,215
4,135
Restructuring expense(1) 3,835 -
-
Transaction related and other expense(2) 3,112 -
-
Non-GAAP Income from Operations$ 124,054 $ 64,040 $
38,034
(1)Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19 pandemic. Approximately$3.2 million and$0.6 million of restructuring expense was recorded within operating expenses and cost of revenue, respectively, for 2020. (2)Transaction related and other expense primarily relates to costs incurred to support our public company readiness, acquisition costs, as well as costs related to a decision to discontinue development of a back-office system. Non-GAAP Net Income (Loss) Non-GAAP Net Income (Loss) is a supplemental measure of operating performance that is not prepared in accordance with GAAP and that does not represent, and should not be considered as, an alternative to net income (loss) as determined in accordance with GAAP. We define Non-GAAP Net Income (Loss) as net income (loss) before income taxes, adjusted for loss on extinguishment of debt, amortization of acquired intangible assets, stock-based compensation expense, restructuring expense, and transaction related and other expense. The Company utilizes a normalized non-GAAP tax rate to provide better consistency across the reporting periods by eliminating the effects of non-recurring and period-specific items, which can vary in size and frequency, and which are not necessarily indicative of the Company's long-term operations. The normalized non-GAAP tax rate applied to each period presented was 25%. We use Non-GAAP Net Income (Loss) to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans. We believe that Non-GAAP Net Income facilitates comparison of our operating performance on a consistent basis between periods, and when viewed in combination with our results prepared in accordance with GAAP, helps provide a broader picture of factors and trends affecting our results of operations. While the amortization expense of acquired technology, partner relationships and tradenames is excluded from Non-GAAP Net Income (Loss), the revenue related to acquired technology, partner relationships and tradenames is reflected in Non-GAAP Net Income (Loss) as these assets contribute to our revenue generation. Non-GAAP Net Income (Loss) has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Non-GAAP Net Income (Loss) should not be considered as a replacement for net income (loss), as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Our presentation of Non-GAAP Net Income (Loss) should not be construed to imply that our future results will be unaffected by the types of items excluded from the calculation of Non-GAAP Net Income (Loss). Non-GAAP Net Income (Loss) is not a presentation made in accordance with GAAP and the use of the term may vary from other companies. 75 -------------------------------------------------------------------------------- Table o f Contents A reconciliation of Non-GAAP Net Income (Loss) to net income (loss), the most directly comparable GAAP measure, is as follows: Year Ended December 31, 2020 2019 2018 (in thousands) GAAP net income (loss)$ 22,498 $ (31,188) $ (37,723) GAAP (provision for) benefit from income taxes (8,062) 2,511
10,041
GAAP income (loss) before income taxes 30,560 (33,699)
(47,764)
Loss on extinguishment of debt 8,488 19,231 - Amortization of acquired intangible assets 22,679 22,600
25,481
Stock-based compensation expense 33,460 12,215
4,135
Restructuring expense(1) 3,835 - - Transaction related and other expense(2) 3,112 - -
Non-GAAP (provision for) benefit income taxes(3) (25,534) (5,088)
4,537 Non-GAAP Net Income (Loss)$ 76,600 $ 15,259 $ (13,611) (1)Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19 pandemic. Approximately$3.2 million and$0.6 million of restructuring expense was recorded within operating expenses and cost of revenue, respectively, for 2020. (2)Transaction related and other expense primarily relates to costs incurred to support our public company readiness, acquisition costs, as well as costs related to a decision to discontinue development of a back-office system. (3)The normalized non-GAAP tax rate applied to each period presented was 25%. The Company may adjust its non-GAAP tax rate as additional information becomes available or events occur which may materially affect this rate, including impacts from the rapidly evolving global tax environment, significant changes in our geographic mix, merger and acquisition activity, or changes in our business outlook. Adjusted EBITDA Adjusted EBITDA is a supplemental measure of operating performance monitored by management that is not defined under GAAP and that does not represent, and should not be considered as, an alternative to net income (loss), as determined by GAAP. We define Adjusted EBITDA as net income (loss) adjusted for interest and other expense, net, loss on extinguishment of debt, depreciation and amortization, (provision for) benefit from income taxes, stock-based compensation expense, restructuring expense and transaction related and other expense. We use Adjusted EBITDA to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans. Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, you should consider Adjusted EBITDA alongside other financial performance measures, including net income (loss) and our other GAAP results. Our presentation of Adjusted EBITDA should not be construed to imply that our future results will be unaffected by the types of items excluded from the calculation of Adjusted EBITDA. Adjusted EBITDA is not a presentation made in accordance with GAAP and the use of the term may vary from other companies.
A reconciliation of Adjusted EBITDA to net income (loss), the most directly comparable GAAP measure, is as follows:
Year Ended December 31, 2020 2019 2018 (in thousands) Net income (loss)$ 22,498 $ (31,188) $ (37,723) Interest and other expense, net(1) 21,920 43,693
56,182
Loss on extinguishment of debt 8,488 19,231
-
Depreciation and amortization 49,113 43,162
41,876
Provision for (benefit from) income taxes 8,062 (2,511) (10,041) Stock-based compensation expense
33,460 12,215
4,135
Restructuring expense(2) 3,835 -
-
Transaction related and other expense(3) 3,112 - - Adjusted EBITDA$ 150,488 $ 84,602 $ 54,429
(1) Interest and other expense, net includes interest expense, net, foreign currency gains and losses and other expenses.
76 -------------------------------------------------------------------------------- Table o f Contents (2)Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19 pandemic. Approximately$3.2 million and$0.6 million of restructuring expense was recorded within operating expenses and cost of revenue, respectively, for 2020. (3)Transaction related and other expense primarily relates to costs incurred to support our public company readiness, acquisition costs, as well as costs related to a decision to discontinue development of a back-office system. Liquidity and Capital Resources
General
As ofDecember 31, 2020 , our balance of cash and restricted cash totaled$170.4 million , as compared to$29.1 million as ofDecember 31, 2019 . In addition, as ofDecember 31, 2020 , we had no debt outstanding and$198.1 million of capacity under our 2020 Revolving Credit Agreement (defined below), as compared to principal balances outstanding under our 2019 Credit Agreement of$562.3 million as ofDecember 31, 2019 . We believe our existing cash and cash provided by our ongoing operations will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Historically, as we invested in our organization and infrastructure to meet increasing demand for our products and services and to drive our rapid growth we have financed our operations primarily through cash received from operations and debt financing. During 2020, in response to the spread of COVID-19 and its impacts on the world economy, we undertook various measures to improve our liquidity position and match our cost structure to our revenue and cash generation activities. In the first quarter of 2020, we drew down the remaining available balance of$32.1 million under our 2019 Revolving Credit Facility for working capital purposes, as well as to strengthen our cash position and maintain flexibility. We also took measures to reduce expenses, including a reduction in workforce inMay 2020 , and deferred certain capital projects. In addition, the COVID-19 pandemic resulted in a reduction of marketing, event and travel costs, including the cancellation of DattoCon and DattoCon EMEA in 2020. We also elected to defer payment of our obligation for social security tax for the remainder of 2020 as provided in the CARES Act, resulting in a reduction in cash outflows of$5.8 million during 2020. These actions combined to increase cash provided by operating activities for 2020 to$108.7 million , as compared to$11.2 million for 2019. In the future we will continue to invest in our organization and infrastructure and expect to resume hosting our world-class partner events in-person as we continue to grow and innovate along with our MSP partners. OnOctober 23, 2020 , we closed our IPO through which we issued and sold 22,000,000 shares of common stock at a price per share of$27.00 . We received aggregate net proceeds of approximately$558.0 million from the IPO, after deducting the underwriting discount of$36.0 million . Shortly after closing the IPO, the Company utilized the IPO proceeds and$38.4 million of available cash to repay the outstanding balances under the 2019 Credit Agreement of$590.2 million , pay$1.6 million of related accrued interest, and pay$1.2 million in debt issuance costs for the 2020 Credit Agreement. In addition, onNovember 3, 2020 , the underwriters exercised their option in full to purchase 3,300,000 additional shares of common stock at a price of$27.00 per share, resulting in net proceeds of approximately$83.6 million , after deducting the underwriting discount of$5.4 million . The total net proceeds from the IPO, after deducting the underwriters discount, were$641.6 million . In addition, we paid$5.3 million in IPO costs throughDecember 31, 2020 . Our future capital requirements will depend on several factors, including but not limited to, our subscription revenue growth rate and the need to invest in our Datto Cloud infrastructure to support such growth, the timing of cash receipts and payments, the timing and extent of spending to support research and development, the pace of expansion of sales and marketing activities, including in international markets, the level of investment in back-office infrastructure, and the cost to operate as a public company. In the future, we may also enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing to meet our future capital requirements. In the event additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital or generate cash flows necessary to fund the expansion of our operations and invest in new technologies, this could reduce our ability to compete successfully and harm our results of operations. Credit Facilities OnOctober 23, 2020 ,Datto, Inc. , as borrower (the "Borrower"),Merritt Holdco, Inc. ,Autotask Superior Holding, Inc. ,Backupify, Inc. ,Autotask Corporation ,Open Mesh, Inc. andSoonR, Inc. , each a direct or indirect wholly-owned subsidiary ofDatto Holding Corp. , entered into a credit agreement (the "2020 Credit Agreement") with the lenders party thereto andMorgan Stanley Senior Funding, Inc. , as administrative agent. The 2020 Credit Agreement is guaranteed byMerritt Holdco, Inc. ,Autotask Superior Holding, Inc. ,Backupify, Inc. ,Open Mesh, Inc. ,Autotask Corporation , andSoonR, Inc. (the "Guarantors," and, together with the Borrower, the "Loan Parties") and is supported by a security interest in substantially all of the Loan Parties' personal property and assets, subject to customary exceptions. 77
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The 2020 Credit Agreement provides for an initial$200.0 million in commitments for revolving credit loans, which may be increased or decreased under specific circumstances, with a$40.0 million letter of credit sublimit and a$100 million alternative currency sublimit (the "2020 Revolving Credit Facility"). In addition, the 2020 Credit Agreement provides for the ability of the Borrower to request incremental term loan facilities. Borrowings pursuant to the 2020 Credit Agreement may be used for working capital and other general corporate purposes, including for acquisitions permitted under the 2020 Credit Agreement. Borrowings under the 2020 Credit Agreement are scheduled to mature onOctober 23, 2025 . The 2020 Credit Agreement contains certain customary events of default, which include failure to make payments when due thereunder, the material inaccuracy of representations or warranties, failure to observe or perform certain covenants, cross-defaults, bankruptcy and insolvency-related events, certain judgments, certain ERISA-related events, or a Change in Control (as defined in the 2020 Credit Agreement). The 2020 Credit Agreement contains certain customary representations and warranties and affirmative and negative covenants, including certain restrictions on the ability of the Loan Parties and their Restricted Subsidiaries (as defined in the 2020 Credit Agreement) to incur any additional indebtedness or guarantee indebtedness of others, to create liens on properties or assets, and to enter into certain asset and stock-based transactions. In addition, under the terms of the 2020 Credit Agreement, the Borrower's First Lien Net Leverage Ratio shall not be more than 4.00 to 1.00. The interest rates applicable to the revolving borrowings under the 2020 Credit Agreement, are, at the Borrower's option, either (i) a base rate, equal to the greater of (a) the Prime Rate, (b) the Federal Funds Effective Rate plus 0.5% or (c) the Adjusted LIBO Rate for a one month Interest Period (each term as defined in the 2020 Credit Agreement) plus 1%, or (ii) the Adjusted LIBO Rate equal to the LIBO Rate for the applicable Interest Period, plus in the case of each of clauses (i) and (ii), the Applicable Rate (as defined in the 2020 Credit Agreement). The Applicable Rate (i) for base rate loans range from 0.25% to 1.0% per annum and (ii) for LIBO Rate loans range from 1.25% to 2.0% per annum, in each case, based on the Senior Secured Net Leverage Ratio (as defined in the 2020 Credit Agreement). The Borrower will pay a commitment fee during the term of the 2020 Credit Agreement ranging from 0.20% to 0.35% per annum of the average daily undrawn portion of the revolving commitments based on the Senior Secured Net Leverage Ratio (as defined in the 2020 Credit Agreement). Any borrowings under the 2020 Credit Agreement may be repaid, in whole or in part, at any time and from time to time without premium or penalty other than customary breakage costs, and any amounts repaid may be reborrowed. No mandatory prepayments will be required other than when borrowings and letter of credit usage exceed the aggregate commitment of all lenders. The 2020 Revolving Credit Facility was undrawn as ofDecember 31, 2020 , with the exception of$1.9 million of outstanding letters of credit. Cash Flows The following table presents a summary of our consolidated cash flows from operating, investing and financing activities for the periods indicated. Year Ended December 31, 2020 2019 2018 (in thousands)
Net cash (used in) provided by operating activities
$ (44,837) $
(38,226)
Operating Activities For 2020, net cash provided by operating activities was$108.7 million , which resulted from net income of$22.5 million , adjusted for non-cash charges of$106.8 million and net cash outflow of$20.6 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of depreciation and amortization expenses of$49.1 million , stock-based compensation expense of$33.5 million , loss on extinguishment of debt of$8.5 million and an increase in deferred income taxes of$7.8 million . The net cash outflow from changes in operating assets and liabilities was primarily driven by an increase in other assets of$13.0 million primarily driven by an increase in deferred contract acquisition costs, as well as an increase in prepaid expenses and other current assets of$7.5 million , primarily driven by the payment of insurance as a result of becoming a public company. 78 -------------------------------------------------------------------------------- Table o f Contents For 2019, net cash provided by operating activities was$11.2 million , which resulted from a net loss of$31.2 million , adjusted for non-cash charges of$80.2 million and net cash outflow of$37.8 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of depreciation and amortization expenses of$43.2 million , loss on extinguishment of debt of$19.2 million and stock-based compensation expense of$12.2 million , partially offset by a decrease in deferred income taxes of$6.1 million . The net cash outflow from changes in operating assets and liabilities was primarily driven by an increase in other assets of$24.2 million , including a$14.9 million increase in deferred contract acquisition costs, an increase of$6.0 million in contract assets, and an increase in capitalized costs for cloud computing arrangements. In addition, accounts receivables increased$10.8 million as a result of the growth in revenue and the timing of cash receipts, which was impacted by a system conversion implemented in 2019 which contributed to collection challenges, and deferred revenue decreased$7.9 million as a result of the timing of invoicing. The increase in operating assets was partially offset by an increase in accounts payable and accrued expenses of$14.8 million as a result of the timing of payments. For 2018, net cash used in operating activities was$10.6 million , which resulted from a net loss of$37.7 million , adjusted for non-cash charges of$40.2 million and net cash outflow of$13.0 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of depreciation and amortization expenses of$41.9 million and stock-based compensation expense of$4.1 million , partially offset by a decrease in deferred income taxes of$11.9 million . The net cash outflow from changes in operating assets and liabilities was primarily driven by an increase in other assets of$15.9 million related to increased deferred commission costs and capitalized costs for cloud computing arrangements, partially offset by an increase in deferred revenue of$13.8 million as a result of the impact of purchase accounting adjustments, related primarily to the fair value assigned to deferred revenue in the formation ofDatto Holding Corp. inOctober 2017 for the purpose of acquiring all of the capital stock ofDatto, Inc. (the "Vista Acquisition"), as well as the overall increase in revenue. Investing Activities Cash used in investing activities was$44.8 million during 2020, primarily resulting from investment in servers for our Datto Cloud infrastructure to support our overall subscription growth. In addition, we incurred expenses for leasehold improvements and furniture and fixtures to expand and update certain offices and purchased computer equipment to support our workforce and global expansion. InJuly 2020 , we acquired two affiliated Australian entities,Gluh Pty Ltd andKeystone Software Holdings Pty Ltd , which offer a quoting tool for MSPs to quote, sell and procure IT goods and services. The amount paid was approximately$4.4 million , reflecting the purchase price of$4.0 million and certain closing adjustments. Cash used in investing activities was$38.2 million during 2019, primarily resulting from investment in servers for our Datto Cloud infrastructure to support our overall subscription growth. In addition, we incurred expenses for leasehold improvements to expand and update certain offices and purchased computer equipment in order to support the growth in our workforce. Cash used in investing activities was$28.2 million during 2018, primarily resulting from investment in servers for our Datto Cloud infrastructure to support our overall subscription growth. In addition, we incurred expenses for leasehold improvements to expand and update certain offices and purchased computer equipment in order to support our growth in workforce. Financing Activities Cash provided by financing activities was$75.7 million during 2020, primarily reflecting proceeds from our IPO, net of the underwriting discount, of$641.6 million , offset by debt repayments of$594.7 million , including$590.2 million to repay all outstanding balances under our 2019 Credit Agreement, payment of IPO costs of$5.3 million , and payment of debt issuance costs of$1.2 million for our 2020 Credit Agreement. In addition, proceeds from the exercise of stock options was$3.2 million . Cash provided by financing activities was$18.5 million during 2019, primarily reflecting proceeds from borrowings under our 2019 Credit Agreement of$562.3 million , partially offset by repayment of our previous term loan of$520.3 million , a pre-payment penalty of$10.4 million incurred on our previous term loan, and deferred financing costs of$8.8 million incurred in securing our 2019 Credit Agreement. In addition, we paid$1.4 million in settlement of certain stock-based awards held by terminated employees. Cash used in financing activities was$5.2 million during 2018, including$4.2 million for the repurchase of common stock and the settlement of stock-based payment awards and$1.0 million for the repayment of outstanding debt related to capital leases. 79 -------------------------------------------------------------------------------- Table o f Contents Contractual Obligations and Commitments The following table sets forth the amounts of our significant contractual obligations and commitments with definitive payment terms as ofDecember 31, 2020 : Payments due by Period Less than More than Total 1 Year 1-3 years 3-5 Years 5 years (in thousands)
Revolving credit facility-commitment fees(1)
68,568 35,434 22,450 10,684 - Operating lease obligations(3) 45,586 9,308 17,283 12,269 6,726 Total$ 116,087 $ 45,142 $ 40,533 $ 23,686 $ 6,726 ________________ (1)We are required to pay a commitment fee of 0.20-0.35%, based on the Company's leverage ratio, on the undrawn portion of the revolving credit facility under the 2020 Credit Agreement. We have estimated the obligations based on the facts and circumstances in place atDecember 31, 2020 . (2)We have unconditional purchase obligations that primarily consist of commitments related to our co-located data centers, telecommunication, networking, subscription and consulting services. (3)Our operating lease obligations consist primarily of office space and warehousing. Impact of Inflation While inflation may impact our net revenues and costs of revenues, we believe the effects of inflation, if any, on our results of operations and financial condition have not been significant. However, there can be no assurance that our results of operations and financial condition will not be materially impacted by inflation in the future. Indemnification Agreements In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify MSP partners, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, services to be provided by us or from intellectual property infringement claims made by third parties. No demands have been made upon us to provide indemnification under such agreements and there are no claims that we are aware of that could have a material effect on our consolidated balance sheet, consolidated statement of operations and comprehensive loss or consolidated statement of cash flows. In addition, in connection with the completion of our IPO, we entered into indemnification agreements with our directors and certain officers and employees that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees. Off-Balance Sheet Arrangements
We did not have any material off-balance sheet arrangements as of
JOBS Act We qualify as an "emerging growth company" pursuant to the provisions of the JOBS Act. For as long as we are an "emerging growth company," we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not "emerging growth companies," including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, exemptions from the requirements of holding shareholder advisory "say-on-pay" votes on executive compensation and shareholder advisory votes on golden parachute compensation. The JOBS Act also permits an emerging growth company like us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We have elected to "opt-in" to this extended transition period for complying with new or revised accounting standards and, therefore, we will not be subject to the same new or revised accounting standards as other public companies that comply with such new or revised accounting standards on a non-delayed basis.U.K.'s Referendum Decision to Exit theEuropean Union TheUnited Kingdom left theEuropean Union onJanuary 31, 2020 and the transition period during which most E.U. rules continued to apply expired onDecember 31, 2020 . Although theU.K. andEuropean Union have reached an agreement on certain terms concerning theU.K.'s withdrawal, there remains substantial uncertainty regarding the details of theU.K.'s ongoing relationship with theEuropean Union . We continue to monitor the status of the negotiations and to plan for potential political, economic and social instability. 80 -------------------------------------------------------------------------------- Table o f Contents Since we have historically provided our Business Management (PSA) and SaaS Protection products to European customers from aU.K. data center and have supported certain older BCDR devices through ourU.K. data center, we have taken the following steps to mitigate the potential impact of Brexit on our operations: •developed infrastructure that will allow us to provide both our PSA and SaaS Protection products out of our data center inGermany ; •permitted European customers to move their PSA, SaaS Protection and BCDR service instances from theU.K. toGermany ; •published a notice on our website regarding our Brexit preparations and the process to migrate accounts out of theU.K. ; •sent emails regarding Brexit to our potentially impacted customers; and •began implementing a system where new customers will be able to track the region in which data is stored and opt for the desired location. The ultimate impact of Brexit on our business operations and financial results is uncertain. For additional information on risks related to Brexit, see "Risk Factors-Risks Related to Our Business and Industry." Critical Accounting Policies Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K. The preparation of our consolidated financial statements in accordance withU.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Actual results may differ from those estimates. Our critical accounting policies are those that materially affect our consolidated financial statements and involve difficult, subjective or complex judgments by management. A thorough understanding of these critical accounting policies is essential when reviewing our consolidated financial statements. Stock-Based Compensation Accounting for stock-based compensation requires us to make a number of judgments, estimates and assumptions. If any of our estimates prove to be inaccurate, our net income (loss) and operating results could be adversely affected. We estimate the fair value of stock options granted to employees and directors using the Black-Scholes option-pricing model, which requires the input of subjective assumptions, including (1) the fair value of common stock, (2) the expected stock price volatility, (3) the expected term of the award, (4) the risk-free interest rate and (5) expected dividends. Also, we made an accounting policy election to account for forfeitures as they occur. The assumptions for the Black-Scholes option-pricing model were estimated as follows: •Fair value of common stock. Prior to our IPO our common stock was not yet publicly traded. As such we were required to estimate the fair value of our common stock, as discussed in "Common Stock Valuation" below. For grants after the IPO, the fair value is based on the closing price of our common stock on the NYSE as reported on the last trading day prior to the grant date. •Expected volatility. As a result of the lack of historical and implied volatility data of our common stock, the expected stock price volatility has been estimated based on the historical volatilities of a specified group of companies in our industry for a period equal to the expected life of the option. We selected companies with comparable characteristics to us, including enterprise value, risk profiles and position within the industry and with historical share price information sufficient to meet the expected term of the stock options. The historical volatility data has been computed using the daily closing prices for the selected companies. •Expected term. We determine the expected term based on the average period the stock options are expected to remain outstanding using the simplified method, generally calculated as the midpoint of the stock options' vesting term and contractual expiration period, as we do not have sufficient historical information to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior. •Risk-free rate. Our risk-free interest rate is based on theU.S. Treasury yield curve in effect at the time of grant for zero-couponU.S. Treasury notes with maturities approximately equal to the stock option's expected term. •Expected dividend yield. We utilize a dividend yield of zero, as we do not currently issue dividends, nor do we expect to do so in the future. 81 -------------------------------------------------------------------------------- Table o f Contents Common Stock Valuation Since our IPO, the fair value of the shares of common stock underlying our equity awards has been based on the closing price of the Company's common stock on the last trading day prior to the grant date, as reported on the NYSE. Prior to our IPO, the fair value of the shares of common stock underlying our equity awards was based on a determination by our Board, with input from management and contemporaneous third-party valuations, as there was no public market for our common stock. In valuing our pre-IPO common stock, our Board determined the value using both the income and the market approach valuation methods. The income approach estimates value based on the expected future cash flows that our company will generate. These future cash flows are discounted to their present values using a discount rate based on our weighted average cost of capital, or WACC. To derive our WACC, a cost of equity was developed using the Capital Asset Pricing Model and comparable company betas, and a cost of debt was determined based on our estimated cost of borrowing. The costs of debt and equity were then weighted based on our actual capital structure. The market approach estimates value based on a comparison of our company to comparable publicly traded companies in a similar line of business and to acquisitions in the market. From the comparable companies, a representative market multiple is determined and subsequently applied to our historical and forecasted financial results to estimate our enterprise value. From the acquisitions analysis, a representative market multiple is determined and subsequently applied to our historical financial results to estimate our enterprise value. Application of these approaches involves the use of estimates, judgment and assumptions that are highly complex and subjective, such as those regarding our expected future revenue, expenses, and cash flows, discount rates, market multiples, the selection of comparable companies and the probability of possible future events. Changes in any or all of these estimates and assumptions or the relationships among those assumptions could have a material impact on the valuation of our common stock as of each valuation date. Revenue Recognition and Contract Balances We recognize revenue in accordance with theFinancial Accounting Standards Board's Accounting Standards Codification Topic 606, which we adopted as ofJanuary 1, 2018 on a modified retrospective basis. We generate revenue from fees received for subscriptions, support and related services, and from the sale of devices. We recognize revenue related to contracts with partners when we transfer promised goods or services to partners in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This is determined by following a five-step process which includes (1) identifying the contract with a partner, (2) identifying the performance obligations in the contract, (3) determining the transaction price, (4) allocating the transaction price and (5) recognizing revenue when or as we satisfy a performance obligation. We identify performance obligations in a contract based on the goods and services that will be transferred to the partner that are identifiable or distinct from other promises in the contract. If not considered distinct, the promised goods or services are combined with other goods or services and accounted for as a combined performance obligation. Determining the distinct performance obligations in a contract requires judgment. Our performance obligations primarily include subscription services, including warranties, unspecified upgrades or enhancements to our hosted SaaS offerings, delivery of devices and training. We believe that our technical support, warranties and unspecified upgrades or enhancements performance obligations each have the same pattern of transfer to the partner and are therefore accounted for as a single distinct performance obligation. We allocate the transaction price of the contract to each distinct performance obligation on a relative standalone selling price basis. Estimating standalone selling prices for our performance obligations requires judgment and is based on multiple factors including, but not limited to, observable cost data, industry margin studies, historical selling prices, internal pricing policies and pricing practices in different regions and through different sales channels and internal cost structure. We review the standalone selling price for our performance obligations periodically and update them, if needed, to ensure that the methodology utilized reflects our current pricing practices. Contract Balances The timing of revenue recognition may differ from the timing of invoicing to customers. We record an accounts receivable when revenue is recognized prior to invoicing and payment will become due solely based on the passage of time, a contract asset when revenue is recognized prior to invoicing and payment is contingent upon transfer of control of another separate performance obligation, or deferred revenue when payment is received prior to the recognition of revenue. We use judgement in determining the standalone selling price for our performance obligations which would affect the amount of contract balances recognized. Deferred revenue that will be realized during the succeeding 12-month period is recorded as current, and the remaining deferred revenue is recorded as non-current. Contract Acquisition Costs We capitalize commission expenses that are incremental to obtaining customer contracts, using a portfolio approach. These contract acquisition costs are deferred and recorded in other assets on our consolidated balance sheets. We make judgments in determining the 82 -------------------------------------------------------------------------------- Table o f Contents amount of costs to be expensed in the period, including amounts which are expensed as incurred, which is the approach if the expected period of benefit is less than one year, and amounts which are capitalized and expensed over future periods, which is the approach if the expected period of benefit is beyond one year. The period of benefit often extends beyond the contract term, as we only pay a commission on the initial contract term and not upon renewal of the contract. We have determined that the expected period of benefit is five years based on evaluation of a number of factors, including customer attrition rates, weighted average useful lives of our partner relationship and developed technology intangible assets, and market factors, including the overall competitive environment and the technology life utilized by competitors. Contract acquisition costs which are capitalized are amortized as a component of sales and marketing expense in our consolidated statements of operations. Recent Accounting Pronouncements For a description of our recently adopted accounting pronouncements and accounting pronouncements issued but not yet adopted, see Note 2. Significant Accounting Policies to our consolidated financial statements in this Annual Report on Form 10-K. ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk Market risk represents the risk of loss that may impact our financial position because of adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of exposure resulting from potential changes in inflation or interest rates. We do not hold financial instruments for trading purposes. Foreign Currency Exchange Risk The functional currencies of our foreign subsidiaries are the respective local currencies. Most of our sales and operating expenses are denominated in the currencies of the countries in which our operations are located, which are primarily inthe United States ,United Kingdom andEurope , although we do have certain arrangements in which we invoice in a non-functional currency, based upon the location of the Partner. Our consolidated results of operations and cash flows are, therefore, subject to fluctuations resulting from changes in foreign currency exchange rates and may be adversely affected in the future because of changes in foreign exchange rates. To date, we have not entered into any hedging arrangements with respect to foreign currency risk or other derivative financial instruments. During the year endedDecember 31, 2020 , a hypothetical 10% change in foreign currency exchange rates applicable to our business would not have had a material impact on our consolidated financial statements. Interest Rate Risk AtDecember 31, 2020 , we had no outstanding borrowings under the 2020 Credit Agreement. To the extent we incur borrowings, our primary market risk exposure is changes to the Prime Rate, the Federal Funds Effective Rate or LIBO Rate (and the LIBOR Successor Rate)-based interest rates. Interest rate risk is sensitive to many factors, includingU.S. monetary and tax policies,U.S. and international economic factors and other factors beyond our control. The interest rate on our revolving borrowings under the 2020 Credit Agreement, are, at our option, either (i) a base rate, equal to the greater of (a) the Prime Rate, (b) the Federal Funds Effective Rate plus 0.5% or (c) the Adjusted LIBO Rate for a one month Interest Period (each term as defined in the 2020 Credit Agreement) plus 1%, or (ii) the Adjusted LIBO Rate equal to the LIBO Rate for the applicable Interest Period, plus in the case of each of clauses (i) and (ii), the Applicable Rate (as defined in the 2020 Credit Agreement). The Applicable Rate (i) for base rate loans range from 0.25% to 1.0% per annum and (ii) for LIBO Rate loans range from 1.25% to 2.0% per annum, in each case, based on the Senior Secured Net Leverage Ratio (as defined in the 2020 Credit Agreement). 83
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