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Guidance Software 10-Q 2008 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008 OR
For the transition period from to Commission File Number 001-33197
GUIDANCE SOFTWARE, INC. (Exact name of registrant as specified in its charter)
Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.001 par value per share. Securities registered pursuant to Section 12(g) of the Act: None.
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act). Large accelerated filer ¨ Accelerated filer þ Non-accelerated filer ¨ Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ As of November 5, 2008, there were approximately 23,255,000 shares of the registrant’s Common Stock outstanding, net of treasury shares.
Table of ContentsGUIDANCE SOFTWARE, INC. FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008 Table of Contents
Table of ContentsPART I. FINANCIAL INFORMATION
CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements
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Table of ContentsCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited)
The accompanying notes are an integral part of these consolidated financial statements
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Table of ContentsCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
The accompanying notes are an integral part of these consolidated financial statements
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Table of ContentsNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Note 1. Description of the Business and Summary of Significant Accounting Policies General Guidance Software, Inc. was incorporated in the state of California during 1997 and reincorporated in Delaware on December 11, 2006. Guidance and its subsidiaries are collectively referred to herein as “Guidance,” “we” or the “Company.” Headquartered in Pasadena, California, Guidance is a global provider of software solutions to conduct digital investigations. Our flagship product is EnCase® Enterprise, a comprehensive, network-enabled digital solution that enables corporations and government agencies to search, collect, preserve and analyze data across all of the servers, desktops and laptops that comprise their network from a single location. We also sell EnCase® Forensic, primarily for use by law enforcement and government agencies for collecting, preserving, analyzing and authenticating electronic computer forensic data for use in criminal and civil court proceedings. We complement our software offerings with a comprehensive array of professional and training services including technical support and maintenance services to help our customers implement our solutions, conduct investigations and train their staff to effectively and efficiently use our software products. Basis of Presentation The accompanying condensed consolidated balance sheet as of September 30, 2008 and the condensed consolidated statements of operations and cash flows for the periods ended September 30, 2008 and 2007 are unaudited. These statements should be read in conjunction with the audited consolidated financial statements and related notes, together with management’s discussion and analysis of financial condition and results of operations, contained in our Annual Report on Form 10-K for the year ended December 31, 2007, filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 17, 2008. The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or (“GAAP”) and pursuant to the rules and regulations of the SEC for interim financial reporting. In the opinion of our management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements in the Annual Report on Form 10-K for the year ended December 31, 2007 and include all adjustments necessary for the fair presentation of our financial position as of September 30, 2008 and our results of operations and cash flows for the periods ended September 30, 2008 and 2007. The condensed consolidated balance sheet as of December 31, 2007 has been derived from the December 31, 2007 audited financial statements. The interim financial information contained in this quarterly report is not necessarily indicative of the results to be expected for any other interim period or for the entire year. The consolidated financial statements include the accounts of Guidance and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Use of Estimates and Assumptions The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates and assumptions, including those related to bad debts, our annual performance-based bonus plan, share-based compensation, income taxes, commitments, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates. Fair Value of Financial Instruments The carrying amounts of cash equivalents, accounts receivable, and accounts payable approximate fair value because of the short-term maturities of these instruments. Based on borrowing rates currently available to us for borrowings with similar terms, the carrying values of our capital lease obligations also approximate fair value. Short-term investments, which are considered available for sale, are stated at fair value based on market quotes. Concentrations of Credit Risk Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash and cash equivalents, marketable debt securities, and accounts receivable. We restrict our investments in cash and cash equivalents to financial institutions and government or federal agency securities and obligations of corporations with high
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Table of Contentscredit standing. At September 30, 2008, the majority of our cash balances were held at financial institutions located in California, which accounts are insured by the Federal Deposit Insurance Corporation up to $100,000 (increased in October 2008 to $250,000). Uninsured balances aggregate approximately $28.7 million as of September 30, 2008. At September 30, 2008, all of our cash equivalents and short-term investments consisted of financial institution, corporate and government agency obligations. We periodically perform credit evaluations of our customers and maintain reserves for potential losses on our accounts receivable. We do not believe we are subject to significant concentrations of credit risk with respect to such receivables. Recent Accounting Pronouncements In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS 157 does not require new fair value measurements but rather defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. We adopted SFAS 157 in the first quarter of 2008 for financial assets and liabilities and are required to adopt SFAS 157 in the first quarter of 2009 for nonfinancial assets and liabilities. Adoption of SFAS 157 with respect to financial assets and liabilities did not have a material impact on our consolidated financial position and results of operations and we do not expect adoption of SFAS 157 with respect to nonfinancial assets and liabilities to have a material impact on our consolidated financial position and results of operations. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities—Including an amendment of FASB Statement No. 115.” SFAS 159 allows companies to elect fair-value measurement when an eligible financial asset or financial liability is initially recognized or when an event, such as a business combination, triggers a new basis of accounting for that financial asset or financial liability. SFAS 159 became effective for us on January 1, 2008, however we did not elect the fair value measurement provision for any of our financial assets or liabilities, so adoption of SFAS 159 had no effect on our consolidated financial position or results of operations. In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” which will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items, including:
SFAS 141R also includes a substantial number of new disclosure requirements. We will be required to adopt SFAS 141R prospectively for any business combinations for which the acquisition date is on or after January 1, 2009. Earlier adoption is prohibited. SFAS 141R will only have an effect on our financial statements in the event that we enter into business combinations subsequent to that date. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — An Amendment of ARB No. 51.” SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the statement of operations. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. We will be required to adopt SFAS 160 effective January 1, 2009. Earlier adoption is prohibited. We do not have a noncontrolling interest in any subsidiaries. Accordingly, we do not anticipate that the initial application of SFAS No. 160 will have an impact on us.
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Table of ContentsNote 2. Net Loss Per Share We calculate net loss per share in accordance with SFAS No. 128, “Earnings Per Share.” Under SFAS No. 128, basic net income or loss per common share is calculated by dividing net income or loss by the weighted-average number of common shares outstanding during the reporting period. Diluted net income per share is calculated based on the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of the shares issuable upon the exercise of stock options and upon the vesting of nonvested stock awards under the treasury stock method. In net loss periods, basic net loss per share and diluted net loss per share are identical since the effect of potential common shares is anti-dilutive and therefore excluded. The following is a reconciliation of the numerators and denominators of the income (loss) per share computations for the periods presented (in thousands, except per share amounts):
Had we been in a net income position for the respective periods, weighted average common share equivalents of 755,000 and 490,000 shares outstanding during the three month periods ended September 30, 2007 and 2008 and 1,105,000 and 610,000 shares outstanding during the nine month periods ended September 30, 2007 and 2008, respectively, would have been dilutive. The weighted average common share equivalents outstanding during each period that were excluded from the computation of diluted earnings per share because the exercise price for these options were greater than the average market price of the Company’s shares of common stock during the three month periods ended September 30, 2007 and 2008 were 315,000 and 2,785,000 respectively, and 105,000 and 2,600,000 during the nine month periods ended September 30, 2008 and 2007, respectively. Note 3. Debt Obligations We maintain a $3,000,000 revolving line of credit with a bank which was amended on October 6, 2008 to extend its expiration date to April 30, 2010 and modify certain administrative terms. Borrowings under this line of credit would bear interest at a rate equal to the bank’s prime rate minus 0.75% or the bank’s LIBOR plus 1.50%, at our election, and be due on the expiration date of the facility and be collateralized by substantially all our assets. The facility requires us to maintain cash, cash equivalents, and marketable securities of not less than $10 million, not to allow a cumulative net loss (excluding non-cash share-based compensation) in excess of $4 million during any one fiscal year and limits additional indebtedness to $2,000,000. As of September 30, 2008, we were in compliance with the covenants associated with the revolving line of credit. At December 31, 2007 and September 30, 2008, no amounts were outstanding under the line. Note 4. Equity Incentive Plan In 2004, our Board of Directors and stockholders approved the 2004 Equity Incentive Plan (the “Plan”). A total of 2,062,000 shares of common stock was initially authorized and reserved for issuance under the Plan in the form of incentive and non-qualified stock options and nonvested share awards (commonly referred to as “restricted stock”). The Plan was amended in 2005 to increase the number of shares available for issuance to 3,977,000. In May 2006, the Board of Directors and stockholders approved increases in the shares available for issuance under the Plan by an additional 1,127,000 shares on May 3, 2006, and an additional 828,000 shares on each of January 1, 2007, 2008 and 2009. At our 2008 Annual Meeting of Stockholders, a proposal to accelerate the January 1, 2009 contribution of shares to July 1, 2008 was approved by our stockholders. Employees, officers and directors are eligible under the Plan, which is administered by the Board of Directors,
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Table of Contentswho determines the terms and conditions of each grant. The terms of the options granted under the Plan are determined at the time of grant, and generally vest 25% annually over a four-year service period and typically must be exercised within 10 years from the date of grant. At September 30, 2008, approximately 1,232,000 shares remain available for grant as options or nonvested share awards under the Plan. Stock Options A summary of stock option activity for the nine months ended September 30, 2008 follows:
We define in-the-money options at September 30, 2008 as options that had exercise prices that were lower than the $4.69 fair market value of our common stock at that date. The aggregate intrinsic value of options outstanding at September 30, 2008 is calculated as the difference between the exercise price of the underlying options and the fair market value of our common stock at that date. The total intrinsic value of the 205,000 options exercised during the nine months ended September 30, 2008 was $1,035,000, determined as of the date of exercise. At September 30, 2008, the weighted average contractual life of outstanding options and exercisable options was 7.7 years and 6.3 years, respectively. For options granted after January 1, 2006, the total fair value of options vested during the nine months ended September 30, 2008 was approximately $2,765,000; options awarded prior to January 1, 2006 were granted prior to our adoption of FAS 123R and did not have an estimable fair value. Nonvested Share Awards During 2007, we began issuing nonvested share awards (commonly referred to as “restricted stock”) to certain executives and employees under the Plan. Compensation expense for such awards, based on the fair market value of the awards on the grant date, is recorded during the vesting period. The first awards of nonvested share awards were made in February 2007, when approximately 40,000 shares were granted with three-month vesting periods. Subsequently, additional grants were awarded which generally vest 25% annually over a four-year period; however, a 100,000 share award to our President and Chief Executive Officer vests 100% in December 2011. A summary of nonvested share awards activity for the nine months ended September 30, 2008 follows:
We experienced disqualifying dispositions of incentive stock options during the nine months ended September 30, 2008. Disqualifying dispositions result in a tax deduction in our corporate tax return equal to the intrinsic value of options at
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Table of Contentsthe time of exercise. Intrinsic value is the total value of exercised shares based on the price of our common stock at the time of exercise less the cash received from employees upon exercise. We did not realize any tax benefits from disqualifying dispositions during the nine months ended September 30, 2008. As a result of disqualifying dispositions of incentive stock options during the nine months ended September 30, 2007, a $1.0 million tax benefit related to options that were granted prior to the adoption of SFAS No. 123R (“SFAS 123R”), “Share-Based Payment” (Note 5) was recorded as a reduction of our 2007 tax liability and an increase to additional paid-in capital. The tax benefit related to the exercise of options granted subsequent to the adoption of SFAS 123R was recorded as a reduction of our 2007 tax expense and tax liability. Note 5. Share-Based Compensation Effective January 1, 2006, we adopted SFAS No. 123R (“SFAS 123R”), “Share-Based Payment.” We adopted SFAS 123R using the prospective transition method and, accordingly, since adoption, we recognize share-based compensation expense for all share-based awards granted after January 1, 2006. Under that transition method, results for prior periods have not been restated. With the exception of one option granted in December 2007 with market-based vesting conditions, discussed further below, the fair values of awards granted under the Plan were estimated at the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions:
The SEC has issued Staff Accounting Bulletin (“SAB”) Topics No. 107 and No. 110 which provide guidance on the implementation of SFAS 123R. We applied the principles of SAB 107 in conjunction with adoption of SFAS 123R. The volatility of our common stock is estimated at the date of grant based on a weighted-average of the implied volatility of publicly traded 30-day to 270-day options on the common stock of a select peer group of similar companies (“Similar Companies”), the historical volatility of the common stock of Similar Companies and, beginning in late 2007, the historical volatility of our common stock, consistent with the requirements of SFAS 123R and SAB 107. The risk-free interest rate that was used in the Black-Scholes option valuation model is based on the implied yield in effect at the time of each option grant, based on U.S. Treasury zero-coupon issues with equivalent remaining terms. We use an expected dividend yield of zero in the Black-Scholes option valuation model, as we have no intention of paying any cash dividends on our common stock in the foreseeable future. SFAS 123R requires us to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. We amortize share-based compensation on a straight-line basis over the requisite service period of the awards, which is generally the vesting period. The expected term (life) of all stock option awards has been calculated using the “simplified method” as defined by SAB 107 and SAB 110 because, due to the limited time our common stock has been publicly traded, we lack sufficient historical data to provide a reasonable basis to estimate the expected term of these options. In December 2007, we granted our President and Chief Executive Officer an option to purchase 500,000 shares of our common stock at the price of $12.80 per share which vests, in 25% increments, only upon attainment of specified market-based conditions tied to the market value of our common stock. Under the provisions of SFAS 123R, the fair value of share-based grants with a market vesting condition must be modeled and valued with a path-dependent valuation technique. Accordingly, using the Monte Carlo binomial simulation model, we estimated that the weighted average grant date fair value of this award was $5.68 per option, with derived service periods ranging from 15 to 32 months for the four performance levels, and averaging 24 months. Under FAS 123R, the calculated $2.8 million fair value of this award must be recognized as expense over a weighted average period of approximately two years whether the market conditions are met or not so long as the grantee meets the service condition. In June 2007 and August 2008, under the terms of the separation agreements of two former executives, we accelerated the vesting of certain options held by those executives permitting them to purchase previously unvested shares of our common stock within specified periods of their terminations. The terms of the August 2008 separation agreement also
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Table of Contentsaccelerated the vesting of an award of approximately 2,000 nonvested shares. The modifications of these awards resulted in $192,000 and $280,000 of compensation expense in 2007 and 2008, respectively. The following table summarizes the share-based compensation expense we recorded in accordance with the provisions of FAS 123R (in thousands):
Approximately $1.4 million of the increase in the stock option and nonvested share awards expense in the nine months ended September 30, 2008 is attributable to the December 2007 award to our President and Chief Executive Officer. As of September 30, 2008, there was approximately $19.6 million of total unrecognized compensation cost related to non-vested share-based compensation that is expected to be recognized over a weighted-average period of 2.4 years. We expect to record approximately $8.9 million in share-based compensation in 2008 related to options and nonvested share awards outstanding at September 30, 2008. Note 6. Income Taxes In connection with the termination of our S Corporation status in December 2006, we recorded deferred tax assets, which were fully offset by a valuation allowance. In 2007, the Company generated additional deferred tax assets that were partially valued in accordance with the provisions of SFAS 109, “Accounting for Income Taxes.” For the three and nine months ended September 30, 2008, our effective tax rates of (85.8%) and (18.5%), respectively, differed from the statutory rate of 34% primarily due to the determination during the three months ended September 30, 2008 that a full valuation allowance was required against our existing net deferred tax assets. Management’s judgment is required in assessing the realizability of future deferred tax assets. In performing these assessments, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of our net deferred tax assets is dependent upon our generating sufficient taxable income in future years in appropriate tax jurisdictions to realize a tax benefit from the reversal of temporary differences and net operating loss carryforwards. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Management will continue to evaluate the realizability of any deferred tax assets and related valuation allowances. If our assessment of the deferred tax assets or the corresponding valuation allowance were to change, we would record the related adjustment as a component of the income tax provision or benefit during the period in which we make that determination. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007 and, accordingly, performed a comprehensive review of our uncertain tax positions as of that date. In this regard, an uncertain tax position represents our expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes. As a result of this review, we recorded uncertain tax positions by recognizing additional liabilities totaling $130,000 through a charge to accumulated deficit. During the year ended December 31, 2007, our liability for uncertain tax positions was reduced to an immaterial amount upon payment of additional taxes to a foreign tax jurisdiction and the balance remains unchanged at September 30, 2008. We do not expect there to be any material changes to the estimated amount of liability associated with our uncertain tax positions over the next twelve months. The tax years 2006 to 2007 remain subject to review by the taxing authorities in several jurisdictions. Note 7. Fair Value Measurements We adopted SFAS 157 effective January 1, 2008 for financial assets and liabilities measured at fair value on a recurring basis. There was no impact upon the adoption of SFAS 157 to the unaudited condensed consolidated financial statements. SFAS 157 requires disclosure that establishes a framework for measuring fair value and expands disclosure about fair value measurements. Under this standard, fair value is defined as the price that would be received to sell an asset or paid to transfer
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Table of Contentsa liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. SFAS 157 establishes a hierarchy for inputs used in measuring fair value that minimizes the use of unobservable inputs by requiring the use of observable market data when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on active market data. Unobservable inputs would be inputs that reflect our assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. The statement requires fair value measurements be classified and disclosed in one of the following three categories:
The following table sets forth, by level within the fair value hierarchy, financial assets (we have no financial liabilities) that are accounted for at fair value on a recurring basis as of September 30, 2008 (in thousands):
We accumulate unrealized gains and losses on our available-for-sale debt securities, net of tax, in accumulated other comprehensive income in the stockholders’ equity section of our balance sheets. The net unrealized loss on our available-for-sale securities at September 30, 2008 was immaterial. Note 8. Contingencies Legal Matters We are from time to time a party to legal proceedings that arise in the normal course of business. We are not currently involved in any litigation, the outcome of which would, in management’s judgment based on information currently available, have a material adverse effect on our results of operations or financial condition, nor is management aware of any such litigation threatened against us. Note 9. Segment Information We have adopted SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard requires segmentation based on our internal organization and reporting of revenue and other performance measures. Our segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which discrete financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. We have four operating segments. The types of products and services provided by each segment are summarized below:
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We refer to the revenue generated by our professional services and training segments, collectively, as services revenue. We refer to the revenue generated by our training segment as training revenue. We refer to the revenue generated by our maintenance segment as maintenance revenue. Currently, we do not separately allocate operating expenses to these segments, nor do we allocate specific assets to these segments. Therefore, the segment information reported includes only revenues, cost of revenues and gross profit. The following tables present the operations by each operating segment:
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Revenue, classified by the major geographic areas in which we operate, is as follows (in thousands):
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The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes that are included elsewhere in this Quarterly Report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this Quarterly Report under “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2007 under “Risk Factors” and in other parts of this Quarterly Report. Overview We develop and provide the leading software solutions for digital investigations, including EnCase® Enterprise, a network-enabled product primarily for large corporations and government agencies, and EnCase® Forensic, a desktop-based product primarily for law enforcement agencies. We were incorporated and commenced operations in 1997. From 1997 through 2002, we generated a substantial portion of our revenues from the sale of our EnCase® Forensic products and related services. We have experienced increases in our revenue as a result of the release of our EnCase® Enterprise products in late 2002, which expanded our customer base into corporate enterprises and federal government agencies. In addition, the releases of our EnCase® eDiscovery solution in late 2005 and EnCase® Information Assurance solution in late 2006 have increased our average transaction size. We anticipate that sales of our EnCase® Enterprise products and related services, in particular our EnCase® eDiscovery and EnCase® Information Assurance solutions, will comprise a substantial portion of our future revenues. Factors Affecting Our Results of Operations There are a number of trends that may affect our business and our industry. Some of these trends or other factors include:
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Table of ContentsCritical Accounting Policies and Estimates In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2007 have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates. There have no significant changes in those critical accounting policies and estimates during the nine months ended September 30, 2008. Results of Operations The following table sets forth selected statements of operations data for each of the periods indicated expressed as a percentage of total revenues:
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Table of ContentsThe following table sets forth share-based compensation expense recorded in each of the respective periods (in thousands):
Comparison of Results of Operations for the Three and Nine Months Ended September 30, 2007 and 2008 Revenues
We generate product revenue principally from sales of our EnCase® Enterprise and EnCase® Forensic products. A substantial portion of the EnCase® Enterprise and EnCase® Forensic license agreements we enter into include perpetual license terms. In conjunction with our EnCase® Forensic software, we also sell our Premium License Support Program product, which is sold on a subscription basis for a term of one or three years. In addition, we sell our Neutrino® mobile forensic device, EnCase® Bit9 Analyzer and certain other forensic hardware which we include in “Other” product revenue. The first two quarters of each fiscal year are typically our period of lowest product sales due to the seasonal budgetary cycles of our customers. The third quarter is typically the strongest sales quarter to our federal government customers. Typically, sales to our corporate customers are highest in the fourth quarter. Product revenues increased by $0.9 million (8%) in the third quarter of 2008 over the 2007 quarter, with that growth driven primarily by increases in Encase® Forensic licenses and subscriptions and EnCase® Bit9 Analyzer revenues, partially offset by slightly lower Enterprise license sales. Total sales revenues from our EnCase® Enterprise products decreased 2%
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Table of Contentsquarter over quarter, with lower sales of the basic EnCase® Enterprise platform outpacing new leasing revenues; module revenues were essentially flat. During third quarter 2008, we sold 19 products that run on the EnCase® Enterprise platform: 11 EnCase® eDiscovery, four EnCase® Data Audit & Policy Enforcement, and four Information Assurance. Included in the 11 sales of EnCase® eDiscovery in the third quarter were five deals sold on a Pay-Per-Use basis, which should begin to generate revenue in fourth quarter 2008. Forensic revenues increased due to increased government sales. The increase in Other product revenues reflects new efforts to sell certain third-party products (principally Bit9 Analyzer) integrated with our software platforms. For the nine months ended September 30, 2008, product revenues increased by $2.1 million (7%) compared to the comparable 2007 period, with that growth also driven primarily by increased Encase® Forensic licenses and subscriptions, due to increased government sales offsetting lower commercial sales and an increase in the amortization of deferred governmental revenues as the expected life of the current version of that product approaches an end. Total sales revenues from our EnCase® Enterprise products decreased 2% year over year due to lower sales of the basic EnCase® Enterprise platform, partially offset by increased add-on module sales, including the Data Audit & Policy Enforcement module. During the first three quarters of 2008 and 2007, we sold 53 and 61, respectively EnCase® eDiscovery, Information Assurance, AIRS and Data Audit & Policy Enforcement add-on modules. The increase in Other product revenues reflects new efforts to sell certain third-party products (principally Bit9 Analyzer) integrated with our software platforms. Services and maintenance revenues increased $1.9 million (23%) in the third quarter of 2008, with our maintenance and professional services segments producing revenue increases of $1.1 million and $0.6 million, respectively, over the comparable 2007 quarter. The continuing growth in maintenance revenues is the result of an on-going overall increase in our installed product base along with maintenance renewals by customers desiring continuing maintenance support on our products. The professional services revenue growth has been driven by eDiscovery services engagements. eDiscovery services accounted for approximately 71% of professional services billings, with implementation and forensic engagements accounting for approximately 13% and 10%, respectively. The number of professional services personnel has increased from approximately 56 at September 30, 2007 to 65 at September 30, 2008. Training services revenue increased $0.2 million in third quarter 2008 as the number of customers we train has increased as compared to the 2007 quarter, due to growth in our installed product base and the greater availability of our training courses. Services and maintenance revenues increased $7.8 million (32%) in the nine months ended September 30, 2008, with our maintenance and professional services segments producing revenue increases of $4.0 million and $2.7 million, respectively, over the comparable 2007 period. The continuing growth in maintenance revenues is the result of the on-going overall increase in our installed product base and high annual renewal rate. The professional services revenue growth has been driven by larger eDiscovery services engagements and increased demand for our services. Training services revenue increased $1.1 million in the first three quarters of 2008 as the number of customers we train has increased due both to growth in our installed product base and the greater availability of our training courses. Cost of Revenues
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Table of ContentsCost of software product revenue consists principally of the cost of producing and distributing our software, including the cost of compact discs, packaging, shipping, customs duties, royalties on third-party products integrated into our software and, to a lesser extent, compensation and related overhead expenses. While these costs are primarily variable with respect to sales volumes, they remain very low in relation to the revenues generated. Our gross margins can be affected by product mix, as our EnCase® Enterprise products are generally higher margin products than our EnCase® Forensic product, which is, in turn, higher margin than our hardware products. The costs of professional services and training revenue are largely comprised of employee compensation, including share-based compensation, costs and related overhead expenses, travel and facilities costs. The cost of maintenance revenue consists primarily of commissions paid to our third party service provider for contract renewals and includes employee compensation cost for customer technical support. The cost of product revenues increased 24% in third quarter 2008, on an overall increase in product revenues of 8%, over the 2007 quarter primarily due to royalties payable on sales of third-party software, which began in 2008, partially offset by generally lower costs otherwise. As a result, the product gross margin decreased slightly from 94.4% in third quarter 2007 to 93.5% in the 2008 quarter. Total cost of services and maintenance revenue increased $1.0 million, or 23%, in third quarter 2008, on an overall increase in services and maintenance revenue of $1.9 million (also 23%) over third quarter 2007. Since September 30, 2007, we increased our team of professional services consulting personnel, which contributed to increased total services and maintenance compensation expense of $1.0 million (including a $0.2 million increase in share-based compensation) and employee benefit costs. In addition, travel expense related to consulting and training increased $0.1 million due to increased activity and bad debt expense increased $0.1 million, while facilities and consulting costs both decreased $0.1 million. Overall, the services and maintenance gross margin decreased slightly to 47.0% in third quarter 2008 compared to 47.1% in the 2007 quarter. Individually, the gross margins of our segments changed from third quarter 2007 to third quarter 2008 as follows: professional services segment, from (4.9%) to (10.7%), training segment, from 39.3% to 40.0%; maintenance segment, from 86.6% to 87.0%. The cost of product revenues in the first nine months of 2008 increased 8%, on a 7% increase in product revenues, over the 2007 period primarily due to royalties payable on sales of third-party software, which began in 2008, partially offset by generally lower costs otherwise. Product gross margin was essentially flat at approximately 93.5% during the first nine months of both 2007 and 2008. For the first nine months of 2008, total cost of services and maintenance revenue increased $3.3 million, or 24%, on an overall increase in services and maintenance revenue of $7.8 million (32%) over the 2007 period, with the majority of the increase ($2.6 million) in the professional services division. As noted for the third quarter, increased professional services staffing has contributed to increased total services and maintenance compensation expense of $2.6 million (including a $0.8 million increase in share-based compensation) and related employee benefit and recruiting costs. In addition, travel and entertainment expense related to consulting and training increased $0.3 million due to increased activity and bad debt expense increased $0.3 million. Overall, the services and maintenance gross margin improved to 46.8% in the first nine months of 2008 compared to 43.5% in the 2007 period. Individually, the gross margins of our segments increased from the first nine months of 2007 to 2008 as follows: professional services segment, from 0.0% to 0.2%, training segment, from 34.6% to 39.2%; maintenance segment, from 85.9% to 87.7%. Selling and Marketing
Selling and marketing expenses consist primarily of base and incentive (sales commissions and share-based) compensation and related overhead expenses for employees engaged in selling and marketing. Selling and marketing
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Table of Contentsexpenses also include expenses relating to advertising, brand building, marketing and trade show events (net of amounts received from sponsors and participants), product management and travel and entertainment. Although we expense our sales commissions at the time the related sale is invoiced to the client, revenues from our EnCase® Enterprise term licenses, EnCase® Forensic product, Premium License Support Program, Neutrino®, the Annual Training Passport, consulting, maintenance and implementation are recognized over the relevant performance or license period. Accordingly, we generally experience a delay between increased selling and marketing expenses and the recognition of a portion of the corresponding revenue. The number of sales and marketing personnel that we employ was approximately 140 and 160 at September 30, 2007 and 2008, respectively. Selling and marketing expenses in third quarter 2008 increased $2.1 million (27%) over 2007, of which $1.6 million consisted of compensation costs largely due to increased staffing and higher commissions and share-based compensation. Higher costs were also incurred for marketing events and public relations ($0.1 million), eMarketing ($0.1 million) and recruiting ($0.1 million). Year to date, selling and marketing expenses increased $4.9 million (20%) in 2008 over 2007, with the majority of that total attributable to higher compensation ($3.5 million) costs, including a $1.2 million increase in share-based compensation, and commission ($1.2 million) costs. Higher costs were also incurred for marketing events and public relations ($0.5 million), eMarketing ($0.4 million) and recruiting ($0.2 million). Research and Development
Research and development expenses consist primarily of compensation, including share-based compensation, and related overhead expenses for research and development personnel, including quality assurance and testing. In order to develop new product offerings, continue developing existing products and improve quality assurance, we increased the number of research and development personnel that we employ from 55 at September 30, 2007 to 75 at September 30, 2008. Research and development expenses increased $1.0 million, or 42%, in the third quarter of 2008 over the 2007 quarter. The higher expenses were driven by increases of $0.8 million in compensation costs (including $0.2 million in share-based compensation) due to increased staffing and $0.2 million in benefits, recruiting and other employee-related costs. For the nine months ended September 30, 2008, research and development expenses increased $3.0 million over the first nine months of 2007, with compensation-related costs (including share-based compensation) accounting for $2.2 million of that increase, and benefits, recruiting and other employee-related costs accounting for the majority of the balance. General and Administrative
General and administrative expenses consist of compensation, including share-based compensation, and related overhead expenses for personnel engaged in the accounting, legal, information systems, human resources and other administrative functions. In addition, general and administrative expense includes professional services fees, including fees from auditors and attorneys, other corporate expenses and related overhead. The number of general and administrative personnel that we employ was approximately 60 and 70 at September 30, 2007 and 2008, respectively.
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Table of ContentsGeneral and administrative expenses in third quarter 2008 increased $1.0 million, or 27%, over the 2007 quarter. Higher compensation costs accounted for $0.7 million of that 2008 quarterly increase, including $0.5 million in share-based compensation, which included $0.3 million as the result of accelerating the vesting of certain of a former executive’s options. In addition, legal fees and settlements and bad debt expense both increased by $0.2 million. Year to date, general and administrative expenses increased $2.8 million, or 28%, in 2008 over the 2007 period. Contributing to the increased expenses were share-based compensation ($1.2 million), bad debt expense ($0.6 million), legal fees and settlements ($0.6 million) and professional services ($0.5 million, including $0.3M related to an ERP implementation). Depreciation and Amortization
Depreciation and amortization expenses consist of depreciation and amortization of our leasehold improvements, furniture and computer hardware and software. Depreciation and amortization expense in third quarter 2008 increased $0.1 million, or 11%, over the 2007 quarter, and increased $0.7 million, or 27%, for the first nine months of 2008, primarily due to the 2007 investment of approximately $8.6 million in the openings or expansions of our facilities and the investment in leasehold improvements, networks and phone equipment to permit several of our remote offices to safely access our corporate network. Interest Income Interest income decreased to $0.2 million in the third quarter of 2008, compared to $0.4 million in the 2007 period, and decreased to $0.6 million year to date 2008 compared to $1.1 million in 2007, with those decreases resulting from lower market interest rates on our cash equivalents and short-term investments. Income Tax Provision
NM – Not meaningful We recorded an income tax provision for the third quarter of 2008 of $1.7 million as compared to a $1.0 million provision for the same period one year prior and a provision of $1.4 million year to date in 2008 compared to a provision of $1.0 million in 2007 based on our estimated effective annual tax rate and taxable income (loss) for the respective years. The third quarter 2008 tax provision included an addition to our deferred tax asset valuation allowance of $1.4 million to fully reserve for the asset based on current projections of taxable losses. For the three and nine months ended September 30, 2008, our effective tax rate of (85.8%) and (18.5%), respectively, differed from the statutory rate of 34% primarily due to the determination during the three months ended September 30, 2008 that a full valuation allowance was required against our net deferred tax assets. For the three and nine months ended September 30, 2007, our effective tax rate of 158.3% and (48.0%), respectively, differed from the statutory rate of 34% primarily due to the determination during the three months ended September 30, 2007 that a partial valuation allowance was required against our net deferred tax assets. Management’s judgment is required in assessing the realizability of future deferred tax assets. In performing these assessments, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of our net deferred tax assets is dependent upon our generating sufficient taxable income in
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Table of Contentsfuture years in appropriate tax jurisdictions to realize a tax benefit from the reversal of temporary differences and net operating loss carryforwards. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Management will continue to evaluate the realizability of any deferred tax assets and related valuation allowances. If our assessment of the deferred tax assets or the corresponding valuation allowance were to change, we would record the related adjustment as a component of the income tax provision or benefit during the period in which we make that determination. Liquidity and Capital Resources Since inception, we have largely financed our operations from our cash flow from operations. In December 2006, we issued and sold 3,250,000 primary shares of our common stock at $11.50 per share, for net proceeds of $34.8 million in our initial public offering. As of September 30, 2008, we had $29.0 million in cash and cash equivalents and $5.0 million in short-term investments. We believe that our cash flow from operations and our cash, cash equivalents and short-term investments are sufficient to fund our working capital and capital expenditure requirements for at least the next 12 months. We generate cash from operations primarily from cash collections related to the sale of our products and services. Net cash used by operating activities was $0.3 million for the nine months ended September 30, 2008 compared with $5.0 million of cash provided in the nine months ended September 30, 2007. This decrease in cash provided by operations is the net result of a number of variances, but primarily reflects lower cash collections on accounts receivable and a lower increase in deferred revenues. The first and fourth quarters are typically our strongest quarters for cash collections, a consequence of much higher sales volumes typically experienced in the third and fourth quarters. Net cash used by investing activities was $8.5 million in the nine months ended September 30, 2008 compared to $18.9 million cash provided by operations in the 2007 period primarily due to the timing of purchases and maturities of short-term investments. In 2007, capital expenditures of $5.8 million were largely related to the construction and build-out of office facilities while in 2008 capital expenditures of $3.5 million are largely related to our implementation of a new ERP system. Net cash provided by financing activities was $0.2 million for the first nine months of 2008 compared with $3.1 million for the 2007 period. The decrease in cash provided by financing activities was primarily due to lower proceeds from the exercise of stock options. In each of the periods, we paid down capital lease obligations and, in 2007, we paid certain remaining costs of our initial public stock offering. We maintain a $3,000,000 revolving line of credit with a bank which was amended on October 6, 2008 to extend its expiration date to April 30, 2010 and modify certain administrative terms. At September 30, 2008, there were no amounts outstanding against this line. The line requires that we maintain certain financial covenants. At September 30, 2008, we were in compliance with the covenants associated with the revolving line of credit. At September 30, 2008, our outstanding contractual cash commitments were largely limited to our non-cancelable lease obligations, primarily relating to real estate. As part of our Annual Report on Form 10-K, we previously reported in Part II, Management’s Discussion and Analysis of Financial Condition and Results of Operations, that our contractual obligation for these non-cancelable lease obligations as of December 31, 2007 was approximately $23.9 million, of which $4.1 million was due during 2008. We currently have no other material cash commitments, except our normal recurring trade payables, expense accruals and leases, all of which are currently expected to be funded through existing working capital and future cash flows from operations. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our selling and marketing activities, the timing and extent of research and development spending to support product development and enhancement efforts, costs associated with expansion into new territories or markets, the timing of the introduction of new products and services and the enhancement of existing products and the continuing market acceptance of our products and services. To the extent that our short-term investments and existing cash, the availability under our line of credit and cash from operations are insufficient to fund our future activities and planned growth, we may need to raise additional funds through public or private equity or debt financings. Although we currently are not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, products or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional debt or equity financing. Additional funds may not be available on terms favorable to us or at all. Furthermore, although we cannot accurately anticipate the effect of inflation or foreign exchange markets on our operations, we do not believe these external economic forces have had, or are likely in the foreseeable future to have, a material impact on our results of operations.
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Table of ContentsAt September 30, 2008, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special-purpose, or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we did not engage in trading activities involving non-exchange traded contracts. As a result, we are not exposed to any financing, liquidity, market or credit risks that could arise if we had engaged in such relationships. We do not have material relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed in this report. Recent Accounting Pronouncements In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS 157 does not require new fair value measurements but rather defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. We adopted SFAS 157 in the first quarter of 2008 for financial assets and liabilities and are required to adopt SFAS 157 in the first quarter of 2009 for nonfinancial assets and liabilities. Adoption of SFAS 157 with respect to financial assets and liabilities did not have a material impact on our consolidated financial position and results of operations and we do not expect adoption of SFAS 157 with respect to nonfinancial assets and liabilities to have a material impact on our consolidated financial position and results of operations. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities—Including an amendment of FASB Statement No. 115.” SFAS 159 allows companies to elect fair-value measurement when an eligible financial asset or financial liability is initially recognized or when an event, such as a business combination, triggers a new basis of accounting for that financial asset or financial liability. SFAS 159 became effective for us on January 1, 2008, however we did not elect the fair value measurement provision for any of our financial assets or liabilities, so adoption of SFAS 159 had no effect on our consolidated financial position or results of operations. In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” which will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items, including:
SFAS 141R also includes a substantial number of new disclosure requirements. We will be required to adopt SFAS 141R prospectively for any business combinations for which the acquisition date is on or after January 1, 2009. Earlier adoption is prohibited. SFAS 141R will only have an effect on our financial statements in the event that we enter into business combinations subsequent to that date. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — An Amendment of ARB No. 51” (“SFAS 160”). SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the statement of operations. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. We will be required to adopt SFAS 160 effective January 1, 2009. Earlier adoption is prohibited. We do not have a noncontrolling interest in any subsidiaries. Accordingly, we do not anticipate that the initial application of SFAS No. 160 will have an impact on us.
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Although we currently bill for our products and services mostly in U.S. dollars, our financial results could be affected by factors such as changes in foreign currency rates or weak economic conditions in foreign markets. A strengthening of the dollar could make our products and services less competitive in foreign markets and therefore could reduce our revenues. We are billed by and pay substantially all of our vendors in U.S. dollars. In the future, an increased portion of our revenues and costs may be denominated in foreign currencies. To date, exchange rate fluctuations have had little impact on our operating results. We do not enter into derivative instrument transactions for trading or speculative purposes. Fixed income securities are subject to interest rate risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of the major portion of our investment portfolio. At September 30, 2008, all of our cash and cash equivalents and short-term investments consisted of federal agency and corporate obligations and deposits with financial institutions.
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the objectives of the control system and, accordingly, management must apply considerable judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. As required by Rule 13a-15(b) under the Exchange Act, we conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon the foregoing evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that as of September 30, 2008, these disclosure controls and procedures were effective. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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Table of ContentsPART II. OTHER INFORMATION
From time to time, we may become involved in various lawsuits and legal proceedings that arise in the ordinary course of business. Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are not currently aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, financial condition or operating results.
Except for the risk factors presented below, there have been no material changes to the risk factors as presented in our Annual Report on Form 10-K for the year ended December 31, 2007, filed with the Securities and Exchange Commission on March 17, 2008. Additional pricing models for our EnCase® Enterprise eDiscovery product could negatively impact our revenue in the short term. We recently announced our intention to release a version of our EnCase® Enterprise eDiscovery software that will be billed to customers based upon the volume of data searched, collected, and processed using the software. We refer to this as our Pay-Per-Use model. Traditionally, our pricing model for this software has been based upon a perpetual license, in which the license revenue is recorded once we deliver the product to our customer (presuming all other criteria of revenue recognition have been met). Under this new model, revenue will be recorded as our customers use the software to search, collect and process data, not at the point in which the software is delivered. During the third quarter of 2008, we signed Pay-Per-Use agreements with five new customers which are expected to begin generating revenue in fourth quarter 2008. We believe this Pay-Per-Use pricing model will drive our long-term growth of eDiscovery revenues due to three factors. First, customers with limited or no capital budgets, will still be able to acquire and use EnCase® eDiscovery. Second, we are no longer limited to competing with other enterprise software companies for capital budget dollars. Third, the pool of target companies is greatly increased as mid-market companies would have the ability to use the product without a major capital outlay. This new pricing model, in conjunction with our traditional perpetual license model, provides extreme flexibility for our customers to choose a pricing structure that best suits their particular situation. However, in the event that customers in our current pipeline choose our Pay-Per-Use pricing model instead of a perpetual license, we could see a short-term decrease in license revenue from our eDiscovery product. Our effective tax rate may fluctuate, which could increase our income tax expense and reduce our net income. In preparing our quarterly and annual consolidated financial statements, we estimate our income tax liability in each of the foreign and domestic jurisdictions in which we operate by estimating our actual current tax exposure and assessing temporary differences resulting from differing treatment of items for tax and financial statement purposes. Our judgments, assumptions and estimates relative to the current provision for income tax take into account current tax laws and our interpretation of current tax laws. Although we believe our judgments, assumptions and estimates are reasonable, changes in tax laws or our interpretation of tax laws and the resolution of any future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements. We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed during the subsequent year. Adjustments based on filed returns are generally recorded in the period when the tax returns are filed and the global tax implications are known and could significantly impact the amounts provided for income taxes. In accordance with accounting principles generally accepted in the United States, in the third quarter of 2008, we fully reserved our deferred tax asset to a net realizable value of zero. In doing so, we have applied judgment regarding the available evidence, both positive and negative, that our tax assets would be realized. A portion of this evidence is based upon forward looking information regarding our expected future taxable income. If we have under-estimated our future taxable income, we may reduce our valuation allowance and record additional income tax benefit in future periods.
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Purchases of Equity Securities by the Issuer In August 2008, our Board of Directors authorized a program to repurchase shares of our common stock having an aggregate value of up to $8,000,000. Acquisitions of shares may be made from time-to-time at management’s discretion, at prevailing prices in the open market, or in privately negotiated transactions, as permitted by securities laws and other legal requirements, and are subject to market conditions and other factors. The program may be discontinued at any time. The following table summarizes our purchases of common stock during the quarter ended September 30, 2008:
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Table of ContentsSIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: November 10, 2008
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