Edgar Filing: Five9, Inc.

September 30, 2018

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Document

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018



o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 001-36383

Five9, Inc.

(Exact Name of Registrant as Specified in Its Charter)



Delaware		94- 3394123
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

Bishop Ranch 8

4000 Executive Parkway, Suite 400

San Ramon, CA 94583

(Address of Principal Executive Offices) (Zip Code)

(925) 201-2000

(Registrant’s Telephone Number, Including Area Code)

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: x No: o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes: x No: o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act.



Large Accelerated Filer	x		Accelerated Filer	o
Non-accelerated filer	o	(Do not check if a smaller reporting Company)	Smaller Reporting Company	o
			Emerging Growth Company	o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. Yes: o No: o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes: o No: x

As of October 26, 2018, there were 58,771,956 shares of the Registrant’s common stock, par value $0.001 per share, outstanding.

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FIVE9, INC.

FORM 10-Q

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS		2

PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements		4
Condensed Consolidated Balance Sheets (Unaudited)		4
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) (Unaudited)		5
Condensed Consolidated Statements of Cash Flows (Unaudited)		6
Notes to Condensed Consolidated Financial Statements (Unaudited)		7
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		27
Overview		27
Key Operating and Financial Performance Metrics		28
Key Components of Our Results of Operations		30
Results of Operations for the Three and Nine Months Ended September 30, 2018 and 2017		32
Liquidity and Capital Resources		34
Critical Accounting Policies and Estimates		36
Recent Accounting Pronouncements		37
Off-Balance Sheet Arrangements		37
Contractual Obligations		37
ITEM 3. Quantitative and Qualitative Disclosure about Market Risk		39
ITEM 4. Controls and Procedures		39

PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings		40
ITEM 1A. Risk Factors		40
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds		68
ITEM 3. Defaults Upon Senior Securities		68
ITEM 4. Mine Safety Disclosures		68
ITEM 5. Other Information		68
ITEM 6. Exhibits		69

SIGNATURES		70

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which involve substantial risks and uncertainties. These statements reflect the current views of our senior management with respect to future events and our financial performance. These forward-looking statements include statements with respect to our business, expenses, strategies, losses, growth plans, product and client initiatives, market growth projections, and our industry. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “forecast,” “estimate,” “may,” “should,” “anticipate” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the federal securities laws or otherwise.

Forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause our actual results to differ materially from those indicated in these statements. These factors include the information set forth under the caption “Risk Factors” and elsewhere in this report, and include the following:


•	our quarterly and annual results may fluctuate significantly, including as a result of the timing and success of new product and feature introductions by us, may not fully reflect the underlying performance of our business and may result in decreases in the price of our common stock;


•	if we are unable to attract new clients or sell additional services and functionality to our existing clients, our revenue and revenue growth will be harmed;


•	our recent rapid growth may not be indicative of our future growth, and even if we continue to grow rapidly, we may fail to manage our growth effectively;


•	failure to adequately expand our sales force could impede our growth;


•	if we fail to manage our technical operations infrastructure, our existing clients may experience service outages, our new clients may experience delays in the deployment of our solution and we could be subject to, among other things, claims for credits or damages;


•	security breaches and improper access to or disclosure of our data or our clients’ data, or other cyber attacks on our systems, could result in litigation and regulatory risk, harm our reputation and adversely affect our business;


•	the markets in which we participate are highly competitive, and if we do not compete effectively, our operating results could be harmed;


•	if our existing clients terminate their subscriptions or reduce their subscriptions and related usage, our revenues and gross margins will be harmed and we will be required to spend more money to grow our client base;


•	our growth depends in part on the success of our strategic relationships with third parties and our failure to successfully grow and manage these relationships could harm our business;


•	we are establishing a network of master agents and resellers to sell our solution; our failure to effectively develop, manage, and maintain this network could materially harm our revenues;


•	we sell our solution to larger organizations that require longer sales and implementation cycles and often demand more configuration and integration services or customized features and functions that we may not offer, any of which could delay or prevent these sales and harm our growth rates, business and operating results;


•	because a significant percentage of our revenue is derived from existing clients, downturns or upturns in new sales will not be immediately reflected in our operating results and may be difficult to discern;


•	any disruption, price increase or degradation in the third-party telecommunications and internet services used by our clients and their customers to connect to and use our cloud contact center software, could impair or reduce our clients’ use of our solution, cause us to lose clients and subject us to reputational harm as well as claims for credits or damages;


•	we have a history of losses and we may be unable to achieve or sustain profitability;


•	the contact center software solutions market is subject to rapid technological change, and we must develop and sell incremental and new products in order to maintain and grow our business;

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•	we may not be able to secure additional financing on favorable terms, or at all, to meet our future capital needs;


•	we may not have sufficient cash to service our convertible senior notes and repay such notes, if required; and


•	failure to comply with laws and regulations could harm our business and our reputation.

The foregoing factors should not be construed as exhaustive and should be read together with the other cautionary statements included in this report. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our actual results may differ materially from what we anticipate. You should not place undue reliance on our forward-looking statements. Any forward-looking statements you read in this report reflect our views only as of the date of this report with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. We undertake no obligation to update any forward-looking statements made in this report to reflect events or circumstances after the date of this report or to reflect new information or the occurrence of unanticipated events, except as required by law.

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PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

FIVE9, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)



	September 30, 2018			December 31, 2017
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	79,619		$	68,947
Marketable investments	200,007			—
Accounts receivable, net	23,903			19,048
Prepaid expenses and other current assets	7,962			4,840
Deferred contract acquisition costs	8,633			—
Total current assets	320,124			92,835
Property and equipment, net	22,909			19,888
Intangible assets, net	724			1,073
Goodwill	11,798			11,798
Other assets	962			2,602
Deferred contract acquisition costs — less current portion	19,599			—
Total assets	$	376,116		$	128,196

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,528		$	4,292
Accrued and other current liabilities	14,144			11,787
Accrued federal fees	1,681			1,151
Sales tax liability	1,322			1,326
Notes payable	—			336
Capital leases	6,909			6,651
Deferred revenue	17,490			13,975
Total current liabilities	46,074			39,518
Convertible senior notes	193,664			—
Revolving line of credit	—			32,594
Sales tax liability — less current portion	884			1,044
Capital leases — less current portion	6,250			7,161
Other long-term liabilities	1,360			1,041
Total liabilities	248,232			81,358
Commitments and contingencies (Note 10)
Stockholders’ equity:
Preferred stock, $0.001 par value; 5,000 shares authorized, no shares issued and outstanding at September 30, 2018 and December 31, 2017	—			—
Common stock, $0.001 par value; 450,000 shares authorized, 58,749 shares and 56,632 shares issued and outstanding at September 30, 2018 and December 31, 2017, respectively	59			57
Additional paid-in capital	283,055			222,202
Accumulated deficit	(155,230		)	(175,421		)
Total stockholders’ equity	127,884			46,838
Total liabilities and stockholders’ equity	$	376,116		$	128,196

See accompanying notes to the unaudited condensed consolidated financial statements.

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FIVE9, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

(Unaudited, in thousands, except per share data)



	Three Months Ended						Nine Months Ended
	September 30, 2018			September 30, 2017			September 30, 2018			September 30, 2017
Revenue	$	65,304		$	50,081		$	185,329		$	144,822
Cost of revenue	26,179			20,497			75,695			60,741
Gross profit	39,125			29,584			109,634			84,081
Operating expenses:
Research and development	9,582			6,689			25,721			20,372
Sales and marketing	17,818			16,502			53,208			49,212
General and administrative	10,746			4,679			29,682			20,384
Total operating expenses	38,146			27,870			108,611			89,968
Income (loss) from operations	979			1,714			1,023			(5,887		)
Other income (expense), net:
Interest expense	(3,595		)	(865		)	(6,783		)	(2,635		)
Interest income and other	1,352			118			1,956			326
Total other income (expense), net	(2,243		)	(747		)	(4,827		)	(2,309		)
Income (loss) before income taxes	(1,264		)	967			(3,804		)	(8,196		)
Provision for income taxes	41			43			150			142
Net income (loss)	$	(1,305	)	$	924		$	(3,954	)	$	(8,338	)
Net income (loss) per share:
Basic	$	(0.02	)	$	0.02		$	(0.07	)	$	(0.15	)
Diluted	$	(0.02	)	$	0.02		$	(0.07	)	$	(0.15	)
Shares used in computing net income (loss) per share:
Basic	58,454			55,310			57,790			54,579
Diluted	58,454			59,441			57,790			54,579
Comprehensive Income (Loss):
Net income (loss) and comprehensive income (loss)	$	(1,305	)	$	924		$	(3,954	)	$	(8,338	)

See accompanying notes to the unaudited condensed consolidated financial statements.

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FIVE9, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



	Nine Months Ended
	September 30, 2018			September 30, 2017
Cash flows from operating activities:
Net loss	$	(3,954	)	$	(8,338	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization	7,436			6,246
Amortization of premium on marketable investments	(317		)	—
Provision for doubtful accounts	81			66
Stock-based compensation	20,991			10,703
Reversal of interest and penalties on accrued federal fees	—			(2,133		)
Gain on sale of convertible note held for investment	(312		)	—
Non-cash adjustment on investment	(40		)	(233		)
Amortization of debt discount and issuance costs	129			60
Amortization of discount and issuance costs on convertible senior notes	4,782			—
Accretion of interest	44			16
Others	(59		)	(50		)
Changes in operating assets and liabilities:
Accounts receivable	(4,931		)	(3,406		)
Prepaid expenses and other current assets	(2,755		)	(1,861		)
Deferred contract acquisition costs	(5,094		)	—
Other assets	68			71
Accounts payable	307			1,409
Accrued and other current liabilities	2,575			1,774
Accrued federal fees and sales tax liability	366			95
Deferred revenue	3,910			3,676
Other liabilities	(75		)	131
Net cash provided by operating activities	23,152			8,226
Cash flows from investing activities:
Purchases of marketable investments	(203,953		)	—
Proceeds from maturities of marketable investments	4,047			—
Purchases of property and equipment	(4,503		)	(1,809		)
Proceeds from sale of convertible note held for investment	1,923			—
Net cash used in investing activities	(202,486		)	(1,809		)
Cash flows from financing activities:
Proceeds from issuance of convertible senior notes, net of issuance costs paid of $8,036	250,714			—
Payments for capped call transactions	(31,412		)	—
Proceeds from exercise of common stock options	7,111			3,280
Proceeds from sale of common stock under ESPP	2,884			1,800
Repayments on revolving line of credit	(32,594		)	—
Payments of notes payable	(318		)	(547		)
Payments of capital leases	(6,379		)	(5,708		)
Net cash provided by (used in) financing activities	190,006			(1,175		)
Net increase in cash and cash equivalents	10,672			5,242
Cash and cash equivalents:
Beginning of period	68,947			58,122
End of period	$	79,619		$	63,364
Supplemental disclosures of cash flow data:
Cash paid for interest	$	1,850		$	2,588
Cash paid for income taxes	$	151		$	113
Non-cash investing and financing activities:
Equipment obtained under capital lease	$	4,981		$	7,482
Equipment purchased and unpaid at period-end	$	779		$	22

See accompanying notes to the unaudited condensed consolidated financial statements.

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FIVE9, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1. Description of Business and Summary of Significant Accounting Policies

Five9, Inc. and its wholly-owned subsidiaries (the “Company”) is a provider of cloud software for contact centers. The Company was incorporated in Delaware in 2001 and is headquartered in San Ramon, California. The Company has offices in Europe and Asia, which primarily provide research, development, sales, marketing, and client support services.

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. In the opinion of management, the condensed consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. All intercompany transactions and balances have been eliminated in consolidation.

Certain prior period amounts included in the condensed consolidated financial statements have been reclassified to conform to the current period presentation.

Use of Estimates

The preparation of condensed consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. The significant estimates made by management affect revenue, the allowance for doubtful accounts, loss contingencies, including the Company’s accrual for federal fees and sales tax liability, and accrued liabilities. Management periodically evaluates such estimates and they are adjusted prospectively based upon such periodic evaluation. Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company’s cash and cash equivalents consist of highly liquid investments with maturities of three months or less at the time of purchase. The Company’s cash equivalents consist of investments in money market funds and commercial paper.

Marketable Investments

The Company’s marketable investments consist of U.S agency securities and government sponsored securities, U.S. treasury securities, certificates of deposit, municipal bonds, corporate bonds and commercial paper. The Company determines the appropriate classification of its investments in marketable investments at the time of purchase and re-evaluates such designation at each balance sheet date. The Company’s marketable investments have been classified and accounted for as available-for-sale. Marketable investments are carried at fair value.

Significant Accounting Policies

The Company’s significant accounting policies are disclosed in its Annual Report on Form 10-K for the year ended December 31, 2017. Other than the accounting policies discussed in Note 2 related to the adoption of ASC 606, there has been no material change to the Company’s significant accounting policies during the nine months ended September 30, 2018. See Note 2 for the updated accounting policies.

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Recently Adopted Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2014-09, Revenue from Contracts with Customers: Topic 606, amending revenue recognition guidance and requiring more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. ASU 2014-09 also includes Subtopic 340-40, Other Assets and Deferred Costs - Contracts with Customers, which requires the deferral of incremental costs of obtaining a contract with a customer. The Company adopted ASU 2014-09 and its related amendments (collectively “ASC 606”) effective on January 1, 2018 using the modified retrospective method. See Note 2 for disclosure on the impact of adopting this standard.

Recent Accounting Pronouncements Not Yet Effective

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). Under the new guidance, a lessee will be required to recognize assets and liabilities for both finance, or capital, and operating leases with lease terms of more than 12 months. The ASU also will require disclosures to help investors and other financial statement users better understand the amount, timing, and uncertainty of cash flows arising from leases. Lessor accounting will remain largely unchanged from current GAAP. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach that includes a number of optional practical expedients that entities may elect to apply. This guidance is effective for the Company beginning in the first quarter of 2019. Early adoption is permitted. The Company, upon adoption of the new guidance, will recognize operating lease liabilities and right-of-use assets for operating lease commitments covered by Topic 842, and the Company’s total assets and total liabilities will increase relative to such amounts prior to adoption. The Company has gathered information and is evaluating the impact this guidance will have on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-15, Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (ASU 2018-15), which clarifies the accounting for implementation costs in cloud computing arrangements. ASU 2018-15 is effective for the Company in the first quarter of fiscal 2020. Early adoption is permitted. The Company is currently evaluating the impact this guidance will have on its consolidated financial statements.

There are several other new accounting pronouncements issued by the FASB, which the Company will adopt. However, the Company does not believe any of those accounting pronouncements will have a material impact on its consolidated financial position, operating results or statements of cash flows.

2. ASC 606 Adoption Impact and Revenue from Contracts with Customers

ASC 606 Adoption Impact

On January 1, 2018, the Company adopted ASC 606 using the modified retrospective method, applying to all contracts. The Company recognized the cumulative effect of applying the new revenue standard as an adjustment to the opening balance of accumulated deficit at the beginning of 2018. The comparative information has not been restated and continues to be reported under the accounting standards in effect for the period presented, or “ASC 605.” In connection with the adoption of ASC 606, the Company also adopted ASC 340-40, Other Assets and Deferred Costs - Contracts with Customers (“ASC 340-40”), which requires the deferral of incremental costs of obtaining a contract with a customer. Collectively, the Company refers to ASC 606 and ASC 340-40 as the “new standard.”

Adoption of the new standard resulted in changes to our accounting policies for revenue recognition, commissions and deferred commissions as discussed below. The Company recorded a net reduction to opening accumulated deficit of $24.1 million as of January 1, 2018 due to the cumulative impact of adopting the new standard. The primary impact of adopting the new standard related to the deferral of $23.1 million in incremental commission costs of obtaining subscription contracts. Under ASC 605, the Company expensed all commission costs as incurred. Under the new standard, the Company defers all incremental commission costs to obtain the contract, and amortizes these costs over a period of benefit determined to be five years. The remaining $1.0 million impact of adopting the new standard related to revenue being recognized earlier than it would have been under ASC 605.

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Practical Expedients and Exemptions

The Company applies a practical expedient that permits the Company to apply ASC 340-40 to a single portfolio of contracts, as they are similar in their characteristics, and the financial statement effects of applying ASC 340-40 to that portfolio would not differ materially from applying it to the individual contracts within that portfolio.

Additionally, the Company has elected the optional exemption which allows for the exclusion of the amounts for remaining performance obligations that are part of contracts with an original expected duration of one year or less.

Impact on Condensed Consolidated Financial Statements

Select condensed consolidated balance sheet line items, which reflects the adoption impact of the new standard, are as follows:



	September 30, 2018
(in thousands)	As Reported			Balances without adoption of ASC 606			Effect of Change Higher (Lower)
Assets:
Accounts receivable, net	$	23,903		$	23,800		$	103
Prepaid expenses and other current assets	7,962			8,042			(80		)
Deferred contract acquisition costs	28,232			—			28,232
Liabilities:
Deferred revenue - current	17,490			19,308			(1,818		)
Shareholders’ Equity:
Accumulated deficit	(155,230		)	(185,303		)	30,073

Select condensed consolidated statement of operations line items, which reflects the adoption of the new standard, are as follows:



	Three Months Ended September 30, 2018
(in thousands, except per share amounts)	As Reported			Balances without adoption of ASC 606			Effect of Change Higher (Lower)
Revenue	$	65,304		$	65,041		$	263
Cost of revenue	26,179			26,040			139
Gross profit	39,125			39,001			124
Sales and marketing	17,818			19,574			(1,756		)
Income (loss) from operations	979			(901		)	1,880
Net income (loss)	(1,305		)	(3,185		)	1,880
Basic and diluted net loss per share	$	(0.02	)	$	(0.05	)	$	0.03



	Nine months ended September 30, 2018
(in thousands, except per share amounts)	As Reported			Balances without adoption of ASC 606			Effect of Change Higher (Lower)
Revenue	$	185,329		$	183,965		$	1,364
Cost of revenue	75,695			75,165			530
Gross profit	109,634			108,800			834
Sales and marketing	53,208			58,302			(5,094		)
Income (loss) from operations	1,023			(4,905		)	5,928
Net income (loss)	(3,954		)	(9,882		)	5,928
Basic and diluted net loss per share	$	(0.07	)	$	(0.17	)	$	0.10

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Select condensed consolidated cash flow line items, which reflects the adoption of the new standard, are as follows:



	Nine months ended September 30, 2018
(in thousands)	As Reported			Balances without adoption of ASC 606			Effect of Change Higher (Lower)
Accounts receivable	$	(4,931	)	$	(4,828	)	$	(103	)
Prepaid expenses and other current assets	(2,755		)	(2,835		)	80
Deferred contract acquisition costs	(5,094		)	—			(5,094		)
Deferred revenue	3,910			5,728			(1,818		)
Net cash provided by operating activities	23,152			23,152			—

Changes in Accounting Policies

Revenue Recognition

Revenue is recognized when control of the promised services are transferred to customers in an amount that reflects the consideration that the Company expects to receive in exchange for those services. The Company generates all of its revenue from contracts with customers. In contracts with multiple performance obligations, it identifies each performance obligation and evaluates whether the performance obligations are distinct within the context of the contract at contract inception. Performance obligations that are not distinct at contract inception are combined. The Company allocates the transaction price to each distinct performance obligation proportionately based on the estimated standalone selling price for each performance obligation. The Company then looks to how services are transferred to the customer in order to determine the timing of revenue recognition. Most services provided under the Company’s agreements result in the transfer of control over time.

The Company’s revenue consists of subscription services and related usage as well as professional services. The Company charges clients subscription fees, usually billed on a monthly basis, for access to the Company’s Virtual Contact Center, or VCC, solution. The monthly subscription fees are primarily based on the number of agent seats, as well as the specific VCC functionalities and applications deployed by the client. Agent seats are defined as the maximum number of named agents allowed to concurrently access the VCC cloud platform. Clients typically have more named agents than agent seats. Multiple named agents may use an agent seat, though not simultaneously. Substantially all of the Company’s clients purchase both subscriptions and related telephony usage. A small percentage of the Company’s clients subscribe to its platform but purchase telephony usage directly from a wholesale telecommunications service provider. The Company does not sell telephony usage on a stand-alone basis to any client. The related usage fees are based on the volume of minutes used for inbound and outbound client interactions. The Company also offers bundled plans, generally for smaller deployments, whereby the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. Professional services revenue is derived primarily from VCC implementations, including application configuration, system integration, optimization, education and training services. Clients are not permitted to take possession of the Company’s software.

The Company offers monthly, annual and multiple-year contracts to its clients, generally with 30 days’ notice required for changes in the number of agent seats and sometimes with a minimum number of agent seats required. Larger clients typically choose annual contracts, which generally include an implementation and ramp period of several months. Fixed subscription fees (including bundled plans) are generally billed monthly in advance, while related usage fees are billed in arrears. Support activities include technical assistance for the Company’s solution and upgrades and enhancements to the VCC cloud platform on a when-and-if-available basis, which are not billed separately.

The Company generally requires advance deposits from its clients based on estimated usage when such usage is not billed as part of a bundled plan. Any unused portion of the deposit is refundable to the client upon termination of the arrangement, provided all amounts due have been paid. All fees, except usage deposits, are non-refundable.

Professional services are primarily billed on a fixed-fee basis and are performed by the Company directly or, alternatively, clients may also choose to perform these services themselves or engage their own third-party service providers.

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The estimation of variable consideration for each performance obligation requires the Company to make subjective judgments resulting in estimated variable consideration that is included in the transaction fee. This is done to the extent that it is probable, in the Company’s judgment, that a significant reversal in the amount of cumulative revenue recognized under the contract will not occur. The Company estimates the variable consideration in order to allocate the overall transaction fee on a relative stand-alone selling price basis to its multiple performance obligations. This requires the estimate of unit quantities, especially during the initial ramp period of the contract, during which the Company bills under an ‘actual usage’ model for subscription-related services.

The Company recognizes revenue on fixed fee professional services performance obligations based on the proportion of labor hours expended compared to the total hours expected to complete the related performance obligation. The determination of the total labor hours expected to complete the performance obligations involves judgment, influencing the initial stand-alone selling price estimate as well as the timing of professional services revenue recognition, although this is typically resolved in a short time frame.

When a contract with a customer is signed, the Company assesses whether collection of the fees under the arrangement is probable. The Company assesses collection based on a number of factors, including past transaction history and the creditworthiness of the client. The Company maintains a revenue reserve for potential credits to be issued in accordance with service level agreements or for other revenue adjustments.

The revenue recognition standards include guidance relating to any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added and excise taxes. The Company records Universal Service Fund, or USF, contributions and other regulatory costs on a gross basis in its condensed consolidated statements of operations and comprehensive loss and records surcharges and sales, use and excise taxes billed to its clients on a net basis. The cost of gross USF contributions payable to the Universal Service Administrative Company, or USAC, other FCC fund administrators and wholesale carriers is presented as a cost of revenue in the condensed consolidated statements of operations and comprehensive loss. Surcharges and sales, use and excise taxes incurred in excess of amounts billed to the Company’s clients are presented in general and administrative expense in the condensed consolidated statements of operations and comprehensive loss.

Disaggregation of Revenue

The Company disaggregates its revenue by geographic region. See Note 11 for more information.

Contract Balances

The following table provides information about accounts receivable, net, deferred contract acquisition costs, contract assets and contract liabilities from contracts with customers (in thousands):



	September 30, 2018			January 1, 2018
Accounts receivable, net	$	23,903		$	19,151

Deferred contract acquisition costs:
Current	$	8,633		$	7,059
Non-current	19,599			16,079
Total deferred contract acquisition costs	$	28,232		$	23,138

Contract assets and contract liabilities:
Contract assets (included in prepaid expenses and other current assets)	$	688		$	736
Contract liabilities (deferred revenue)	17,490			13,568
Net contract assets (liabilities)	$	(16,802	)	$	(12,832	)

The Company receives payments from customers based upon billing cycles. Invoice payment terms are usually 30 days or less. Accounts receivable are recorded when the right to consideration becomes unconditional.

Deferred contract acquisition costs are recorded when incurred and are amortized over a customer benefit period of five years.

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The Company’s contract assets consist of unbilled amounts typically resulting from professional services revenue recognition when it exceeds the total amounts billed to the customer. The Company’s contract liabilities consist of advance payments and billings in excess of revenue recognized.

In the three and nine months ended September 30, 2018, the Company recognized revenue of $1.2 million and $9.3 million, respectively, related to its contract liabilities at January 1, 2018.

Deferred Contract Acquisition Costs

In connection with the adoption of ASC 340-40, the Company capitalizes certain contract acquisition costs consisting primarily of commissions paid when contracts are signed and related incremental fringe benefits. As of January 1, 2018, the date of ASC 340-40 adoption, the Company had $23.1 million capitalized in deferred contract acquisition costs related to contracts where the benefit period had not yet expired. In the three and nine months ended September 30, 2018, amortization from amounts capitalized was $2.2 million and $6.1 million, respectively, and amounts expensed as incurred were $0.5 million and $1.5 million, respectively. As of September 30, 2018, the Company had no impairment loss in relation to costs capitalized.

Remaining Performance Obligations

As of September 30, 2018, the aggregate amount of the total transaction price allocated in contracts with original duration of greater than one year to the remaining performance obligations was $93.4 million. The Company expects to recognize revenue on approximately three-quarters of the remaining performance obligation over the next 24 months, with the balance recognized thereafter. The Company has elected the optional exemption, which allows for the exclusion of the amounts for remaining performance obligations that are part of contracts with an original expected duration of one year or less. Such remaining performance obligations represent unsatisfied or partially unsatisfied performance obligations pursuant to ASC 606.

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3. Investments and Fair Value Measurements

Marketable Investments

The Company’s marketable investments have been classified and accounted for as available-for-sale. The Company’s marketable investments as of September 30, 2018 were as follows (in thousands):



	September 30, 2018
	Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Certificates of deposit	$	5,318	$	1	$	—		$	5,319
U.S. treasury	1,132		—		—			1,132
U.S. agency securities and government sponsored securities	144,208		—		(173		)	144,035
Commercial paper	3,727		—		—			3,727
Municipal bonds	6,085		—		(9		)	6,076
Corporate bonds	39,753		—		(35		)	39,718
Total	$	200,223	$	1	$	(217	)	$	200,007

The following table presents the gross unrealized losses and the fair value for those marketable investments that were in an unrealized loss position as of September 30, 2018 (in thousands):



	September 30, 2018
	Less than 12 months
	Gross Unrealized Losses			Fair Value
U.S. treasury	$	—		$	1,132
U.S. agency securities and government sponsored securities	(173		)	144,035
Municipal bonds	(9		)	6,076
Corporate bonds	(35		)	39,718
Total	$	(217	)	$	190,961

The contractual maturities of the Company’s marketable investments as of September 30, 2018 were less than one year.

Fair Value Measurements

The Company carries cash equivalents and marketable investments at fair value. Fair value is based on the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement:

Level 1 — Observable inputs which include unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 — Observable inputs other than Level 1 inputs, such as quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 — Unobservable inputs that are supported by little or no market activity and that are based on management’s assumptions, including fair value measurements determined by using pricing models, discounted cash flow methodologies or similar techniques.

The Company determined the fair value of its Level 1 financial instruments, which are traded in active markets, using quoted market prices for identical instruments.

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Marketable investments classified within Level 2 of the fair value hierarchy are valued based on other observable inputs, including broker or dealer quotations or alternative pricing sources. When quoted prices in active markets for identical assets or liabilities are not available, the Company relies on non-binding quotes from its investment managers, which are based on proprietary valuation models of independent pricing services. These models generally use inputs such as observable market data, quoted market prices for similar instruments, historical pricing trends of a security as relative to its peers. To validate the fair value determination provided by its investment managers, the Company reviews the pricing movement in the context of overall market trends and trading information from its investment managers. In addition, the Company assesses the inputs and methods used in determining the fair value in order to determine the classification of securities in the fair value hierarchy.

The following table sets forth the Company’s assets measured at fair value by level within the fair value hierarchy (in thousands):



	September 30, 2018
	Level 1		Level 2		Level 3		Total
Assets
Cash equivalents
Commercial paper	$	—	$	249	$	—	$	249
Money market funds	20,094		—		—		20,094
Total cash equivalents	$	20,094	$	249	$	—	$	20,343
Marketable investments
Certificates of deposit	—		5,319		—		5,319
U.S. treasury	1,132		—		—		1,132
U.S. agency securities and government sponsored securities	—		144,035		—		144,035
Commercial paper	—		3,727		—		3,727
Municipal bonds	—		6,076		—		6,076
Corporate bonds	—		39,718		—		39,718
Total marketable investments	$	1,132	$	198,875	$	—	$	200,007

	December 31, 2017
	Level 1		Level 2		Level 3		Total
Assets
Cash equivalents
Money market funds	$	20,092	$	—	$	—	$	20,092
Other Assets
Embedded conversion option held for investment	$	—	$	—	$	984	$	984

In March 2018, the Company received proceeds of $1.9 million from the conversion and sale of a convertible note with a carrying value of $1.6 million. Proceeds from the sale of the investment totaled $2.1 million. The Company expects to receive the remainder of the proceeds in 2019.

As of September 30, 2018, the estimated fair value of the Company’s outstanding 0.125% convertible senior notes due 2023 was $313.4 million. The fair value was determined based on the quoted price of the convertible senior notes in an inactive market on the last trading day of the reporting period and has been classified as Level 2 in the fair value hierarchy. See Note 6 for further information on the Company’s 0.125% convertible senior notes due 2023.

There were no assets or liabilities measured at fair value on a non-recurring basis as of September 30, 2018.

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4. Financial Statement Components

Cash and cash equivalents consisted of the following (in thousands):



	September 30, 2018		December 31, 2017
Cash	$	59,276	$	48,855
Commercial paper	249		—
Money market funds	20,094		20,092
Cash and cash equivalents	$	79,619	$	68,947

Accounts receivable, net consisted of the following (in thousands):



	September 30, 2018			December 31, 2017
Trade accounts receivable	$	22,427		$	17,481
Unbilled trade accounts receivable, net of advance client deposits	1,491			1,600
Allowance for doubtful accounts	(15		)	(33		)
Accounts receivable, net	$	23,903		$	19,048

Prepaid expenses and other current assets consisted of the following (in thousands):



	September 30, 2018		December 31, 2017
Prepaid expenses	$	4,961	$	2,437
Other current assets	2,313		2,403
Contract assets	688		—
Prepaid expenses and other current assets	$	7,962	$	4,840

Property and equipment, net consisted of the following (in thousands):



	September 30, 2018			December 31, 2017
Computer and network equipment	$	50,694		$	47,195
Computer software	8,191			6,974
Internal-use software development costs	500			500
Furniture and fixtures	1,479			1,282
Leasehold improvements	804			801
Property and equipment	61,668			56,752
Accumulated depreciation and amortization	(38,759		)	(36,864		)
Property and equipment, net	$	22,909		$	19,888

Depreciation and amortization expense associated with property and equipment was $2.6 million and $7.1 million for the three and nine months ended September 30, 2018, respectively, and $1.8 million and $5.9 million for the three and nine months ended September 30, 2017, respectively.

Property and equipment capitalized under capital lease obligations consist primarily of computer and network equipment and was as follows (in thousands):



	September 30, 2018			December 31, 2017
Gross	$	47,527		$	46,624
Less: accumulated depreciation and amortization	(31,905		)	(30,438		)
Total	$	15,622		$	16,186

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Accrued and other current liabilities consisted of the following (in thousands):



	September 30, 2018		December 31, 2017
Accrued compensation and benefits	$	11,787	$	8,657
Accrued expenses	2,357		3,130
Accrued and other current liabilities	$	14,144	$	11,787

5. Intangible Assets

The components of intangible assets were as follows (in thousands):



	September 30, 2018							December 31, 2017
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Developed technology	$	2,460	$	(1,741	)	$	719	$	2,460	$	(1,478	)	$	982
Customer relationships	520		(515		)	5		520		(437		)	83
Domain names	50		(50		)	—		50		(42		)	8
Total	$	3,030	$	(2,306	)	$	724	$	3,030	$	(1,957	)	$	1,073

Amortization expense for intangible assets was $0.1 million and $0.3 million for the three and nine months ended September 30, 2018, respectively, and $0.1 million and $0.3 million for the three and nine months ended September 30, 2017, respectively.

As of September 30, 2018, the expected future amortization expense for intangible assets was as follows (in thousands):



Period	Expected Future Amortization Expense
2018	$	93
2019	351
2020	280
Total	$	724

6. Debt

0.125% Convertible Senior Notes and Capped Call

In May 2018, the Company issued $225.0 million aggregate principal amount of 0.125% convertible senior notes due May 1, 2023 in a private offering and an additional $33.75 million aggregate principal amount of such notes pursuant to the exercise in full of the over-allotment option of the initial purchasers (collectively the “Notes”). The Notes are the Company’s senior unsecured obligations and bear interest at a fixed rate of 0.125% per annum, payable semiannually in arrears on May 1 and November 1 of each year, beginning on November 1, 2018. The total net proceeds from the offering, after deducting initial purchase discounts and estimated debt issuance costs, were approximately $250.7 million.

Each $1,000 principal amount of the Notes is initially convertible into 24.4978 shares of our common stock (the “Conversion Option”) which is equivalent to an initial conversion price of approximately $40.82 per share of common stock, subject to adjustment upon the occurrence of specified events. The Notes are convertible, in multiples of $1,000 principal amount, at the option of the holders at any time prior to the close of business on the business day immediately preceding November 1, 2022, only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2018 (and only during such calendar quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;

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(2) during the five business day period after any five consecutive trading day period (the “Measurement Period”) in which the trading price (as defined in the indenture governing the Notes) per $1,000 principal amount of Notes for each trading day of the Measurement Period was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate in effect on each such trading day; (3) if the Company calls any or all of the Notes for redemption, at any time prior to the close of business on the second scheduled trading day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events. On or after November 1, 2022 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert all or any portion of their Notes, in multiples of $1,000 principal amount, at the option of the holder regardless of the foregoing circumstances.

Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of the Company’s common stock or a combination of cash and shares of the Company’s common stock, at the Company’s election. If the Company undergoes a fundamental change (as defined in the indenture governing the Notes), subject to certain conditions, holders may require the Company to repurchase for cash all or any portion of their Notes, in principal amounts of $1,000 or a multiple thereof, at a fundamental change repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest, if any, to, but excluding, the fundamental change repurchase date. In addition, following certain corporate events that occur prior to the maturity date or if the Company issues a notice of redemption, it will, under certain circumstances, increase the conversion rate for holders who elect to convert their Notes in connection with such corporate event or during the relevant redemption period.

During the nine months ended September 30, 2018, the conditions allowing holders of the Notes to convert were not met. The Notes were therefore not convertible during the nine months ended September 30, 2018 and were classified as long-term debt.

The Company may not redeem the Notes prior to May 5, 2021. The Company may redeem for cash all or any portion of the Notes, at its option, on or after May 5, 2021 if the last reported sale price of its common stock has been at least 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period (including the last trading day of such period) ending not more than two trading days immediately preceding the date on which the Company provides notice of redemption at a redemption price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest, if any, to, but excluding, the redemption date. No sinking fund is provided for the Notes.

The Notes are the Company’s senior unsecured obligations and will rank senior in right of payment to any of the Company’s indebtedness that is expressly subordinated in right of payment to the Notes; equal in right of payment to any of the Company’s unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of the Company’s secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness and other liabilities (including trade payables) of the Company’s subsidiaries.

In accounting for the transaction, the Notes were separated into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar debt instrument that does not have an associated conversion feature. The carrying amount of the equity component representing the conversion option was $63.8 million and was determined by deducting the fair value of the liability component from the par value of the Notes. The equity component was recorded in additional paid-in-capital and is not remeasured as long as it continues to meet the conditions for equity classification. The excess of the principal amount of the liability component over its carrying amount (the “Debt Discount”) is being amortized to interest expense over the contractual term of the Notes at an effective interest rate of 6.39%.

In accounting for the debt issuance cost of $8.1 million related to the Notes, the Company allocated the total amount incurred to the liability and equity components of the Notes based on their relative values. Issuance costs attributable to the liability component were $6.1 million and are being amortized to interest expense using the effective interest method over the contractual term of the Notes. Issuance costs attributable to the equity component were netted with the equity component in additional paid-in-capital.

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The net carrying amount of the liability component of the Notes is as follows (in thousands):



	September 30, 2018
Principal	$	258,750
Unamortized debt discount	(59,392		)
Unamortized issuance costs	(5,694		)
Net carrying amount	$	193,664

The net carrying amount of the equity component of the Notes is as follows (in thousands):

Interest expense related to the Notes is as follows (in thousands):



	Three Months Ended September 30, 2018		Nine Months Ended September 30, 2018
Contractual interest expense	$	81	$	129
Amortization of debt discount	2,782		4,364
Amortization of issuance costs	267		418
Total interest expense	$	3,130	$	4,911

In connection with the pricing of the Notes, the Company entered into privately negotiated capped call transactions (the “Capped Call Transactions”) with certain financial institutions. The Capped Call Transactions are expected generally to reduce the potential dilution to the Company’s common stock upon any conversion of the Notes and/or offset any cash payments the Company is required to make in excess of the principal amount of converted Notes, as the case may be, with such reduction and/or offset subject to a cap based on the cap price. The initial cap price of the Capped Call Transactions is $62.80 per share, and is subject to certain adjustments under the terms of the Capped Call Transactions. The Capped Call Transactions cover, subject to anti-dilution adjustments, approximately 6.3 million shares of the Company’s common stock. For accounting purposes, the Capped Call Transactions are separate transactions, and not part of the terms of the Notes. As these transactions meet certain accounting criteria, the Capped Call Transactions are recorded in stockholders’ equity and are not accounted for as derivatives. The cost of $31.4 million incurred in connection with the Capped Call Transactions was recorded as a reduction to additional paid-in capital.

The net impact to the Company’s stockholders’ equity, included in additional paid-in capital, relating to the issuance of the Notes is as follows (in thousands):

2016 Loan and Security Agreement

In August 2016, the Company entered into a loan and security agreement, or the 2016 Loan and Security Agreement, with the lenders party thereto and City National Bank, as agent for such lenders. The 2016 Loan and Security Agreement provided for a revolving line of credit, of up to $50.0 million and was scheduled to mature on August 1, 2019. The revolving line of credit bore a variable interest rate equal to the prime rate plus 0.50%, subject to a 0.25% increase if the Company’s adjusted EBITDA was negative at the end of any fiscal quarter. The Company was also required to pay a commitment fee equal to 0.25% of the unused portion of the revolving line of credit as well as an anniversary fee of $31,250 on each of August 1, 2017 and 2018. The obligations of the Company under the 2016 Loan and Security Agreement were guaranteed by its subsidiary, Five9 Acquisition LLC, and were secured by a first

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priority lien on substantially all of the assets of the Company and Five9 Acquisition LLC. In May 2018, the Company paid off the then outstanding principal balance of the revolving line of credit and on July 1, 2018, the Company terminated the 2016 Loan and Security Agreement.

FCC Civil Penalty

In June 2015, the Company entered into a consent decree with the Federal Communications Commission, or FCC, Enforcement Bureau, in which the Company agreed to pay a civil penalty of $2.0 million to the U.S. Treasury in twelve equal quarterly installments starting in July 2015 without interest. As a result, the Company discounted the $2.0 million liability, which was accrued in the third quarter of 2014 for the then tentative civil penalty, to its then present value of $1.7 million at an annual interest rate of 12.75% to reflect the imputed interest and reclassified this discounted liability from ‘Accrued federal fees’ to ‘Notes payable.’ The $0.3 million discount was recorded as a reduction to general and administrative expense in the three months ended June 30, 2015 and was recognized as interest expense over the payment term of the civil penalty. As of September 30, 2018, the Company did not have any outstanding obligations under the civil penalty. As of December 31, 2017, the outstanding civil penalty payable was $0.3 million, of which the net carrying value was $0.3 million, and was included as ‘Notes payable’ in the accompanying condensed consolidated balance sheet.

The Company’s outstanding debt is summarized as follows (in thousands):



	September 30, 2018		December 31, 2017
Note payable - FCC civil penalty, gross	$	—	$	333
Less: discount	—		(7		)
Note payable, net carrying value	—		326
Convertible senior notes	193,664		—
Revolving line of credit	—		32,594
Interest accretion under 2016 line of credit	—		10
Total debt, net carrying value	$	193,664	$	32,930
Less: current portion of debt *	$	—	$	336
Total debt, less current portion **	$	193,664	$	32,594


* Included in ‘Notes payable’ in the condensed consolidated balance sheet as of December 31, 2017.
** Included in ‘Convertible senior notes’ and ‘Revolving line of credit’ as of September 30, 2018 and December 31, 2017, respectively, in the condensed consolidated balance sheets.

Maturity of the Company’s outstanding debt as of September 30, 2018 is as follows (in thousands):



Period	Amount to Mature
2023	$	258,750
Total	$	258,750

7. Stockholders’ Equity

Capital Structure

The Company is authorized to issue 450,000,000 shares of common stock with a par value of $0.001 per share. As of September 30, 2018 and December 31, 2017, the Company had 58,748,746 and 56,631,647 shares of common stock issued and outstanding, respectively.

The Company is also authorized to designate and issue up to 5,000,000 shares of preferred stock with a par value of $0.001 per share in one or more series without stockholder approval and to fix the rights, preferences, privileges and restrictions thereof. As of September 30, 2018 and December 31, 2017, the Company had no shares of preferred stock issued and outstanding.

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Warrants

As of December 31, 2017, the Company had outstanding warrants to purchase 13,013 shares of common stock with a weighted-average exercise price of $5.76 per share. These warrants were exercised in the third quarter of 2018. As of September 30, 2018, the Company had no warrants outstanding.

Common Stock Reserved for Future Issuance

Shares of common stock reserved for future issuance related to outstanding equity awards, common stock warrants, and employee equity incentive plans were as follows (in thousands):



		September 30, 2018
Stock options outstanding		3,051
Restricted stock units outstanding		2,408
Shares available for future grant under 2014 Plan		8,784
Shares available for future issuance under ESPP		1,801
Total shares of common stock reserved		16,044

Equity Incentive Plans

Prior to the Company’s initial public offering (“IPO”), the Company granted stock options under its Amended and Restated 2004 Equity Incentive Plan, as amended (the “2004 Plan”).

In March 2014, the Company’s board of directors and stockholders approved the 2014 Equity Incentive Plan (“2014 Plan”) and 5,300,000 shares of common stock were reserved for issuance under the 2014 Plan. In addition, on the first day of each year beginning in 2015 and ending in 2024, the 2014 Plan provides for an annual automatic increase to the shares reserved for issuance in an amount equal to 5% of the total number of shares outstanding on December 31st of the preceding calendar year or a lesser number as determined by the Company’s board of directors. Pursuant to the automatic annual increase, 2,831,582 additional shares were reserved under the 2014 Plan on January 1, 2018.

No further grants were made under the 2004 Plan once the 2014 Plan became effective on April 3, 2014. Upon the effectiveness of the 2014 Plan, all shares reserved for future issuance under the 2004 Plan became available for issuance under the 2014 Plan. After the IPO, any forfeited or expired shares that would have otherwise returned to the 2004 Plan instead return to the 2014 Plan.

The 2004 Plan and the 2014 Plan are described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

Stock Options

A summary of the Company’s stock option activity during the nine months ended September 30, 2018 is as follows (in thousands, except years and per share data):



	Number of Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
Outstanding as of December 31, 2017	4,047		$	8.00
Options granted (weighted average grant date fair value of $14.19 per share)	282		30.48
Options exercised	(1,172	)	6.01
Options forfeited or expired	(106	)	18.02
Outstanding as of September 30, 2018	3,051		$	10.50	6.1	$	101,257

The Company has computed the aggregate intrinsic value amounts disclosed in the above table based on the difference between the exercise price of the options and the closing market price of the Company’s common stock of $43.69 per share as of September 30, 2018 for all in-the-money stock options outstanding.

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Restricted Stock Units

A summary of the Company’s restricted stock unit (“RSU”) activity during the nine months ended September 30, 2018 is as follows (in thousands, except per share data):



	Number of Shares		Weighted Average Grant Date Fair Value Per Share
Outstanding as of December 31, 2017	2,033		$	12.81
RSUs granted	1,375		30.98
RSUs vested and released	(803	)	12.66
RSUs forfeited	(197	)	17.84
Outstanding as of September 30, 2018	2,408		$	22.82

Employee Stock Purchase Plan

The Company’s 2014 Employee Stock Purchase Plan (“ESPP”) became effective on April 3, 2014 and is described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The number of shares of common stock originally reserved for issuance under the ESPP was 880,000 shares, which increases automatically each year, beginning on January 1, 2015 and continuing through January 1, 2024, by the lesser of (i) 1% of the total number of shares of the Company’s common stock outstanding on December 31 of the preceding calendar year; (ii) 1,000,000 shares of common stock (subject to adjustment to reflect any split or combination of the Company’s common stock); or (iii) such lesser number as determined by the Company’s board of directors. Pursuant to the automatic annual increase, 566,316 additional shares were reserved under the ESPP on January 1, 2018.

During the nine months ended September 30, 2018, 136,321 shares were purchased on May 15, 2018 at a price of $21.16 per share under the ESPP.

Stock-Based Compensation

Stock-based compensation expenses were as follows (in thousands):



	Three Months Ended				Nine Months Ended
	September 30, 2018		September 30, 2017		September 30, 2018		September 30, 2017
Cost of revenue	$	860	$	599	$	2,391	$	1,608
Research and development¹	2,352		797		4,293		2,235
Sales and marketing	1,613		1,084		4,560		3,236
General and administrative	4,044		1,240		9,747		3,624
Total stock-based compensation	$	8,869	$	3,720	$	20,991	$	10,703


(1)	Includes an incremental stock-based compensation cost due to modification of certain stock-based awards of a former executive of the Company in the third quarter of 2018.

As of September 30, 2018, unrecognized stock-based compensation expenses by award type and their expected weighted-average recognition periods are summarized in the following table (in thousands, except years).



	Stock Option		RSU		ESPP
Unrecognized stock-based compensation expense	$	9,004	$	51,586	$	224
Weighted-average amortization period	2.5 years		2.9 years		0.1 years

The Company recognizes stock-based compensation expense that is calculated based upon awards that have vested, reduced for actual forfeitures. All stock-based compensation for equity awards granted to employees and non-employee directors is measured based on the grant date fair value of the award.

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The weighted-average assumptions used to value stock options granted during the periods presented were as follows:



Stock Options	Three Months Ended				Nine Months Ended
	September 30, 2018		September 30, 2017		September 30, 2018	September 30, 2017
Expected term (years)	6.1		6.1		6.0	6.2
Volatility	44	%	53	%	45%	49%
Risk-free interest rate	2.8	%	2.0	%	2.7%	2.0%
Dividend yield ⁽¹⁾	—		—		—	—


(1)	The Company has not paid, and does not anticipate paying, cash dividends on its shares of common stock. Accordingly, the expected dividend yield is zero.

8. Net Income (Loss) Per Share

Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period, and excludes any dilutive effects of employee stock-based awards and warrants. Diluted net income (loss) per share is computed giving effect to all potentially dilutive common shares, including common stock issuable upon exercise of stock options and warrants and vesting of restricted stock units.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):



	Three Months Ended					Nine Months Ended
	September 30, 2018			September 30, 2017		September 30, 2018			September 30, 2017
Net income (loss)	$	(1,305	)	$	924	$	(3,954	)	$	(8,338	)
Weighted-average shares of common stock outstanding	58,454			55,310		57,790			54,579
Basic net income (loss) per share	$	(0.02	)	$	0.02	$	(0.07	)	$	(0.15	)

Net income (loss)	$	(1,305	)	$	924	$	(3,954	)	$	(8,338	)
Weighted-average shares of common stock outstanding	58,454			55,310		57,790			54,579
Effect of dilutive shares	—			4,131		—			—
Weighted average shares of common stock outstanding	58,454			59,441		57,790			54,579
Diluted net income (loss) per share	$	(0.02	)	$	0.02	$	(0.07	)	$	(0.15	)

The following securities were excluded from the calculation of diluted net loss per share because their effect would have been anti-dilutive (in thousands):



	Three Months Ended		Nine Months Ended
	September 30, 2018	September 30, 2017	September 30, 2018	September 30, 2017
Stock options	3,051	471	3,051	4,597
Restricted stock units	2,408	29	2,408	2,133
Common stock warrants	—	—	—	13
Total	5,459	500	5,459	6,743

The Company may settle the conversions of the Notes in cash, shares of the Company’s common stock or any combination thereof at its election. The maximum number of shares of the Company’s common stock issuable at the

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conversion price of $40.82 per share is expected to be 6.3 million shares. However, the Capped Call Transactions are expected to reduce the potential dilution of the Company’s common stock upon any conversion of Notes and/or offset the cash payments the Company is required to make in excess of the principal amount of the Notes. Under the Capped Call Transactions, the number of shares of common stock issuable at the conversion price of $62.80 is expected to be 4.1 million shares. For more information on the Notes and the Capped Call Transactions, see Note 6.

9. Income Taxes

The provision for income taxes for the three and nine months ended September 30, 2018 was approximately $41 thousand and $150 thousand, respectively. The provision for income taxes for the three and nine months ended September 30, 2017 was approximately $43 thousand and $142 thousand, respectively. The provision for income taxes consisted primarily of foreign income taxes.

For the three and nine months ended September 30, 2018 and 2017, the provision for income taxes differed from the statutory amount primarily due to the Company realizing no benefit for current year losses due to maintaining a full valuation allowance against its domestic net deferred tax assets.

The realization of tax benefits of deferred tax assets is dependent upon future levels of taxable income, of an appropriate character, in the periods the items are expected to be deductible or taxable. Based on the available objective evidence, the Company does not believe it is more likely than not that the net deferred tax assets will be realizable. Accordingly, the Company has provided a full valuation allowance against the domestic net deferred tax assets as of September 30, 2018 and December 31, 2017. The Company intends to maintain the remaining valuation allowance until sufficient positive evidence exists to support a reversal of, or decrease in, the valuation allowance. During the three and nine months ended September 30, 2018, there were no material changes to the total amount of unrecognized tax benefits.

10. Commitments and Contingencies

Commitments

The Company’s principal commitments consist of future payment obligations under capital leases to finance data centers and other computer and networking equipment purchases, debt agreements (see Note 6), operating lease agreements for office space, research and development, and sales and marketing facilities, and agreements with third parties to provide co-location hosting, telecommunication usage and equipment maintenance services. These commitments as of December 31, 2017 are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, and did not change materially during the nine months ended September 30, 2018 except for the issuance of the Notes, the repayment of borrowings under the 2016 Loan and Security Agreement, the acquisition of certain additional data center and network equipment and software under multiple capital leases, and certain hosting and telecommunications agreements. As of September 30, 2018, the total minimum future payment commitments under these capital leases added during the nine months ended September 30, 2018 were approximately $6.3 million, of which $0.7 million is due during the remainder of 2018, with the remaining $5.6 million due in 2019 to 2021.

As of September 30, 2018, $258.8 million of the Notes were outstanding. The Notes are due May 1, 2023. For more information concerning the Notes, see Note 6.

During the nine months ended September 30, 2018, the Company entered into or renewed various hosting and telecommunications agreements for terms of 12 to 36 months commencing on various dates in 2018. These agreements require the Company to make monthly payments over the service term in exchange for certain network services. The Company’s total minimum future payment commitments under these agreements are $2.9 million.

Universal Services Fund Liability

During the third quarter of 2012, the Company determined that based on its business activities, it is classified as a telecommunications service provider for regulatory purposes and it should make direct contributions to the federal USF and related funds based on revenues it receives from the resale of interstate and international telecommunications services. In order to comply with the obligation to make direct contributions, the Company made a voluntary self-disclosure to the FCC Enforcement Bureau and registered with the USAC, which is charged by the FCC with administering the USF. The Company filed exemption certificates with its wholesale

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telecommunications service providers in order to eliminate its obligation to reimburse such wholesale telecommunications service providers for their USF contributions calculated on services sold to the Company. In April 2013, the Company began remitting required contributions on a prospective basis directly to USAC.

The Company’s registration with USAC subjects it to assessments for unpaid USF contributions, as well as interest thereon and civil penalties, due to its late registration and past failure to recognize its obligation as a USF contributor and as an international carrier. The Company is required to pay assessments for periods prior to the Company’s registration. As of December 31, 2012, the total past due USF contribution being imposed by USAC and accrued by the Company for the period from 2003 through 2012 was $8.1 million, of which $4.7 million was undisputed and $3.4 million was disputed. The Company subsequently updated its filings and increased the liability related to 2008 through 2012 by $0.5 million, arriving at a new total of $3.9 million in disputed liability. In July 2013, the Company and USAC agreed to a financing arrangement for $4.1 million of the undisputed $4.7 million of the unpaid USF contributions whereby the Company issued to USAC a promissory note payable in the principal amount of the $4.1 million and paid off the remaining undisputed $0.6 million. The Company had fully paid the promissory note as of January 2017.

In January 2017, the FCC’s Wireline Competition Bureau ruled in the Company’s favor with respect to most of the disputed amount. In September 2017, USAC issued a credit to the Company reflecting the FCC’s ruling for the $3.1 million of the $3.9 million in disputed liability. In addition, USAC reversed the interest and penalties related to the disputed liability of $3.1 million. The remaining $0.8 million in dispute involves USAC’s assessment of liability for the period of 2003 through 2007, which was prior to the five year window during which the Company was required to maintain financial records for USF contribution purposes. The Company filed a Request for Review (a form of appeal) of this disputed amount with the FCC’s Wireline Competition Bureau in 2013, which remains pending. If the Request for Review is not resolved in the Company’s favor, it is possible that the Company will be held to the back assessments of $0.8 million, which includes interest and penalties on that amount.

As of September 30, 2018, the accrued liability on the remaining disputed assessments, including interest and penalties for the period of 2003 through 2007, was $0.8 million offset by $0.7 million in other USF credits.

State and Local Taxes and Surcharges

In April 2012, the Company commenced collecting and remitting sales taxes on sales of subscription services in all the U.S. states in which it determined it was obligated to do so. During the first quarter of 2015, the Company conducted an updated sales tax review of the taxability of sales of its subscription services. As a result, the Company determined that it may be obligated to collect and remit sales taxes on such sales in four additional states. Based on its best estimate of the probable sales tax liability in those four states relating to its sales of subscription services during the period 2011 through 2014, during the three months ended March 31, 2015, the Company recorded a general and administrative expense of $0.6 million to accrue for such taxes.

During 2013, the Company analyzed its activities and determined it may be obligated to collect and remit various state and local taxes and surcharges on its usage-based fees. The Company had not remitted state and local taxes on usage-based fees in any of the periods prior to 2014 and therefore accrued a sales tax liability for this contingency. In January 2014, the Company commenced paying such taxes and surcharges to certain state authorities. In June 2014, the Company commenced collecting state and local taxes or surcharges on usage-based fees from its clients on a current basis and remitting such taxes to the applicable U.S. state taxing authorities.

As of September 30, 2018 and December 31, 2017, the Company had accrued liabilities of $1.3 million and $1.5 million, respectively, for such contingent sales taxes and surcharges that were not being collected from its clients but may be imposed by various taxing authorities, of which $0.2 million and $0.4 million, respectively, were included in current “Sales tax liability” on the condensed consolidated balance sheets, and the remaining were included in non-current “Sales tax liability” on the condensed consolidated balance sheets. The Company’s estimate of the probable loss incurred under this contingency is based on its analysis of the source location of its usage-based fees and the regulations and rules in each tax jurisdiction.

Legal Matters

The Company is involved in various legal and regulatory matters arising in the normal course of business. In management’s opinion, resolution of these matters is not expected to have a material impact on the Company’s consolidated results of operations, cash flows, or its financial position. However, due to the uncertain nature of legal

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matters, an unfavorable resolution of a matter could materially affect the Company’s future consolidated results of operations, cash flows or financial position in a particular period. The Company expenses legal fees as incurred.

Indemnification Agreements

In the ordinary course of business, the Company enters into agreements of varying scope and terms pursuant to which it agrees to indemnify clients, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of breach of such agreements, services to be provided by the Company or from intellectual property infringement claims made by third parties. In addition, the Company has entered into indemnification agreements with directors and certain officers and employees that will require it, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees. Other than as described below, no demands have been made upon the Company to provide indemnification under such agreements and there are no claims that it is aware of that could have a material effect on the consolidated balance sheet, consolidated statement of operations and comprehensive loss, or consolidated statements of cash flows.

On October 27, 2016, the Company received notice from Lance Fried, a former officer and director of Face It, Corp., of his claim for indemnification by the Company (as successor in interest to Face It), and for advancement of all legal fees and expenses he incurs in connection with the defense of a lawsuit captioned Melcher, et al. v. Five9, Inc., et al., No. 16-cv-02440, in the U.S. District Court for the Southern District of California. In the lawsuit, plaintiff Carl Melcher, a purported former stockholder of Face It, and his related investment entity Melcher Family Limited Partnership, allege that Face It repurchased the plaintiffs’ stock in September 2013 before the Company acquired Face It, and that in connection with the repurchase, Fried made material misstatements or omissions to Melcher, by failing to disclose that Face It allegedly was in concurrent discussions about a potential sale of the company to the Company. The lawsuit alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, as well as various claims under state law and common law. To date, the Company has advanced Mr. Fried $62 thousand in connection with this claim. However, the Company disputes that Mr. Fried is entitled to advancement in connection with the Melcher litigation. On January 9, 2018, Mr. Fried initiated an arbitration against the Company in which he alleged that the Company breached advancement obligations to him. On June 11, 2018, the arbitrator ordered the Company to advance the fees Mr. Fried incurs (and has already incurred) in connection with the defense of the Melcher litigation. After the arbitrator’s order, the Company has advanced $0.5 million to date.

Regardless of the arbitrator’s order, Mr. Fried is required to reimburse the Company for any amounts advanced to him if it is ultimately determined that Mr. Fried is not entitled to indemnification in connection with the Melcher litigation. In addition, the Company believes that it has indemnification rights against the former stockholders of Face It (including Mr. Fried) for all losses that are incurred by the Company in connection with the Melcher litigation, including without limitation, amounts incurred to indemnify or advance the legal fees and expenses of Mr. Fried pursuant to his indemnification claim against the Company. The Company has asserted claims in arbitration against both Mr. Fried and the representative of the former Face It stockholders to recoup these losses. These claims are stayed pending the resolution of the Melcher litigation.

11. Geographical Information

The following table is a summary of revenues by geographic region based on client billing address and has been estimated based on the amounts billed to clients during the periods presented (in thousands):



	Three Months Ended				Nine Months Ended
	September 30, 2018		September 30, 2017		September 30, 2018		September 30, 2017
United States	$	60,315	$	46,897	$	172,376	$	136,085
International	4,989		3,184		12,953		8,737
Total revenue	$	65,304	$	50,081	$	185,329	$	144,822

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The following table summarizes total property and equipment, net in the respective locations (in thousands):



	September 30, 2018		December 31, 2017
United States	$	20,976	$	17,949
International	1,933		1,939
Property and equipment, net	$	22,909	$	19,888

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion in conjunction with the condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2017.

Overview

We are a pioneer and leading provider of cloud software for contact centers, facilitating more than three billion interactions between our more than 2,000 clients and their customers per year. We believe we achieved this leadership position through our expertise and technology, which has empowered us to help organizations of all sizes transition from legacy on-premise contact center systems to our cloud solution. Our solution, which is comprised of our Virtual Contact Center, or VCC, cloud platform and applications, allows simultaneous management and optimization of customer interactions across voice, chat, email, web, social media and mobile channels, either directly or through our application programming interfaces, or APIs. Our VCC cloud platform routes each customer interaction to an appropriate agent resource, and delivers relevant customer data to the agent in real-time to optimize the customer experience. Unlike legacy on-premise contact center systems, our solution requires minimal up-front investment and can be rapidly deployed and adjusted depending on our client’s requirements.

Since founding our business in 2001, we have focused exclusively on delivering cloud contact center software. We initially targeted smaller contact center opportunities with our telesales team and, over time, invested in expanding the breadth and depth of the functionality of our cloud platform to meet the evolving requirements of our clients. In 2009, we made a strategic decision to expand our market opportunity to include larger contact centers. This decision drove further investments in research and development and the establishment of our field sales team to meet the requirements of these larger contact centers. We believe this shift has helped us diversify our client base, while significantly enhancing our opportunity for future revenue growth. To complement these efforts, we have also focused on building client awareness and driving adoption of our solution through marketing activities, which include internet advertising, digital marketing campaigns, social media, trade shows, industry events and telemarketing.

We provide our solution through a SaaS business model with recurring subscriptions. We offer a comprehensive suite of applications delivered on our VCC cloud platform that are designed to enable our clients to manage and optimize interactions across inbound and outbound contact centers. We primarily generate revenue by selling subscriptions and related usage of our VCC cloud platform. We charge our clients monthly subscription fees for access to our solution, primarily based on the number of agent seats, as well as the specific functionalities and applications our clients deploy. We define agent seats as the maximum number of named agents allowed to concurrently access our solution. Our clients typically have more named agents than agent seats, and multiple named agents may use an agent seat, though not simultaneously. Substantially all of our clients purchase both subscriptions and related telephony usage from us. A small percentage of our clients subscribe to our platform but purchase telephony usage directly from wholesale telecommunications service providers. We do not sell telephony usage on a stand-alone basis to any client. The related usage fees are based on the volume of minutes for inbound and outbound interactions. We also offer bundled plans, generally for smaller deployments, where the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. We offer monthly, annual and multiple-year contracts to our clients, generally with 30 days’ notice required for changes in the number of agent seats. Our clients can use this notice period to rapidly adjust the number of agent seats used to meet their changing contact center volume needs, including to reduce the number of agent seats to zero. As a general matter, this means that a client can effectively terminate its agreement with us upon 30 days’ notice. Our larger clients typically choose annual contracts, which generally include an implementation and ramp period of several months. Fixed subscription fees, including bundled plans, are generally billed monthly in advance, while related usage fees are billed in arrears. For each of the three and nine months ended September 30, 2018, subscription and related usage fees accounted for 93% of our revenue. For the three and nine months ended September 30, 2017, subscription and related usage fees accounted for 93% and 94% of our revenue, respectively. The remainder was comprised of professional services revenue from the implementation and optimization of our solution.

Key GAAP Operating Results

Our revenue increased to $65.3 million and $185.3 million for the three and nine months ended September 30, 2018, respectively, from $50.1 million and $144.8 million for the three and nine months ended September 30, 2017, respectively. Revenue growth has primarily been driven by our larger clients. For each of the three and nine months

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ended September 30, 2018 and 2017, no single client accounted for more than 10% of our total revenue. As of September 30, 2018, we had over 2,000 clients across multiple industries. Our clients’ subscriptions generally range in size from fewer than 10 agent seats to approximately 3,000 agent seats. We had a net loss of $1.3 million and $4.0 million in the three and nine months ended September 30, 2018, respectively, compared to net income of $0.9 million and net loss of $8.3 million in the three and nine months ended September 30, 2017, respectively.

We have continued to make significant expenditures and investments, including in sales and marketing, research and development and infrastructure. We primarily evaluate the success of our business based on revenue growth, adjusted EBITDA and the efficiency and effectiveness of our investments. The growth of our business and our future success depend on many factors, including our ability to continue to expand our client base, particularly in larger opportunities, grow revenue from our existing client base, develop innovative products and features, and expand internationally. While these areas represent significant opportunities for us, they also pose risks and challenges that we must successfully address in order to sustain the growth of our business and improve our operating results. In order to pursue these opportunities, we anticipate that we will continue to expand our operations and headcount in the near term.

Due to our continuing investments to grow our business, increase our sales and marketing efforts, pursue new opportunities, enhance our solution and build our technology, we expect our cost of revenue and operating expenses to increase in absolute dollars in future periods. However, we expect these expenses to decrease as a percentage of revenue as we grow our revenue and gain economies of scale by increasing our client base without direct incremental development costs and by utilizing more of the capacity of our data centers.

Key Operating and Non-GAAP Financial Performance Metrics

In addition to measures of financial performance presented in our condensed consolidated financial statements, we monitor the key metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies.

Annual Dollar-Based Retention Rate

We believe that our Annual Dollar-Based Retention Rate provides insight into our ability to retain and grow revenue from our clients, and is a measure of the long-term value of our client relationships. Our Annual Dollar-Based Retention Rate is calculated by dividing our Retained Net Invoicing by our Retention Base Net Invoicing on a monthly basis, which we then average using the rates for the trailing twelve months for the period being presented. We define Retention Base Net Invoicing as recurring net invoicing from all clients in the comparable prior year period, and we define Retained Net Invoicing as recurring net invoicing from that same group of clients in the current period. We define recurring net invoicing as subscription and related usage revenue excluding the impact of service credits, reserves and deferrals. Historically, the difference between recurring net invoicing and our subscription and related usage revenue has been within 10%.

The following table shows our Annual Dollar-Based Retention Rate for the periods presented:



	Twelve Months Ended
	September 30, 2018	September 30, 2017
Annual Dollar-Based Retention Rate	101%	98%

Our Dollar-Based Retention Rate improved year over year primarily due to our larger clients increasing the number of agent seats.

Adjusted EBITDA

We monitor adjusted EBITDA, a non-GAAP financial measure, to analyze our financial results and believe that it is useful to investors, as a supplement to U.S. GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance. We believe that adjusted EBITDA helps illustrate underlying trends in our business that could otherwise be masked by the effect of the income or expenses that we exclude from adjusted EBITDA. Furthermore, we use this measure to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that adjusted EBITDA provides an additional

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tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry.

Adjusted EBITDA should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with U.S. GAAP, and our calculation of adjusted EBITDA may differ from that of other companies in our industry. We compensate for the inherent limitations associated with using adjusted EBITDA through disclosure of these limitations, presentation of our financial statements in accordance with U.S. GAAP and reconciliation of adjusted EBITDA to the most directly comparable U.S. GAAP measure, net income (loss). We calculate adjusted EBITDA as net income (loss) before (1) depreciation and amortization, (2) stock-based compensation, (3) interest income, expense and other, (4) provision for income taxes, and (5) other items that do not directly affect what we consider to be our core operating performance.

The following table shows a reconciliation from net income (loss) to adjusted EBITDA for the periods presented (in thousands):



	Three Months Ended						Nine Months Ended
	September 30, 2018			September 30, 2017			September 30, 2018			September 30, 2017
Net income (loss)	$	(1,305	)	$	924		$	(3,954	)	$	(8,338	)
Non-GAAP adjustments:
Depreciation and amortization ⁽¹⁾	2,667			1,881			7,436			6,246
Stock-based compensation ⁽²⁾	8,869			3,720			20,991			10,703
Interest expense	3,595			865			6,783			2,635
Interest income and other	(1,352		)	(118		)	(1,956		)	(326		)
Legal settlement ⁽³⁾	—			—			—			1,700
Legal and indemnification fees related to settlement ⁽³⁾	258			—			499			135
Reversal of interest and penalties on accrued federal fees ⁽⁴⁾	—			(2,133		)	—			(2,133		)
Provision for income taxes	41			43			150			142
Adjusted EBITDA	$	12,773		$	5,182		$	29,949		$	10,764


(1)	Depreciation and amortization expenses included in our results of operations are as follows (in thousands):



	Three Months Ended				Nine Months Ended
	September 30, 2018		September 30, 2017		September 30, 2018		September 30, 2017
Cost of revenue	$	2,021	$	1,397	$	5,679	$	4,689
Research and development	278		182		705		625
Sales and marketing	30		30		89		90
General and administrative	338		272		963		842
Total depreciation and amortization	$	2,667	$	1,881	$	7,436	$	6,246


(2)	See Note 7 to the condensed consolidated financial statements for stock-based compensation expense included in our results of operations for the periods presented.


(3)	Represents settlement amount and legal and indemnification fees related to the Melcher litigation.


(4)	Represents the reversal of accrued interest and penalties related to the Universal Services Fund (“USF”) liability following a favorable ruling from the FCC’s Wireline Competition Bureau. See Note 10 to the condensed consolidated financial statements included in this report for additional information.

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Key Components of Our Results of Operations

Revenue

Our revenue consists of subscription and related usage as well as professional services. We consider our subscription and related usage to be recurring revenue. This recurring revenue includes fixed subscription fees for the delivery and support of our VCC cloud platform, as well as related usage fees. The related usage fees are based on the volume of minutes for inbound and outbound client interactions. We also offer bundled plans, generally for smaller deployments, where the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. We offer monthly, annual and multiple-year contracts for our clients, generally with 30 days’ notice required for changes in the number of agent seats. Our clients can use this notice period to rapidly adjust the number of agent seats used to meet their changing contact center volume needs, including to reduce the number of agent seats to zero. As a general matter, this means that a client can effectively terminate its agreement with us upon 30 days’ notice.

Fixed subscription fees, including plans with bundled usage, are generally billed monthly in advance, while variable usage fees are billed in arrears. Fixed subscription fees are recognized on a straight-line basis over the applicable term, predominantly the monthly contractual billing period. Support activities include technical assistance for our solution and upgrades and enhancements on a when and if available basis, which are not billed separately. Variable subscription related usage fees for non-bundled plans are billed in arrears based on client-specific per minute rate plans and are recognized as actual usage occurs. We generally require advance deposits from clients based on estimated usage. All fees, except usage deposits, are non-refundable.

In addition, we generate professional services revenue from assisting clients in implementing our solution and optimizing use. These services include application configuration, system integration and education and training services. Professional services are primarily billed on a fixed-fee basis and are typically performed by us directly. In limited cases, our clients choose to perform these services themselves or engage their own third-party service providers to perform such services. Professional services are recognized as the services are performed using the proportional performance method, with performance measured based on labor hours, provided all other criteria for revenue recognition are met.

The adoption of ASC 606, the new revenue recognition guidance, in January 2018, did not have a material impact on the recognition or timing of revenue. See Note 2 to the condensed consolidated financial statements included in this report for additional information.

Cost of Revenue

Our cost of revenue consists primarily of personnel costs (including stock-based compensation), fees that we pay to telecommunications providers for usage, USF contributions and other regulatory costs, depreciation and related expenses of servers and equipment, costs to build out and maintain co-location data centers, and allocated office and facility costs and amortization of acquired technology. Cost of revenue can fluctuate based on a number of factors, including the fees we pay to telecommunications providers, which vary depending on our clients’ usage of our VCC cloud platform, the timing of capital expenditures and related depreciation charges and changes in headcount. We expect to continue investing in our network infrastructure and operations and client support function to maintain high quality and availability of service, resulting in absolute dollar increases in cost of revenue. As our business grows, we expect to realize economies of scale in network infrastructure, personnel and client support.

Operating Expenses

We classify our operating expenses as research and development, sales and marketing, and general and administrative expenses.

Research and Development. Our research and development expenses consist primarily of salary and related expenses (including stock-based compensation) for personnel related to the development of improvements and expanded features for our services, as well as quality assurance, testing, product management and allocated overhead. We expense research and development expenses as they are incurred except for internal-use software development costs that qualify for capitalization. We believe that continued investment in our solution is important for our future growth, and we expect research and development expenses to increase in the foreseeable future.

Sales and Marketing. Sales and marketing expenses consist primarily of salaries and related expenses (including stock-based compensation) for personnel in sales and marketing, sales commissions, as well as advertising,

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marketing, corporate communications, travel costs and allocated overhead. Prior to the adoption of ASC 606, we expensed sales commissions associated with the acquisition of client contracts as incurred in the period the contract was acquired. Upon the adoption of ASC 606 in January 2018, a significant amount of our sales commission expenses have been deferred over an expected benefit period of five years as required by ASC 340-40, Other Assets and Deferred Costs - Contracts with Customers (“ASC 340-40”). See Note 2 to the condensed consolidated financial statements included in this report for additional information. We believe it is important to continue investing in sales and marketing to continue to generate revenue growth. Accordingly, while we expect sales and marketing expenses to increase in absolute dollars as we continue to support our growth initiatives, with the adoption of ASC 606 in January 2018, we expect sales and marketing expense as a percentage of revenue to decrease through the end of fiscal 2018 in our consolidated statements of operations due to the deferral of a significant portion of sales commissions as required by ASC 340-40.

General and Administrative. General and administrative expenses consist primarily of salary and related expenses (including stock-based compensation) for management, finance and accounting, legal, information systems and human resources personnel, professional fees, compliance costs, other corporate expenses and allocated overhead. We expect that general and administrative expenses will fluctuate in absolute dollars from period to period, but decline as a percentage of revenue over time.

Other Income (Expense), Net

Other income (expense), net consists primarily of interest expense associated with our debt including our convertible senior notes and capital leases. We expect interest expense for our capital leases to increase as a result of our continued capital spending funded by capital leases.

Provision for Income Taxes

Our provision for income taxes consists primarily of corporate income taxes resulting from profits generated in foreign jurisdictions by our wholly-owned subsidiaries, along with state income taxes payable in the United States. We do not expect the Tax Cuts and Jobs Act to have a significant impact on our future income tax provision.

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Results of Operations for the Three and Nine Months Ended September 30, 2018 and 2017

Based on the condensed consolidated statements of operations and comprehensive loss set forth in this Quarterly Report on Form 10-Q, the following table sets forth our operating results as a percentage of revenue for the periods indicated:



	Three Months Ended				Nine Months Ended
	September 30, 2018		September 30, 2017		September 30, 2018		September 30, 2017
Revenue	100	%	100	%	100	%	100	%
Cost of revenue	40	%	41	%	41	%	42	%
Gross profit	60	%	59	%	59	%	58	%
Operating expenses:
Research and development	15	%	13	%	14	%	14	%
Sales and marketing	27	%	<