Alphatec Holdings, Inc. (ATEC) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statemen

ts and the notes to those statements appearing elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this report include the identification of certain trends and other statements that may predict or anticipate future business or financial results that are subject to important factors that could cause our actual results to differ materially from those indicated. See “Item 1A Risk Factors” included elsewhere in this Annual Report on Form 10-K.

Overview

We are a medical technology company focused on the design, development, and advancement of technology for better surgical treatment of spinal disorders. We are dedicated to revolutionizing the approach to spine surgery through clinical distinction. We are focused on developing new approaches that integrate seamlessly with our expanding Alpha InformatiX™ product platform to better inform surgery and to achieve the goal of spine surgery more safely and reproducibly. We have a broad product portfolio designed to address the spine’s various pathologies. Our ultimate vision is to be the standard bearer in spine.

We intend to drive growth by capitalizing on our collective spine experience and investing in the research and development to continually differentiate our solutions and improve spine surgery. We believe our future success will be fueled by introducing market-shifting innovation to the spine market, and that we are well-positioned to capitalize on current spine market dynamics.

We market and sell our products through a network of independent distributors and direct sales representatives. An objective of our leadership team is to deliver increasingly consistent, predictable growth. To accomplish this, we have partnered more closely with new and existing distributors to create a more dedicated and loyal sales channel for the future. We have added, and intend to continue to add, new high-quality exclusive and dedicated distributors to expand future growth. We believe this will allow us to reach an untapped market of surgeons, hospitals, and national accounts across the U.S., as well as better penetrate existing accounts and territories.

We have continued to make progress in the transition of our sales channel since late 2017, driving the percent of sales contributed by our strategic independent distributors from approximately 92% for the year ended December 31, 2020 to 97% for the year ended December 31, 2021. Going forward, we intend to continue to relentlessly drive toward a fully exclusive network of independent and direct sales agents. Consolidation in the industry has facilitated this process, as large, seasoned agents seek opportunities to partner with spine-focused companies that have broad, growing product portfolios.

Recent Developments

0.75% Senior Convertible Notes due 2026

In August 2021, we issued $316.3 million principal amount of unsecured senior convertible notes with a stated interest rate of 0.75%, (the “2026 Notes”). Interest on the 2026 Notes is payable semi-annually in arrears on February 1 and August 1 of each year, beginning on February 1, 2022. The 2026 Notes are convertible into shares of our common stock based upon an initial conversion rate of 54.5316 shares of our common stock per $1,000 principal amount of 2026 Notes (equivalent to an initial conversion price of approximately $18.34 per share). The initial conversion price of the 2026 Notes represents a premium of approximately 100% over the closing price of our common stock on August 5, 2021, the date the 2026 Notes offering was priced. The net proceeds from the sale of the 2026 Notes were approximately $306.2 million after deducting the offering expenses. The 2026 Notes will mature on August 1, 2026, unless earlier converted, redeemed, or repurchased.

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We used $39.9 million of the net proceeds from the 2026 Notes offering to enter into separate capped call instruments with certain financial institutions. The Capped Call Transactions are generally expected to reduce potential dilution to our common stock beyond the conversion prices up to the cap prices on any conversion of the 2026 Notes and/or offset any payments we make in excess of the principal amount upon conversion.

In addition, we repurchased 1,806,358 shares of our common stock in privately negotiated transactions for approximately $25.0 million concurrently with the issuance of the 2026 Notes. We also used approximately $53.4 million of the net proceeds to repay all obligations under our secured term loan with Squadron Medical Finance Solutions, LLC (the “Term Loan”) and our inventory finance agreement with an inventory supplier (the “Inventory Financing Agreement”). We intend to use the remainder of the net proceeds from the 2026 Notes for general corporate purposes.

Acquisition of EOS

On May 13, 2021, we acquired a controlling interest in EOS imaging S.A. (“EOS”), pursuant to the Tender Offer Agreement (the “Tender Offer Agreement”) we entered into on December 16, 2020, and in June 2021, we purchased the remaining issued and outstanding ordinary shares for a 100% interest in EOS. EOS, which now operates as our wholly owned subsidiary, is a global medical device company that designs, develops and markets innovative, low dose 2D/3D full body scans for biplanar weight-bearing imaging, rapid 3D modeling of EOS patient X-ray images, web-based patient-specific surgical planning, and integration of surgical plan into the operating room. We plan to integrate this technology into our Alpha InformatixTM product platform to better inform and better achieve spinal alignment objectives in surgery.

In connection with the Tender Offer Agreement, we entered into a Securities Purchase Agreement with certain purchasers, providing for the sale of 12,421,242 shares of our common stock at a purchase price of $11.11 per share for aggregate gross proceeds of $138.0 million. The private placement closed on March 1, 2021, and generated net proceeds of approximately $131.8 million, net of fees related to the private placement.

COVID-19 Pandemic

Since the beginning of the COVID-19 pandemic, we have seen volatility in sales trends since elective surgeries that use our products and services have been impacted to varying degrees.

We continue to monitor the impact of the COVID-19 pandemic on our business and recognize it may continue to negatively impact our business and results of operations during the remainder of 2022 and beyond. Given the present uncertainty surrounding the pandemic, we expect to continue to see volatility through at least the remaining duration of the pandemic as the impact on individual markets and responses to conditions by international, state and local governments continues to vary.

We continue to believe that existing funds, cash generated from operations and existing sources of and access to financing are adequate to satisfy our needs for working capital, capital expenditures and debt service requirements as well as to engage in other business initiatives that we plan to strategically pursue.

Revenue and Expense Components

The following is a description of the primary components of our revenue and expenses:

Revenue. We derive our revenue primarily from the sale of spinal surgery implants used in the treatment of spine disorders as well as the sale of medical imaging equipment which is used for surgical planning and post-operative assessment. Spinal implant products include pedicle screws and complementary implants, interbody devices, plates, and tissue-based materials. Medical imaging equipment includes our EOS full-body and weight-bearing x-ray imaging devices, and related services. Our revenue is generated by our direct sales force and independent distributors. Our products are shipped and invoiced to hospitals and surgical centers.  Currently, most of our business is conducted with customers within markets in which we have experience and with payment terms that are customary to our business. We may defer revenue until the time of collection if circumstances related to payment terms, regional market risk or customer history indicate that collectability is not certain.

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Cost of sales. Cost of sales consists of direct product costs, royalties, milestones and the amortization of purchased intangibles. Our product costs consist primarily of direct labor, overhead, and raw materials and components. The product costs of certain of our biologics products include the cost of procuring and processing human tissue. We incur royalties related to the technologies that we license from others and the products that are developed in part by surgeons with whom we collaborate in the product development process. Amortization of purchased intangibles consists of amortization of developed product technology.

Research and development expenses. Research and development expenses consist of costs associated with the design, development, testing, and enhancement of our products. Research and development expenses also include salaries and related employee benefits, research-related overhead expenses, and fees paid to external service providers and development consultants in the form of both cash and equity.

Sales, general and administrative expenses. Sales, general and administrative expenses consist primarily of salaries and related employee benefits, sales commissions and other variable costs, depreciation of our surgical instruments, regulatory affairs, quality assurance costs, professional service fees, travel, medical education, trade show and marketing costs, insurance, and legal expenses.

Litigation-related expenses. Litigation-related expenses are costs incurred for our ongoing litigation, primarily with NuVasive, Inc.

Transaction-related expenses. Transaction-related expenses are certain costs incurred related primarily to the acquisition and integration of EOS.

Restructuring expenses. Restructuring expenses consist of severance, social plan benefits and related taxes in connection with cost rationalization efforts, as well as costs associated with the opening of our Memphis distribution center and closing costs related to our old headquarters office in Carlsbad, California.

Loss on debt extinguishment, net. Loss on debt extinguishment, net is associated with debt extinguishment, including the write-off of the unamortized debt issuance costs. These are primarily non-cash and are associated with debt paydown transactions which are non-recurring.

Total interest and other expense, net. Total interest and other expense, net includes interest income, interest expense, gains and losses from foreign currency exchanges and other non-operating gains and losses.

Income tax provision. Income tax provision from continuing operations primarily consists of an estimate of federal, state, and foreign income taxes based on enacted state and foreign tax rates, as adjusted for allowable credits, deductions, uncertain tax positions, changes in the valuation of our deferred tax assets and liabilities, and changes in tax laws.

Results of Operations

Total revenue

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Total revenue was $243.2 million for the year ended December 31, 2021, compared to $144.9 million for the year ended December 31, 2020, representing an increase of $98.4 million, or 68%. Revenue associated with our acquisition of EOS accounted for approximately 21% of the increase in total revenue for the year ended December 31, 2021, compared to the same period in 2020. Product volume for our business, excluding the EOS acquisition, increased our revenue by approximately 47% for the year ended December 31, 2021, compared to the year ended December 31, 2020, primarily due to the continued expansion of our new product portfolio, increases in our surgeon user base, and progress related to the transformation of our sales network.

Revenue from international supply agreement, which is attributed to sales to Globus Medical Ireland, Ltd., a subsidiary of Globus Medical, Inc., and its affiliated entities (collectively “Globus Medical”), under which we supplied to Globus Medical certain of its implants and instruments at agreed-upon prices for a minimum term of three years, decreased by $2.8 million, or 75%, during the year ended December 31, 2021, compared to the year ended December 31, 2020. The decrease in revenue from the international supply was primarily due the expiration and termination of the international supply agreement with Globus Medical on August 31, 2021.

Cost of sales

Total cost of sales, excluding EOS, for the year ended December 31, 2021 increased by $18.0 million, or 43%, primarily due to product volume. Expense related to the purchase accounting fair value mark-up of inventory as part of the EOS acquisition accounted for approximately 15% of the total increase for the year ended December 31, 2021. Cost of sales associated with EOS operations accounted for approximately 44% of the increase for the year ended December 31, 2021, compared to the year ended December 31, 2020.

Cost of sales from the international supply agreement decreased by $2.4 million, or 69%, for the year ended December 31, 2021, as compared to the year ended December 31, 2020. The decrease was primarily due to the expiration and termination of the international supply agreement with Globus Medical on August 13, 2021.

Operating expenses

Research and development expenses. Research and development expenses increased by $13.3 million, or 71%, primarily related to the hiring of new personnel and new project costs. Research and development costs associated with EOS accounted for approximately 17% of the total increase for the year ended December 31, 2021, as compared to the year ended December 31, 2020.

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Sales, general and administrative expenses. Sales, general and administrative expenses, excluding EOS, increased by $89.3 million, or 69%, during the year ended December 31, 2021, as compared to the year ended December 30, 2020. The increase was primarily due to higher compensation-related costs and variable selling expenses associated with the increase in revenue, and our continued investment in building our strategic distribution channel. Additionally, we have increased our investment in our sales and marketing functions by increasing headcount to support the growth of our business. Sales, general and administrative expenses associated with EOS accounted for approximately 9% of the total increase for the year ended December 31, 2021, as compared to the year ended December 31, 2020.

Litigation-related expenses. Litigation-related expenses increased by $2.6 million, or 30%, and was primarily related to our ongoing litigation with NuVasive, Inc. and fluctuations related to the timing of related legal activities.

Amortization of acquired intangible assets. Amortization of acquired intangible assets primarily includes amortization of intangible assets acquired in the EOS acquisition.

Transaction-related expenses. The increase in transaction-related expenses was primarily due to third-party advisory and legal fees related to our acquisition of EOS, which closed on May 13, 2021, as well as costs to support our ongoing integration activities.

Restructuring expenses. The increase in restructuring costs for the year ended December 31, 2021 was primarily due to severance, social plan benefits and related taxes in connection with cost rationalization efforts as well as costs associated with the opening of our Memphis distribution center and closing costs related to our old headquarters office.

Total interest and other expense, net

The decrease during the year ended December 31, 2021 as compared to the year ended December 30, 2020 was primarily due to lower interest expense related to the early payoff of the Term Loan, offset by foreign currency losses related to forward contract settlements.

Income tax provision

Income tax provision for the year ended December 31, 2021 was negligible and remained consistent compared to the year ended December 31, 2020.

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Liquidity and Capital Resources

Our principal sources of liquidity are our existing cash, cash equivalents and cash from operations. Our liquidity and capital structure are evaluated regularly within the context of our annual operating and strategic planning process. We consider the liquidity necessary to fund our operations, which include working capital needs, investments in research and development, investments in inventory and instrument sets to support our customers, as well as other operating costs. Our future capital requirements will depend on many factors including our rate of revenue growth, the timing and extent of spending to support development efforts, the expansion of sales, marketing and administrative activities, and the timing of introductions of new products and enhancements to existing products. As current borrowing sources become due, we may be required to access the capital markets for additional funding. If we are required to access the debt market, we expect to be able to secure reasonable borrowing rates.

Cash and cash equivalents were $187.2 million and $107.8 million at December 31, 2021 and December 31, 2020, respectively. We believe that our existing funds, cash generated from our operations and our existing sources of and access to financing are adequate to satisfy our needs for working capital, capital expenditure and debt service requirements, and other business initiatives we plan to strategically pursue.

Summary of Cash Flows

The following is a summary of cash provided by (used in) operating, investing, and financing activities, the effect of exchange rate changes on cash and cash equivalents, and the net change in cash and cash equivalents:

Operating Activities

We used net cash of $73.4 million from operating activities for the year ended December 31, 2021. The cash used in operating activities primarily related to costs associated with the expansion of our business, inventory purchases and the general timing of cash receipts, offset by the timing of cash distributions.

Investing Activities

We used cash of $157.7 million in investing activities for the year ended December 31, 2021, which is primarily related to our acquisition of EOS, including the purchase of its convertible bonds (“OCEANEs”), the purchase of surgical instruments to support our business growth and the commercial launch of new products, capital expenditures associated with product development machinery and tools and the build-out of our distribution facility in Memphis, and other investments.

Financing Activities

Financing activities provided net cash of $312.0 million for the year ended December 31, 2021, primarily related to the proceeds from the issuance of our 2026 Notes and the closing of the Private Placement on March 1, 2021, partially offset by cash paid for the full repayment of our obligations under the Term Loan and Inventory Financing Agreement, purchase of the Capped Calls, and repurchase of our common stock.

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Debt and Commitments

As of December 31, 2021, we had $316.3 million outstanding under the 2026 Notes. The 2026 Notes accrue interest at a rate of 0.75%, payable semi-annually in arrears on February 1 and August 1 of each year. Prior to maturity in August 2026, the holders of the 2026 Notes may, under certain circumstances, choose to convert their notes into shares of our common stock. Based on the terms, we have the option to pay or deliver cash, shares of our common stock, or a combination thereof, when a conversion notice is received.

We assumed the OCEANE convertible bonds issued by EOS in connection with our acquisition of EOS. The OCEANEs bear interest at 6% per year, payable semi-annually in arrears on May 31 and November 30 of each year. Unless either earlier converted or repurchased, the outstanding OCEANEs of $14.1 million (€12.5 million) will mature on May 31, 2023.

We also assumed $5.3 million (€4.8 million) in other debts with the acquisition of EOS that are due in monthly and quarterly installments beginning in 2023 through maturity in 2027.

As of December 31, 2021, we have made $49.0 million in Orthotec settlement payments and there remains an outstanding balance of $8.5 million in Orthotec settlement payments to be paid by us in quarterly installments through October 2023.

With the acquisition of EOS, we assumed its inventory purchase commitment agreement with a third-party supplier. The Company is obligated to certain minimum purchase commitment requirements through December 2025. As of December 31, 2021, the remaining minimum purchase commitment under the agreement was $33.5 million.

Contractual obligations and commercial commitments

Total contractual obligations and commercial commitments as of December 31, 2021 are summarized in the following table (in thousands):

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Real Property Leases

On April 9, 2021, we entered into 7-year operating lease agreement for a new distribution center which consists of approximately 75,643 square feet of office and warehouse space in Memphis, Tennessee. The term of the lease commenced on May 1, 2021 and will terminate on May 1, 2028, subject to two thirty-six-month options to renew. Base rent under the building lease will be commensurate with our proportionate share of occupancy of the building as we expand and will increase annually by 3.0% throughout the remainder of the lease.

With the acquisition of EOS, we assumed its right-of-use assets and lease liabilities in the amount of $4.3 million. EOS occupies its main office in Paris, France. The EOS office in Paris, France is an operating lease that commenced in 2019 and will terminate in September 2028.

On December 4, 2019, we entered into a new lease agreement, or New Building Lease, for our headquarters location which consists of 121,541 square feet of office, engineering, and research and development space in Carlsbad, California. The term of the New Building Lease commenced on February 1, 2021 and terminates January 31, 2031, subject to two sixty-month options to renew. Base rent under the New Building Lease for the first twelve months of the term will be $0.2 million per month subject to full abatement during months two through ten, and thereafter will increase annually by 3.0% throughout the remainder of the lease.

Off-Balance Sheet Arrangements

As of December 31, 2021, we did not have any off-balance sheet arrangements.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an on-going basis, we evaluate our estimates and assumptions, including those related to revenue recognition, allowances for accounts receivable, inventories and intangible assets, stock-based compensation and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumption conditions.

We believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue from product sales in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Revenue from Contracts with Customers (“Topic 606”). This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements, and financial instruments. Under Topic 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration that the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements that an entity determines are within the scope of Topic 606, the entity performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services that we transfer to the customer.

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Sales are derived primarily from the sale of spinal implant products to hospitals and medical centers through direct sales representatives and independent distributor agents, and with the acquisition of EOS, includes imaging equipment and related services. Revenue is recognized when obligations under the terms of a contract with customers are satisfied, which occurs with the transfer of control of products to customers, either upon shipment of the product or delivery of the product to the customer depending on the shipping terms, or when the products are used in a surgical procedure (implanted in a patient). Revenue from the sale of imaging equipment is recognized as each distinct performance obligation is fulfilled and control transfers to the customer, beginning with shipment or delivery, depending on the terms. Revenue from other distinct performance obligations, such as maintenance on imaging equipment, and other imaging related services, is recognized in the period the service is performed, and makes up less than 10% of our total revenue. Revenue is measured based on the amount of consideration expected to be received in exchange for the transfer of the goods or services specified in the contract with each customer.  In certain cases, we offer the ability for customers to lease our imaging equipment primarily on a non-sales type basis, but such arrangements are immaterial to total revenue in the years presented. We generally do not allow returns of products that have been delivered. Costs incurred by us associated with sales contracts with customers are deferred over the performance obligation period and recognized in the same period as the related revenue, except for contracts that complete within one year or less, in which case the associated costs are expensed as incurred. Payment terms for sales to customers may vary but are commensurate with the general business practices in the country of sale.

To the extent that the transaction price includes variable consideration, such as discounts, rebates, and customer payment penalties, we estimate the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable consideration. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information that is reasonably available, including historical, current, and forecasted information.

We record a contract liability, or deferred revenue, when we have an obligation to provide a product or service to the customer and payment is received in advance of our performance. When we sell a product or service with a future performance obligation, revenue is deferred on the unfulfilled performance obligation and recognized over the related performance period. Generally, we do not have observable evidence of the standalone selling price related to our future service obligations; therefore, we estimate the selling price using an expected cost plus a margin approach. The transaction price is allocated using the relative standalone selling price method. The use of alternative estimates could result in a different amount of revenue deferral.

Excess and Obsolete Inventory

Most of our inventory is comprised of finished goods, and we primarily utilize third-party suppliers to produce our products. Specialized implants, fixation products, biologics, and disposables are determined by utilizing a standard cost method, which includes capitalized variances, which approximates the weighted average cost. Imaging equipment and related parts are valued at weighted average cost. Inventories are stated at the lower of cost or net realizable value. We review the components of inventory on a periodic basis for excess and obsolescence and adjust inventory to its net realizable value as necessary.

We record a lower of cost or net realizable value inventory reserve (“LCNRV”) for estimated excess and obsolete inventory based upon our expected use of inventory on hand. Our inventory, which consists primarily of specialized implants, fixation products, biologics, and disposables is at risk of obsolescence due to the need to maintain substantial levels of inventory. In order to market our products effectively and meet the demands of interoperative product placement, we maintain and provide surgeons and hospitals with a variety of inventory products and sizes. For each surgery, fewer than all components will be consumed. The need to maintain and provide such a variety of inventory causes inventory to be held that is not likely to be used.

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Our estimates and assumptions for excess and obsolete inventory are reviewed and updated on a quarterly basis. The estimates and assumptions are determined primarily based on current usage of inventory and the age of inventory quantities on hand. Additionally, we consider recent experience to develop assumptions about future demand for our products, while considering market conditions, product life cycles and new product launches. Increases in the LCNRV reserve for excess and obsolete inventory result in a corresponding charge to cost of sales.

For the year ended December 31, 2021 and December 31, 2020, we recorded a write-down for excess and obsolete inventory of $11.1 million and $7.0 million, respectively.

Valuation of Goodwill

Our goodwill represents the excess of the cost over the fair value of net assets acquired from our business combinations. The determination of the value of goodwill and intangible assets arising from business combinations and asset acquisitions requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired. Goodwill is assessed for impairment using fair value measurement techniques on an annual basis or more frequently if facts and circumstance warrant such a review. Goodwill is considered to be impaired if we determine that the carrying value of the reporting unit exceeds its respective fair value.

Valuation of Intangible Assets

Our intangible assets are comprised primarily of purchased technology, customer relationships, trade name, trademarks, and in-process research and development. We make significant judgments in relation to the valuation of intangible assets resulting from business combinations and asset acquisitions. Intangible assets are generally amortized on a straight-line basis over their estimated useful lives of 2 to 12 years. We base the useful lives and related amortization expense on the period of time we estimate the assets will generate net sales or otherwise be used. We also periodically review the lives assigned to our intangible assets to ensure that our initial estimates do not exceed any revised estimated periods from which we expect to realize cash flows. If a change were to occur in any of the above-mentioned factors or estimates, the likelihood of a material change in our reported results would increase. We evaluate our intangible assets with finite lives for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that could trigger an impairment review include significant under-performance relative to expected historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business or significant negative industry or economic trends. If this evaluation indicates that the value of the intangible asset may be impaired, we make an assessment of the recoverability of the net carrying value of the asset over its remaining useful life. If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the asset over the remaining amortization period, we reduce the net carrying value of the related intangible asset to fair value and may adjust the remaining amortization period. Significant judgment is required in the forecasts of future operating results that are used in the discounted cash flow valuation models. It is possible that plans may change and estimates used may prove to be inaccurate. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur additional impairment charges.

Valuation of Stock-Based Compensation

Stock-based compensation expense for equity-classified awards, principally related to restricted stock units, or RSUs, and performance restricted stock units, or PRSUs, is measured at the grant date based on the estimated fair value of the award. The fair value of equity instruments that are expected to vest is recognized and amortized over the requisite service period. We have granted awards with up to four year graded or cliff vesting terms. No exercise price or other monetary payment is required for receipt of the shares issued in settlement of the respective award; instead, consideration is furnished in the form of the participant’s service.

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The fair value of RSUs including PRSUs with pre-defined performance criteria is based on the stock price on the date of grant whereas the expense for PRSUs with pre-defined performance criteria is adjusted with the probability of achievement of such performance criteria at each period end. The fair value of the PRSUs that are earned based on the achievement of pre-defined market conditions, is estimated on the date of grant using a Monte Carlo valuation model. The key assumptions in applying this model are an expected volatility and a risk-free interest rate.

Stock-based compensation recorded in our consolidated statements of operations is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. Our estimated forfeiture rates may differ from our actual forfeitures. We consider our historical experience of pre-vesting forfeitures on awards by each homogenous group of employees as the basis to arrive at our estimated annual pre-vesting forfeiture rates.

We estimate the fair value of stock options issued under our equity incentive plans and shares issued to employees under our employee stock purchase plan, or ESPP, using a Black-Scholes option-pricing model on the date of grant. The Black-Scholes option-pricing model incorporates various assumptions including expected volatility, expected term and risk-free interest rates. The expected volatility is based on the historical volatility of our common stock over the most recent period commensurate with the estimated expected term of our stock options and ESPP offering period which is derived from historical experience. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield in effect at the time of grant. We have never declared or paid dividends and have no plans to do so in the foreseeable future.

We account for stock option grants to non-employees under provisions which require that the fair value of these instruments be recognized as an expense over the period in which the related services are rendered.

Recent Accounting Pronouncements

See “Notes to Financial Statements - Note 2 - Recent Accounting Pronouncements” included elsewhere in this Annual Report on Form 10-K.

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