Freshworks Inc. (FRSH) FY 2022 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Annual Report on Form 10-K. As described in the section titled "Special Note Regarding Forward-Looking Statements," the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in “Risk Factors” and elsewhere in this Annual Report on Form 10-K.
Overview
Our mission is to make it fast and easy for businesses to delight their customers and employees.
We provide businesses of all sizes with modern SaaS products that are designed with the end-user in mind. Our primary product offerings include Freshdesk, our customer experience (CX) product; Freshservice, our IT service management (ITSM) product; and our customer relationship management (CRM) solutions, which include Freshsales and Freshmarketer for sales and marketing automation. We currently have more than 63,400 businesses using our software to delight their customers and employees.
We generate revenue primarily from the sale of subscriptions for accessing our cloud-based software products over the contract term. Our subscription arrangements are available in monthly, quarterly, semi-annual, and annual plans, and we typically invoice for the full term in advance. We also sell professional services that include product configuration, data migration, systems integration, and training. Professional services revenue is recognized as services are performed.
Our customer base and operations have scaled over time. Our total revenue was $498.0 million, $371.0 million and $249.7 million in the years ended December 31, 2022, 2021 and 2020, respectively, representing year-over-year growth rates of 34% and 49%, respectively. We incurred operating losses of $233.4 million, $204.8 million and $56.1 million in the years ended December 31, 2022, 2021 and 2020, respectively, and our net losses were $232.1 million, $192.0 million and $57.3 million in the years ended December 31, 2022, 2021 and 2020, respectively.
Macroeconomic and Other Factors
Current macroeconomic uncertainties, including inflationary pressures, significant volatility in global markets, geopolitical developments, and the ongoing impacts of the COVID-19 pandemic have impacted and may continue to impact business spending and the overall economy, and in turn our business. These macroeconomic events could adversely affect demand for our products and services. Additionally, foreign currency exchange rate fluctuations have negatively impacted our revenue growth in 2022. Recently, the U.S. dollar has strengthened significantly against certain foreign currencies in the markets in which we operate, particularly against the Euro and British Pound Sterling. For the year ended December 31, 2022, we had approximately 26% of revenue exposure related to the Euro and British Pound Sterling. If these conditions persist, they could have a material adverse impact on our results and our ability to accurately predict our future results and earnings.
Given our subscription-based business model, the effects of the macroeconomic conditions may not be fully reflected in our revenue until future periods. The ultimate impact on our business and operations remains highly uncertain, and it is not possible for us to predict the duration and extent to which this will affect our business, productivity of our employees, future results of operations, and financial condition. See the section titled “Risk Factors” for further discussion of the challenges and risks we have encountered and could encounter related to these macroeconomic events.
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Key Factors Affecting Our Performance
The growth and future success of our business depends on many factors. While each of these factors presents significant opportunities for our business, they also pose important challenges that we must successfully address in order to sustain our growth and improve our results of operations. For complete definitions of our key metrics, please refer to the section titled “Key Business Metrics” below.
Acquiring New Customers
We will continue to invest in acquiring new customers across all of our products. We believe that our focus on offering products that delight our users facilitates our go-to-market strategy, which is designed to be product-led and self-service in nature, reducing the friction new customers have to overcome to adopt our products within their organization. Our approach to acquiring new customers allows us to benefit from user-driven, organic adoption of our products across organizations of all sizes, as well as enable our customers to standardize on our products across the organization. As of December 31, 2022 and 2021, we had more than 63,400 and 56,000 paying customers, respectively.
We have made and continue to make significant investments in strengthening our outbound sales motion to enable adoption of department-specific and organization-wide use cases for mid-market and enterprise customers. We believe that larger businesses can benefit from implementing multiple Freshworks products, as once they are a customer they are able to expand their use of these products. We define annual recurring revenue (ARR) as the sum total of the subscription revenue we would contractually expect to recognize over the next 12 months from all customers at a point in time, assuming no increases, reductions, or cancellations in their subscriptions. For monthly subscriptions, we take the recurring revenue run-rate of such subscriptions for the last month of the period and multiply it by 12 to get to ARR. While monthly subscribers as a group have historically maintained or increased their subscriptions over time, there is no guarantee that any particular customer on a monthly subscription will renew its subscription in any given month, and therefore the calculation of ARR for these monthly subscriptions may not accurately reflect revenue to be received over a 12-month period from such customers. As of December 31, 2022 and 2021, 17,722 and 14,814 of our customers contributed more than $5,000 in ARR, respectively, demonstrating the broad appeal of our products to customers of all sizes and geographies, and as of December 31, 2022 and 2021, customers contributing more than $5,000 in ARR represented 87% and 85% of total ARR, respectively. We believe that the number of customers that contribute more than $5,000 in ARR is an indicator of our success in expanding upmarket to larger businesses.
We also run focused programs to acquire startup and incubator customers. These programs include free credits to use our products, and webinars and events specifically tailored to highlight the benefits of our products for these types of customers. By encouraging startups and incubators to use our products early on in their company’s lifecycle, we believe we have the opportunity to convert these organizations to paying customers and grow with these customers as they grow their businesses.
Retaining and Expanding Within Existing Customers
Our business model relies on rapidly and efficiently landing new customers and expanding our relationships with them over time. We have experienced, and expect to continue to experience that, over time, a significant portion of our revenue growth will come from our existing customers expanding their usage of our products and buying additional products.
We measure the rate of expansion within our customer base using net dollar retention rate (as defined under Key Business Metrics), and we believe that our net dollar retention rate demonstrates a significant rate of expansion within our existing customer base. As of December 31, 2022 and 2021, our net dollar retention rate was 108% and 114%, respectively.
We have a significant opportunity to expand within our existing customer base and substantially increase the number of customers that purchase multiple Freshworks products. As of December 31, 2022, approximately 24% of our customers purchased two or more Freshworks products, which includes customers on our Freshdesk Omnichannel Suite and Freshsales Suite subscription plans counting as customers who purchased multiple products. These customers represented 48% of total ARR as of December 31, 2022, illustrating the large opportunity we have to sell additional products to our current customer base and drive growth.
We continue to increase the number of customers that have entered into larger subscriptions with us. We had 1,908 customers each contributing $50,000 or more in ARR as of December 31, 2022, representing an increase of 35% year-over-year from 1,416 customers as of December 31, 2021. As of December 31, 2022 and December 31, 2021, customers contributing more than $50,000 in ARR represented approximately 44% and 41% of total ARR, respectively. We believe that the number of customers contributing $50,000 or more in ARR indicates the strategic importance of our products for our customers and our ability to both initially land significant accounts or grow customers into significant accounts over time. No single customer
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accounted for more than 1% of ARR and our top 10 customers represented less than 5% of ARR as of December 31, 2022, and we have no significant concentration in a specific industry vertical.
Investing in Our Growth
We believe that we are early in addressing our large market opportunity and we intend to continue to make investments to support the growth and expansion of our business. We have a track record of bringing new products to market and scaling these new products over time. As of December 31, 2022, we have two primary products with over $100 million in ARR, Freshdesk and Freshservice. We intend to invest in growing our research and development team to extend the functionality of our solutions and continue to bring new solutions to market. Our investments in our Neo platform have helped us accelerate the pace of innovation.
We believe that our market remains largely underserved. We intend to invest aggressively in our direct and indirect sales and marketing capabilities, including investments in our outbound sales motion. We have been global from our earliest product sales and our global footprint continues to expand, with customers in more than 170 countries. During the year ended December 31, 2022, 43%, 39%, and 18% of our revenue was derived from customers in North America; Europe, Middle East and Africa; and the rest of the world, respectively. We have a significant opportunity to further expand globally. We plan to support more languages, recruit partners, hire sales and customer experience personnel in additional countries as needed, and expand our presence in countries where we already operate. A critical part of our go-to-market strategy has been our broad and diverse set of partners that enrich our offerings, scale our geographic coverage, and help us reach a broader audience than we would be able to reach on our own, thus amplifying our go-to-market investments. We plan to continue to invest in growing our partner ecosystem to fuel additional customer acquisition and expand use cases within our existing customer base.
We are also focused on attracting new talent and retaining our employees. Our culture is a critical part of our success, and attracting and retaining the best available talent will help us make customer delight easy and continue our growth trajectory.
Key Business Metrics
We monitor and review a number of metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate financial projections, and make strategic decisions. Key business metrics and our financial performance are impacted by various factors discussed below, including fluctuations in the value of foreign currencies relative to the U.S. dollar. We also review customer data used for calculating these key business metrics on an ongoing basis and make the necessary modifications resulting from such review. We believe these key business metrics provide meaningful supplemental information for management and investors in assessing our operating performance.
| December 31, | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | |||||||||
| Number of customers contributing more than $5,000 in ARR | 17,722 | 14,814 | 11,570 | ||||||||
| ARR from customers contributing more than $5,000 in ARR as a percent of total ARR | 87 | % | 85 | % | 82 | % | |||||
| Net dollar retention rate | 108 | % | 114 | % | 111 | % |
Number of Customers Contributing More Than $5,000 in ARR
We define our total customers contributing more than $5,000 in annual recurring revenue (ARR) as of a particular date as the number of business entities or individuals, represented by a unique domain or a unique email address, with one or more paid subscriptions to one or more of our products that contributed more than $5,000 in ARR. We believe that the number of customers that contribute more than $5,000 in ARR is an indicator of our success in attracting, retaining, and expanding with larger businesses.
Net Dollar Retention Rate
Our net dollar retention rate measures our ability to increase revenue across our existing customer base through expansion of users and products associated with a customer as offset by our churn and contraction in the number of users and products associated with a customer. To calculate net dollar retention rate as of a particular date, we first determine "Entering ARR," which is ARR from the population of our customers as of 12 months prior to the end of the reporting period. We then calculate the "Ending ARR" from the same set of customers as of the end of the reporting period. We then divide the Ending ARR by the Entering ARR to arrive at our net dollar retention rate. Ending ARR includes upsells, cross-sells, and renewals during the measurement period and is net of any contraction or attrition over this period.
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For monthly subscriptions, we take the recurring revenue run-rate of such subscriptions for the last month of the period and multiply it by 12 to get to ARR. While monthly subscribers as a group have historically maintained or increased their subscriptions over time, there is no guarantee that any particular customer on a monthly subscription will renew its subscription in any given month, and therefore the calculation of ARR for these monthly subscriptions may not accurately reflect revenue to be received over a 12-month period from such customers, and net dollar retention rate may reflect a higher rate than the actual rate if customers on monthly subscriptions choose not to renew during the course of the 12 months. Monthly subscriptions represented 20%, 24%, and 28% of ARR as of December 31, 2022, 2021 and 2020 respectively. The net dollar retention rate for customers on monthly contracts has generally been lower than our overall net dollar retention rate. In addition, as part of our regular review of customer data that includes reviewing customers purchasing our products via resellers so we can properly attribute them as end customers, we may make adjustments that could impact the calculation of net dollar retention.
We expect our net dollar retention rate could fluctuate in future periods due to a number of factors, including our expected growth, the level of penetration within our customer base, our ability to upsell and cross-sell products to existing customers, and our ability to retain our customers.
Non-GAAP Financial Measures
In addition to our results determined in accordance with U.S. generally accepted accounting principles (GAAP), we believe the following non-GAAP financial measures are useful in evaluating our operating performance: non-GAAP loss from operations, non-GAAP net loss, and free cash flow. We use these non-GAAP financial measures to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe these non-GAAP financial measures may be helpful to investors because they provide consistency and comparability with past financial performance.
Non-GAAP financial measures have limitations in their usefulness to investors and should not be considered in isolation or as substitutes for financial information presented under GAAP. Non-GAAP financial measures have no standardized meaning prescribed by GAAP and are not prepared under any comprehensive set of accounting rules or principles. In addition, other companies, including companies in our industry, may calculate similarly titled non-GAAP financial measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. As a result, our non-GAAP financial measures are presented for supplemental informational purposes only.
We exclude the following items from one or more of our non-GAAP financial measures, including the related income tax effect of these adjustments:
•Stock-based compensation expense. We exclude stock-based compensation expense, which is a non-cash expense, from certain of our non-GAAP financial measures because we believe that excluding this expense provides meaningful supplemental information regarding operational performance. In particular, stock-based compensation expense is not comparable across companies due to the variety of valuation methodologies and assumptions.
•Employer payroll taxes on employee stock transactions. We exclude the amount of employer payroll taxes on equity awards from certain of our non-GAAP financial measures because they are dependent on our stock price at the time of vesting or exercise and other factors that are beyond our control and do not believe these expenses have a direct correlation to the operation of the business.
•Amortization of acquired intangibles. We exclude amortization of acquired intangibles, which is a non-cash expense, from certain of our non-GAAP financial measures. Our expenses for amortization of acquired intangibles are inconsistent in amount and frequency because they are significantly affected by the timing, size of acquisitions, and the allocation of purchase price. We exclude these amortization expenses because we do not believe these expenses have a direct correlation to the operation of our business.
•Acquisition-related expenses. We exclude transaction, integration, and retention expenses that are directly related to business combinations from certain of our non-GAAP financial measures because we believe that excluding these items provides meaningful supplemental information regarding operational performance and investors to make more meaningful comparisons between our operating results and those of other companies.
•Gain on sale of non-marketable equity investments. We exclude gains on the sale of non-marketable equity investments from certain of our non-GAAP financial measures because we believe they are unrelated to our ongoing operating performance and are not expected to recur in our continuing operating results.
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Non-GAAP Loss From Operations and Non-GAAP Net Loss
We define non-GAAP loss from operations as GAAP loss from operations excluding stock-based compensation expense, employer payroll taxes on employee stock transactions, amortization of acquired intangibles, and acquisition-related expenses.
We define non-GAAP net loss as GAAP net loss, excluding stock-based compensation expense, employer payroll taxes on employee stock transactions, amortization of acquired intangibles, acquisition-related expenses, and gain on sale of non-marketable equity investments, net of their related tax effects.
The following tables present a reconciliation of our GAAP loss from operations to our non-GAAP loss from operations and our GAAP net loss to our non-GAAP net loss for each of the periods presented (in thousands):
Non-GAAP Loss from Operations
| Year Ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | ||||||||
| Loss from operations | $ | (233,372) | $ | (204,782) | $ | (56,112) | ||||
| Non-GAAP adjustments: | ||||||||||
| Stock-based compensation expense | 207,696 | 173,443 | 43,280 | |||||||
| Employer payroll taxes on employee stock transactions | 1,827 | 8,754 | — | |||||||
| Amortization of acquired intangibles | 1,591 | 4,329 | 4,268 | |||||||
| Acquisition-related expenses | — | — | 304 | |||||||
| Non-GAAP loss from operations | $ | (22,258) | $ | (18,256) | $ | (8,260) |
Non-GAAP Net Loss
| Year Ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | ||||||||
| Net loss | $ | (232,132) | $ | (191,995) | $ | (57,294) | ||||
| Non-GAAP adjustments: | ||||||||||
| Stock-based compensation expense | 207,696 | 173,443 | 43,280 | |||||||
| Employer payroll taxes on employee stock transactions | 1,827 | 8,754 | — | |||||||
| Amortization of acquired intangibles | 1,591 | 4,329 | 4,268 | |||||||
| Acquisition-related expenses | — | — | 304 | |||||||
| Gain on sale of non-marketable equity investments | — | (23,830) | — | |||||||
| Income tax adjustments | 1,978 | 1,802 | — | |||||||
| Non-GAAP net loss | $ | (19,040) | $ | (27,497) | $ | (9,442) |
Free Cash Flow
We define free cash flow as net cash provided by (used in) operating activities, less purchases of property and equipment and capitalized internal-use software costs. We believe that free cash flow is a useful indicator of liquidity as it measures our ability to generate cash from our core operations after purchases of property and equipment. Free cash flow is a measure to determine, among other things, cash available for further investments in our business and potential acquisitions of businesses.
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The following table presents a reconciliation of free cash flow to net cash provided by (used in) operating activities, the most directly comparable measure calculated in accordance with GAAP for each of the periods presented (in thousands):
| Year Ended December 31, | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | |||||||||
| Net cash provided by (used in) operating activities | $ | (2,525) | $ | 11,460 | $ | 32,530 | |||||
| Less: | |||||||||||
| Purchases of property and equipment | (7,129) | (5,565) | (4,383) | ||||||||
| Capitalized internal-use software | (5,116) | (3,552) | (4,631) | ||||||||
| Free cash flow | $ | (14,770) | $ | 2,343 | $ | 23,516 | |||||
| Net cash used in investing activities | $ | (284,827) | $ | (420,296) | $ | (11,425) | |||||
| Net cash provided by (used in) financing activities | $ | (156,354) | $ | 1,058,369 | $ | (1,909) |
Components of Our Results of Operations
Revenue
Substantially all of our revenue is derived from subscriptions, which is comprised of fees paid by customers for accessing our cloud-based software products during the term of the subscription. Subscription revenue is recognized ratably over the contract term beginning on the commencement date of each subscription, which is the date that the cloud-based software is made available to customers.
Professional services revenue comprises less than 5% of total revenue and includes fees charged for product configuration, data migration, systems integration, and training. Professional services revenue is recognized as services are performed.
Our subscription arrangements are available in monthly, quarterly, semi-annual, and annual plans, and we typically invoice for the full term in advance. Our payment terms generally require the customers to pay the invoiced amount in advance or within 30 days from the invoice date. Our professional services are generally billed in advance along with the related subscription arrangements.
Cost of Revenue
Cost of revenue consists primarily of personnel-related expenses (including salaries, related benefits, and stock-based compensation expense) for employees associated with our cloud-based infrastructure, payment gateway fees, voice, product support, and professional services organizations, as well as costs for hosting capabilities. Cost of revenue also includes third-party license fees, amortization of acquired technology intangibles, amortization of capitalized internal-use software, and allocation of general overhead costs such as facilities and information technology.
We expect our cost of revenue to continue to increase in dollar amount as we invest additional resources in our cloud-based infrastructure and customer support and professional services organizations. However, our gross profit and gross margin may fluctuate from period to period due to the timing and extent of our investments in third-party hosting capacity, expansion of our cloud-based infrastructure, and customer support, and professional services organizations, as well as the amortization of costs associated with capitalized internal-use software.
Overhead Allocation
We allocate shared costs, such as facilities costs (including rent, utilities, and depreciation on capital expenditures related to facilities shared by multiple departments), information technology costs, and certain administrative personnel costs to all departments based on headcount and location. Allocated shared costs are reflected in each of the expense categories described below, in addition to cost of revenue as described above.
Operating Expenses
Research and Development. Research and development expense consists primarily of personnel-related costs, including salaries, related benefits, and stock-based compensation expense for engineering and product development employees, software license fees, rental of office premises, third-party product development services and consulting expenses, and depreciation expense for equipment used in research and development activities. We capitalize a portion of our research and development expenses that meet the criteria for capitalization of internal-use software. All other research and development costs are expensed as incurred.
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We believe that continued investment in our products is important for our growth, and as such, we expect that our research and development expenses will continue to increase in dollar amount for the foreseeable future, however, we expect it to decline as a percentage of revenue over the longer term. This percentage may fluctuate from period to period depending upon the timing and amount of these expenses.
Sales and Marketing. Sales and marketing expense consists primarily of personnel-related costs, including salaries, related benefits, and stock-based compensation expense for our sales personnel, sales commissions for our sales force and reseller commissions for our channel sales partners, as well as costs associated with marketing activities, travel and entertainment costs, software license fees, and rental of office premises. Sales commissions are considered incremental costs incurred to obtain contracts with customers, and these costs are deferred and amortized over the expected benefit period of three years. Marketing activities include online lead generation, advertising, and promotional events.
We expect to continue to make significant investments as we expand our customer acquisition, retention efforts and in-person marketing events and associated business travel. As a result, we expect that our sales and marketing expenses will continue to increase in dollar amount for the foreseeable future, however, we expect it to decline as a percentage of revenue over the longer term. This percentage may fluctuate from period to period depending upon the timing and amount of these expenses.
General and Administrative. General and administrative expense consists primarily of personnel-related costs, including salaries, related benefits, and stock-based compensation expense for certain executives and other general and administrative personnel, third-party professional services fees; including consulting, legal, audit, and accounting services, travel and entertainment costs, accounting, legal, human resources, and recruiting personnel, costs of director and officer insurance, costs associated with acquisitions of businesses, software license fees, and rental of office premises.
As a publicly traded company, we expect to increase personnel-related and professional service expenses associated with ongoing compliance and reporting obligations and costs to broaden our IT related infrastructure. Our general and administrative expenses are expected to continue to increase in dollar amount for the foreseeable future, however, we expect it to decline as a percentage of revenue over the longer term. This percentage may fluctuate from period to period depending upon the timing and amount of our general and administrative expenses.
Interest and Other (expense) Income, Net
Interest and other income, net primarily consists of interest income from our investment portfolios, amortization of premium or discount on marketable securities, and foreign currency gains and losses.
Provision for (Benefit from) Income Taxes
Provision for (benefit from) income taxes consists primarily of income taxes related to U.S. states and foreign jurisdictions in which we conduct business. We maintain a full valuation allowance on our U.S. federal and state net deferred tax assets as we have concluded that it is not more likely than not that the deferred tax assets will be realized. Our effective tax rate is affected by tax rates in foreign jurisdictions and the relative amounts of income we earn in those jurisdictions, as well as non-deductible expenses, such as stock-based compensation, and changes in our valuation allowance.
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Results of Operations
The following tables sets forth our consolidated statements of operations data for the periods presented (in thousands):
| Year Ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | ||||||||
| Revenue | $ | 497,999 | $ | 371,022 | $ | 249,659 | ||||
| Cost of revenue(1) | 95,772 | 78,030 | 52,492 | |||||||
| Gross profit | 402,227 | 292,992 | 197,167 | |||||||
| Operating expenses: | ||||||||||
| Research and development(1) | 135,543 | 120,407 | 69,210 | |||||||
| Sales and marketing(1) | 343,207 | 260,345 | 133,277 | |||||||
| General and administrative(1) | 156,849 | 117,022 | 50,792 | |||||||
| Total operating expenses | 635,599 | 497,774 | 253,279 | |||||||
| Loss from operations | (233,372) | (204,782) | (56,112) | |||||||
| Interest and other income, net | 12,582 | 23,303 | 2,833 | |||||||
| Loss before income taxes | (220,790) | (181,479) | (53,279) | |||||||
| Provision for income taxes | 11,342 | 10,516 | 4,015 | |||||||
| Net loss | $ | (232,132) | $ | (191,995) | $ | (57,294) |
__________________
(1)Includes stock-based compensation expense as follows:
| Year Ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | ||||||||
| Cost of revenue | $ | 7,039 | $ | 5,604 | $ | — | ||||
| Research and development | 36,413 | 45,162 | 15,890 | |||||||
| Sales and marketing | 64,328 | 53,169 | 7 | |||||||
| General and administration | 99,916 | 69,508 | 27,383 | |||||||
| Total stock-based compensation expense | $ | 207,696 | $ | 173,443 | $ | 43,280 |
Recognition of Stock-Based Compensation
Prior to our initial public offering (IPO), there was no stock-based compensation expense recognized from our equity awards as the liquidity event-related performance condition was not probable. The performance condition was satisfied upon the completion of the IPO in September 2021, and we began to recognize stock-based compensation expense. During the year ended December 31, 2021, stock-based compensation expense recognized included a cumulative charge associated with certain RSUs for which the service-based vesting condition had been satisfied upon the completion of the liquidity event.
During the year ended December 31, 2020, as described in Note 10 to our consolidated financial statements included elsewhere in this report, we facilitated certain secondary equity transactions from which we recognized stock-based compensation expense for shares that were repurchased at excess value.
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The following table sets forth our consolidated statements of operations data for the periods presented, as a percentage of revenue:
| Year Ended December 31, | ||||||||
|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | ||||||
| Revenue | 100 | % | 100 | % | 100 | % | ||
| Cost of revenue | 19 | 21 | 21 | |||||
| Gross profit | 81 | 79 | 79 | |||||
| Operating expense: | ||||||||
| Research and development | 27 | 32 | 28 | |||||
| Sales and marketing | 69 | 70 | 53 | |||||
| General administrative | 32 | 32 | 20 | |||||
| Total operating expenses | 128 | 134 | 101 | |||||
| Loss from operations | (47) | (55) | (22) | |||||
| Interest and other income, net | 2 | 6 | 1 | |||||
| Loss before income taxes | (45) | (49) | (21) | |||||
| Provision for income taxes | 2 | 3 | 2 | |||||
| Net loss | (47) | % | (52) | % | (23) | % |
Comparison of Fiscal Years Ended December 31, 2022 and 2021
Revenue
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Subscription services | $ | 485,322 | $ | 360,506 | $ | 124,816 | 35 | % | ||||||
| Professional services | $ | 12,677 | $ | 10,516 | $ | 2,161 | 21 | % | ||||||
| Total revenue | $ | 497,999 | $ | 371,022 | $ | 126,977 | 34 | % |
Revenue increased by $127.0 million, or 34%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. Of the total increase in revenue, approximately $94.9 million was attributable to revenue from existing customers as of December 31, 2021, net of contraction and churn, and approximately $32.1 million was attributable to revenue from new customers acquired during the year ended December 31, 2022, net of contraction and churn. Our net dollar retention rate of 108% for the year ended December 31, 2022 reflects the expansion within existing customers and the sale of additional products to these customers.
Cost of Revenue and Gross Margin
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Cost of revenue | $ | 95,772 | $ | 78,030 | $ | 17,742 | 23 | % | ||||||
| Gross Margin | 81 | % | 79 | % |
Cost of revenue increased by $17.7 million, or 23%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. This increase was primarily due to increases of $8.5 million in third-party hosting costs, $5.3 million in personnel-related costs due to annual compensation adjustments and higher headcount, $3.8 million in software license fees, $1.4 million in stock-based compensation expense, $1.1 million increase in professional fees including legal costs, and $1.0 million in payment gateway fees, partially offset by $2.7 million decrease in amortization of developed technology and a decrease of $2.0 million in cloud voice service costs. Our gross margin increased to 81% from 79% as we increased revenue and realized benefits from economies of scale primarily related to our third party hosting costs.
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Operating Expenses
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Research and development | $ | 135,543 | $ | 120,407 | $ | 15,136 | 13 | % | ||||||
| Sales and marketing | 343,207 | 260,345 | 82,862 | 32 | % | |||||||||
| General and administrative | 156,849 | 117,022 | 39,827 | 34 | % | |||||||||
| Total operating expenses | $ | 635,599 | $ | 497,774 | $ | 137,825 |
The increases in our operating expenses in the year ended December 31, 2022 compared to the year ended December 31, 2021 were primarily driven by personnel-related costs due to higher headcount to support the growth of our business, compensation adjustments and changes in stock-based compensation expense.
Research and Development
Research and development expense increased by $15.1 million, or 13%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. This increase was primarily due to increases of $18.9 million in personnel-related costs due to compensation adjustments and higher headcount, $2.3 million in professional services fees and $1.2 million in third party cloud infrastructure expenses to support the operations of our research and development, partially offset by a decrease of $8.7 million in stock-based compensation expense.
Sales and Marketing
Sales and marketing expense increased by $82.9 million, or 32%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. This increase was primarily due to increases of $48.5 million in personnel-related costs due to compensation adjustments and higher headcount, $11.2 million in stock-based compensation expense, $5.5 million in travel related expenses for sales and marketing events, $4.8 million in higher advertising, branding and event costs, $4.0 million in reseller commissions, $3.8 million in software license fees and $2.9 million in professional services fees.
General and Administrative
General and administrative expense increased by $39.8 million, or 34%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. This increase was primarily due to increases of $30.4 million in stock-based compensation expense, $6.8 million in personnel-related costs due to compensation adjustments and higher headcount, $4.7 million in directors and officers insurance, and $1.1 million in software license fees, partially offset by decreases of $3.3 million related to legal settlements and $1.5 million in professional services fees, comprised primarily of legal, accounting, and consulting fees.
Interest and Other Income, Net
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Interest income | $ | 14,771 | $ | 2,454 | $ | 12,317 | 502 | % | ||||||
| Other income (expense) net | (2,189) | 20,849 | (23,038) | (110) | % | |||||||||
| Interest and other income, net | $ | 12,582 | $ | 23,303 | $ | (10,721) | (46) | % |
Interest income increased primarily due to $13.8 million higher interest income earned from marketable securities.
Other income (expense), net decreased primarily due to a $23.8 million gain from the sale of non-marketable equity investments and $0.9 million of benefit from the release of interest and penalties accrued for indirect taxes recorded during fiscal 2021 that did not recur in fiscal 2022, partially offset by $1.3 million in decrease in foreign exchange loss during fiscal 2022.
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Provision for Income Taxes
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Provision for income taxes | $ | 11,342 | $ | 10,516 | $ | 826 | 8 | % |
We are subject to federal and state income taxes in the United States and taxes in foreign jurisdictions. For the years ended December 31, 2022 and 2021, we recorded a provision for income taxes of $11.3 million, and $10.5 million, respectively, on loss before taxes of $220.8 million and $181.5 million, respectively. The effective tax rates for the years ended December 31, 2022 and 2021 were (5.1)% and (5.8)% respectively. The effective tax rates differ from the statutory rate primarily due to maintaining a full valuation allowance on our U.S. federal and state net deferred tax assets as it was more likely than not that those deferred tax assets will not be realized. The $0.8 million increase in tax expense was due to a $1.7 million increase in foreign taxes due to higher pre-tax earnings and foreign sales, partially offset by a decrease in unrecognized tax benefit of $0.9 million for the year ended December 31, 2022.
Comparison of Fiscal Years Ended December 31, 2021 and 2020
Revenue
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Subscription services | $ | 360,506 | $ | 242,879 | $ | 117,627 | 48 | % | ||||||
| Professional services | $ | 10,516 | $ | 6,780 | $ | 3,736 | 55 | % | ||||||
| Total revenue | $ | 371,022 | $ | 249,659 | $ | 121,363 | 49 | % |
Revenue increased by $121.4 million, or 49%, for the year ended December 31, 2021 compared to the year ended December 31, 2020. Of the total increase in revenue, approximately $35.4 million was attributable to revenue from new customers acquired during the year ended December 31, 2021, net of contraction and churn, and approximately $86.0 million was attributable to revenue from existing customers as of December 31, 2020, net of contraction and churn. Our net dollar retention rate of 114% for the year ended December 31, 2021 reflects the expansion within existing customers and the sale of additional products to these customers.
Cost of Revenue and Gross Margin
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Cost of revenue | $ | 78,030 | $ | 52,492 | $ | 25,538 | 49 | % | ||||||
| Gross Margin | 79 | % | 79 | % |
Cost of revenue increased by $25.5 million, or 49%, for the year ended December 31, 2021 compared to the year ended December 31, 2020. This increase was primarily due to increases of $5.6 million in stock-based compensation expense, $6.9 million in third-party hosting costs, $5.7 million in personnel-related costs due to annual compensation adjustments and higher headcount, $1.9 million in software license fees, $1.6 million increase in professional fees including legal costs, $1.5 million in cloud voice service costs, $1.4 million in payment gateway fees, and approximately $1.1 million in amortization of capitalized internal-use software. Our gross margin remained consistent at 79% for the years ended December 31, 2021 and 2020.
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Operating Expenses
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Research and development | $ | 120,407 | $ | 69,210 | $ | 51,197 | 74 | % | ||||||
| Sales and marketing | 260,345 | 133,277 | 127,068 | 95 | % | |||||||||
| General and administrative | 117,022 | 50,792 | 66,230 | 130 | % | |||||||||
| Total operating expenses | $ | 497,774 | $ | 253,279 | $ | 244,495 |
The increases in our operating expenses in the year ended December 31, 2021 compared to the year ended December 31, 2020 were primarily headcount driven to support the growth of our business, as well as cumulative stock-based compensation recognized in connection with the IPO.
Research and Development
Research and development expense increased by $51.2 million, or 74%, for the year ended December 31, 2021 compared to the year ended December 31, 2020. This increase was primarily due to increases of $29.3 million in stock-based compensation expense recognized (which reflects the increase related to cumulative stock-based compensation expense in connection with our IPO, net of the absence in the current period of stock-based compensation expense of $15.9 million recognized in connection with certain secondary equity transactions occurring in the year ended December 31, 2020 (the 2020 Equity Transactions) as described above), $20.2 million in personnel-related costs due to annual compensation adjustments and higher headcount, and $1.3 million in software license fees.
Sales and Marketing
Sales and marketing expense increased by $127.1 million, or 95%, for the year ended December 31, 2021 compared to the year ended December 31, 2020. This increase was primarily due to increases of $53.2 million in stock-based compensation expense, $41.9 million in personnel-related costs due to annual compensation adjustments and higher headcount, $22.8 million in higher advertising, branding and event costs, $5.3 million in reseller commissions, and $4.3 million in software license fees.
General and Administrative
General and administrative expense increased by $66.2 million, or 130%, for the year ended December 31, 2021 compared to the year ended December 31, 2020. This increase was primarily due to $42.1 million in stock-based compensation expense (which reflects the increase related to the cumulative stock-based compensation expense in connection with our IPO, net of the absence in the current period of stock-based compensation expense of $27.4 million recognized in connection with the 2020 Equity Transactions as described above), $11.9 million in personnel-related costs due to annual compensation adjustments and higher headcount, $4.5 million in professional services fees, comprised primarily of legal, accounting, and consulting fees, $3.9 million related to a legal settlement, $1.9 million in directors and officers insurance, $0.5 million in software license fees, $0.5 million in other taxes and licenses, and $0.7 million in other individually immaterial costs.
Interest and Other Income, Net
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Interest income | $ | 2,454 | $ | 4,210 | $ | (1,756) | (42) | % | ||||||
| Other income (expense) net | 20,849 | (1,377) | 22,226 | * | ||||||||||
| Interest and other income, net | $ | 23,303 | $ | 2,833 | $ | 20,470 | 723 | % |
*Not meaningful
Interest income decreased primarily due to $1.9 million lower lower coupon rates and bond premium amortization.
Other income (expense), net increased by $22.2 million, primarily due to a $23.8 million gain from the sale of non-marketable equity investments and $0.9 million of benefit from the release of interest and penalties accrued for indirect taxes that was originally reserved in fiscal 2020, partially offset by $3.0 million of foreign exchange losses.
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Provision for Income Taxes
| Year Ended December 31, | Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ | % | |||||||||||
| (dollars in thousands) | ||||||||||||||
| Provision for income taxes | $ | 10,516 | $ | 4,015 | $ | 6,501 | 162 | % |
We are subject to federal and state income taxes in the United States and taxes in foreign jurisdictions. For the years ended December 31, 2021 and 2020, we recorded provision for income taxes of $10.5 million and $4.0 million, respectively, on loss before taxes of $181.5 million and $53.3 million, respectively. The effective tax rates for the years ended December 31, 2021 and 2020 were (5.8)% and (7.6)% respectively. The effective tax rates differ from the statutory rate primarily due to maintaining a full valuation allowance on our U.S. federal and state net deferred tax assets as it was more likely than not that those deferred tax assets will not be realized. The $6.5 million increase in tax expense was due to a $3.7 million increase in foreign taxes due to higher pre-tax earnings and a $2.8 million increase in uncertain tax position for the year ended December 31, 2021.
Liquidity and Capital Resources
As of December 31, 2022 we had cash and cash equivalents of $304.1 million and marketable securities of $843.4 million. Since inception, we have funded our operations primarily with financing through the issuance of redeemable convertible preferred and common stock to investors, and in September 2021, we completed our IPO that generated net proceeds of approximately $1.1 billion. As of December 31, 2022, we had an accumulated deficit of $3.5 billion. Our operating activities resulted in cash outflows of $2.5 million for the year ended December 31, 2022.
Our other material cash requirements are related to the settlement of future contractual obligations associated with operating leases and other service subscription agreements (as described in Contractual Obligations below).
We believe our existing cash, cash equivalents and marketable securities, will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. We believe we will meet longer term expected future cash requirements and obligations through a combination of our existing cash and cash equivalents balances, cash flow from operations, and issuances of equity securities or debt offerings. Our future capital requirements will depend on many factors, including the rate of our revenue growth, the timing and extent of spending on research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and other business initiatives and the continuing market adoption of our products. We may in the future enter into arrangements to acquire or invest in complementary businesses, services, and technologies, including intellectual property rights. We may be required to seek additional equity or debt financing in connection with such activities. If we raise additional funds through the incurrence of indebtedness, such indebtedness may have rights that are senior to holders of our equity securities and could contain covenants that restrict our operational flexibility. Any additional equity or convertible debt financing may be dilutive to stockholders. In the event that additional financing is required from outside sources, we may not be able to raise such financing on terms acceptable to us or at all.
Cash Flows
The following table summarizes our cash flows for the periods presented (in thousands):
| Year Ended December 31, | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | |||||||||
| Net cash provided by (used in) operating activities | $ | (2,525) | $ | 11,460 | $ | 32,530 | |||||
| Net cash used in investing activities | $ | (284,827) | $ | (420,296) | $ | (11,425) | |||||
| Net cash provided by (used in) financing activities | $ | (156,354) | $ | 1,058,369 | $ | (1,909) |
Operating Activities
Net cash used in operating activities of $2.5 million for the year ended December 31, 2022 reflects our net loss of $232.1 million, adjusted for non-cash items such as stock-based compensation of $207.7 million, depreciation and amortization of $11.5 million, amortization of deferred contract acquisition costs of $18.5 million, non-cash lease expense of $6.2 million, premium amortization on marketable securities of $1.6 million, and net cash outflows of $11.1 million from changes in operating assets and liabilities. The net cash outflows from changes in operating assets and liabilities were due to increases of operating assets of $28.6 million in deferred contract acquisition costs, $18.9 million in accounts receivable, $8.1 million in
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prepaid expenses and other assets and a decrease of $8.8 million in operating lease liabilities; partially offset by increases in operating liabilities of $45.5 million in deferred revenue and $7.7 million in accrued and other liabilities.
Net cash provided by operating activities of $11.5 million for the year ended December 31, 2021 reflects our net loss of $192.0 million, adjusted for non-cash items such as stock-based compensation of $173.4 million, gain realized on sale of non-marketable equity investment of $23.8 million, depreciation and amortization of $13.3 million, amortization of deferred contract acquisition costs of $12.8 million, deferred income taxes of $1.9 million, premium amortization on marketable securities of $1.8 million, and net cash inflows of $28.0 million from changes in operating assets and liabilities. The net cash inflows from changes in operating assets and liabilities were due to increases of $56.0 million in deferred revenue, $17.7 million in accrued and other liabilities, and $2.0 million in accounts payable, partially offset by increases in assets of $24.2 million in deferred contract acquisition costs, $17.5 million in accounts receivable, and $5.9 million in prepaid expenses and other assets.
Net cash provided by operating activities of $32.5 million for the year ended December 31, 2020 reflects our net loss of $57.3 million, adjusted for non-cash items such as stock-based compensation of $43.3 million, depreciation and amortization of $11.2 million, amortization of deferred contract acquisition costs of $7.7 million, deferred income taxes of $2.4 million and net cash inflows of $28.9 million from changes in operating assets and liabilities. The net cash inflows from changes in operating assets and liabilities were due to increases in operating liabilities of $36.4 million in deferred revenue and $24.9 million in accrued and other liabilities, partially offset by increases in assets of $14.3 million in deferred contract acquisition costs, $9.9 million in accounts receivable, and $8.2 million in prepaid expenses and other assets.
Investing Activities
Net cash used in investing activities of $284.8 million for the year ended December 31, 2022 consisted of $272.7 million in purchases, net of maturities and sales, of marketable securities, $7.0 million in purchases, net of proceeds from sale of property and equipment, and $5.1 million related to the capitalization of internal-use software.
Net cash used in investing activities of $420.3 million for the year ended December 31, 2021 consisted of $435.8 million in purchases, net of maturities and sales, of marketable securities, $4.9 million in purchases, net of proceeds from sale of property and equipment, $3.6 million related to the capitalization of internal-use software, offset by $24.0 million in proceeds from sale of non-marketable equity investments.
Net cash used in investing activities of $11.4 million for the year ended December 31, 2020 consisted of $5.1 million net payment for acquisitions, $4.6 million related to the capitalization of internal-use software, $4.4 million in purchases of property and equipment, $1.8 million acquisition of intangibles, offset by $4.4 million proceeds, net of purchases, from maturities and sales of marketable securities.
Financing Activities
Net cash used in financing activities of $156.4 million for the year ended December 31, 2022 consisted primarily of $167.2 million in payment of withholding taxes on net share settlement of equity awards, partially offset by $10.9 million in proceeds from issuance of common stock under employee stock purchase plan, net.
Net cash provided by financing activities of $1.1 billion for the year ended December 31, 2021 consisted primarily of $1.1 billion in proceeds from our IPO, net of underwriting discounts, offset by $6.8 million in payments for deferred offering costs, $3.3 million in payment of withholding taxes on net share settlement of equity awards, and $0.9 million in payments for acquisition-related liabilities.
Net cash used in financing activities of $1.9 million for the year ended December 31, 2020 consisted primarily of $2.2 million in payments for acquisition-related liabilities.
Remaining Performance Obligations on Customer Contracts
We generally enter into subscription agreements with our customers on monthly, annual, or multi-year terms and invoice customers in advance in either monthly or annual installments. A small portion of our annual contracts may have billing terms that are different from their subscription terms, and our multi-year contracts are invoiced annually. As of December 31, 2022, remaining performance obligations totaled $301.5 million, which comprised $205.6 million of deferred revenue and $95.9 million of unbilled revenue.
We expect that the value of the remaining performance obligations will change from one period to another for several reasons, including new contracts, timing of renewals, cancellations, contract modifications and foreign currency fluctuations.
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We believe that fluctuations in remaining performance obligations are not necessarily a reliable indicator of future revenue and we do not utilize it as a key management metric internally.
Contractual Obligations and Commitments
Our principal commitments consist of operating lease obligations for office space and contractual obligations under third-party cloud infrastructure agreements and service subscription agreements.
As of December 31, 2022, our estimated future contractual obligations totaled $140.0 million, of which $34.9 million and $105.1 million were operating lease commitments and other contractual obligations, respectively. As disclosed in Notes 8 and 9 to the consolidated financial statements included elsewhere in this report, our operating leases included short-term and long-term commitments of $6.8 million and $28.2 million, respectively. Our other contractual obligations included short-term and long-term commitments of $46.2 million and $58.9 million respectively.
Our operating leases expire on varying dates through 2031. Our other contractual obligations have commitments outstanding through December 2025.
Off-Balance Sheet Arrangements
As of December 31, 2022, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Indemnification Agreements
In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify customers, vendors, lessors, business partners, and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, services to be provided by us, or from data breaches or intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain officers and employees that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers, or employees. No demands have been made upon us to provide indemnification under such agreements and there are no claims that we are aware of that could have a material effect on our consolidated balance sheets, consolidated statements of operations and comprehensive loss, or consolidated statements of cash flows.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these consolidated financial statements requires our management to make estimates, assumptions, and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the applicable periods. We base our estimates, assumptions, and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances. Different assumptions and judgments would change the estimates used in the preparation of our consolidated financial statements, which, in turn, could change the results from those reported. We evaluate our estimates, assumptions, and judgments on an ongoing basis.
Our significant accounting policies are discussed in detail in Note 2, Summary of Significant Accounting Policies, to the consolidated financial statements included in Item 8 of Part II of this 10-K. The critical accounting estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are described below.
Revenue Recognition
We derive revenue from subscription fees and related professional services. We sell subscriptions for our cloud-based solutions directly to customers and indirectly through channel partners through arrangements that are non-cancelable and non-refundable. Our subscription arrangements do not provide customers with the right to take possession of the software supporting the solutions and, as a result, are accounted for as service arrangements. We record revenue net of sales or value-added taxes.
Subscription Revenue
Subscription revenue is primarily comprised of fees paid by our customers for accessing our cloud-based software during the term of the arrangement. Our cloud-based services allow customers to use the multi-tenant software without requiring them
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to take possession of the software. Given that access to the cloud-based software represents a series of distinct services that comprise a single performance obligation that is satisfied over time, subscription revenue is recognized ratably over the contract term beginning on the commencement date of each contract, which is the date that the cloud-based software is made available to customers.
Professional Services Revenue
Professional services revenue is comprised of fees charged for services ranging from product configuration, data migration, systems integration and training. Professional services revenue is recognized as services are performed and represents less than 5% of total revenue.
Customers with Multiple Performance Obligations
Some of our contracts with customers contain both subscriptions and professional services. For these contracts, we account for individual performance obligations separately. The transaction price is allocated to the separate performance obligations on the basis of relative standalone selling price (SSP). We determine SSP by taking into consideration historical selling price of these performance obligations in similar transactions, as well as current pricing practices and other observable inputs including, but not limited to, customer size and geography. As our go-to-market strategies evolve, we may modify our pricing practices in the future, which could result in changes to SSP.
Evaluating the terms and conditions of our customer contracts for appropriate revenue recognition and determining whether products and services are considered distinct performance obligations may require significant judgment. Judgment is also used to estimate the contract's transaction price and allocate it to each performance obligation.
Deferred Contract Acquisition Costs
Deferred contract acquisition costs are incremental costs that are associated with acquiring customer contracts and consist primarily of sales commissions and the associated payroll taxes and certain referral fees paid to independent third parties. The costs incurred upon the execution of initial and expansion contracts are primarily deferred and amortized over an expected benefit period of three years. The Company considers the expected benefit period to exceed the initial contract term for certain costs because of anticipated renewals and because sales commission rates for renewal contracts are not commensurate with sales commissions for initial contracts. Significant judgement is used to determine the expected benefit period by taking into consideration the Company’s technology life cycle and an estimated customer relationship period, including expected contract renewals.
Stock-Based Compensation
We issue stock options and RSUs to employees, consultants, and directors, and stock purchase rights granted under the Employee Stock Purchase Plan (ESPP) to employees based on their estimated fair value on the date of the grant. For stock options and ESPP, the fair value is estimated using the Black-Scholes option-pricing model, and stock-based compensation is recognized in the consolidated statements of operations using the straight-line attribution method. The fair value of RSUs is based on the closing market price of our Class A common stock on the date of the grant. We recognize stock-based compensation expense over the requisite service period, which is the vesting period of the respective awards. Forfeitures are accounted for when they occur.
Prior to our IPO, the fair value of our common stock on the date of the grant was determined based on independent third-party valuations as there was no public market, and there was no stock-based compensation expense recognized from the RSUs as the liquidity event-related performance condition was not probable. Upon the completion of the IPO, the performance condition became probable, and we began to recognize stock-based compensation expense.
We also granted a performance-based award with both a service-based vesting condition and a market condition involving a certain range of stock price targets, and the fair value of such award was determined by using the Monte-Carlo simulation model. The associated stock-based compensation expense is recognized over the longer of the derived service period or the requisite service period, using the accelerated attribution method.
Changes in the assumptions, which are subjective and generally require significant analysis and judgement to develop, can materially affect the valuation of our equity awards and impact how much stock-based compensation expense is recognized.
Leases
The Company determines whether an arrangement constitutes a lease and records lease liabilities and right-of-use (ROU) assets on its consolidated balance sheets at the lease commencement date. Lease liabilities are measured based on the present
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value of the total lease payments not yet paid, discounted based on either the rate implicit in the lease or the Company's incremental borrowing rate (the estimated rate the Company would be required to pay for a collateralized borrowing equal to the total lease payments over the term of the lease), whichever is more readily determinable. The incremental borrowing rate is based on an estimate of the Company's expected unsecured borrowing rate for its notes, adjusted for tenor and collateralized security features. We estimate the incremental borrowing rate using yields for maturities that are in line with the duration of the lease payments.
Recent Accounting Pronouncements
See “Summary of Significant Accounting Policies” in Note 2 of the notes to our consolidated financial statements for more information.