Guidewire Software, Inc. (GWRE) FY 2021 MD&A

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

The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes thereto included in Item 8 and the Risk Factors included in Item 1A of Part I of this Annual Report on Form 10-K. All information presented herein is based on our fiscal calendar. Unless otherwise stated, references in this Annual Report on Form 10-K to particular years or quarters refer to our fiscal years ended in July and the associated quarters of those fiscal years. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

We have elected to omit discussion on the earliest of the three years covered by the consolidated financial statements presented. Refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located in our Form 10-K for the fiscal year ended July 31, 2020, filed on September 28, 2020, for reference to discussion of the fiscal year ended July 31, 2019, the earliest of the three fiscal years presented.

Overview

Guidewire delivers a leading platform that P&C insurers trust to engage, innovate, and grow efficiently. Guidewire’s platform combines core operations, digital engagement, analytics, and AI applications delivered as a cloud service or self-managed software. As a partner to our customers, we continually evolve to enable their success and assist them in navigating a rapidly changing insurance market.

Our core operational services and products are InsuranceSuite via Guidewire Cloud, InsuranceNow, and InsuranceSuite for self-managed installations. These services and products are transactional systems of record that support the entire insurance lifecycle, including insurance product definition, distribution, underwriting, policyholder services, and claims management. InsuranceSuite via Guidewire Cloud is a highly configurable and scalable product, delivered as a service and primarily comprised of three core applications (PolicyCenter, BillingCenter, and ClaimCenter) that can be subscribed to separately or together. These applications are built on and optimized for our Guidewire Cloud Platform (“GWCP”) architecture and leverage our in-house Guidewire Cloud operations team. InsuranceSuite via Guidewire Cloud is designed to support multiple releases each year to ensure that cloud customers remain on the latest version and gain fast access to our innovation efforts. Additionally, InsuranceSuite via Guidewire Cloud embeds digital and analytics capabilities natively into our platform. Most new sales and implementations are for InsuranceSuite via Guidewire Cloud. InsuranceNow is a complete, cloud-based application that offers policy, billing, and claims management functionality to insurers that have limited internal information technology resources. InsuranceSuite for self-managed installations is comprised of three core applications (PolicyCenter, BillingCenter, and ClaimCenter) that can be licensed separately or together and can be deployed and updated by our customers and their implementation partners. Our digital engagement applications enable digital sales, omni-channel service, and enhanced claims experiences for policyholders, agents, vendor partners, and field personnel. Our Analytics and AI offerings enable insurers to manage data more effectively, gain insights into their business, drive operational efficiencies, and underwrite new and evolving risks. To support P&C insurers globally, we have localized, and will continue to localize, our platform for use in a variety of international regulatory, language, and currency environments.

Our customers range from some of the largest global insurance companies or their subsidiaries to predominantly national or local insurers that serve specific states and/or regions. Our customer engagement is led by our direct sales team and supported by our SI partners. We maintain and continue to grow our sales and marketing efforts globally, and maintain regional sales centers throughout the world.

Because our platform is critical to our new and existing customers’ businesses, their decision-making and product evaluation process is long, which results in an extended sales cycle. These evaluation periods can extend further if a customer purchases multiple services and products or assesses the benefits of a cloud-based subscription. Sales to new customers also involve extensive customer due diligence and reference checks. Our sales cycle has lengthened due to the COVID-19 pandemic. The success of our sales efforts relies on continued improvements and enhancements to our current services and products, the introduction of new services and products, efficient operation of our cloud infrastructure, continued development of relevant local content and automated tools for updating content, and successful implementations.

We sell our cloud-delivered offerings through subscription services and our self-managed products through term licenses. We generally price our services and products based on the amount of DWP that will be managed by our platform. Our subscription, term license, and support fees are typically invoiced annually in advance. Subscription services are generally sold with an initial term of between three and five years with optional annual renewals commencing after the initial term.

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Subscription revenue is recognized on a ratable basis over the committed term, once all revenue recognition criteria is met including providing access to the service. Term licenses are primarily sold with an initial two-year committed term with optional annual renewals commencing after the initial term. We may enter into term license arrangements with our customers that have an initial term of more than two years or may renew license arrangements for longer than one year. A small portion of our revenue is derived from perpetual licenses. Term and perpetual license revenue are typically recognized when software is made available to a customer, provided that all other revenue recognition criteria have been met. Our support revenue is generally recognized ratably over the committed support term of the licensed software. Our support fees are typically priced as a fixed percentage of the associated license fees. We also offer professional services, both directly and through SI partners, to help our customers deploy, migrate, and utilize our platform, services, and products. Substantially all of our services revenue is billed monthly on a time and materials basis.

Over the past few years, we have primarily been entering into cloud-based subscription arrangements with our new and existing customers, and we anticipate that subscription arrangements will be a majority of annual new sales going forward. As this sales model matures, we may decide to change certain contract terms in new arrangements to remain competitive or otherwise meet market demands.

To extend our technology leadership in the global market and to drive operating efficiency, we continue to invest in product development and cloud operations to enhance and improve our current services and products, introduce new services and products, and advance our ability to cost-effectively deliver our services in the cloud. Continued investment is critical as we seek to assist our customers in achieving their technology goals, maintain our competitive advantage, grow our revenue, expand internationally, and meet evolving customer demands. In certain cases, we may also acquire skills and technologies to manage our cloud infrastructure and accelerate our time to market for new services, products, solutions, and upgrades.

Our track record of success with customers and their implementations is central to maintaining our strong competitive position. We rely on our global services team and SI partners to ensure that teams with the right combination of product and language skills are used in the most efficient way to meet our customers’ implementation needs. We have extensive relationships with SI, consulting, technology, and industry partners. Our network of partners has expanded as interest in and adoption of our platform has grown. We encourage our partners to co-market, pursue joint sales initiatives, and drive broader adoption of our technology, helping us grow our business more efficiently and enabling us to focus our resources on continued innovation and further enhancement of our solutions.

We work closely with our network of third-party SI partners to facilitate new sales and implementations of both our subscription services and self-managed products. Our partnerships with leading SI partners allow us to increase efficiency and scale while reducing customer implementation costs. We continue to invest time and resources to increase the number of qualified consultants employed by our SI partners, develop relationships with new partners in existing and new markets, and ensure that all SI partners are qualified to assist with implementing our services and products. We believe this model will continue to serve us well, and we intend to continue to expand our network of partners and the number of certified consultants with whom we work so we can leverage our SI partners more effectively, especially for future subscription migrations and implementations.

We face a number of risks in the execution of our strategy, including risks related to expanding to new markets, managing lengthy sales cycles, competing effectively in the global market, relying on sales to a relatively small number of large customers, developing new or acquiring existing services and products successfully, migrating our business towards a subscription model with ratable revenue recognition, increasing the overall adoption of our services and products, and cost-effectively managing the infrastructure of our cloud-based customers. In response to these and other risks we might face, we continue to invest in many areas of our business, including product development, cloud operations, implementation services and sales and marketing.

COVID-19 Impact

In March 2020, the World Health Organization declared the outbreak of COVID-19 a pandemic, which has continued to spread throughout the United States and the world and has resulted in authorities implementing numerous measures to contain the virus, including travel bans and restrictions, quarantines, shelter-in-place orders, and business limitations and shutdowns. While we are unable to accurately predict the full impact that COVID-19 will have on our results of operations, financial condition, liquidity, and cash flows due to numerous uncertainties, including the duration and severity of the pandemic, containment measures, and if there are periods of increases in the number of COVID-19 cases or future variants of the virus in areas in which we operate, our compliance with containment measures has impacted our day-to-day operations and could continue to disrupt our business and operations, as well as that of our key customers, SI partners, vendors, and other counterparties, for an indefinite period of time. To support the health and well-being of our employees, customers, SI partners and communities, a vast majority of our employees are working remotely. In addition, many of our existing and potential

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customers are working remotely, which may continue to delay the timing of new orders and professional services engagements in the future.

Our business and financial results since the third fiscal quarter of 2020 have been impacted due to these disruptions, including decreases in ARR growth rates, services revenue and margins, operating cash flow and the change in fair value of strategic investments. ARR and revenue, especially services revenue, continued to be impacted in fiscal year 2021 as a result of the challenges related to our compliance with government-mandated or recommended shelter-in-place orders in jurisdictions in which we, our customers, SI partners and vendors operate.

Although vaccines are making progress against the COVID-19 pandemic in the United States and certain other parts of the world where vaccinations are widely available, the economic impact of the pandemic on our business and the businesses of our customers, SI partners, and vendors may continue into fiscal year 2022, if not longer. We believe that new sales activities are being delayed, not cancelled, and implementation engagements are being rescheduled to later periods or being completed over a longer period of time. Certain marketing events have or will be cancelled or postponed, while the majority are being hosted virtually, like our customer conference, Connections. Our customers may be unable to pay or may request amended payment terms for their outstanding invoices due to the economic impacts from COVID-19, and we may need to increase our accounts receivable allowances. A decrease in orders in a given period could negatively affect our revenues and ARR in future periods, particularly if experienced on a sustained basis, because a substantial proportion of our new software subscription services orders is recognized as revenue over time. Also, the pandemic’s global economic impact could affect our customers’ DWP, which could ultimately impact our revenue as we generally price our services and products based on the amount of DWP that will be managed by our platform. Additionally, we may be required to record impairment related to our operating lease assets, investments, long-lived assets, or goodwill.

In response to the pandemic, various government programs have been announced which provide financial relief to affected businesses. As an example, the Canadian Government enacted the Canada emergency Wage Subsidy (“CEWS”) under their COVID-19 Economic Response Plan to prevent layoffs and help employers offset, for a limited time, a portion of their employee salaries and wages. Beginning in January 2021, we have applied for the CEWS, to the extent we met the requirements to receive a subsidy, and recorded a reduction of compensation expense of approximately $3 million that is reflected in cost of revenue and operating expenses in our consolidated statements of operations during fiscal year 2021. We will continue to review and apply for additional subsidies or relief, where applicable.

We will continue to evaluate the nature and extent of the impact of COVID-19 on our business.

Key Business Metrics

We use certain key metrics and financial measures not prepared in accordance with GAAP to evaluate and manage our business, including ARR and Free Cash Flow. For a further discussion of how we use key metrics and certain non-GAAP financial measures, see “Non-GAAP Financial Measures.”

Annual Recurring Revenue (“ARR”)

We use ARR to quantify the annualized recurring value outlined in active customer contracts at the end of a reporting period. ARR includes the annualized recurring value of term licenses, subscription agreements, support contracts, and hosting agreements based on customer contracts, which may not be the same as the timing and amount of revenue recognized. All components of the licensing and other arrangements that are not expected to recur (primarily perpetual licenses and professional services) are excluded. In some arrangements with multiple performance obligations, a portion of recurring license and support or subscription contract value is allocated to services revenue for revenue recognition purposes, but does not get allocated for purposes of calculating ARR. This revenue allocation only impacts the initial term of the contract. This means that as we increase arrangements with multiple performance obligations that include services at discounted rates, more of the total contract value will be recognized as services revenue, but our reported ARR amount will not be impacted. In fiscal year 2021, the recurring license and support or subscription contract value recognized as services revenue was $5.5 million.

If a customer contract contains invoicing amounts that increase over the contract term, then ARR reflects the annualized invoicing amount outlined in the contract for the current reporting period. For example, given a contract with annual invoicing of $1.0 million at the beginning of year one, $2.0 million at the beginning of year two, and $3.0 million at the beginning of year three, and the reporting period is subsequent to year two invoicing and prior to year three invoicing, the reported ARR for that contract would be $2.0 million.

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As of July 31, 2021, ARR was $582 million, or $575 million based on currency exchange rates as of July 31, 2020. We measure ARR on a constant currency basis during the fiscal year and revalue ARR at year end to current currency rates. ARR grew in fiscal year 2021 by 13%, or 12% on a constant currency basis.

Free Cash Flow

We monitor our free cash flow, as a key measure of our overall business performance, which enables us to analyze our financial performance without the effects of certain non-cash items such as depreciation, amortization, and stock-based compensation expenses. Additionally, free cash flow takes into account the impact of changes in deferred revenue, which reflects the receipt of cash payment for services and products before they are recognized as revenue, and unbilled accounts receivable, which reflects revenue that has been recognized that has yet to be invoiced to our customers. Our net cash provided by (used in) operating activities is significantly impacted by the timing of invoicing and collections of accounts receivable, the timing and amount of annual bonus payments, as well as payroll and tax payments. Our capital expenditures consist of purchases of property and equipment, primarily computer hardware, software, leasehold improvements, and capitalized software development costs. In the third fiscal quarter of 2020, free cash flow was impacted by a $9.9 million partial early bonus payout, which correspondingly resulted in lower bonus payments in the first fiscal quarter of 2021. This partial early bonus payout was approved by our board of directors in order to support our employees and, in turn, their local economies during the extraordinary situation created by the COVID-19 pandemic. In the first fiscal quarter of 2022, we will pay the entire bonus amount for fiscal year 2021 along with accrued vacation for U.S. employees, as we have announced a move to an unlimited vacation policy. The build out and furnishing of our corporate headquarters in San Mateo, California impacted free cash flow by $11.1 million for the fiscal year ended July 31, 2020. The build out and furnishing of our new offices in Mississauga, Canada and Dublin, Ireland impacted free cash flow by a total of $15.6 million for the fiscal year ended July 31, 2021. For a further discussion of our operating cash flows, see “Liquidity and Capital Resources - Cash Flows.”

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with GAAP. Accounting policies, methods, and estimates are an integral part of the preparation of our consolidated financial statements in accordance with GAAP and, in part, are based upon management’s current judgments. Those judgments are normally based on knowledge and experience with regard to past and current events and assumptions about future events. Certain accounting policies, methods, and estimates are particularly sensitive because of their significance to our consolidated financial statements and because of the possibility that future events affecting them may differ markedly from management’s current judgments. While there are a number of significant accounting policies, methods, and estimates affecting our consolidated financial statements, which are described in Note 1 “The Company and a Summary of Significant Accounting Policies and Estimates” to our consolidated financial statements included in this Annual Report on Form 10-K, our revenue recognition policies are critical to the periods presented.

Revenue Recognition

Revenue recognition requires judgment and the use of estimates, especially in identifying and evaluating the various non-standard terms and conditions in our contracts with customers as to their effect on reported revenue.

Our revenue is derived from contracts with customers. The majority of our revenue is derived from subscriptions to our cloud services, licensing arrangements for our software, and implementation and other professional services arrangements. We account for revenue in accordance with Accounting Standards Codification 606, Revenue from Contracts with Customers (“ASC 606”). The core principle of ASC 606 is to recognize revenue upon the transfer of services or products to customers in an amount that reflects the consideration we expect to be entitled to in exchange for those services or products. We apply a five-step framework to recognize revenue as described in our Revenue Recognition policy included in Note 1 of our consolidated financial statements included in this Annual Report on Form 10-K.

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Our customers have significant negotiating power during the sales process, which can and does result in terms and conditions that are different from our standard terms and conditions. When terms and conditions of our customer contracts are not standard, certain negotiated terms may require significant judgment in order to determine the appropriate revenue recognition in accordance with ASC 606.

The estimates and assumptions requiring significant judgment under our revenue policy in accordance with ASC 606 are as follows:

Allocation of the transaction price to the performance obligations in the contract

If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on its standalone selling price (“SSP”) in relation to the total fair value of all performance obligations in the arrangement. Some of our performance obligations, such as support, implementation services, and training services, have observable inputs that are used to determine the SSP of those distinct performance obligations. Where SSP is not directly observable, we determine the SSP using information that may include market conditions and other observable inputs. In the circumstances when available information to determine SSP is highly variable or uncertain, such as for our term licenses, we will use the residual method.

The majority of our contracts contain multiple performance obligations, such as when licenses are sold with support, implementation services or training services. As customers enter into a subscription agreement to migrate from an existing term license agreement, customers may be under contract for self-managed licenses and support, in addition to subscription services, for a period of time, which may require an allocation of the transaction price to each performance obligation. Additionally, contract modifications for services and products that are distinct but are not priced commensurate with their SSP or are not distinct from the existing contract may affect the initial transaction price or the allocation of the transaction price to the performance obligations in the contract. In such cases, revenue recognized may be adjusted.

Changes from Prior Periodic Reports

In this Annual Report on Form 10-K, we have revised our disclosures to comply with SEC Release No. 33-10825, “Modernization of Regulation S-K Items 101, 103, and 105.” In addition, we have early adopted the changes in the disclosure standards included in SEC Release No. 33-10890, “Management’s Discussion and Analysis, Selected Financial Data, Supplementary Financial Information.”

Modernization of Regulation S-K Items 101, 103, and 105

The SEC issued Release No. 33-10825, “Modernization of Regulation S-K Items 101, 103, and 105,” effective for annual periods beginning subsequent to November 2020. This release was adopted to modernize the description of business, legal proceedings, and risk factor disclosures that registrants are required to make pursuant to Regulation S-K. Specifically, this release requires registrants to provide disclosures relating to their human capital resources and to restructure their risk factor disclosures. Additionally, the release increases the threshold for disclosure of environmental proceedings to which the government is a party.

Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information

The SEC issued Release No. 33-10890 “Management’s Discussion and Analysis, Selected Financial Data, Supplementary Financial Information” which became fully effective on August 9, 2021. This release was adopted to modernize, simplify, and enhance certain financial disclosure requirements in Regulation S-K. Specifically, the SEC eliminated the requirement for selected financial data, only requiring quarterly disclosure when there are retrospective changes affecting comprehensive income, and amending the matters required to be presented under Management’s Discussion and Analysis (“MD&A”) to, among other things, eliminate the requirement of the contractual obligations table.

With our adoption of this release, we have eliminated from this document the items discussed above that are no longer required. Information on our contractual obligations is still disclosed in narrative form within the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of Part II of this Annual Report on Form 10-K.

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Recent Accounting Pronouncements

See Note 1 “The Company and Summary of Significant Accounting Policies and Estimates” in the notes to the consolidated financial statements in Item 8 of Part II of this Annual Report on Form 10-K, for a full description of recent accounting pronouncements adopted, including the dates of adoption, which is incorporated herein by reference.

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Results of Operations

The following table sets forth our results of operations for the years presented. The data has been derived from the consolidated financial statements contained in this Annual Report on Form 10-K which, in the opinion of our management, reflect all adjustments, consisting only of normal recurring adjustments, necessary to fairly present the financial position and results of operations for the fiscal years presented. The operating results for any period should not be considered indicative of results for any future period.

Comparison of the Fiscal Years Ended July 31, 2021 and 2020

Revenue

We derive our revenue primarily from delivering cloud-based services, licensing our software applications, providing support, and delivering professional services.

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Subscription and Support

A growing portion of our revenue consists of fees for our subscription services, which are generally priced based on the amount of DWP that is managed by our subscription services. Subscription revenue is recognized ratably over the term of the arrangement, beginning at the point in time our provisioning process has been completed and access has been made available to the customer. The initial term of such arrangements is generally from three to five years. Subscription agreements contain optional annual renewals commencing upon the expiration of the initial contract term. A majority of our subscription customers are billed annually in advance. In some arrangements with multiple performance obligations, a portion of recurring subscription contract value may be allocated to license revenue or services revenue for revenue recognition purposes. For example, in arrangements with multiple performance obligations that include services at discounted rates, a portion of the total contract value related to subscription services will be allocated and recognized as services revenue.

Our support revenue is generally recognized ratably over the committed support term of the licensed software. Our support fees are typically priced as a fixed percentage of the associated term license fees. We generally invoice support annually in advance.

License

A substantial majority of our license revenue consists of term license fees. Our term license revenue is primarily generated through license fees that are billed annually in advance during the term of the contract, including any renewals. Our term license fees are generally priced based on the amount of DWP that will be managed by our licensed software. Our term licenses have generally been sold under a two-year initial term with optional annual renewals after the initial term. However, we do enter into license arrangements that have an initial term of more than two years and renewal terms of more than one year. Term license revenue for the committed term of the customer agreement is generally fully recognized upon delivery of the software or at the beginning of the renewal term.

In a limited number of cases, we license our software on a perpetual basis. Perpetual license revenue is generally recognized upon delivery. We invoice our perpetual license customers either in full at contract signing or on an installment basis.

Services

Our services revenue is primarily derived from implementation services performed for our customers, reimbursable travel expenses, and training fees. A substantial majority of our services engagements are billed and recognized on a time and materials basis upon providing our services.

Subscription and Support

We anticipate subscriptions will continue to represent a majority of new arrangements, including customers migrating from existing term license arrangements to subscription services, in future periods. Due to the ratable recognition of subscription revenue, growth in subscription revenue will lag behind the growth of subscription orders and will impact the comparative growth of our reported revenue. If we complete a higher percentage of subscription arrangements in a given period, our short-term growth rates will be negatively impacted. Due to the seasonal nature of our business, the impact of new subscription orders in the fourth fiscal quarter, our historically largest quarter for new orders, is not reflected in revenues until the following fiscal year.

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Subscription revenue increased by $49.0 million, compared to the prior year, primarily due to the impact of new subscription services agreements for InsuranceSuite via Guidewire Cloud entered into and provisioned since July 31, 2020.

License support revenue was flat, compared to the prior year. Support related to subscription arrangements is included in subscription revenue, as support is not quoted or priced separately from the subscription services. As customers enter into a subscription agreement to migrate from an existing term license agreement, the timing and amount of revenue recognized will be impacted by allocations of the total contract value between the license, subscription, and support performance obligations. As a result, we expect the increase in subscription orders as a percentage of total new sales and customers migrating from term licenses to subscription services will continue to reduce the growth in, or result in lower, support revenue in the future.

License

Revenue related to new term licenses and multi-year term license renewals is generally recognized upfront and, as a result, no additional license revenue is recognized until after the committed term expires. As a customer enters into a subscription agreement to migrate from an existing term license agreement, the timing and amount of revenue recognition will be impacted by allocations of total contract value between license, subscription, and support performance obligations. License revenue growth has and will be negatively impacted as subscription sales increase as a percentage of total new sales and as customers migrate from term licenses to subscription services instead of renewing their term licenses.

Term license revenue decreased by $25.2 million, compared to the prior year, primarily driven by lower revenue from new term licenses of $12.4 million and term license renewals of $12.3 million. Included in these amounts is the impact of term license contracts with an initial term of greater than two years or a renewal term of greater than one year. The impact on term license revenue from contracts that deviated from our standard contract durations was $23.4 million in fiscal year 2021 compared with $37.6 million in the prior year.

Perpetual license revenue decreased by $2.6 million, compared to the prior year, and accounted for less than 1% of total revenue in fiscal year 2021. We expect perpetual license revenue to continue to represent a small percentage of our total revenue. Perpetual license revenue may potentially be volatile across periods due to the large amount of perpetual revenue that may be generated from a single customer order.

Services Revenue

Services revenue decreased $20.2 million, compared to the prior year. The decrease is primarily driven by contracts with lower average services billing rates and increased investments in customer implementations to accelerate their transition to the cloud, and to a lesser extent a $6.8 million reduction in revenue from billable travel costs due to travel restrictions associated with the COVID-19 pandemic during fiscal year 2021.

We expect modestly higher levels of variability in our services revenue in future periods. As we successfully leverage our SI partners to lead more implementations, our services revenue could decrease further. We expect challenges related to COVID-19 will also continue to negatively impact services revenue. As we continue to expand into new markets and develop new services and products, we have, and may continue to, enter into contracts with lower average billing rates, make investments in customer implementation and migration engagements, and enter into fixed price contracts, which may impact services revenue and services margins.

Cost of Revenue and Gross Profit

Our cost of subscription and support revenue consists of personnel costs for our cloud operations and technical support teams, cloud infrastructure costs, development of online training curriculum, amortization of our intangible assets, and royalty fees paid to third parties. Our cost of license revenue primarily consists of development of online training curriculum, royalty fees paid to third parties, and amortization of our intangible assets. Our cost of services revenue primarily consists of personnel costs for our professional service employees, third-party contractors, and travel-related costs. In instances where we have primary responsibility for the delivery of services, subcontractor fees are expensed as cost of services revenue. In each case, personnel costs include salaries, bonuses, benefits, and stock-based compensation.

We allocate overhead such as information technology support, information security, facilities, and other administrative costs to all functional departments based on headcount. As such, these general overhead expenses are reflected in cost of revenue and each functional operating expense.

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Cost of Revenue:

Cost of subscription and support revenue increased by $47.8 million primarily due to increases of $33.1 million in personnel costs due to our continued investment in our cloud operations to increase operational efficiency and scale and $16.3 million in cloud infrastructure costs for our growing cloud customer base. The increase in personnel costs is net of a $1.6 million benefit related to CEWS received in fiscal year 2021.

Due to our growth in cloud operations, new cloud-based customers, and increased usage from existing cloud-based customers, the costs to provide our subscription services increased. We expect our cost of subscription revenue to increase as we continue to invest in our cloud operations and incur higher cloud infrastructure costs to support our growing cloud customer base, to improve efficiencies, and to continuously improve and maintain secure environments. However, we believe that the cost of subscription revenue will grow at a slower rate than subscription revenue in future years as we achieve economies of scale and other efficiencies. Cost of support revenue is expected to remain flat or slightly decrease over time as term license customers transition to the cloud. The short-term impact of these trends along with mix within subscription and support revenue may result in a decline in subscription and support gross margin even though subscription and support gross profit increases in absolute dollars.

The $1.0 million decrease in our cost of license revenue was primarily attributable to decreases in amortization of acquired intangible assets of $1.3 million, partially offset by costs associated with the development of online training curriculum included with the latest releases of InsuranceSuite. We continue to anticipate lower cost of license revenue over time as our term license customers transition to cloud subscription agreements.

The $9.8 million decrease in cost of services revenue was primarily attributable to decreases of $8.2 million in billable subcontractor expenses, $7.4 million in employee and third party consultant travel-related costs resulting from COVID-19 travel restrictions, and $1.0 million in professional services, general office and software costs, partially offset by an increase of $6.9 million in personnel-related costs mainly due to higher bonus attainment based on company performance. The increase in personnel-related costs is net of a $0.4 million benefit related to the CEWS received in fiscal year 2021.

We had 600 cloud operations and technical support employees and 657 professional service employees at July 31, 2021 compared to 378 cloud operations and technical support employees and 758 professional services employees at July 31, 2020. In fiscal year 2020, certain professional services employees supported our cloud operations and research and development activities, and the related personnel costs were reflected within cost of subscription revenue and research and development expense. Since July 31, 2020, approximately 115 employees have been transferred from professional services to cloud operations and research and development to support the growth in our cloud customers.

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Gross Profit

Our gross profit decreased $36.1 million compared to the prior year. Gross profit was impacted by the decrease in term license revenue due to lower impact of multi-year term license arrangements entered into in fiscal year 2021 compared to fiscal year 2020 and decreases in professional services revenue driven by contracts with lower average services billing rates and increased investment in implementation engagements.

Our gross margin decreased to 50% in fiscal year 2021, as compared to 54% in fiscal year 2020. Gross margin was impacted by lower subscription and support gross margins resulting from increasing investments in cloud operations and lower services gross margin resulting from contracts with lower average services billing rates and investments in implementation engagements.

We expect subscription and support gross margins will fluctuate as our subscription revenue increases and we continue to invest in our cloud operations. However, as we gain efficiencies and increase the number of cloud customers, we expect subscription gross margins to improve over time. In addition to the impact of our investment in customer migrations and implementations, challenges related to COVID-19 may negatively impact services gross margin beyond this fiscal year. We expect license gross margin will fluctuate based on changes in revenue due to the timing of delivery of new multi-year term licenses and the execution of multi-year term license renewals, as cost of license revenue is expected to be relatively consistent with prior years in the future. Overall, we expect gross margins to decline in the short-term primarily due to the mix between license revenue and subscription and support revenue.

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Operating Expenses

Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The largest components of our operating expenses are personnel costs for our employees and, to a lesser extent, professional services. In each case, personnel costs include salaries, bonuses, commissions, benefits, and stock-based compensation. We allocate overhead such as information technology support, information security, facilities, and other administrative costs to all functional departments based on headcount. As a result, general overhead expenses are reflected in cost of revenue and each functional operating expense.

Research and Development

Our research and development expenses primarily consist of personnel costs for our technical staff and consultants providing professional services.

The $18.9 million increase in research and development expenses was primarily due to increases of $17.6 million in personnel costs associated with higher headcount and bonus attainment that is based on company performance in fiscal year 2021, $2.6 million of cloud infrastructure costs for our development environments, and $0.8 million in professional services costs for consultants that support the development of our subscription offerings, information security requirements and cloud strategy. The increase in personnel costs is net of a $1.2 million benefit related to the CEWS received in fiscal 2021. These increases were partially offset by a decrease in travel costs of $2.1 million due to COVID-19 travel restrictions.

Our research and development headcount was 853 as of July 31, 2021 compared with 809 as of July 31, 2020.

We expect our research and development expenses to increase in absolute dollars as we continue to hire and dedicate internal resources to develop, improve, and expand the functionality of our solutions and migrating our solutions to the cloud. Research and development expenses may also increase if we pursue additional acquisitions.

Sales and Marketing

Our sales and marketing expenses primarily consist of personnel costs for our sales and marketing employees. Included in our personnel costs are commissions, which are considered contract acquisition costs and are capitalized when earned and expensed over the anticipated period of time that goods and services are expected to be provided to a customer, which we estimate is to be approximately five years. Sales and marketing expenses also includes travel expenses, professional services for marketing activities, and amortization of certain acquired intangibles.

The $18.1 million increase in sales and marketing expenses was primarily due to increases of $23.0 million in personnel costs due to higher headcount to sell and market our services and products, including an increase of $3.5 million related to the net effect of the capitalization and amortization of contract acquisition costs (primarily commissions), and $1.0 million in professional services costs to assist in the development of business strategies and customer success alliances. The increase in personnel costs is net of a $0.2 million benefit related to the CEWS received in fiscal year 2021. These increases were partially offset by decreases of $5.3 million in travel costs due to COVID-19 travel restrictions, $0.7 million in marketing and advertising costs mainly due to the hosting of Connections Reimagined as a series of virtual events in fiscal year 2021 compared to an in-person event in fiscal year 2020, and $0.7 million due to lower amortization of acquired intangible assets.

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Our sales and marketing headcount was 426 as of July 31, 2021 compared with 399 as of July 31, 2020.

We expect our sales and marketing expenses to continue to increase in absolute dollars as we continue to invest in sales and marketing activities to support our business growth and objectives. Additionally, we anticipate that Connections will be an in-person event in the future, supplemented by virtual content, which may contribute to an increase in sales and marketing expenses.

General and Administrative

Our general and administrative expenses include executive, finance, human resources, legal, and corporate development and strategy functions, and primarily consist of personnel costs, as well as professional services.

The $8.6 million increase in our general and administrative expenses was primarily due to increases of $7.0 million in personnel-related costs due to higher headcount and bonus attainment that is based on company performance and $1.3 million increase in software and professional services costs to support our growth and remote environment.

Our general and administrative headcount was 406 as of July 31, 2021 compared with 346 as of July 31, 2020. General and administrative headcount includes personnel in information technology support, information security, facilities, and recruiting whose costs are allocated across all functional departments.

We expect that our general and administrative expenses will increase in absolute dollars as we continue to invest in personnel, corporate infrastructure, and systems required to support our strategic initiatives, the growth of our business, and our compliance and reporting obligations.

Other Income (Expense)

Interest Income

Interest income represents interest earned on our cash, cash equivalents, and investments.

Interest income decreased by $17.3 million in fiscal year 2021, primarily due to lower yields on invested funds and, to a lesser extent, lower funds available for investment due to our share repurchase program.

Interest Expense

Interest expense includes both stated interest and the amortization of debt discount and issuance costs associated with the $400.0 million aggregate principal amount of our Convertible Senior Notes. The amortization of debt discount and issuance costs are recognized on an effective interest basis. Stated interest expense is consistent in the comparative periods as the outstanding principal and stated interest rate have not changed.

Interest expense for fiscal years 2021 and 2020 consist of non-cash interest expense related to the amortization of debt discount and issuance costs of $13.6 million and $12.9 million, respectively, and stated interest of $5.0 million in both periods.

Other Income (Expense), Net

Other income (expense), net includes foreign exchange gains and losses resulting from fluctuations in foreign exchange rates on monetary asset and monetary liability balances that are denominated in currencies other than the functional currency of the entity in which they are recorded. Our monetary assets and liabilities denominated in currencies in other than the functional currency of the entity in which they are recorded consist primarily of trade accounts receivable, unbilled accounts receivable and intercompany receivables and payables. We currently have entities with a functional currency of the Argentine Peso, Australian Dollar, Brazilian Real, British Pound, Canadian Dollar, Danish Kroner, Euro, Indian Rupee, Japanese Yen, Malaysian Ringgit, New Zealand Dollar, Polish Zloty, Russian Ruble, and Swiss Franc.

Other income (expense), net in fiscal year 2021 was income of $12.6 million, compared to expense of $7.2 million in fiscal year 2020, which included a $10.7 million reduction in fair value of one of our strategic investments. Excluding the effect of the reduction in strategic investment fair value, other income increased $9.1 million primarily due to gains from exchange rate movements on monetary assets and monetary liabilities denominated in currencies other than the functional currency of the entity in which they were recorded.

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Provision for (benefit from) Income Taxes

We are subject to taxes in the United States as well as other tax jurisdictions and countries in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to current U.S. income tax.

We recognized an income tax benefit of $37.8 million for fiscal year 2021 compared to an income tax provision of $2.9 million for fiscal year 2020. The increase in our income tax benefit for fiscal year 2021 was primarily due to an increase in pre-tax net loss, the release of a reserve for an uncertain tax position, and the impact related to the tax status change of certain foreign subsidiaries for U.S. tax purposes, partially offset by an increase in the valuation allowance.

As of July 31, 2021, we had unrecognized tax benefits of $10.9 million that, if recognized, would affect our effective tax rate as certain unrecognized tax benefits have a valuation allowance.

The effective tax rate of 36% for fiscal year 2021 differs from the statutory U.S. Federal income tax rate of 21% mainly due to permanent differences for stock-based compensation, including excess tax benefits, the release of a reserve for an uncertain tax position, research and development credits, the tax status change of certain foreign subsidiaries, change in valuation allowance, and certain non-deductible expenses including executive compensation.

Comparison of the Fiscal Years Ended July 31, 2020 and 2019

Refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located in our 10-K for the fiscal year ended July 31, 2020, filed on September 28, 2020, for the discussion of the comparison of the fiscal year ended July 31, 2020 to the fiscal year ended July 31, 2019, the earliest of the three fiscal years presented in the consolidated financial statements.

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Quarterly Results of Operations

Our quarterly results of operations may fluctuate significantly due to a variety of factors, many of which are outside of our control, making our results of operations variable and difficult to predict. Such factors include those discussed above and those set forth in “Risk Factors—Risks Related to our Business and Industry—We may experience significant quarterly and annual fluctuations in our results of operations due to a number of factors” and “Risk Factors—Risks Related to our Business and Industry—Seasonal sales patterns may cause significant fluctuations in our results of operations and cash flows and may prevent us from achieving our quarterly or annual forecasts, which may cause our stock price to decline” in Item 1A of Part I of this Annual Report on Form 10-K. One or more of these factors may cause our results of operations to vary widely. As such, we believe that our quarterly results of operations may vary significantly in the future and that sequential quarterly comparisons of our results of operations may not be meaningful and should not be relied upon as an indication of future performance.

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Non-GAAP Financial Measures

In addition to the key business metrics presented above, we believe that the following non-GAAP financial measures provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. Management uses these non-GAAP measures to compare our performance to that of prior periods for trend analysis, for purposes of determining executive and senior management incentive compensation and for budgeting and planning purposes. We believe that the use of these non-GAAP financial measures provides an additional tool for investors to use in evaluating ongoing operating results and trends and in comparing our financial results with other software companies because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, many of which present similar non-GAAP financial measures to investors. However, our management does not consider these non-GAAP measures in isolation or as an alternative to financial measures determined in accordance with GAAP.

The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. The principal limitation of these non-GAAP financial measures is that they exclude significant expenses and income that are required by GAAP to be recorded in our financial statements. In addition, they are subject to inherent limitations as they reflect the exercise of judgment by management about which expenses and income are excluded or included in determining these non-GAAP financial measures. We urge investors to review the reconciliation of non-GAAP financial measures to the comparable GAAP financial measures included herein and not to rely on any single financial measure to evaluate the Company’s business.

The following table reconciles the specific items excluded from GAAP in the calculation of non-GAAP financial measures for the periods indicated below:

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(1) Effective the second fiscal quarter of 2021, the COVID-19 Canada Emergency Wage Subsidy benefit was included as a non-GAAP adjustment. Prior to the second fiscal quarter of 2021, this program was not available.

(2) Effective the third fiscal quarter of 2020, changes in fair value of strategic investments are excluded from non-GAAP measures. Prior to the third fiscal quarter of 2020, there were no changes in fair value of strategic investments in any periods presented.

(3) Adjustments reflect the impact on the tax benefit (provision) resulting from all non-GAAP adjustments.

(4) Due to the occurrence of a net loss on a GAAP basis, potentially dilutive securities were excluded from the calculation of GAAP net income (loss) per share, as they would have an anti-dilutive effect. However, these shares have a dilutive effect on non-GAAP net income (loss) per share and, therefore, are included in the non-GAAP net income (loss) per share calculation.

Liquidity and Capital Resources

Our principal sources of liquidity are as follows (in thousands):

Cash, Cash Equivalents, and Investments

Our cash equivalents are comprised of liquid investments with remaining maturities of 90 days or less from the date of purchase, primarily commercial paper and money market funds. Our investments primarily consist of corporate debt securities, U.S. government and agency debt securities, commercial paper, asset-backed securities, and non-U.S. government securities, which include state, municipal and foreign government securities.

As of July 31, 2021, approximately $58.7 million of our cash and cash equivalents were domiciled in various foreign jurisdictions. While we have no current plans to repatriate these funds to the United States, we may repatriate foreign earnings in the future to the extent that the repatriation is not restricted by local laws or there are no substantial incremental costs associated with such repatriation.

Share Repurchase Program

In October 2020, our board of directors authorized and approved a stock repurchase program of up to $200.0 million of our outstanding common stock. During the fiscal year ended July 31, 2021, we repurchased 1,488,991 shares of common stock

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at an average price of $109.17 per share for an aggregate purchase price of $162.5 million. As of July 31, 2021, $37.5 million remained available for future share repurchases.

Cash Flows

Our cash flows from operations are significantly impacted by timing of invoicing and collections of accounts receivable, annual bonus payments, as well as payments of payroll, commissions, payroll taxes, and other taxes. We expect that we will continue to generate positive cash flows from operations on an annual basis, although this may fluctuate significantly on a quarterly basis. In particular, we typically use more cash during the first fiscal quarter ended October 31, as we generally pay cash bonuses to our employees for the prior fiscal year during that period and seasonally higher sales commissions from increased customer orders booked in our fourth fiscal quarter of the prior year. Additionally, our capital expenditures may fluctuate depending on future office build outs and development activities subject to capitalization.

We believe that our existing cash and cash equivalents and sources of liquidity will be sufficient to fund our operations for at least the next 12 months. Our future cash requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of our spending to support our research and development efforts, investments in cloud infrastructure and operating costs, and expansion into other markets. We also may invest in or acquire complementary businesses, applications or technologies, or may expand our board-authorized stock repurchase program, which may require the use of significant cash resources and/or additional financing.

The following summary of cash flows for the periods indicated has been derived from our consolidated financial statements included elsewhere in this Annual Report on Form 10-K (in thousands):

Cash Flows from Operating Activities

Net cash provided by operating activities decreased by $1.5 million in fiscal year 2021 as compared to fiscal year 2020. The decrease in operating cash was primarily attributable to a $55.7 million increase in net loss after excluding the impact of non-cash charges such as deferred taxes, stock-based compensation expense, depreciation and amortization expense, change in fair value of our strategic investments, and other non-cash items, partially offset by a $54.2 million increase in cash provided by working capital activity as compared to the prior year.

Cash Flows from Investing Activities

Net cash provided by investing activities increased by $70.0 million in fiscal year 2021 as compared to fiscal year 2020. The increase in net cash provided by investing activities was primarily due to an increase of $73.4 million in net cash flows from marketable securities transactions and lower office build out costs of $2.4 million after completing the build out and furnishing of our corporate headquarters in San Mateo, California in fiscal year 2020, offset by a $5.6 million increase in capitalized cloud software development costs and a $0.2 million increase related to strategic investments.

Cash Flows from Financing Activities

Net cash used in financing activities increased by $164.3 million in fiscal year 2021 as compared to fiscal year 2020. The increase in net cash used in financing activities was due to $161.3 million of repurchased common stock under our share repurchase program and, to a lesser extent, a decrease in proceeds from option exercises of $3.0 million

Contractual Obligations

Our estimated future obligations consist of leases, royalties, purchase obligations, debt, and unrecognized tax benefits as of July 31, 2021. Refer to Note 8 “Commitments and Contingencies” and Note 10 “Income Taxes” to our consolidated financial statements included in this Annual Report on Form 10-K for more information.

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Off-Balance Sheet Arrangements

Through July 31, 2021, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.