# LEGALZOOM.COM, INC. (LZ) FY 2022 MD&A Verbatim Item 7 Management's Discussion and Analysis from LEGALZOOM.COM, INC.'s 10-K for fiscal year 2022. SEC filing source: https://www.sec.gov/Archives/edgar/data/1286139/000128613923000036/lz-20221231.htm Accession: 0001286139-23-000036 Filing date: 2023-03-01 Report date: 2022-12-31 Extracted from a substantive MD&A body after the formal Item 7 span was a TOC or reference stub. Confidence: high Company profile: /company/LZ/ All MD&A years: /company/LZ/mda/ Previous year: /company/LZ/mda/fy2021/ (FY 2021) Next year: /company/LZ/mda/fy2023/ (FY 2023) Overview LegalZoom is a leading online platform for legal and compliance solutions in the United States, or U.S. Our core offerings include business formations, intellectual property and estate planning services, and we have recently expanded our platform to include professional expertise and other products, both legal and non-legal, to better meet the needs of small businesses. Our unique position at business inception allows us to become a trusted business advisor, supporting the evolving needs of a new business throughout its lifecycle. Along with formations, our services include ongoing compliance and tax advice and filings, virtual mailbox solutions, trademark filings, and estate plans. Additionally, we have unique insights into our customers and leverage our product as a channel to introduce small businesses to leading brands in our partner ecosystem, solving even more of their business needs. We operate across all 50 states and over 3,000 counties in the U.S. and have more than 20 years of experience navigating complex regulation and simplifying the legal and compliance process for our customers. Initial Public Offering The registration statement related to our initial public offering, or IPO, was declared effective on June 29, 2021, and our common stock began trading on the Nasdaq Global Select Market on June 30, 2021. On July 2, 2021, we completed our IPO for the sale of 19,121,000 shares of our common stock at an offering price of $28.00 per share, for proceeds of $505.9 million, net of underwriting discounts and commissions. In addition, we sold 2,868,150 shares of our common stock for net proceeds of $75.9 million pursuant to the full exercise of the underwriter’s option to purchase additional shares in connection with the IPO. In addition, on July 2, 2021, we sold 3,214,285 shares of our common stock in a private placement with an existing related party stockholder for proceeds of $85.0 million, net of underwriting discounts and commissions. We raised aggregate proceeds of $666.9 million from our IPO and private placement after deducting underwriting discounts and commissions. We incurred stock issuance costs of $5.6 million. Proceeds raised from our IPO were used to repay the full outstanding balance of $521.6 million on our 2018 term loan. Upon the completion of our IPO, 23,081,080 outstanding shares of redeemable convertible preferred stock with a carrying value of $70.9 million converted into an aggregate of 46,162,160 shares of common stock. Following the completion of the IPO, we have one class of authorized and outstanding common stock. Our Business Model and Growth Strategy Our business model is to acquire customers at the time of business formation and then continue to serve their legal, compliance and tax solutions needs over the life of their businesses with our mix of transaction, subscription, and partner offerings. Transaction products include legal documents, business filings, and related services for small business owners and their families, such as business formations, annual compliance filings, intellectual property, estate planning documents, forms, and agreements. Subscription products include compliance solutions and credentialed professional subscription services, including legal and tax advisory and preparation services as well as additional owned services such as virtual mail. We also introduce our customers to a variety of third-party partners, giving them access to critical services they need to start and run their businesses, such as business license services, credit card and banking services, website development, productivity tools, and business insurance, among others. Our strategy is to scale our existing business and gain market share by investing in core products and sales and marketing; integrating our independent attorney network and tax professionals into our core product set; expanding our addressable market; and attracting additional customers and increasing conversion through the introduction of lower-priced products and services. We are innovating our product lineup to target more price-sensitive customer segments and have made certain of our business formation services available at a low cost or without charge in certain geographies on a test-basis. We expect this new lineup, with a free formation product as a foundational element, will be rolled out to 100% of traffic by the end of the first quarter. We expect to continue to test new products and price points going forward as we seek to optimize our product offerings across our lineup. We also aim to grow average revenue per subscription unit, or ARPU, and partnership revenue through building in-house adjacencies and expanding our partner ecosystem to provide new recurring revenue streams. For additional information regarding our business and strategy, see Part I, Item 1, Business of this Annual Report on Form 10-K. 32 Key Business Metrics In addition to the measures presented in our consolidated financial statements, we regularly monitor the following financial and operating metrics to evaluate the growth of our business, measure the effectiveness of our marketing efforts, identify trends, formulate financial forecasts and make strategic decisions. Number of business formations We define the number of business formations in a given period as the number of limited liability company, or LLC, incorporation, not-for-profit and doing business as, or DBA orders placed on our platform in such period, excluding such orders from our operations in the U.K. We consider the number of business formations to be an important metric considering that it is typically the first product or service small business customers purchase on our platform, creating the foundation for additional products and subsequent subscription and partner revenue as customers adopt additional products and services throughout the lifecycle of their business. We believe that including customers filing DBAs on our platform provides a more accurate representation of the number of newly formed businesses we serve. These transactions are most often completed by sole proprietors who represent potential future transaction and subscription cross-sell opportunities as their businesses mature. Furthermore, we believe our definition of the number of business formations is most closely aligned with U.S. Census reporting of new applications for Employer Identification Numbers, or EINs, which we believe to be the most relevant source of publicly available U.S. market data. The below table sets forth the number of business formations for the years ended December 31, 2022 and 2021: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Number of business formations","474","","483"]] [[/GREPCENT_TABLE]] We experienced a 2% decrease in business formation transactions during the year ended December 31, 2022 compared to the year ended December 31, 2021. While year-over-year growth in the number of business formations on our platform accelerated in the second half of 2022 due to higher volumes in our partner integration channel and further testing of our lower-priced business formation offerings, the decline for the full year was primarily due to a decline in overall U.S. business formations during this period based on a review of U.S. Census data revealing new applications for EINs. We expect the decline in overall U.S. business formations to continue in 2023. Number of transactions We define the number of transactions in a given period as gross transaction order volume, prior to refunds, on our platform during such period. Transactions may include one or more services purchased at the same time. For example, a customer of our business formation services may choose to form an LLC and purchase an operating agreement and business licenses at the same time. This constitutes a single transaction. Refunds, or partial refunds, may be issued under certain circumstances pursuant to the terms of our customer satisfaction guarantee. We consider the number of transactions to be an important metric considering that our customers generally begin their LegalZoom journey with a transaction, creating the foundation for generating subsequent subscription and partner revenue. The below table sets forth the number of transactions for the years ended December 31, 2022 and 2021 : [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Number of transactions","929","","977"]] [[/GREPCENT_TABLE]] We experienced a 5% decrease in the number of transactions during the year ended December 31, 2022 compared to the year ended December 31, 2021. The decrease in the number of transactions during the year ended December 31, 2022 resulted from a reduction in estate planning and other consumer transactions, lower volumes in our intellectual property business largely due to the discontinuation of our do-it-yourself trademark product in favor of our attorney-assisted solution and, to a lesser extent, the decrease in business formations during this same period. Our estate planning and other consumer transactions declined as a percentage of total transactions in the year ended December 31, 2022. We expect the proportion of estate planning and other consumer transactions to continue to decrease over time as we focus more of our investment in small business formations. Over the long-term, we expect to continue to grow transactions; however, the growth may fluctuate period-over-period based on the variability of overall business formations and estate planning transactions. 33 Average order value We define average order value for a given period as total transaction revenue divided by total number of transactions in such period. We consider average order value to be an important metric given it indicates how much customers are spending on our platform per transaction. Estate planning transactions are generally at a lower price point, making our overall average order value lower than our typical price point for small business formations. The below table sets forth the average order value for the years ended December 31, 2022 and 2021: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["Average order value","$","258","","","$","264"]] [[/GREPCENT_TABLE]] Average order value decreased by 2% during the year ended December 31, 2022 compared to the year ended December 31, 2021. The reduction in average order value for the year ended December 31, 2022 was primarily driven by an increase in transactions from our wholesale-priced partner integration channel as a percentage of total transactions and testing of lower-priced business formation services partially offset by the timing of revenue recognition. Transactions offered through our partner integration channel are generally at lower price points than our other small business products and services. During the year ended December 31, 2022, we also made certain of our business formation services available at a low cost or without charge in certain geographies on a test-basis as we continued to innovate our product lineup to target more price-sensitive customer segments. Finally, we were more efficient in our fulfillment in the year ended December 31, 2022, resulting in additional recognized revenue during the period. Growth in our average order value may fluctuate period-over-period based on the mix of business formations relative to estate planning and other consumer transactions, the timing of transaction revenue recognition, and our ability to introduce and sell new products. We expect average order value to decline year-over-year in 2023 as we introduce lower-priced products and services. We expect to continue to test new products and price points going forward as we optimize our product offerings across our lineup. Number of subscription units We define the number of subscription units in a given period as the paid subscriptions at the end of such period, including those that are not yet 60 days past their subscription order dates. Refunds, or partial refunds, may be issued under certain circumstances pursuant to the terms of our customer satisfaction guarantee. We consider the number of subscription units to be an important metric since subscriptions enable us to increase the lifetime value of a customer through deeper, longer-term relationships. Subscriptions typically range from 30 days to one year in duration and the vast majority of our new subscriptions originate from business formation orders and have an annual term. Our customers can have multiple subscriptions at the end of a period. For example, a popular combination for a new small business owner is attorney advice and registered agent subscriptions. The below table sets forth the number of subscription units as of December 31, 2022 and 2021: [[GREPCENT_TABLE]] [["","As of December 31,"],["","2022","","2021"],["","(in thousands)"],["Number of subscription units","1,441","","1,329"]] [[/GREPCENT_TABLE]] We achieved 8% growth in our number of subscription units from December 31, 2021 to December 31, 2022, reflecting strong growth in subscriptions acquired through our partner integration channel, our registered agent, compliance, and tax products, as well as from our purchase of Earth Class Mail during the fourth quarter of 2021. We aim to continue to grow subscription units by increasing the proportion of our small business customers that purchase a subscription service at the time of their initial formation purchase and by improving retention rates. Average revenue per subscription unit We define average revenue per subscription unit, or ARPU as of a given date as subscription revenue for the last twelve-month period ended on such date, or LTM, divided by the average of the number of subscription units at the beginning and end of the LTM period. We consider ARPU to be an important metric because it helps to illustrate our ability to deepen our relationship with our existing customers as they purchase incremental and higher-value services. The below table sets forth ARPU as of December 31, 2022 and 2021: 34 [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["Average revenue per subscription unit","$","258","","","$","236"]] [[/GREPCENT_TABLE]] ARPU increased 9% as of December 31, 2022 as compared to December 31, 2021. The increase in ARPU primarily resulted from growth of our tax service, subscriptions acquired through our purchase of Earth Class Mail and growth of our registered agent and compliance products, which carry higher average price points than our other subscription products. ARPU also increased as a result of a price increase to our small business legal advisory plan that was implemented in the fourth quarter of 2021. These increases were partially offset by an increase in wholesale-priced subscriptions from our partner integration channel. We expect year-over-year ARPU growth to moderate in 2023 as we anniversaried the acquisition of Earth Class Mail in the fourth quarter of 2022. Key Factors Affecting Our Performance We believe that our future performance will depend on many factors, including the following: •Our share of business formations. The majority of our transaction revenue is generated by providing formation services to guide our customers through the transition from being aspiring business owners to actually launching their entities. We offer entity formation services for LLCs, corporations and non-profits. In the years ended December 31, 2022 and 2021, business formations represented the largest share of our total transaction orders. In addition, business formations act as an entrance point for many customers to the LegalZoom ecosystem, where they then often purchase additional products and services. Our business depends on the continuation of new business formations in the U.S., which may be seasonal in nature and dependent on macroeconomic factors, and even more so, on our ability to increase our share of these formations.  •Product leadership. We have invested significantly and expect to continue to invest in our user experience, which we believe is critical to attracting and converting customers and improving retention. These investments consist mainly of creating educational content, improving our website and application user interface, and creating and offering additional products and services, including the growing use of experts in the customer journey. The performance of our product is important to attracting new customers to our platform, maintaining a healthy subscriber base and retaining our customers. •Ability to enhance customer lifetime value. Many of our subscribers have increased their cumulative spend with us over time as they have expanded their use of our platform to include additional products and subscription services. Our relationship with our small business customers typically starts with the formation of their business and deepens as their businesses grow and their needs become more complex. By continuing to develop new products and subscription services such as tax advice and preparation to address such needs, we expect to see higher customer engagement and retention, which in turn would further increase our customer lifetime value. Additionally, we offer third-party services via our partner ecosystem, such as our partnership with Wix, which enables our small business customers to build their online presence, and we expect to be able to generate incremental revenue via these offerings. •Investment in marketing. We have invested, and expect that we will continue to invest, in our brand and the promotion of our services through our various customer acquisition channels, including search engine marketing, search engine optimization, television, digital video, social, radio, and our inside sales team to acquire new customers and grow our business. We frequently evaluate how we price, market, and sell transaction products in order to optimize our subscription business.     •Investment in tax offerings. Tax represents a natural adjacency in our mission to make legal and compliance services accessible to small businesses. To address the customer need, we launched our Tax advisory and preparation offering. We anticipate incurring additional costs related to our tax offerings as we continue to invest in these offerings throughout 2023. We believe that our tax offerings represent an attractive opportunity for incremental revenue growth. •Talent acquisition and retention. We are focused on providing a quality employee experience as we believe the future success of our business is heavily dependent on our ability to attract and retain talented and highly productive employees. We compete for talent within the technology industry and believe that our strong brand recognition and greater company purpose are important, positive considerations in our ability to recruit talent. We also are scaling an in-house team of certified public accountants or CPAs, and enrolled agents that are critical to our tax offerings. •Macroeconomic factors. Fluctuations in general macroeconomic, political, regulatory and market conditions, such as recessionary fears, the current inflationary environment, rising interest rates and lingering effects of the COVID-19 pandemic can adversely impact consumer spending patterns, the success of existing small businesses and the formation of new small businesses. For example, overall U.S. business formations declined in the year ended December 31, 2022 compared to 2021 based on a review of U.S. Census data and 35 we expect the this decline to continue in 2023 due, in part, to the current challenging macroeconomic environment. While we believe that secular trends toward greater adoption of online services continue to exist, future negative or decelerating impact from sustained inflation, higher interest rates or other macroeconomic fluctuations remains uncertain. Key Components of our Results of Operations Revenue We generate revenue from the sources identified below. Transaction revenue. Transaction revenue is primarily generated from our customized legal document services upon fulfillment of these services. Transaction revenue includes filing fees and is net of cancellations, promotional discounts, sales allowances and credit reserves. Until April 2020, when we ceased providing such services, we also generated transaction revenue from our residential and commercial conveyancing business in the United Kingdom, or U.K., and revenue for these services was recognized when delivered to the customer. In the fourth quarter of 2020, we commenced providing tax preparation services in the U.S. which are recognized at the point in time when the customer’s tax return is filed and accepted by the applicable government authority. Subscription revenue. Subscription revenue is generated primarily from subscriptions to our registered agent services, compliance packages, attorney advice, legal forms services, tax advisory and preparation services, and virtual mail services in addition to software-as-a-service, or SaaS, subscriptions in the U.K. In the fourth quarter of 2020, we commenced providing tax and payroll subscription services. We generally recognize revenue from our subscriptions ratably over the subscription term. Subscription terms generally range from thirty days to one year. Subscription revenue includes the transaction price allocated to bundled free trials for our subscription services and is net of promotional discounts, cancellations, sales allowances and credit reserves and payments to third-party service providers such as legal plan law firms and tax service providers. For transaction and subscription revenue, we generally collect payments and fees at the time orders are placed and prior to services being rendered. We record amounts collected for services that have not been performed as deferred revenue on our consolidated balance sheet. The transaction price that we record is generally based on the contractual amounts and is reduced for estimated sales allowances for price concessions, charge-backs, sales credits and refunds, which are accounted for as variable consideration when estimating the amount of revenue to recognize. Partner revenue. Partner revenue consists primarily of one-time or recurring fees earned from third-party providers from leads generated to such providers through our online legal platform. Revenue is recognized when the related performance-based criteria have been met. We assess whether performance criteria have been met on a cost-per-click or cost-per-action basis. We expect partner revenue will continue to decline in 2023 as we transition away from legacy partners that do not align with our new strategic direction and focus more on long-term opportunities to have strategic partnerships that build on recurring revenue models. See the section titled “—Critical Accounting Estimates—Revenue Recognition” for a description of the accounting policies related to revenue recognition, including arrangements that contain multiple deliverables. Cost of revenue Cost of revenue includes all costs of providing and fulfilling our services. Cost of revenue primarily includes government filing fees; costs of fulfillment, customer care and credentialed professionals, and related benefits, including stock-based compensation; costs of independent contractors for document preparation; telecommunications and data center costs; amortization of acquired developed technology; depreciation and amortization of network computers, equipment and internal-use software; printing, shipping and handling charges; credit and debit card fees; allocated overhead; legal document kit expenses; and sales and use taxes. We defer direct and incremental costs primarily related to government filing fees incurred prior to the associated service meeting the criteria for revenue recognition. These contract assets are recognized as cost of revenue in the same period the related revenue is recognized. We expect our cost of revenue to increase in absolute dollars as we continue to invest in enhancing our customer experience and in new product development, including expert-assisted offerings for our tax and attorney-assisted legal offerings. Gross profit and gross margin Gross profit, or revenue less cost of revenue, and gross margin, or gross profit as a percentage of revenue, have been and will continue to be affected by various factors, primarily the mix between transaction, subscription and partner revenue. Our gross margin on subscription and partner revenue is higher than our gross margin on transaction revenue. Our long-term gross margin expansion is also expected to be driven by automation improvements and digitization efforts. Further, our acquisitions of other companies have negatively impacted our gross margin in the short term, and any such future acquisitions could have a similar effect. 36 In the short term, we expect our gross profit to increase in absolute dollars but our gross margin to be impacted by our continued investment in scaling our tax business, which has lower gross margins than other products in our portfolio. However, we expect our gross margin to increase modestly over the longer term as we continue to focus on growing higher-margin subscription revenue and invest in fulfillment automation technologies. In addition, our gross margin could fluctuate from period to period due to fulfillment rates and seasonality. Operating expenses Our operating expenses consist primarily of sales and marketing, technology and development, general and administrative expenses, and to a lesser extent, impairments of goodwill, long-lived assets and other assets. Sales and marketing Sales and marketing expenses consist of customer acquisition media costs; compensation and related benefits, including stock-based compensation for marketing and sales personnel; media production; public relations and other promotional activities; general business development activities; an allocation of depreciation and amortization and allocated overhead. Customer acquisition media costs consist primarily of search engine marketing, television and radio costs. Marketing and advertising costs to promote our services are expensed in the period incurred. Media production costs are expensed the first time the advertisement is aired. We intend to continue to invest in sales and marketing to drive additional revenue, further penetrate our expanding addressable market, and build on our digital brand leadership and awareness. While we anticipate that sales and marketing expenses will continue to be our largest operating expense category for the foreseeable future, we expect marketing expenses to decline in the near-term as we pivot our media spend toward search engine marketing and other performance-based channels to provide additional flexibility given the uncertain macroeconomic environment. Technology and development Technology and development expenses consist primarily of personnel costs and related benefits, including stock-based compensation, expenses for outside consultants, an allocation of depreciation and amortization and allocated overhead. These expenses include costs incurred in the development and implementation of our products, websites, mobile applications, online legal platform, research and development and related infrastructure. Technology and development expenses are expensed as incurred, except to the extent that such costs are associated with internal-use software costs that qualify for capitalization. Excluding stock-based compensation, we expect our technology and development expenses to continue to increase in absolute dollars for the foreseeable future as we invest in new products and services and in production automation technologies to enhance our customer experience. We expect our technology and development expenses to remain relatively consistent or increase as a percentage of our revenue over the long-term, although our technology and development expenses may fluctuate as a percentage of our revenue from period-to-period due to seasonality and the timing and extent of these expenses. General and administrative Our general and administrative expenses relate primarily to compensation and related benefits, including stock-based compensation, for executive and corporate personnel, professional and consulting fees, an allocation of depreciation and amortization, allocated overhead and legal costs. We expense legal costs for defending legal proceedings as incurred. Excluding stock-based compensation, we expect our general and administrative expenses to increase in absolute dollars for the foreseeable future due to additional costs associated with accounting, compliance, insurance and investor relations as we have recently become a public company. Over the next year, we will continue to incur stock-based compensation expense as a result of certain modifications to equity awards that occurred in connection with our IPO; however, we expect our general and administrative expenses to decrease as a percentage of our revenue over the longer term. Our general and administrative expenses may fluctuate as a percentage of our revenue from period-to-period due to seasonality and the timing and extent of these expenses. Interest expense, net Interest income (expense), net, consists primarily of interest income generated from our investment in money market fund offset by amortization of debt issuance costs related to our Amended and Restated Credit and Guaranty Agreement, or 2021 Revolving Facility. Prior year interest income (expense), net, consisted of interest expense on our prior credit facility, hedging instruments and amortization of debt issuance costs, which were extinguished after our IPO in July 2021. We expect interest income (expense), net, to remain insignificant in the near term as we have no outstanding indebtedness. However, we would incur interest expense in the longer term should we draw down on our 2021 Revolving Facility or incur other indebtedness. 37 Income taxes Our provision for income taxes consists of current and deferred federal, state and foreign income taxes. At December 31, 2022, we had federal net operating loss, or NOL, carryforwards of $16.8 million, which will begin to expire in 2032. At December 31, 2022, we had state NOL carryforwards of $59.9 million, which will begin to expire in 2027 and we had foreign NOL carryforwards of $33.6 million, which can be carried forward indefinitely and are not subject to expiration. In general, under Sections 382 and 383 of the Internal Revenue Code of 1986, as amended, or the Code, if a corporation undergoes an “ownership change,” generally defined as a greater than 50% change, by value, in its equity ownership by certain stockholders over a three-year period, the corporation’s ability to use its pre-change NOLs and other pre-change tax attributes, such as research tax credits, to offset its post-change income or taxes may be limited. We had an ownership change in prior years, and as a result certain federal and state NOLs were limited pursuant to Section 382 of the Code. This limitation has been accounted for in calculating our available NOL carryforwards. Results of Operations The following table sets forth our consolidated statement of operations data for each of the periods indicated. The period-to-period comparison of financial results should not be considered as a prediction or indicative of our future results. [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Revenue","$","619,979","","","$","575,080"],["Cost of revenue(1)(2)","211,095","","","189,364"],["Gross profit","408,884","","","385,716"],["Operating expenses:"],["Sales and marketing(1)(2)","263,884","","","279,281"],["Technology and development(1)(2)","70,434","","","84,003"],["General and administrative(1)(2)","116,057","","","106,584"],["Impairment of long-lived and other assets","248","","","924"],["Total operating expenses","450,623","","","470,792"],["Loss from operations","(41,739)","","","(85,076)"],["Interest income (expense), net","1,543","","","(27,984)"],["Other (expense) income, net","(4,477)","","","1,193"],["Impairment of other equity security","(3,000)","","","\u2014"],["Loss on debt extinguishment","\u2014","","","(7,748)"],["Loss before income taxes","(47,673)","","","(119,615)"],["Provision for (benefit from) income taxes","1,060","","","(10,951)"],["Net loss","$","(48,733)","","","$","(108,664)"]] [[/GREPCENT_TABLE]] (1)Includes stock-based compensation expense as follows: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Cost of revenue","$","2,931","","","$","1,733"],["Sales and marketing","10,144","","","15,746"],["Technology and development","16,574","","","38,796"],["General and administrative","50,820","","","56,557"],["Total stock-based compensation expense","$","80,469","","","$","112,832"]] [[/GREPCENT_TABLE]] Stock-based compensation expense decreased significantly for the year ended December 31, 2022 compared to the year ended December 31, 2021 due to the modification of certain equity awards in connection with our IPO. Refer to Note 16 of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. 38 (2)Includes depreciation and amortization expense for our property and equipment, including capitalized internal-use software and intangible assets as follows: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Cost of revenue","$","8,581","","","$","6,430"],["Sales and marketing","7,014","","","6,017"],["Technology and development","2,834","","","2,361"],["General and administrative","3,316","","","1,878"],["Total depreciation and amortization expense","$","21,745","","","$","16,686"]] [[/GREPCENT_TABLE]] Comparison of the Year Ended December 31, 2022 and 2021 Revenue [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Revenue by type"],["Transaction","$","239,799","","","$","258,122","","","$","(18,323)","","","(7","%)"],["Subscription","358,023","","","288,941","","","69,082","","","24","%"],["Partner","22,157","","","28,017","","","(5,860)","","","(21","%)"],["Total revenue","$","619,979","","","$","575,080","","","$","44,899","","","8","%"]] [[/GREPCENT_TABLE]] The increase in total revenue was primarily driven by an increase in subscription revenue. Subscription revenue was 58% and 50% of total revenue for the year ended December 31, 2022 and 2021, respectively, and transaction revenue was 39% and 45% of total revenue for the year ended December 31, 2022 and 2021, respectively. Subscription revenue for the year ended December 31, 2022 increased primarily due to a 15% increase in the average number of subscription units and a 9% improvement in ARPU compared to the year ended December 31, 2021. The increase in average subscription units was primarily driven by strong growth in subscriptions acquired through our partner integration channel, our registered agent, compliance, and tax products, as well as from our purchase of Earth Class Mail during the fourth quarter of 2021. The increase in ARPU was primarily due to a change in mix, as our tax services, subscriptions from Earth Class Mail, compliance and registered agent products, which carry higher average price points than our other subscription services, increased as a percentage of total subscription units. ARPU also increased as a result of a price increase to our small business legal advisory plan that was implemented in the fourth quarter of 2021. These increases were partially offset by an increase in wholesale-priced subscriptions from our partner integration channel. Transaction revenue for the year ended December 31, 2022 decreased due to a 5% decrease in the number of transactions and a 2% reduction in average order value compared to the year ended December 31, 2021. The decrease in the number of transactions resulted from a reduction in estate planning and other consumer transactions, lower volumes in our intellectual property business largely due to the discontinuation of our do-it-yourself trademark product in favor of our attorney-assisted solution and, to a lesser extent, the decrease in business formations during this same period. The reduction in average order value for the year ended December 31, 2022 was primarily driven by an increase in transactions from our wholesale-priced partner integration channel as a percentage of total transactions and testing of lower-priced business formation services partially offset by the timing of revenue recognition. Partner revenue for the year ended December 31, 2022 decreased due to lower formation volumes and our transition away from certain legacy partner relationships that no longer align with our strategic direction. 39 Cost of revenue [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Cost of revenue","$","211,095","","","$","189,364","","","$","21,731","","","11","%"]] [[/GREPCENT_TABLE]] Cost of revenue for the year ended December 31, 2022 increased mainly due to higher fulfillment costs, partially offset by a reduction in filing fees and other variable costs related to the decline in transaction revenue. Fulfillment costs increased by $23.4 million compared to the year ended December 31, 2021, including an $8.3 million increase resulting from our acquisition of Earth Class Mail, an $8.0 million increase related to expanded headcount in our tax business for the 2022 tax filing season and to support future growth as well as a $5.1 million increase in our core business due to higher depreciation expense and investment in additional production capacity to enhance our customer experience. Gross profit [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Gross profit","$","408,884","","","$","385,716","","","$","23,168","","","6","%"]] [[/GREPCENT_TABLE]] The increase in gross profit was driven by a $44.9 million increase in revenue partially offset by a $21.7 million increase in cost of revenue. Sales and marketing [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Sales and marketing","$","263,884","","","$","279,281","","","$","(15,397)","","","(6","%)"]] [[/GREPCENT_TABLE]] Sales and marketing expenses for the year ended December 31, 2022 decreased primarily due to a $20.7 million reduction in customer acquisition marketing spend and a $5.6 million decrease in stock-based compensation, mainly in connection with award modifications from our IPO in July 2021, partially offset by a $6.4 million increase in payroll and related costs due to higher average headcount and a $3.8 million increase in media production and other non-programmatic spend. Customer acquisition marketing spend was $174.6 million and $195.4 million for the year ended December 31, 2022 and 2021, respectively, as we reduced our marketing spend in response to the year-over-year decline in overall U.S. business formations and the uncertain macroeconomic environment. Technology and development [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Technology and development","$","70,434","","","$","84,003","","","$","(13,569)","","","(16","%)"]] [[/GREPCENT_TABLE]] Technology and development expenses for the year ended December 31, 2022 decreased primarily due to a decrease in stock-based compensation of $22.2 million, mainly in connection with award modifications from our IPO in July 2021. This decrease was partially offset by a $3.8 million increase in professional services expense, including contingent staff costs related to our purchase of Earth Class Mail, an increase in other payroll and related benefits of $2.7 million resulting from higher headcount as we added staff to support our investment in new products and services, and a $1.6 million increase in software licensing costs. 40 General and administrative [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["General and administrative","$","116,057","","","$","106,584","","","$","9,473","","","9","%"]] [[/GREPCENT_TABLE]] General and administrative expenses for the year ended December 31, 2022 increased primarily due to a $9.0 million increase in payroll and related benefits, largely due to increased headcount, $1.4 million of additional insurance expense as a public company and a $1.9 million increase in restructuring costs, partially offset by a $5.7 million reduction in stock-based compensation, mainly in connection with award modifications from our IPO in July 2021 and a $1.2 million decrease in professional services expense. Impairment of long-lived and other assets [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Impairment of long-lived and other assets","$","248","","","$","924","","","$","(676)","","","(73","%)"]] [[/GREPCENT_TABLE]] In 2022, we recorded non-cash charges related to the impairment of certain customer relationship assets and in 2021 we recorded non-cash charges related to the impairment of internal-use software projects that were no longer aligned with our go-forward strategy. Interest (income) expense, net [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Interest (income) expense, net","$","(1,543)","","","$","27,984","","","$","(29,527)","","","(106","%)"]] [[/GREPCENT_TABLE]] The change in interest (income) expense, net, was primarily due to the repayment of the 2018 term loan in July 2021 in connection with our IPO. Other (expense) income, net [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Other (expense) income, net","$","(4,477)","","","$","1,193","","","$","(5,670)","","","(475","%)"]] [[/GREPCENT_TABLE]] The change in other (expense) income, net, between 2022 and 2021 was primarily due to changes in foreign currency movements related to our intercompany loans which were denominated in British Pound Sterling, or GBP. Loss on debt extinguishment [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Loss on debt extinguishment","$","\u2014","","","$","7,748","","","$","(7,748)","","","(100","%)"]] [[/GREPCENT_TABLE]] Loss on debt extinguishment for the year ended December 31, 2021 of $7.7 million was due to the write down of unamortized debt issuance costs associated with the full repayment of our 2018 term loan in July 2021. 41 Impairment of other equity security [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Impairment of other equity security","$","(3,000)","","","$","\u2014","","","$","(3,000)","","","100","%"]] [[/GREPCENT_TABLE]] Impairment of other equity security for the year ended December 31, 2022 was due to the impairment of our investment in Mylo, LLC. Provision for (benefit from) income taxes [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","$ change","","% change"],["","(in thousands, except percentages)"],["Provision for (benefit from) income taxes","$","1,060","","","$","(10,951)","","","$","12,011","","","(110","%)"],["Effective tax rate","(2","%)","","9","%"]] [[/GREPCENT_TABLE]] The provision for income taxes for the year ended December 31, 2022 resulted from a $12.0 million unfavorable change in our income taxes as compared to the year ended December 31, 2021. The change was primarily due to changes in pre-tax book income, utilization of net operating losses and capitalization of research expenditures for the year ended December 31, 2022 compared to the year ended December 31, 2021. Comparison of the Years Ended December 31, 2021 and 2020 For a discussion related to the results of operations and changes in financial condition for the year ended December 31, 2021 compared to the year ended December 31, 2020, refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2021, which was filed with the Securities and Exchange Commission, or SEC, on March 24, 2022. Liquidity and Capital Resources Overview Since inception, we have funded our operations and capital expenditures primarily from public and private sales of equity securities, cash flows provided by operating activities and equity and debt financing arrangements, including the proceeds of our IPO. Our primary requirements for liquidity and capital are to finance working capital, capital expenditures and general corporate purposes. At December 31, 2022, our principal sources of liquidity were cash and cash equivalents of $189.1 million, which consisted of cash on deposit with banks and a money market fund, of which approximately $1.1 million related to our foreign subsidiaries. Our cash and cash equivalents decreased by $50.2 million from December 31, 2021 to December 31, 2022, primarily from the stock repurchases during the period. We currently anticipate that our available cash, cash equivalents and cash provided by operating activities will be sufficient to meet our operational cash needs for at least the next year. We have the ability to supplement our liquidity needs over the longer term with borrowings under our 2021 Revolving Facility. In addition, we previously announced our intention to sell our operating headquarters in Austin, Texas, which is discussed in more detail in Note 4 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. We have historically considered the undistributed earnings of our foreign subsidiaries to be indefinitely reinvested, and accordingly no taxes have been provided on such earnings. We continue to evaluate our plans for reinvestment or repatriation of unremitting foreign earnings and have not changed our previous indefinite reinvestment determination following the enactment of the 2017 Tax Cuts and Jobs Act. We have not repatriated funds to the U.S. to satisfy domestic liquidity needs, nor do we anticipate the need to do so. If we determine that all or a portion of our foreign earnings are no longer indefinitely reinvested, we may be subject to foreign withholding taxes and U.S. state income taxes. Furthermore, our board of directors has authorized our management to repurchase up to $150.0 million of shares of our common stock from time to time. As of the date of this filing, we have repurchased $95.1 million of our common stock under our stock repurchase program. For additional information regarding our stock repurchase program, refer to Note 15 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Borrowings 2021 Revolving Facility 42 On July 2, 2021, we entered into our 2021 Revolving Facility with JPMorgan Chase Bank, N.A., as the administrative agent. This agreement amends and restates our first lien credit and guarantee agreement with JPMorgan Chase Bank, N.A, or 2018 Credit Facility, and permits revolving borrowings of up to $150.0 million. The 2021 Revolving Facility provides for the issuance of up to $20.0 million of letters of credit as well as borrowings on same-day notice, referred to as swingline loans, in an amount of up to $10.0 million. We have no amounts outstanding and $150.0 million available for use under our 2021 Revolving Facility. Subject to the satisfaction of certain criteria, we will be able to increase the facility by an amount equal to the sum of (i) the greater of $90.0 million and 75% of consolidated last year cash earnings before interest expense, tax, depreciation and amortization, or Cash EBITDA, which is defined in the 2018 Credit Facility, or LTM Cash EBITDA, plus (ii) unused amounts under the general debt basket (i.e., an amount equal to the greater of $50.0 million and an equivalent percentage of consolidated LTM Cash EBITDA), plus (iii) an unlimited amount so long as the borrower is in pro forma compliance with the Financial Covenant (as defined below), in each case, with the consent of the lenders participating in the increase. We are required to pay a commitment fee in respect of unutilized commitments under the 2021 Revolving Facility. The commitment fee is, initially, 0.35% per annum. The commitment fee is subject to a reduction of 0.10% if the total net first lien leverage ratio does not exceed 3.50 to 1.00. We are also required to pay customary letter of credit fees and agency fees. The interest rate applicable to the 2021 Revolving Facility is, at our option, at a rate equal to the greatest of (i) the administrative agent’s prime rate; (ii) the federal funds effective rate plus 1/2 of 1.0% and (iii) one month LIBOR (subject to a 1.00% floor), plus 1.00% or LIBOR (subject to a 0.00% floor) plus 2.00%. The interest rate margins under the 2021 Revolving Facility are subject to a reduction of 0.25% and a further reduction of 0.25% if the total net first lien leverage ratio does not exceed 3.50 to 1.00 and 2.50 to 1.00, respectively. We have the option to voluntarily repay outstanding loans at any time without premium or penalty, other than customary “breakage” costs with respect to LIBOR loans. There is no scheduled amortization under the 2021 Revolving Facility. The principal amount outstanding is due and payable in full at maturity, five years from the closing date of the 2021 Revolving Facility. Obligations under the 2021 Revolving Facility are guaranteed by our existing and future direct and indirect material wholly-owned domestic subsidiaries, subject to certain exceptions. The 2021 Revolving Facility is secured by a first-priority security interest in substantially all of our assets, subject to certain exceptions. The 2021 Revolving Facility contains a number of covenants that, among other things and subject to certain exceptions, restrict our ability and the ability of our restricted subsidiaries to incur additional indebtedness and guarantee indebtedness; create or incur liens; pay dividends and distributions or repurchase capital stock; merge, liquidate and make asset sales; change lines of business; change our fiscal year; incur restrictions on our subsidiaries’ ability to make distributions and create liens; modify our organizational documents; make investments, loans and advances; and enter into certain transactions with affiliates. The 2021 Revolving Facility requires compliance with a total net first lien leverage ratio of 4.50 to 1.00, or Financial Covenant. The Financial Covenant will be tested at quarter-end only if the total principal amount of all revolving loans, swingline loans and drawn letters of credit that have not been reimbursed exceeds 35% of the total commitments under the 2021 Revolving Facility on the last day of such fiscal quarter. Cash flows The following table sets forth a summary of our cash flows for the periods indicated: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Net cash provided by operating activities","$","73,837","","","$","54,152"],["Net cash used in investing activities","(30,622)","","","(77,673)"],["Net cash (used in) provided by financing activities","(93,343)","","","123,359"],["Effect of exchange rate changes on cash, cash equivalents and restricted cash equivalent","(87)","","","(11)"],["Net (decrease) increase in cash, cash equivalents and restricted cash equivalent","$","(50,215)","","","$","99,827"]] [[/GREPCENT_TABLE]] For a discussion related to our cash flows for the year ended December 31, 2020, refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 43 10-K for the year ended December 31, 2021, which was filed with the Securities and Exchange Commission on March 24, 2022. Net cash provided by operating activities Our largest source of operating cash is cash collections from our customers for our transaction and subscription services. Our primary uses of cash in operating activities are for our fulfillment, production and customer care costs, employee salaries and benefits, sales and marketing expenses and third-party consulting expenses. Net cash provided by operating activities is impacted by our net loss adjusted for certain non-cash items, including depreciation and amortization expense, stock-based compensation and impairments of long-lived assets, as well as the effect of changes in operating assets and liabilities. In 2022, cash provided by operating activities was $73.8 million resulting from a net loss of $48.7 million, adjusted for stock-based compensation and other non-cash expenses of $110.5 million and net cash flows provided by changes in operating assets and liabilities of $12.0 million. The $12.0 million of net cash flows provided from changes in our operating assets and liabilities included a $17.1 million increase in deferred revenue largely due to growth of our subscription units, which are predominantly billed in advance of our revenue recognition, partially offset by a net $2.2 million reduction in accounts payable, accrued expenses, operating lease liability and other liabilities due to the timing of our payments and a $2.8 million net increase in accounts receivable, prepaid expenses and other assets. In 2021, cash provided by operating activities was $54.2 million resulting from a net loss of $108.7 million, adjusted for stock-based compensation and other non-cash expenses of $139.1 million and net cash flows provided by changes in operating assets and liabilities of $23.7 million. The $23.7 million of net cash flows provided from changes in our operating assets and liabilities included a $17.9 million increase in deferred revenue resulting from growth of our subscription units, which are predominantly billed in advance of our revenue recognition, a $16.0 million increase in accounts payable, accrued expenses and other liabilities due to the timing of our payments, partially offset by a $10.1 million increase in accounts receivable, prepaid expenses and other assets. Net cash used in investing activities Our primary investing activities have consisted of capital expenditures to purchase property and equipment necessary to support our customer contact center, network and operations, the capitalization of internal-use software necessary to develop and maintain our platform and deliver new products and features, which provide value to our customers, business acquisitions and investments in other companies. As our business grows, we expect our capital expenditures to continue to increase. In 2022, net cash used in investing activities was $30.6 million, resulting primarily from $22.1 million paid for property and equipment, including capitalized internal-use software and payments for the acquisition of UA Services of $2.5 million and $6.3 million primarily for developed technology acquired from Revvsales Inc. In 2021, net cash used in investing activities was $77.7 million, resulting primarily from the acquisition of Earth Class Mail, Inc. in November 2021 for $61.5 million, net of cash acquired, $11.7 million paid for property and equipment, including capitalized internal-use software and a $3.3 million payment on the extinguishment of interest rate swaps in the third quarter. Net cash provided by (used in) financing activities Our primary uses of cash in financing activities are for repurchases of common stock. Net cash provided by financing activities is primarily impacted by exercises of stock options by our employees and issuance of common stock. In 2022, net cash used in financing activities was $93.3 million, primarily for the repurchase of common stock under our stock repurchase program. In 2021, net cash provided by financing activities was $123.4 million, primarily from issuance of common stock for net proceeds of $666.9 million, offset by full repayment of our 2018 Term Loan and hybrid debt totaling $525.6 million and payment of offering costs of $5.6 million. Material Cash Requirements We believe our current cash and cash equivalents, as well as cash expected to be generated by future operating activities, will be sufficient to meet our material cash requirements for the next twelve months. Our material cash requirements include the below contractual and other obligations: Advertising, Media and Other Commitments We use a variety of media to advertise our services, including search engine marketing, television and radio. At December 31, 2022, we had non-cancelable minimum advertising and media commitments for future advertising spots of $8.1 million, substantially all of which will be paid over a two year period. We also have non-cancelable agreements with various vendors, which require us to pay $67.9 million over a five year period, of which $51.1 million remains to be paid as of December 31, 2022. 44 Lease Obligations At December 31, 2022, we had various non-cancelable operating leases for office space and equipment, which expire between December 31, 2022 and November 30, 2029. As of December 31, 2022, we had total minimum operating lease maturities of $12.8 million, $2.8 million of which mature within twelve months. See Note 9 of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding our future operating lease payments. Non-GAAP Financial Measures To supplement our consolidated financial statements, which are prepared and presented in accordance with U.S. generally accepted accounting principles, or GAAP, we use certain non-GAAP financial measures, as described below, to understand and evaluate our core operating performance. These non-GAAP financial measures, which may be different than similarly titled measures used by other companies, are presented to enhance investors’ overall understanding of our financial performance and should not be considered a substitute for, or superior to, the financial information prepared and presented in accordance with GAAP. We believe that these non-GAAP financial measures provide useful information about our financial performance, enhance the overall understanding of our past performance and future prospects and allow for greater transparency with respect to important measures used by our management for financial and operational decision-making. We are presenting these non-GAAP measures to assist investors in seeing our financial performance using a management view and because we believe that these measures provide an additional tool for investors to use in comparing our core financial performance over multiple periods with other companies in our industry. Adjusted EBITDA and Adjusted EBITDA Margin We define Adjusted EBITDA as Net (loss) income adjusted to exclude interest expense, net, provision for (benefit from) income taxes, depreciation and amortization, other (income) expense, net, stock-based compensation, impairment of other equity security, loss on debt extinguishment, impairment of goodwill, long-lived and other assets, losses from impairment of available-for-sale debt securities, restructuring expenses, IPO-related costs and other transaction-related expenses and certain other non-recurring expenses. Our Adjusted EBITDA financial measure differs from GAAP in that it excludes certain items of income and expense. We define Adjusted EBITDA margin as Adjusted EBITDA as a percentage of revenue. We define Net (loss) income margin as Net (loss) income as a percentage of revenue based on our consolidated financial statements. Adjusted EBITDA is one of the primary performance measures used by our management and our board of directors to understand and evaluate our financial performance and operating trends, including period-to-period comparisons, prepare and approve our annual budget, develop short- and long-term operational plans and determine appropriate compensation plans for our employees. Accordingly, we believe that Adjusted EBITDA provides useful information to investors and others in understanding and evaluating our results of operations in the same manner as our management team and board of directors. In assessing our performance, we exclude certain expenses that we believe are not comparable period over period. Adjusted EBITDA should not be considered in isolation of, or as an alternative to, measures prepared and presented in accordance with GAAP. There are a number of limitations related to the use of Adjusted EBITDA rather than net (loss) income, which is the nearest GAAP equivalent of Adjusted EBITDA, and it may be calculated differently by other companies in our industry, limiting its usefulness as a comparative measure. Some of these limitations include that the non-GAAP financial measure: •does not reflect interest expense, or the cash requirements necessary to service interest or principal payments, which reduces cash available to us; •does not reflect provision for income taxes that may result in payments that reduce cash available to us; •excludes depreciation and amortization and, although these are non-cash expenses, the assets being depreciated may be replaced in the future; •does not reflect foreign currency exchange or other gains or losses, which are included in other (expense) income, net; •excludes stock-based compensation expense, which has been, and will continue to be, a significant recurring expense for our business and an important part of our compensation strategy; •excludes impairments of other equity securities; •excludes losses from impairments of long-lived and other assets; •excludes restructuring expenses, which reduce cash available to us; •excludes IPO-related costs and other transaction-related expenses that are not considered representative of our underlying performance, which reduce cash available to us; and •does not reflect certain other non-recurring expenses that are not considered representative of our underlying performance, which reduce cash available to us. 45 The following table presents a reconciliation of net (loss) income to Adjusted EBITDA for each of the periods indicated: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Reconciliation of Net income (loss) to Adjusted EBITDA"],["Net loss","$","(48,733)","","","$","(108,664)"],["Interest (income) expense, net","(1,543)","","","27,984"],["Provision for (benefit from) income taxes","1,060","","","(10,951)"],["Depreciation and amortization","21,745","","","16,686"],["Other (income) expense, net","4,477","","","(1,193)"],["Stock-based compensation","80,469","","","112,596"],["Impairment of other equity security","3,000","","","\u2014"],["Impairment of long-lived and other assets","237","","","924"],["Acquisition related expenses","758","","","1,356"],["Restructuring costs(1)","1,795","","","\u2014"],["Loss on debt extinguishment","\u2014","","","7,748"],["IPO-related costs and other transaction related expenses(2)","\u2014","","","852"],["Certain other non-recurring expenses(3)","440","","","369"],["Adjusted EBITDA","$","63,705","","","$","47,707"],["Net income (loss) margin","(8","%)","","(19","%)"],["Adjusted EBITDA margin","10","%","","8","%"]] [[/GREPCENT_TABLE]] (1)     Restructuring expenses related to a phased severance event to reduce the U.S. headcount. Restructuring expenses include severance for the impacted employees and are included in general and administrative expenses in the accompanying consolidated statements of operations. (2)     IPO-related costs and other transaction related expenses includes certain non-recurring expenses, which occurred in connection with our IPO in 2021. (3)    For 2022, certain other non-recurring expenses includes severance costs incurred related to the departure of a member of management. In 2021, we incurred expenses related to early termination of our U.K. lease agreement. The increase in Adjusted EBITDA of $16.0 million for the year ended December 31, 2022 reflects an increase in revenue of $44.9 million offset by increases in cost of revenue of $18.3 million and other operating expenses of $10.6 million, excluding non-cash and non-recurring items. We expect our Adjusted EBITDA to increase in absolute dollars in the longer term, although the rate at which our Adjusted EBITDA may grow could vary based upon the interplay of the foregoing factors. Free cash flow Free cash flow is a liquidity measure used by management in evaluating the cash generated by our operations after purchases of property and equipment including capitalized internal-use software. We consider free cash flow to be an important measure because it provides useful information to management and investors about the amount of cash generated by our business that can be used for strategic opportunities, including investing in our business and strengthening our balance sheet. Once our business needs and obligations are met, cash can be used to maintain a strong balance sheet and invest in future growth. The usefulness of free cash flow as an analytical tool has limitations because it excludes certain items that are settled in cash, does not represent residual cash flow available for discretionary expenses, does not reflect our future contractual commitments, and may be calculated differently by other companies in our industry. Accordingly, it should not be considered in isolation or as a substitute for analysis of other GAAP financial measures, such as net cash provided by operating activities. 46 The following table presents a reconciliation of net cash provided by operating activities, the most directly comparable GAAP measure, to free cash flow: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021"],["","(in thousands)"],["Reconciliation of Net Cash Provided by Operating Activities to Free Cash Flow"],["Net cash provided by operating activities","$","73,837","","","$","54,152"],["Purchase of property and equipment","(22,098)","","","(11,740)"],["Free cash flow","$","51,739","","","$","42,412"]] [[/GREPCENT_TABLE]] We experienced an increase in our free cash flow from $42.4 million for the year ended December 31, 2021 to $51.7 million for the year ended December 31, 2022, primarily due to a $19.7 million increase in net cash provided by operating activities. The increase in net cash provided by operating activities resulted from a $31.3 million increase in net income after adjusting for stock-based compensation and other non-cash items, offset by an $11.6 million unfavorable change in our operating assets and liabilities primarily due to the timing of our accounts payable payments and accrued expenses partially offset by a favorable change in prepaid expenses and other assets. Free cash flow was also impacted by higher capital expenditures for the purchase of property and equipment, including capitalization of internal-use software. We expect our free cash flow to increase in absolute dollars over the longer term, although the rate at which our free cash flow may grow could vary based upon the interplay of the factors discussed above. Recent Accounting Pronouncements See Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for further information on certain accounting standards adopted in 2022 and recent accounting announcements that have not yet been required to be implemented and may be applicable to our future operations. Critical Accounting Estimates The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenue and expenses, and related disclosures of contingent liabilities in the consolidated financial statements and accompanying notes. Estimates are used for, however not limited to, revenue recognition, sales allowances and credit reserves, available-for-sale debt securities, recoverability of long-lived assets and goodwill, income taxes, commitments and contingencies, valuation of assets and liabilities acquired in business combinations, valuation of assets in asset acquisitions, fair value of derivative instruments and stock-based compensation. Actual results could differ materially from those estimates. Our most critical accounting policies are summarized below. See Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a discussion of our other significant accounting policies. Revenue recognition We derive our revenue from the following sources: Transaction revenue—Transaction revenue is primarily generated from our customized legal document services upon fulfillment of these services. Transaction revenue includes filing fees and is net of cancellations, promotional discounts, sales allowances and credit reserves. Tax preparation services are recognized at the point in time when the customer’s tax return is filed and accepted by the applicable government authority. Subscription revenue—Subscription revenue is generated primarily from subscriptions to our registered agent services, compliance packages, attorney advice, legal forms services, tax advisory and preparation services, and virtual mail services in addition to software-as-a-service, or SaaS, subscriptions in the U.K. We generally recognize revenue from our subscriptions ratably over the subscription term. Subscription terms generally range from thirty days to one year. Subscription revenue includes the transaction price allocated to bundled free trials for our subscription services and is net of promotional discounts, cancellations, sales allowances and credit reserves and payments to third-party service providers such as legal plan law firms and tax service providers. For transaction and subscription revenue, we generally collect payments and fees at the time orders are placed and prior to services being rendered. We record amounts collected for services that have not been performed as deferred revenue on our consolidated balance sheet. The transaction price that we record is generally based on the contractual amounts and is reduced for estimated sales allowances for price concessions, charge-backs, sales credits and refunds, which are accounted for as variable consideration when estimating the amount of revenue to recognize. Partner revenue—Partner revenue consists primarily of one-time or recurring fees earned from third-party providers from leads generated to such providers through our online legal platform. Revenue is recognized when the 47 related performance-based criteria have been met. We assess whether performance criteria have been met on a cost-per-click or cost-per-action basis. We determine revenue recognition through the following five steps: identification of a contract with a customer; identification of the performance obligations in the contract; determination of the transaction price; allocation of the transaction price to the performance obligations in the contract; and recognition of revenue when or as the performance obligations are satisfied. Our customers generally pay for transactions in advance by credit or debit card except for certain services provided under installment plans where we allow customers to pay for their order in either two, three or twelve equal payments. The first installment due under the installment plans is charged to the customer’s debit or credit card on the date the order is placed, and the remaining installments are generally charged on a monthly basis thereafter. We recognize revenue for the amount we expect to be entitled to for providing the services to our customers. The total fees collected by us for our services include, as applicable, expedited services fees, government filing fees and shipping fees. Subscription services are generally paid monthly or annually in advance of the subscription period except for SaaS services in the U.K., which are invoiced monthly in arrears. Amounts collected in advance of revenue recognition are recorded in deferred revenue. Customers may pay for services, however, may not provide the necessary information to complete a transaction. We attempt to contact the customer to complete the abandoned order. We recognize revenue on abandoned services, or breakage, when it is likely to occur and the amount can be recognized without significant risk of reversal. We recognize breakage in proportion to the pattern of rights exercised by the customer. Judgment is required to determine the amount of breakage and when breakage is likely to occur, which we estimate based on historical data of breakage for similar services. Services we offer can generally either be purchased on a stand-alone basis or bundled together as part of a package of services. Accordingly, a significant number of our arrangements include multiple performance obligations, such as the preparation of legal documents combined with related document revision, document storage, registered agent services, and free trial periods of our legal plans. At contract inception, we assess the services promised in our contracts with customers and identify performance obligations for each promise to transfer to the customer a service or bundle of services that is distinct. The identification of distinct performance obligations within our packages may require significant judgment. The transaction price allocated to each separate performance obligation represents the amount of consideration to which we expect to be entitled in exchange for the services we provide. The transaction price is based on the contractual amounts in our contracts and is reduced for estimated sales allowances for price concessions, charge-backs, sales credits and refunds, which are accounted for as variable consideration when estimating the amount of revenue to recognize. We only include variable consideration in the transaction price to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. We estimate sales allowances using the expected value method. We recognize a liability or a reduction of accounts receivable, and a reduction to revenue based on the estimated amount of sales allowances. We record sales allowances as a reduction of accounts receivable where we expect not to collect the full amount of the outstanding accounts receivable and we record sales allowances as a liability for estimated refunds or credits where we have collected the amounts due from the customer. We have established a sufficient history of estimating sales allowances given the large number of homogeneous transactions. The majority of our allowances and reserves are known within a relatively short period of time following our balance sheet date. The estimated provision for sales allowances has varied from actual results within ranges consistent with management’s expectations. The transaction price excludes sales taxes. Contracts with our customers may include options to purchase additional future services, and in the case of subscription services, options to auto-renew the subscription service. Additional consideration attributable to either the option to purchase additional future services or the option to renew are excluded from the transaction price until such time that the option is exercised, unless these options provide a material right to the customer. For arrangements that contain multiple performance obligations, such as our bundled arrangements, we allocate the transaction price to each performance obligation based on estimates of the standalone selling price of each performance obligation within the bundle. For the services we sell on a standalone basis, we use the sales price of these services in the allocation of the transaction price in bundled arrangements. Where we do not sell the service on a standalone basis, we estimate the standalone selling price based on the adjusted market assessment approach or the expected cost plus a margin approach when market information is not observable. In these cases, the determination of the standalone selling price may require significant judgment. We recognize revenue when we satisfy the performance obligation by transferring the promised good or service to the customer. For our transaction-based services, we generally recognize revenue at a point-in-time when the services are delivered to the customer. For our subscription-based services we generally recognize revenue on a straight-line basis over the subscription term. For our partner-based services, we recognize revenue at a point-in-time when the related performance-based criteria have been met. We do not have significant financing components in arrangements with our customers. 48 Principal agent considerations In certain of our arrangements, another party may be involved in providing services to our customer. We evaluate whether we can recognize revenue gross as a principal or net as an agent. We record revenue on a gross basis when we are the principal in the arrangement. To determine whether we are a principal or an agent, we identify the specified good or service to be provided to the customer and assess whether we control the specified good or service before that good or service is transferred to the customer. We evaluate a number of indicators of whether we control the good or service before it is transferred to the customer, including whether we have primary fulfillment responsibility and obligation to perform the services being sold to the customer; we have latitude in establishing the sales price; and we have inventory risk. In arrangements in which we are the principal, we record as revenue the amounts we have billed to our customer, net of sales allowance, and we record the fee payable to the third-party as cost of revenue. We are the principal in most of our legal document preparation and registered agent services, including legal entity formations and similar arrangements and formation, and formerly, conveyancing services, in the U.K and since December 2021, tax advisory and preparation services through our fulfilled tax subscription, LZ Tax. For these services, revenue includes filing and similar fees. Our alternative business structures, or ABS, offer legal advisory services that are marketed through our websites. Our ABSs provide independent legal advice to our customers and are directly responsible for, and control the fulfillment of, the legal services. Accordingly, for services provided by our ABSs, we recognize revenue as the principal. In arrangements in which we are not the principal, we record revenue on a net basis, which is equal to the amount billed to our customer, net of sales allowances and the fee payable to the third-party or partner that is primarily responsible for performing the services for the customer. Except for our Arizona ABS, we are not a law firm in the U.S. and cannot provide legal advice through our U.S. entities. Therefore, the participating independent law firms in our legal plans control the service to the customer and have the primary service obligation to provide attorney consultations to our customers, for which we pay the law firms a monthly fee. For these arrangements, we recognize revenue on a net basis as an agent. For other services provided by third-parties, including deed transfer, accounting, tax, credit monitoring, business data protection and logo design services, revenue is recognized net of fees payable to third-parties. For partner revenue, we receive a fee for the referral of our customer to the partner or we retain a portion of the fee paid by the customer and share the remainder with the partner. Our partner controls the service to the customer and the partner is responsible for fulfilling the referred service to the customer; accordingly, we recognize revenue for these arrangements on a net basis. Revenue includes shipping and handling fees charged to customers. Business combinations The results of businesses acquired in a business combination are included in our consolidated financial statements from the date of the acquisition. Purchase accounting results in assets and liabilities of an acquired business being recorded at their estimated fair values on the acquisition date. Any excess purchase consideration over the fair value of assets acquired and liabilities assumed is recognized as goodwill. We perform valuations of assets acquired and liabilities assumed for an acquisition and allocate the purchase price to their respective net tangible and intangible assets. Determining the fair value of assets acquired and liabilities assumed requires management to use significant judgment and estimates. Intangible assets consist primarily of customer relationships and developed technology. Judgment and estimates include the selection of valuation methodologies, estimates of future revenue and cash flows, the rate of customer subscription non-renewals, discount rates, the estimated level of effort and related costs of reproducing or replacing the assets acquired, and selection of comparable companies. We generally engage the assistance of third-party valuation specialists in determining fair values of assets acquired and liabilities assumed and contingent consideration, if any, in a business combination. Amounts recorded in a business combination may change during the measurement period, which is a period not to exceed one year from the date of acquisition, as additional information about conditions existing at the acquisition date becomes available. Transaction costs associated with business combinations are expensed as incurred and are included in general and administrative expenses in the accompanying consolidated statements of operations. Goodwill Goodwill represents the excess of the aggregate fair value of the consideration transferred in a business combination over the fair value of the assets acquired, net of liabilities assumed. Goodwill is not amortized, however, it is subject to impairment testing at the reporting unit level annually during the fourth quarter of our fiscal year or more frequently if events or changes in circumstances indicate that goodwill may be impaired. In assessing impairment, we have the option to first assess qualitative factors to determine whether or not a reporting unit is impaired. Alternatively, we may perform a quantitative impairment assessment or if the qualitative assessment indicates that it is more-likely-than-not that the reporting unit’s fair value is less than its carrying amount, a quantitative analysis is required. The quantitative analysis compares the estimated fair value of the reporting unit with its respective carrying amount, including goodwill. If the estimated fair value of the reporting unit exceeds its 49 carrying amount including goodwill, goodwill is considered not to be impaired. If the fair value is less than the carrying amount including goodwill, then a goodwill impairment charge is recorded by the amount that the carrying value exceeds the fair value, up to the carrying amount of goodwill. For our goodwill impairment test performed in the fourth quarter of 2022 and 2021, the fair value of our consolidated reporting unit significantly exceeded our carrying value. Loss contingencies We record loss contingencies in our consolidated financial statements in the period when they are probable and reasonably estimable. If the amount is probable and we are able to reasonably estimate a range of loss, we accrue the amount that is the best estimate within that range, and if no amount is better than any other in the range, we record the amount at the low end in the range. We disclose those contingencies that we believe are at least reasonably possible but not probable regardless of whether they are reasonably estimable. The likelihood of a loss is determined using several factors including the nature of the matter, advice of our internal and external counsel, previous experience and historical and relevant information available to us. The determination of the likelihood of loss or the range of loss requires significant management judgment. We expense legal costs for defending legal proceedings as incurred. As discussed in Note 14 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we are subject to pending matters for which we believe that we have meritorious defenses to the claims and intend to defend against vigorously. Income taxes We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements. Deferred income tax assets and liabilities are measured using enacted tax rates anticipated to be in effect when those tax assets and liabilities are expected to be realized or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the consolidated statements of operations in the period that includes the enactment date. We make judgments in evaluating whether deferred tax assets will be recovered from future taxable income on a jurisdictional basis. A valuation allowance is established if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We consider all available evidence, both positive and negative, including historical levels of income. We also consider expectations and risk associated with estimates of future taxable income in assessing the need for a valuation allowance. If our assumptions and consequently our estimates, change in the future, the valuation allowance may be increased or decreased, resulting in an increase or decrease, which may be material, to our (benefit from) provision for income taxes and the related impact on our net (loss) income. We recognize tax benefits from an uncertain position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits. If this threshold is met, we measure the tax benefit as the largest amount of the benefit that is greater than fifty percent likely to be realized upon ultimate settlement. We recognize penalties and interest accrued with respect to uncertain tax positions as a component of the income tax provision. See Note 20 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further information on our income taxes. Stock-based compensation We estimate the fair value of employee stock-based payment awards on the grant-date and recognize the resulting fair value, net of estimated forfeitures, over the requisite service period. We use the Black-Scholes option pricing model for estimating the fair value of options granted under our stock option plans that vest based on service and performance conditions. The fair value of restricted stock units, or RSUs, that vest based on service and performance conditions is determined based on the value of the underlying common stock at the date of grant. For awards that contain market conditions, we estimate the fair value using a Monte Carlo simulation model. We record expense for awards that contain performance conditions only to the extent that we determine it is probable that the performance condition will be achieved. Expense for awards containing market conditions is not reversed even if the market condition is not achieved. We have elected to treat stock-based payment awards with graded vesting schedules and time-based service conditions as a single award and recognize stock-based compensation on a straight-line basis, net of estimated forfeitures, over the requisite service period. Awards with performance or market conditions are recognized using graded vesting. Options. The Black-Scholes option pricing model and the Monte Carlo simulation model requires us to make certain assumptions including the fair value of our underlying common stock, the expected term, the expected stock price volatility, the risk-free interest rates and the expected dividend yield of our common stock. These assumptions 50 used in the Black-Scholes option pricing model, other than the fair value of our common stock (see the section titled “Common Stock Valuations” below), are estimated as follows: •Expected term. The expected term of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding. The expected term of options granted is estimated based upon actual historical exercise and post-vesting cancellations, adjusted for expected future exercise behavior. •Risk-free interest rate. The risk-free interest rate assumption is based upon observed interest rates on the U.S. government securities appropriate for the expected term of our stock options. •Expected volatility. Because our common stock has limited publicly traded history, we estimate the expected volatility from the historical volatility of selected public companies with comparable characteristics to us, including similarity in size, lines of business, market capitalization and revenue and financial leverage. We determine the expected volatility assumption using the frequency of daily historical prices of comparable public company’s common stock for a period equal to the expected term of the options. We periodically assess the comparable companies and other relevant factors used to measure expected volatility for future stock option grants. •Expected dividend yield. The dividend yield assumption is based on our history and expectation of dividend payouts. Other than the special dividends declared in 2015, 2017 and 2018 which resulted in corresponding reductions in the exercise price of the stock options, we have not declared any cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. Stock-based compensation expense is recognized based on awards that are ultimately expected to vest. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on our historical experience and future expectations. If any of the assumptions used in the Black-Scholes option pricing model change significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously. The determination of stock-based compensation is inherently uncertain and subjective and involves the application of valuation models and assumptions requiring the use of judgment. If we had made different assumptions, our stock-based compensation expense, and our net loss for 2022, 2021 and 2020, may have been materially different. The weighted-average assumptions that were used to calculate the grant-date fair-value of our stock option grants were as follows: [[GREPCENT_TABLE]] [["","Year Ended December 31,"],["","2022","","2021","","2020"],["Expected term (years)","5.6","","5.4","","5.2"],["Risk-free interest rate","2.6","%","","1.0","%","","1.1","%"],["Expected volatility","48","%","","46","%","","45","%"],["Expected dividend yield","\u2014","","","\u2014","","","\u2014"]] [[/GREPCENT_TABLE]] Restricted stock units. RSUs that vest upon the satisfaction of service-based vesting conditions, which is typically over a four-year period. For these RSUs we recognize stock-based compensation expense on a straight-line basis over the vesting period of 4 years. RSUs with performance or market conditions are recognized using graded vesting. Common stock valuations. Prior to our IPO, we determined the fair value of our common stock using valuation approaches in accordance with the American Institute of Certified Public Accountants, Accounting and Valuation Guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation. Subsequent to our IPO, we utilized our common stock values as traded in the public market as an input into our valuation models. Award issuances and modifications in connection with our IPO. For retention purposes, in connection with our IPO, we amended certain vesting conditions of existing options and RSUs, and granted additional options and RSUs to our executive officers. See Note 16 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further discussion. Emerging Growth Company Status Upon completion of our IPO, we elected to be an Emerging Growth Company, or EGC, as defined in the Jumpstart Our Business Startups Act. Effective December 31, 2022, we lost our EGC status due to becoming a “large accelerated filer”. As a result, we must comply with all financial disclosure and governance requirements applicable to a “large accelerated filer”. For further information, see Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. 51