Vertex, Inc. (VERX) FY 2023 MD&A

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

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, beliefs, and expectations that involve risks and uncertainties. Our actual results and the timing of events could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in the sections titled “Risk Factors” and “Special Note Regarding Forward-Looking Statements.”

This section of this Annual Report on Form 10-K generally discusses 2023 and 2022 items and year-to-year comparisons between 2023 and 2022. Discussions of 2021 items and year-to-year comparisons between 2022 and 2021 are not included in this Annual Report on Form 10-K, and can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.

Overview

Vertex is a leading global provider of indirect tax software and solutions. Our mission is to deliver the most trusted tax technology enabling global businesses to transact, comply, and grow with confidence. Vertex provides cloud-based and on-premise solutions that can be tailored to specific industries for every major line of indirect tax, including sales and consumer use, value added, and payroll. Headquartered in North America, and with offices in South America and Europe, Vertex employs over 1,500 professionals and serves companies across the globe.

We derive the majority of our revenue from software subscriptions. These subscriptions include use of our software and ongoing monthly content updates. Our software is offered on a subscription basis to our customers, regardless of their deployment preferences. On-premise subscriptions are typically sold through one-year contracts and cloud-based subscriptions are typically sold through one- to three-year contracts. We bill the majority of our customers annually in advance of the subscription period.

Our customers include a majority of the Fortune 500, as well as a majority of the top 10 companies by revenue in multiple industries such as retail, technology, and manufacturing, in addition to leading marketplaces. As our customers expand geographically and pursue omnichannel business models, their tax determination and compliance requirements increase and become more complex, providing sustainable organic growth opportunities for our business. Our flexible, tiered transaction-based pricing model also results in our customers growing their spend with us as they grow and continue to use our solutions. We principally price our solutions based on a customer’s revenue base, in addition to a number of other factors.

We employ a hybrid deployment model to align to our customers’ technology preferences for their core financial management software across on-premise, cloud deployments, or any combination of these models. Over time, we expect both existing and newly acquired customers to continue to shift toward cloud deployment models. Cloud-based subscription sales to new customers have grown at a significantly faster rate than on-premise software subscription sales, which is a trend that we expect to continue over time. We generated 45% and 41% of software subscription revenues from cloud-based subscriptions in 2023 and 2022, respectively. While our on-premise software subscription revenues comprised 55% and 59% of our software subscription revenues for 2023 and 2022, respectively, they continue to decrease as a percentage of total software subscriptions revenues as cloud-based subscriptions grow.

We license our solutions primarily through our direct sales force, which focuses on selling to qualified leads provided by our marketing efforts, and through our network of referral partners. We also utilize indirect sales to a lesser extent to efficiently grow and scale our enterprise and mid-market revenues.

Our partner ecosystem is a differentiating, competitive strength in both our software development and our sales and marketing activities. We integrate with key technology partners that span ERP, CRM, procurement, billing, POS, and eCommerce. These partners include Adobe/Magento, Coupa, Microsoft Dynamics, NetSuite, Oracle, Salesforce, SAP, SAP Ariba, Shopify, Workday, and Zuora. We also collaborate with numerous accounting firms who have built implementation practices around our software to serve their customer base.

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We believe that global commerce and the compliance environment provides durable and accelerating growth opportunities for our business. We generated revenues of $572.4 million and $491.6 million in 2023 and 2022, respectively. We had a net loss of ($13.1) million and ($12.3) million in 2023 and 2022, respectively. These amounts are presented in accordance with generally accepted accounting principles in the U.S. (“GAAP”).

We define Adjusted EBITDA as net income or loss before interest (including adjustments to the settlement value of deferred purchase commitment liabilities), taxes, depreciation, and amortization, as adjusted to exclude charges for asset impairments, stock-based compensation expense, amortization of cloud computing arrangement implementation costs, severance expense, acquisition contingent consideration, changes in the settlement value of deferred purchase commitment liabilities recorded as interest expense, litigation settlements, and transaction costs. Adjusted EBITDA was $100.8 million and $78.7 million in 2023 and 2022, respectively. Adjusted EBITDA is a non-GAAP financial measure. Refer to “Key Business Metrics” and “Use and Reconciliation of Non-GAAP Financial Measures” for further discussion of key business metrics and non-GAAP financial measures and their comparison to GAAP financial measures.

Key Factors Affecting Performance

The growth of our business and our future success depends on many factors, including our ability to retain and expand our revenues from existing customers, acquire new customers, broaden and deepen our partner ecosystem, continually innovate our software, invest in growth and scale our business, and manage customer migrations to cloud solutions. While these areas represent significant opportunities for us, we also face significant risks and challenges that we must successfully address in order to sustain the growth of our business and improve our operating results. We anticipate that we will continue to expand our operations and headcount. The expected addition of new personnel and the investments that we anticipate will be necessary to manage our anticipated growth may make it more difficult for us to achieve or maintain profitability. Many of these investments will occur in advance of experiencing any direct benefit and will make it difficult to determine if we are allocating our resources efficiently.

Retention and expansion of revenues from existing customers. Given the breadth of our customer base and their own internal growth, the majority of our revenues and revenue growth comes from existing customers. This revenue growth is comprised of the acquisition of new licenses for additional products, increases in subscription fees due to expanded usage of currently licensed software and price increases. We plan to continue to invest in new innovations and offerings and in our sales and marketing teams in order to support the ongoing strong retention and expansion of revenues with our existing customers. We monitor our net revenue retention rate (“NRR”) in order to understand our ability to retain and grow revenues from our customers. Our NRR was 113% and 110% in 2023 and 2022, respectively. We believe our gross revenue retention rate (“GRR”) provides insight into and demonstrates to investors our ability to retain revenues from our existing customers. Our GRR was 95% and 96% in 2023 and 2022, respectively. Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations– Key Business Metrics– Net Revenue Retention Rate and Gross Revenue Retention Rate” and for further discussion.

Acquire new customers. Our solutions address the complexity of aligning commerce and compliance, and we believe the market for our software and solutions is large and underpenetrated, both in the U.S. and globally. As enterprise and mid-market companies continue to expand their business operations—both through their product and service offerings and their global footprint—we expect demand for our tax solutions to increase due to the fact that legacy solutions such as spreadsheets, manual processes, native ERP functionality, or home-built solutions are error prone, inefficient, and cannot scale. We plan to continue to invest in our sales and marketing teams and our solution development in order to address this increased demand from new customers. This increased investment will result in increases in expenses in advance of revenues attributable to these investments.

Broaden and deepen our partner ecosystem. We have an extensive network of partners that spans ERP, CRM, procurement, billing, POS, and eCommerce platforms. Our partners enhance the coverage and adoption of our solutions and promote our thought leadership. We leverage our partnerships to maximize the benefits of our solutions for our customers and to identify new customer opportunities. By forming additional strategic alliances with participants in the global digital transformation, such as payments and eCommerce platforms, we can continue to expand our exposure to all transactions, both business-to-consumer and business-to-business. Future partnerships with large-scale digital payments companies will allow us to develop additional customer-centric solutions and further expand our customer base.

Continued innovation of our software. With the pace of change in commerce and compliance, we believe it is important to continue innovating and extending the functionality and breadth of our software. We plan to continue

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investing to further enhance our content and the speed and usability of our software. Historically such innovation has been accomplished through internal development efforts. However, we may pursue acquisitions, development arrangements with partners or similar activities to accelerate these investments. We believe continuing to enhance our existing software and expanding our tax content will increase our ability to generate revenues by broadening the appeal of our software to new customers as well as increasing our engagement with existing customers. See Note 3, Business Combinations to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K for a discussion of our  acquisitions.

Investing in growth and scaling our business. We believe that our market opportunity is large, and we will continue to invest significantly in scaling across organizational functions in order to support the anticipated growth in our operations both domestically and internationally. Any investments we make in our research and development and our sales and marketing organization will occur in advance of experiencing the benefits from such investments; therefore, it may be difficult for us to determine if we are efficiently allocating resources in those areas. The company may pursue acquisitions or partner arrangements to accelerate its growth initiatives. See Note 3, Business Combinations to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K for a discussion of our acquisitions.

Customer migration to cloud solutions. Over time, we expect a continued shift to our cloud solutions by our existing and newly acquired customers. When existing customers migrate from our on-premise to our cloud-based solutions, this generally has a favorable impact on our long-term ARR due to price structures and opportunities to promote additional license sales. Over the past three years, cloud sales to new customers have grown at a faster rate than sales of on-premise solutions, which is a trend that we expect to continue over time. We generated 45% and 41% of software subscription revenues from cloud-based subscriptions in 2023 and 2022, respectively. We host our cloud-based subscriptions. To the extent that revenues from our cloud-based solutions continue to increase as a percentage of total revenues, our gross margin may decrease due to the associated hosting costs of those offerings.

Recent Developments

On December 13, 2023, we announced that we had commenced a public tender offer to acquire a global provider of e-invoicing solutions. On January 14, 2024, we withdrew our public tender offer following competing offers. As a result, we incurred approximately $4.9 million in transaction costs during 2023, related to legal and financial due diligence. More information is provided in Note 3 to our consolidated financial statements, beginning on page F-1 of this Annual Report on Form 10-K.

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Components of Our Results of Operations

Revenues

We generate revenues from software subscriptions and services.

Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration expected to be received in exchange for those products or services. We enter into contracts that include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of allowance for subscription and non-renewal cancellations and any taxes collected from customers that are subsequently remitted to governmental authorities.

Software Subscriptions

Licenses for on-premise software subscriptions, which are generally one year, provide the customer with a right to use the software as it exists when made available to the customer. Customers purchase a subscription to these licenses, which includes the related software and tax content updates and product support. The updates and support, which are part of the subscription agreement, are essential to the continued utility of the software; therefore, we have determined the software and the related updates and support to be a single performance obligation. Accordingly, when on-premise software is licensed, the revenue associated with this combined performance obligation is recognized ratably over the license term as these subscriptions are provided for the duration of the license term. Revenue recognition begins on the later of the beginning of the subscription period or the date the software is made available to the customer to download. Prior to January 1, 2022, certain on-premise software subscription prices in the initial subscription year were higher than standard renewal prices. The excess initial year price over the renewal price is a material right that provides customers

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with the right to this reduced renewal price. We recognize revenue associated with this material right over the estimated period of benefit to the customer, which is generally three years. Effective January 1, 2022, we changed the pricing structure for on-premise software so the initial year price and renewal prices were consistent, thus removing the material right for transactions after this date. The material right for applicable transactions prior to this pricing change will continue to be recognized over the remaining estimated period of benefit to the customer.

Our cloud-based subscriptions allow customers to use Vertex-hosted software over the contract period without taking possession of the software. The contracts are generally for one to three years and are generally billed annually in advance of the subscription period. Our cloud-based offerings also include related updates and support. Revenue recognition begins on the later of the beginning of the subscription period or the date the customer is provided access to the cloud-based solutions. All services within the cloud-based contracts consistently provide a benefit to the customer during the subscription period, thus the associated revenue is recognized ratably over the subscription period.

Revenue is impacted by the timing of sales and our customers’ growth or contractions resulting in their need to expand or contract their subscription usage, the purchase of new solutions, or the non-renewal of existing solutions. In addition, revenue will fluctuate with the cessation of extended product support fees charged for older versions of our software subscription solutions when they are retired and these fees are no longer charged. Contracts for on-premise licenses permit cancellations at the end of the license term, which is generally one year. Legacy cloud-based subscription contracts for multi-year periods previously provided customers the right to terminate their contract for services prior to the end of the subscription period at a significant penalty. This penalty requires the payment of a percentage of the remaining months of the then current contract term. Current cloud-based contracts do not contain such termination rights. Terminations of cloud-based subscriptions prior to the end of the subscription term have occurred infrequently and the impact has been immaterial. The allowance for subscription and non-renewal cancellations reflects an estimate of the amount of such cancellations and non-renewals based on past experience, current information, and forward-looking economic considerations.

Services Revenue

We generate services revenue primarily in support of our customers’ needs associated with our software and to enable them to realize the full benefit of our solutions. These software subscription-related services include configuration, data migration and implementation, and premium support and training. In addition, we generate services revenue through our managed services offering which allows customers to outsource all or a portion of their indirect tax operations to us. These services include indirect tax return preparation, filing and tax payment, and notice management. We generally bill for services on a per-transaction or time and materials basis, and we recognize revenue from deliverable-based professional services as services are performed.

Fluctuations in services revenue are directly correlated to fluctuations in our subscription revenues with respect to implementation and training services as we have historically experienced an attachment rate to subscription sales for these services of approximately 60%. In addition, our managed services offering has continued to experience increased revenues associated with returns processing volume increases attributable to regulatory changes, as customers expanded their tax filings into more jurisdictions.

Cost of Revenue

Software Subscriptions

Cost of software subscriptions revenue consists of costs related to providing and supporting our software subscriptions and includes personnel and related expenses, including salaries, benefits, bonuses, and stock-based compensation. In addition, cost of revenue includes direct costs associated with information technology, such as data center and software hosting costs, and tax content maintenance. Cost of software subscriptions revenue also includes amortization associated with direct labor and related expenses for capitalized internal-use software for cloud-based subscription solutions and software developed for sale for new products and enhancements to existing products, and costs associated with the amortization of certain acquired intangible assets. We plan to continue to significantly expand our infrastructure and personnel to support our future growth and increases in transaction volumes of our cloud-based solutions, including through acquisitions. We expect growth in our business will result in an increase in cost of software subscriptions revenue in absolute dollars.

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Services

Cost of services revenue consists of direct costs of software subscription-related services and our managed services offering. These costs include personnel and related expenses, including salaries, benefits, bonuses, stock-based compensation, and the cost of third-party contractors and other direct expenses. We plan to continue to expand our infrastructure and personnel as necessary to support our future growth and related increases in our service revenue. We expect growth in our business will result in an increase in the cost of services revenue in absolute dollars.

Research and Development

Research and development expenses consist primarily of personnel and related expenses for our research and development activities, including salaries, benefits, bonuses, and stock-based compensation, and the cost of third-party developers and other contractors. Research and development costs, other than software development expenses qualifying for capitalization, are expensed as incurred.

We devote substantial resources to developing new products and enhancing existing products, conducting quality assurance testing and improving our core technology. We believe continued investments in research and development are critical to attain our strategic objectives and expect research and development costs to increase in absolute dollars. These investments include enhancing our solution offerings to address changing customer needs to support their growth, as well as implementing changes required to keep pace with our partners’ technology to ensure the continued ability of our solutions to work together and deliver value to our customers. The market for our solutions is characterized by rapid technological change, frequent new product and service introductions and enhancements, changing customer demands, and evolving industry standards. As a result, although we are making significant research and development expenditures, which may be incurred and certain of which may be capitalized, there is no guarantee these solutions will be accepted by the market. This could result in increased costs or an impairment of capitalized development costs with no resulting future revenue benefit.

Selling and Marketing Expenses

Selling expenses consist primarily of personnel and related expenses in support of sales and marketing efforts. These costs include salaries, benefits, bonuses, and stock-based compensation. In addition, selling expense includes costs related to advertising and promotion efforts, branding costs, partner-based commissions, costs associated with our annual customer conferences and amortization of certain acquired intangible assets. We intend to continue to invest in our sales and marketing capabilities in the future to continue to increase our brand awareness and expect these costs to increase on an absolute dollar basis as we grow our business and continue to expand our market and partner ecosystem penetration. Sales and marketing expense in absolute dollars and as a percentage of total revenue may fluctuate from period-to-period based on total revenue levels and the timing of our investments in our sales and marketing functions, as these investments will occur in advance of experiencing the benefits from such investments and may vary in scope and scale over future periods.

General and Administrative

General and administrative expenses consist primarily of personnel and related expenses for administrative, finance, information technology, legal, risk management, facilities, and human resources staffing, including salaries, benefits, bonuses, severance, stock-based compensation, professional fees, insurance premiums, facility costs, amortization of cloud computing arrangement implementation costs related to our ERP modernization initiative,  and other internal support and infrastructure costs.

We expect our general and administrative expenses to increase in absolute dollars as we continue to expand our operations, hire additional personnel, integrate current and future acquisitions, and incur additional costs associated with being a publicly-listed company. As a public company, we expect to incur increased expenses related to accounting, tax and auditing activities, legal, insurance, SEC compliance, and internal control compliance, including the design, implementation, and testing of increasingly formalized systems of internal control over financial reporting in compliance with Section 404(b) of the Sarbanes-Oxley Act of 2002.

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Depreciation and Amortization

Depreciation and amortization expense consists of the allocation of purchased and developed asset costs over the future periods benefitted by the use of these assets. These assets include leasehold improvements for our facilities, computers and equipment needed to support our customers and our internal infrastructure and capitalized internal-use software associated with our internal tools. Depreciation and amortization will fluctuate in correlation with our ongoing investment in internal infrastructure costs to support our growth.

Other Operating Expense (Income), net

Other operating expense (income), net consists primarily of transactions costs associated with merger and acquisition activities, periodic remeasurement of contingent consideration associated with completed acquisitions, realized gains and losses on foreign currency fluctuations, and other operating gains and losses. These amounts will fluctuate as a result of ongoing merger and acquisition activities and for changes in foreign currency rates.

Interest (Income) Expense, net

Interest (income) expense, net reflects the net amount of interest expense and interest income over the same period.

Interest expense consists primarily of interest incurred related to borrowings, bank credit facility and leases. Interest expense includes amortization of deferred financing fees over the term of the credit facility or write-downs of such costs upon redemption of debt. Interest expense will vary as a result of fluctuations in the level of debt outstanding as well as interest rates on such debt. In addition, interest expense will include adjustments to the fair value of contracts that may be entered into to hedge risks associated with currency fluctuations for cash receipts or cash payments denominated in currencies other than U.S. dollars and which do not qualify for hedge accounting. In addition, changes in the settlement value of the future payment obligation for the Systax Sistemas Fiscais Limited (“Systax”) acquisition and amortization of the discount on deferred purchase consideration associated with the LCR-Dixon Corporation (“LCR-Dixon”)  acquisition were recorded as interest expense.

Interest income reflects earnings on investments of our cash on hand and our investment securities. Interest income will vary as a result of fluctuations in the future level of funds available for investment and the rate of return available in the market on such funds.

Income Tax Expense (Benefit)

Income tax expense (benefit) consists primarily of federal, foreign, state, and local taxes on our loss or income. In determining our annualized effective income tax rates, net deferred tax assets, valuation allowances, and cash paid for income taxes, we are required to make judgments and estimates about domestic and foreign profitability, the timing and usage of net operating loss carryforwards, applicable tax rates, and transfer pricing methodologies. Judgments and estimates related to our projections and assumptions are inherently uncertain; therefore, actual results could materially differ from our projections.

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Our subsidiaries in foreign jurisdictions are generally taxed at the corporate level, and the income tax provision or benefit is based on the income or loss sourced to these foreign jurisdictions at the tax rates applicable in those jurisdictions.

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Results of Operations

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes thereto beginning on page F-1 of this Annual Report on Form 10-K. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. The following table sets forth our consolidated statements of comprehensive loss for the periods indicated.

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(1) Includes stock-based compensation expenses as follows in the table below.

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The following table sets forth our results of operations as a percentage of our total revenues for the periods presented.

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Year Ended December 31, 2023 Compared to Year Ended December 31, 2022

Revenues

Revenues increased $80.8 million, or 16.4%, to $572.4 million in 2023 compared to $491.6 million in 2022. The increase in software subscriptions revenues of $65.4 million, or 15.7%, was primarily driven by an increase of $35.5 million, primarily from cross selling new products to existing customers, and to a lesser extent, increases from expanded use of our products and services, and price increases. Software subscriptions revenues derived from new customers averaged 6.2% and 8.0% of total software subscriptions revenues in 2023 and 2022, respectively.

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The $15.4 million increase in services revenues was primarily driven by an increase of $11.3 million in software subscription-related services associated with the growth in subscription revenues, which includes new customers implementing our solutions and upgrading existing customers to newer versions of our solutions. In addition, our managed services offering experienced a $4.1 million increase in recurring services revenues over the prior year due to returns processing volume increases related to regulatory changes as customers expanded their tax filings into more jurisdictions.

Cost of Software Subscriptions Revenues

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Cost of software subscriptions revenues increased $20.8 million, or 14.7%, to $162.9 million in 2023 compared to $142.1 million in 2022. This increase was primarily driven by a $12.1 million increase in costs of personnel supporting period-over-period growth of sales and customers, and ongoing hosting and infrastructure investments to support expansion of customer transaction volumes for our cloud-based subscription customers. In addition, this included an increase in depreciation and amortization of capitalized software and acquired intangible assets of $9.1 million associated with our ongoing investments in internal-use software for cloud-based subscription solutions, software developed for sale for new products and enhancements to existing products, and costs associated with the amortization of acquired intangible assets. Lastly, stock-based compensation increased by $0.7 million for the twelve months ended December 31, 2023 over the same period in 2022.

As a percentage of software subscriptions revenues, the cost of software subscriptions revenues decreased to 33.9% in 2023 compared to 34.2% in 2022. After excluding stock-based compensation expense, as a percentage of software subscriptions revenues, cost of software subscriptions revenues decreased to 33.3% in 2023 compared to 33.7% in 2022.

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Cost of Services Revenues

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Cost of services revenues increased $9.8 million, or 19.2%, to $60.9 million in 2023 compared to $51.1 million in 2022. This increase was primarily driven by a $9.4 million increase in costs of service delivery personnel to support revenue growth in software-subscription related services and our managed services offering.  In addition, this amount includes an increase in stock-based compensation of $0.4 million for the twelve months ended December 31, 2023 over the same period in 2022.

As a percentage of services revenues, cost of services revenues decreased to 66.5% in 2023 compared to 67.1% for the same period in 2022. After excluding stock-based compensation expense, as a percentage of services revenues, cost of services revenues decreased to 64.5% in 2023 compared to 65.2% for the same period in 2022.

Research and Development

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Research and development expenses increased $16.3 million, or 39.0%, to $58.2 million in 2023 compared to $41.9 million in 2022. This increase was primarily due to a $12.1 million increase in personnel costs related to development work associated with new solutions to address end-to-end data analysis and compliance needs of our customers, and continued expansion of connectors and application program interfaces (“APIs”) to customer ERP and other software platforms. In addition, this amount includes an increase in stock-based compensation of $4.2 million for the twelve months ended December 31, 2023 over the same period in 2022.

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As a percentage of total revenues, research and development expenses increased to 10.2% in 2023 compared to 8.5% in 2022. After excluding stock-based compensation, research and development expenses as a percentage of total revenue increased to 9.1% in 2023 compared to 8.2% in 2022.

Selling and Marketing

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Selling and marketing expenses increased $14.9 million, or 11.9%, to $140.2 million in 2023 compared to $125.3 million in 2022, primarily driven by a $13.5 million increase in payroll and related expenses associated with the growth in period-over-period subscription sales and services revenues and expansion of our partner and channel management programs. In addition, this included an increase of $0.4 million in advertising and promotional spending related to expanded brand awareness efforts. Lastly, there was an increase in stock-based compensation of $2.1 million. The increase in the period was partially offset by a decrease of $1.1 million associated with the amortization of acquired intangible assets associated with prior acquisitions for the twelve months ended December 31, 2023 compared to the same period in 2022.

As a percentage of total revenues, selling and marketing expenses decreased to 24.5% in 2023 compared to 25.5% for the same period in 2022. After excluding stock-based compensation expense, as a percentage of total revenues, selling and marketing expenses decreased to 23.0% in 2023 compared to 24.2% in 2022.

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General and Administrative

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General and administrative expenses increased $24.3 million, or 20.0%, to $145.9 million in 2023 compared to $121.7 million in 2022, primarily driven by an increase of $15.0 million associated with planned strategic investments in information technology infrastructure, business process re-engineering, and other initiatives to drive future operating leverage. This increase also reflects investments in employees, systems, and other resources in support of our growth, and public company reporting and compliance activities. Additionally, there was an increase of $2.6 million for the amortization of capitalized cloud computing implementation costs related to our ERP modernization initiative. Lastly, there was an increase in stock-based compensation of $6.7 million for the year ended December 31, 2023 over the same period in 2022.

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As a percentage of total revenues, general and administrative expenses increased to 25.5% in 2023 compared to 24.7% in 2022. After excluding stock-based compensation expense, as a percentage of total revenues general and administrative expenses decreased to 22.9% in 2023 compared to 23.1% in 2022.

Depreciation and Amortization

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Depreciation and amortization increased $2.8 million, or 22.2%, to $15.2 million in 2023 compared to $12.4 million in 2022. The increase was primarily due to the impact of infrastructure and technology purchases and other capitalized infrastructure costs to support our growth, which were placed in service during 2023 and 2022. As a percentage of revenues, depreciation expense increased slightly to 2.7% in 2023 compared to 2.5% for the same period in 2022.

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Other Operating Expense, Net

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Other operating expense, net, increased $1.2 million, or 23.4%, to $6.5 million of expense in 2023 compared to $5.3 million in 2022. Other operating expense, net for the year ended December 31, 2023, was primarly comprised of $4.9 million related to costs associated with our public tender offer, which occurred on December 13, 2023, and was later withdrawn on January 14, 2024 (see Note 3 to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K), as well as a $1.5 million increase in the contingent consideration liability associated with our 2021 acquisition of Tellutax, LLC (“Tellutax”), and $0.1 million in foreign currency losses. Other operating expense, net for the year ended December 31, 2022 was primarily comprised of $2.0 million in costs related to a legal settlement, $2.3 million of an increase to the Tellutax contingent consideration liability, and $0.7 million in offering costs related to the sale of shares of certain of our Class B common stock shareholders.

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As a percentage of total revenues, other operating expense, net was 1.1% for 2023, which was unchanged compared to the same period in 2022.

Interest Expense, Net

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Interest expense, net increased $2.1 million, or 103.3%, to $4.2 million in 2023 compared to $2.0 million in 2022. This change was attributable to increases in interest expense primarily associated with: (i) an increase in interest expense of $3.2 million that reflects a year-over-over increase to the settlement value of our deferred purchase commitment liability associated with our acquisition of Systax, which is treated as a financing cost; and (ii) a year-over-year increase in note payable interest expense of $1.3 million primarily due to increased borrowing costs from rising interest rates under our credit agreement. Offsetting these expense increases were: (i) a one-time $0.4 million expense recognized in 2022 from the write off of deferred financing costs related to debt refinancing in 2022; and (ii) an increase in interest and dividend income of $2.0 million, primarily due to higher yields on our investments in 2023 as compared to 2022.

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Income Tax Expense (Benefit)

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Income tax benefit was $8.6 million in 2023 as compared to $2.2 million income tax expense in 2022. The decrease in tax expense was primarily driven by changes in tax benefits on exercises and vestings of stock awards, tax credits, valuation allowances on net deferred tax assets established for certain foreign jurisdictions, loss before income taxes, and  limitations on deductions of certain employees’ compensation under Internal Revenue Code Section 162(m).

Seasonality and Quarterly Trends

We have historically signed a higher percentage of software subscription agreements with new and existing customers in the fourth quarter of each year. This can be attributed to buying patterns typical in the software industry. Since most of our customer agreement terms are annual, agreements initially entered into in the fourth quarter will generally come up for renewal at that same time in subsequent years. As a result, customer agreement cancellations, or customer usage tier true-ups,  may have a higher concentration during the end of the year. This seasonality is reflected in our revenues, though the impact to overall annual or quarterly revenues is typically minimal since we recognize subscription revenue ratably over the term of the customer contract. Additionally, this seasonality is reflected in commission expenses to our sales personnel and our partners.

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Our quarterly revenues have generally increased over the last two years primarily due to new sales to existing customers and sales to new customers. However, the pace of our revenue growth has not been consistent. Many of our customers are enterprise and large corporations and their purchase patterns can be sensitive to timing of budget decisions. Depending on such timing, these decisions can create volatility in the amount of business transacted by our sales team and the amount of revenues recorded in each quarter. As such, certain periods may be less comparable due to the timing of our customers purchase patterns.

Quarterly fluctuations in our costs and expenses overall primarily reflect changes in our headcount, infrastructure, and sales and marketing investments, and other costs related to certain technology development projects and the development and scaling of our cloud solutions. In particular, research and development expenses have fluctuated based on the timing of personnel additions, capitalized costs and related spending on product development. Increases in our selling and marketing expenses primarily reflect our current and past investments related to the expansion of our brand awareness and product innovation. We have also invested in acquisitions and product innovation to expand our product portfolio. We anticipate our operating expenses will increase in future periods as we invest to support the ongoing expansion of our business.

Historical patterns should not be considered a reliable indicator of our future performance.

Liquidity and Capital Resources

As of December 31, 2023, we had unrestricted cash and cash equivalents of $68.2 million and an accumulated deficit of $0.6 million. In addition, we had $9.5 million in investment securities with a maturity date exceeding three months as of December 31, 2023 which are not included in unrestricted cash and cash equivalents. Our primary sources of capital include sales of our solutions, proceeds from bank lending facilities, and the offering of existing or future classes of stock.

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Historical Cash Flows

Years Ended December 31, 2023 and 2022

The following table presents a summary of our cash flows for the periods indicated:

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Operating Activities. Net cash provided by operating activities was $74.3 million in 2023 compared to $63.8 million in 2022, an increase of $10.5 million. This was driven by an increase in cash generated from operations pertaining to net loss adjusted for non-cash charges aggregating $18.9 million, primarily driven by year-over-year increases in depreciation and amortization, and stock-based compensation. These increases were partially offset by a $8.4 million decrease in net cash from changes in operating assets and liabilities, due to changes in investments and timing of cash receipts and disbursements.

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Investing Activities. Net cash used in investing activities was $66.2 million in 2023 compared to $72.0 million in 2022, a decrease in use of funds for investing activities of $5.9 million. The decrease in use of funds was primarily driven by increased proceeds from maturities of investment securities of $13.0 million. This was partially offset by a year-over-year increase in investments in commercial solutions supporting our customers and infrastructure investments to drive operating leverage.

Financing Activities. Net cash used by financing activities was $26.5 million in 2023 compared to net cash provided by financing activities of $17.1 million in 2022, an increase in cash used in financing activities of $43.6 million. The increase in cash used in financing activities was primarily driven by cash received in 2022 in connection with borrowings under our term loan of $50.0 million associated with the credit agreement, as well as an $8.6 million increase in payments for taxes in connection with the exercise and/or vesting of stock-based awards. These items were partially offset by an increase in customer funds obligations of $17.0 million in 2023 primarily due to timing differences between receipt of funds from customers and taxing jurisdiction withdrawals of these funds.

Sources of Credit

As of December 31, 2023, we had a $200.0 million line of credit (the “Line of Credit”) and a $50.0 million term loan (the “Term Loan”) in connection with the third amendment to the credit agreement.

The Term Loan requires quarterly principal payments over five years, with a balloon payment due on March 8, 2027. The interest rate on the Term Loan was 6.46% at December 31, 2023 as we selected the Secured Overnight Financing Rate (“SOFR”) option (the “SOFR Option”). Outstanding borrowings under the Term Loan were $46.9 million at December 31, 2023.

The Line of Credit expires in March 2027. We are required to pay a quarterly fee on the difference between the $200.0 million allowed maximum borrowings and the unpaid principal balance outstanding under the line at the applicable rate. At December 31, 2023, the base rate option and the SOFR Option applicable to the Line of Credit were 8.50% and 6.48%, respectively. There were no outstanding borrowings under the Line of Credit at December 31, 2023.

Outstanding borrowings under the credit agreement are collateralized by nearly all of the assets of the Company and contain financial and operating covenants. The Company was in compliance with these covenants at December 31, 2023. The credit agreement also limits the declaration or payment of certain dividends, not to exceed an aggregate of $2.0 million.

For more information on our indebtedness refer to Note 10 to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K.

Material Future Cash Obligations and Commercial Commitments

Cash Requirements. We believe that our existing cash resources and our Line of Credit will be sufficient to meet our capital requirements and fund our operations for the next 12 months as well as our longer-term liquidity needs.

Also, we expect to have access to additional sources of funds in the capital markets, and we may, from time to time, seek additional capital through a combination of additional debt and/or equity financings. If we were to raise additional funds by issuing equity securities, our stockholders may experience dilution. Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. Any debt financing or additional equity that we raise may contain terms that are not favorable to us or our stockholders. Additional financing may not be available at all, or in amounts or on terms unacceptable to us.

Funds Held for Customers and Customer Funds Obligations. We maintain trust accounts with financial institutions, to accumulate cash from our customers that outsource their tax remittance functions to us. We have legal ownership over the accounts utilized for this purpose. Funds held for customers represent cash and cash equivalents that, based upon our intent, are restricted solely for satisfying the obligations to remit funds relating to our tax remittance services. Funds held for customers are not commingled with our operating funds. Customer funds obligations represent our contractual obligations to remit collected funds to satisfy customer tax payments. Customer funds obligations are reported as a current liability on our consolidated balance sheets as the obligations are expected to be settled within one year. Cash flows related to changes in customer funds obligations are presented as cash flows from financing activities.

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Contractual Obligations and Commitments. Our contractual obligations and commitments as of December 31, 2023 are summarized in the table below:

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Key Business Metrics

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We regularly review the metrics identified below to evaluate growth trends, measure our performance, formulate financial projections and make strategic decisions.

Annual Recurring Revenue (“ARR”) and Average Annual Revenue Per Customer (“AARPC”).

We derive the vast majority of our revenue from recurring software subscriptions. We believe ARR provides us with visibility to our projected software subscription revenue in order to evaluate the health of our business. Because we recognize subscription revenue ratably, we believe investors can use ARR to measure our expansion of existing customer revenues, new customer activity, and as an indicator of future software subscription revenues. ARR is based on monthly recurring revenue (“MRR”) from software subscriptions for the most recent month at period end, multiplied by twelve. MRR is calculated by dividing the software subscription price, inclusive of discounts, by the number of subscription covered months. MRR only includes customers with MRR at the end of the last month of the measurement period.

AARPC represents average annual revenue per customer and is calculated by dividing ARR by the number of software subscription customers at the end of the respective period:

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ARR increased by $81.4 million or 18.9% in 2023 as compared to 2022. The increase was primarily driven by $23.7 million of growth in revenues from subscriptions of our tax solutions to new customers, and $57.7 million of growth in revenues from existing customers through their expanded use of our solutions as well as price increases.

We had 4,310 customers and AARPC was approximately $118,910 at December 31, 2023. We had 4,289 customers and approximately $100,500 of AARPC at December 31, 2022. The increase in customers and AARPC was due to expansion of usage by existing customers and adding new customers through organic growth.

Net Revenue Retention Rate (“NRR”).

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We believe that our NRR provides insight into our ability to retain and grow revenue from our customers, as well as their potential long-term value to us. We also believe it demonstrates to investors our ability to expand existing customer revenues, which is one of our key growth strategies. Our NRR refers to the ARR expansion during the 12 months of a reporting period for all customers who were part of our customer base at the beginning of the reporting period. Our NRR calculation takes into account any revenue lost from departing customers or customers who have downgraded or reduced

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usage, as well as any revenue expansion from migrations, new licenses for additional products or contractual and usage-based price changes.

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The 300 basis point increase in NRR to 113% at December 31, 2023 from 110% for the same period in 2022 was primarily attributable to an increase in customer cross-sell and additional entitlements.

Gross Revenue Retention Rate (“GRR”).

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We believe our GRR provides insight into and demonstrates to investors our ability to retain revenues from our existing customers. Our GRR refers to how much of our MRR we retain each month after reduction for the effects of revenues lost from departing customers or those who have downgraded or reduced usage. GRR does not take into account revenue expansion from migrations, new licenses for additional products or contractual and usage-based price changes. GRR does not include revenue reductions resulting from cancellations of customer subscriptions that are replaced by new subscriptions associated with customer migrations to a newer version of the related software solution.

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The 100 basis point decline in GRR to 95% at December 31, 2023 from 96% for the same period in 2022 was primarily attributable to an increase in customer attrition due in part to a change in customer’s filing requirements where they no longer required Vertex products. GRR has historically been in the 94-96% range.

Adjusted EBITDA and Adjusted EBITDA Margin.

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We believe that Adjusted EBITDA is a measure widely used by securities analysts and investors to evaluate the financial performance of our company and other companies. We believe that Adjusted EBITDA and Adjusted EBITDA margin are useful as supplemental measures to evaluate our overall operating performance as they measure business performance focusing on cash related charges and because they are important metrics to lenders under our credit agreement. We define Adjusted EBITDA as net income or loss before interest (including adjustments to the settlement value of deferred purchase commitment liabilities), taxes, depreciation, and amortization, as adjusted to exclude charges for asset impairments, stock-based compensation expense, amortization of cloud computing arrangement implementation costs, severance expense, acquisition contingent consideration, litigation settlements, and transaction costs. Adjusted EBITDA margin represents Adjusted EBITDA divided by total revenues for the same period. For purposes of comparison, our net loss was ($13.1) million and ($12.3) million in 2023 and 2022, respectively, while our net loss margin was (2.3)% and (2.5)% over the same periods, respectively. The following schedules reconcile Adjusted EBITDA and Adjusted EBITDA margin to net loss, the most closely directly comparable GAAP financial measure.

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The increase in Adjusted EBITDA of $22.2 million in 2023 was primarily driven by an increase of $60.4 million in non-GAAP gross profit, offset by increases in various non-GAAP operating expense categories including $13.9 million in non-GAAP selling and marketing expense, $12.3 million in non-GAAP general and administrative expense, and $12.1 million in non-GAAP research and development expense. Increased investment in selling and marketing expense was driven by increased expenses associated with the growth in period over period subscription sales and services revenue, and expansion of our partner and channel management programs. In addition, there was increased advertising and promotional spending and brand awareness efforts. Increased general and administrative expense was driven by planned strategic investments in information technology infrastructure, business process reengineering, and other initiatives to drive future operating leverage, as well as investments in employees, systems, and resources in support of our growth and compliance requirements associated with being a public company. Transaction costs were comprised of $4.9 million related to costs associated with our public tender offer, which occurred on December 13, 2023, and was later withdrawn on January 14, 2024 (see Note 3 to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K).

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Adjusted EBITDA margin increased in 2023 by 160 basis points in comparison to 2022 primarily due to increased non-GAAP gross margin from our software subscriptions revenue partially offset by increased operating expenses driven by our previously noted investments to enable future growth.

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Free Cash Flow and Free Cash Flow Margin.

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We use free cash flow as a critical measure in the evaluation of liquidity in conjunction with related GAAP amounts. We also use this measure when considering available cash, including for decision-making purposes related to dividends and discretionary investments. We consider free cash flow to be an important measure for investors because it measures the amount of cash we generate from our operations after our capital expenditures and capitalization of software development costs. In addition, we base certain of our forward-looking estimates and budgets on free cash flow and free cash flow margin. We define free cash flow as the total of net cash provided by operating activities less purchases of property and equipment and capitalized software. We define free cash flow margin as free cash flow divided by total revenues for the same period.

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Our net cash provided by operating activities was $74.3 million and $63.8 million in 2023 and 2022, respectively, while our operating cash flow margin was 13.0% and 13.0% over the same periods, respectively. The following schedule reconciles free cash flow and free cash flow margin to net cash provided by operating activities, the most closely directly comparable GAAP financial measure.

Free cash flow increased by $2.7 million in 2023 compared to 2022, driven primarily by a net increase of $10.5 million in cash provided by operating activities, partially offset by a year-over-year increase in investments in commercial solutions supporting our customers and infrastructure investments to drive operating leverage. Free cash flow margin increased in 2023 by 400 basis points compared to 2022.

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Use and Reconciliation of Non-GAAP Financial Measures

In addition to our results determined in accordance with GAAP, we have calculated Adjusted EBITDA, Adjusted EBITDA margin, free cash flow, free cash flow margin, non-GAAP cost of revenues, non-GAAP gross profit, non-GAAP gross margin, non-GAAP research and development expense, non-GAAP selling and marketing expense, non-GAAP general and administrative expense, non-GAAP operating income, and non-GAAP net income, which are each non-GAAP financial measures. We have provided tabular reconciliations of each of these non-GAAP financial measures to its most directly comparable GAAP financial measure.

We use these non-GAAP financial measures to understand and compare operating results across accounting periods, for internal budgeting and forecasting purposes, and to evaluate financial performance. We use non-GAAP financial measures of free cash flow and free cash flow margin to evaluate liquidity. Our non-GAAP financial measures are presented as supplemental disclosure as we believe they provide useful information to investors and others in understanding and evaluating our results, prospects, and liquidity period-over-period without the impact of certain items that do not directly correlate to our operating performance and that may vary significantly from period to period for reasons unrelated to our operating performance, as well as comparing our financial results to those of other companies. Our definitions of these non-GAAP financial measures may differ from similarly titled measures presented by other companies, and therefore, comparability may be limited. In addition, other companies may not publish these or similar metrics. Thus, our non-GAAP financial measures should be considered in addition to, not as a substitute for, or in isolation from, the financial information prepared in accordance with GAAP financial measures, and should be read in conjunction with the consolidated financial statements included in this Annual Report on Form 10-K.

Additional Non-GAAP Financial Measures

In addition to Adjusted EBITDA, Adjusted EBITDA margin, free cash flow, and free cash flow margin calculated and discussed in “Key Business Metrics,” the following additional non-GAAP financial measures are calculated and presented further below:

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We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure and to view these non-GAAP financial measures in conjunction with the related GAAP financial measures.

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The following schedules reflect our additional non-GAAP financial measures and reconciles our additional non-GAAP financial measures to the related GAAP financial measures.

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Critical Accounting Estimates

The preparation of these consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the reporting periods. These estimates, assumptions and judgments are necessary because future events and their effects on our consolidated financial statements cannot be determined with certainty and are made based on our historical experience and on other assumptions that we believe to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. Because the use of estimates is inherent in the financial reporting process, actual results could materially differ from those estimates.

The estimates discussed below are considered by management to be critical to an understanding of our consolidated financial statements because their application places the most significant demands on management’s judgment. Specific risks for these critical accounting estimates are described in the following sections. For all of these estimates, we caution that future events rarely develop exactly as forecast, and such estimates routinely require adjustment. We have reviewed these critical accounting estimates and related disclosures with our Audit Committee.

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Our discussion of critical accounting estimates is intended to supplement, not duplicate, our summary of significant accounting policies so that readers will have greater insight into the uncertainties involved in applying our critical accounting policies and estimates. For a summary of our significant accounting policies, see Note 1 to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K.

Revenue Recognition

We account for our revenue in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers, which requires judgment and the use of estimates. Revenue is recognized upon transfer of control of promised goods or services to customers in an amount that reflects the consideration expected to be received in exchange for those products or services. Our most critical judgments required in applying ASC 606 relate to the identification of performance obligations.

Identification of the Performance Obligations

We enter into contracts with customers that may include promises to transfer various combinations of software subscriptions and services. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. Software subscriptions include the related software, consisting of both on-premise and cloud-based software, tax content updates, and product support. The updates and support, which are part of the subscription agreement, are essential to the continued utility of the software. Therefore, we have determined that the software, updates, and support should be combined into a single performance obligation.

Income taxes

We estimate our income taxes based on the various jurisdictions where we conduct business. Significant judgment is required in determining our worldwide income tax provision.  In foreign jurisdictions, our subsidiaries are generally taxed at the corporate level, and the income tax provision or benefit is based on income or loss sourced to these foreign jurisdictions at the tax rates applicable in those jurisdictions.

We account for income taxes using the asset and liability method resulting in the recognition of deferred tax assets and liabilities for future tax consequences of events that have been previously recognized in the Company’s consolidated financial statements or tax returns. The measurement of deferred tax assets and liabilities is based on provisions of the enacted tax law and rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled, the determination of which requires management judgement and which could result in a different result should our expectations of the recovery or settlement timing differ from the actual events. The effect of a change in tax laws or rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. The effects of future changes in tax laws or rates are not anticipated. A valuation allowance is recorded when management determines it is more likely than not that some or all of the deferred tax assets will not be realized. We record uncertain tax positions in accordance with ASC 740, Income Taxes, on the basis of a two-step process requiring judgement whereby: (i) we determine whether it is more likely than not that the tax positions will be sustained based on the technical merits of the position, and (ii) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with the related tax authority. We record interest related to underpayment of income taxes as interest expense and penalties as other operating expenses in the consolidated statements of comprehensive loss.

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The impact as a result of the application of ASC 740 is reflected in the consolidated financial statements. We assess our income tax positions and record tax benefits or expense based upon our evaluation of the facts, circumstances, and information available at the reporting date. Variations in the actual outcome of these future tax consequences could materially impact the consolidated financial statements.

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Recent Accounting Pronouncements

A discussion of recent accounting pronouncements is included in Note 1 to our consolidated financial statements beginning on page F-1 of this Annual Report on Form 10-K.

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