SOLARWINDS, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the "Selected Consolidated Financial Data" and our consolidated financial statements and related notes included elsewhere in this report. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially and adversely from those anticipated in the forward-looking statements. See the "Safe Harbor Cautionary Statement" above for a discussion of the uncertainties, risks and assumptions associated with these statements.

Overview We design, develop, market, sell and support powerful yet easy-to-use enterprise IT infrastructure management software to IT professionals in organizations of all sizes. Our offerings range from individual software tools to more comprehensive software products that solve problems faced every day by IT professionals and help to enable efficient and effective management of their infrastructure, including networks, applications, storage and physical and virtual servers. All of our products are ready-to-use, featuring intuitive and easily customized user interfaces and built-in workflows. Our products can be downloaded directly from our websites and installed and configured by our end-users in a matter of hours. Our customers include small- and mid-size businesses, enterprises, and local, state and federal government entities that have purchased our products.

We made a number of strategic investments in our business during 2011 that we believe are important to our long-term growth. Through our product launches and strategic acquisitions we entered into several new markets including the system and application market, virtualization management market and the log and event management market. We continued to focus on increasing our presence in several geographic markets including Asian-Pacific, Latin America, Europe, Middle East and Africa. We increased our presence in the Asian-Pacific market by establishing new relationships with several distributors and reseller partners in Japan and establishing our Asian-Pacific headquarters in Brisbane. We also began the process of localizing certain products with country-specific product documentation, websites and marketing material. Despite these investments and many others, we have continued to grow revenue and increase our cash flow from operations.

In the coming year, we plan to continue to focus on growth opportunities in the IT infrastructure management market while expanding our customer base and brand awareness in the network, application, storage resource, virtualization and log and event management markets. We believe our market penetration is low in all geographic and end user markets in which we sell products; therefore, our focus will continue to be on expanding partner relationships, localized web presence and products in various key international markets. Specifically, we intend to continue to expand in Brazil, Japan, China and Germany. In the new markets we have entered, we will continue our strategy of delivering powerful, easy to use and affordable software along with leveraging the web as the primary method to reach potential customers. We will continue to look for acquisitions similar to those we have completed over the last year to supplement our internal product development efforts.

Key Financial Highlights Key financial highlights for 2011 include the following: • Total revenue was $198.4 million for 2011 compared to $152.4 million for 2010, or an increase of 30%; • Net income was $62.4 million compared to $44.7 million for 2010, or an increase of 40%; • Net income was $0.84 per share on a fully diluted basis for 2011 compared to $0.61 per share on a fully diluted basis for 2010; and • Cash flow from operations was $111.4 million for 2011 compared to $66.0 million for 2010, or an increase of 69%.

28 -------------------------------------------------------------------------------- Table of Contents Acquisitions We have made multiple acquisitions of businesses as part of our growth strategy.

Each of these acquisitions has been accounted for using the acquisition method of accounting. Accordingly, the financial results for these entities have been included in our consolidated financial results since the applicable acquisition dates. The more recent acquisitions are as follows: • In January 2011, we acquired Hyper9, Inc., or Hyper9, for approximately $23.0 million in cash and contingent consideration ranging from $0 to $7.0 million based on sales milestones for the one year period after the closing of the acquisition. Hyper9 increased our product offerings to include virtualization management software and eliminated the normal time to market required to develop a new software product.

• In July 2011, we acquired TriGeo Network Security, Inc., or TriGeo, for approximately $35.5 million in cash. By acquiring TriGeo, we increased our product offerings to include log and event management software.

• In October 2011, we acquired DNS Enterprise, Inc., or DNS, a provider of free tools and inexpensive subscription-based tools used by a community of system administrators, application administrators, network engineers and IT professionals. We do not believe this acquisition will have a material impact on our consolidated financial statements.

• In December 2011, we acquired certain assets of privately-held DameWare Development LLC, or DameWare, for $40.0 million in cash. DameWare increased our product offerings to include remote system management and administration software tools.

For further information regarding these acquisitions, see Note 2, Acquisitions, in the Notes to Consolidated Financial Statements in Item 15 of Part IV of this Annual Report on Form 10-K.

Key Business Metrics We review a number of key business metrics to help us monitor the performance of our business model and to identify trends affecting our business. The measures that we believe are the primary indicators of our quarterly and annual performance are as follows: Revenue Growth We have employed a differentiated business model for marketing and selling high volumes of enterprise-class software, which is focused on rapid revenue growth at high operating margins. We regularly review our total revenue growth to measure our success. We have built a pricing model for our products that aims to maximize our recurring revenue and the value of a customer over time and not upfront license revenue. This is an important component of our financial model.

This model is based on the premise that we will be able to deliver ongoing value to our customers and maintain a long-term financial relationship with the users of our core enterprise-class IT management products. Our annual revenue growth percentages were 30.2%, 30.9% and 25.0% for the years ended December 31, 2011, 2010 and 2009, respectively.

Core Product Transaction Growth for New License Sales.

We focus our sales, marketing and research and development efforts on IT professionals in organizations of all sizes, with the goal of driving purchases of our software by these IT professionals in short sales cycles. In addition, many of our customers make small initial purchases of our software to manage specific components of their infrastructures and, then, make additional purchases over time to expand the use of the product that they purchased or to buy additional software products from us. We review the core product transaction growth to ensure the effectiveness of our marketing and sales model.

29-------------------------------------------------------------------------------- Table of Contents We define our core product transactions as the number of new license sales transactions that include at least one of our core products. We define a transaction as each invoice issued for the sale of one or more of our products.

If none of our core products is included in a particular transaction, then that transaction is not a core product transaction. While our transactional products are important by creating broad awareness which may influence the purchase of our core products, the new license sales of core products represented more than 90% of our license revenue for 2011. Accordingly, we believe that management can better evaluate changes in our product portfolio, expansion into new markets and the addition of new customers by evaluating the transactional growth of our core products. Our core product transaction growth for new license sales was 30.9%, 24.7% and 6.2% for the years ended December 31, 2011, 2010 and 2009, respectively.

Non-GAAP Operating Income Our management uses non-GAAP operating income to measure our performance.

Because non-GAAP operating income excludes certain non-cash expenses including amortization, stock-based compensation and certain expenses that may not be indicative of our core business, we believe that this measure provides us with additional useful information to measure and understand our performance, particularly with respect to changes in performance from period to period. We use non-GAAP operating income in the preparation of our budgets and to measure and monitor our performance. Non-GAAP operating income is not determined in accordance with GAAP and is not a substitute for, or superior to, financial measures determined in accordance with GAAP.

Free Cash Flow We believe free cash flow is an important liquidity measure that reflects the cash generated by the business after the purchase of property and equipment that can then be used for, among other things, strategic acquisitions and investments in the business, stock repurchases and funding ongoing operations. We regularly review our free cash flow generation to measure our effectiveness at running our operations efficiently and in a manner that maximizes the value of our customers. We define free cash flow as cash flows from operating activities plus the excess tax benefit from stock-based compensation and less the purchase of property and equipment. Free cash flow does not represent the total increase or decrease in the cash balance for the period, is not determined in accordance with GAAP and is not a substitute for, or superior to, financial measures determined in accordance with GAAP.

For further discussion regarding non-GAAP financial measures including non-GAAP operating income and free cash flow, see "Non-GAAP Financial Measures" below.

Opportunities and Trends Businesses, governments and other organizations are increasingly relying on data networks and IT infrastructures to execute their operations, facilitate their internal and external communications and transact business with their customers and partners. The size of these networks, the number of applications and servers, and the complexity of physical and virtual server environments are increasing as organizations place more reliance on them. We believe that the increasing challenges of IT infrastructure management and the limitations of existing offerings present a market opportunity for our products. In addition to the network management products that we have offered since 2001, we also offer products that we have developed or acquired and we believe these products allow us to compete effectively in the adjacent markets of systems and application, storage resource, virtualization and log and event management. We expect our revenue to continue to grow as we capitalize on these and other market opportunities. While we feel that we have integrated or begun to integrate our acquired businesses successfully, any revenue growth and operating synergies of our acquired products may be lower than expected if we are unable to do so in the future.

In 2011, we recognized 23.7% of our revenue from sales by our international subsidiaries. We believe there is a substantial opportunity for additional sales of our software in the Europe, Middle East and Africa region 30-------------------------------------------------------------------------------- Table of Contents ("EMEA") and the Asian-Pacific region, and we intend to increase our sales, marketing and support operations in these regions. However, we believe there is significant uncertainty regarding the economic conditions in certain of these geographic regions, particularly in parts of Europe. We believe that any difficult economic conditions may adversely affect the sales of our products, but could offer us an opportunity to market and sell our products to mid-size businesses and enterprise customers at compelling prices compared to the prices of many competing products.

We expect the U.S. federal government to continue to be a significant market opportunity, as we believe the ease of deployment, power and scalability of our products gives us an enhanced opportunity to sell to various agencies and departments of the U.S. federal government. The U.S. federal government new license sales were 12.8% of our total new licenses sales in 2011. We have experienced and continue to expect inconsistency in the buying pattern of the U.S. federal government for larger transactions with our products. Our sales, both new licenses and maintenance renewals, to the U.S. federal government are largely dependent on systems integrators, distributors and resellers whose purchases from us have been difficult to predict. In addition, we believe that many of our larger transactions with the U.S. federal government are dependent on specific projects that may or may not be continued at the same scale in the future due to budgetary cuts or other reasons, and the reduction or cancellation of specific projects such as these may change the buying patterns of the U.S.

federal government and could result in our sales to the U.S. government being less than expected.

Key Components of Our Results of Operations Sources of Revenue Our revenue is primarily comprised of license and maintenance revenue. We license our software under perpetual licenses, which ordinarily includes one year of maintenance as part of the initial purchase price of the product.

License revenue reflects the revenue recognized from sales of new licenses and upgrades to our software. We have experienced annual growth in license revenue.

Customers can renew, and generally have renewed, their maintenance agreements at our standard list maintenance renewal pricing for their software products.

Current customers with maintenance agreements are entitled to receive unspecified upgrades or enhancements when and if they become available.

Maintenance revenue is an important source of our future revenue. We have experienced strong and consistent annual and quarterly growth in maintenance and other revenue. Because our maintenance base grew during 2009, 2010 and 2011 due to new license sales and high customer retention and acquisitions, we expect maintenance revenue to continue to increase in future periods.

Cost of Revenue Cost of revenue primarily consists of personnel costs related to providing technical support services and amortization of acquired developed product technologies and third party software licenses. Personnel costs include salaries, bonuses and stock-based compensation and related employer-paid payroll taxes for technical support personnel, as well as an allocation of our facilities, information technology and other overhead costs and our employee benefit costs. We allocate stock-based compensation expense and related employer-paid payroll taxes to personnel costs based on the expense category in which the option or restricted stock unit holder works. We allocate overhead, such as rent, computer and other technology costs, and employee benefit costs to personnel costs in each expense category based on worldwide headcount in that category. We expect our cost of revenue to increase in absolute dollars and to fluctuate as a percentage of revenue as we acquire additional companies and integrate the businesses.

Operating Expenses We classify our operating expenses into four categories: sales and marketing, research and development and general and administrative and accrued earnout (gain) loss.

31 -------------------------------------------------------------------------------- Table of Contents Our operating expenses primarily consist of personnel costs, contract research and development costs, marketing program costs and legal, accounting, consulting and other professional service fees. Personnel costs for each category of operating expenses primarily include employee compensation costs and facility overhead costs.

Our operating expenses increased in absolute dollars and decreased as a percentage of revenue in 2011 compared to 2010 and 2009, as we have continued to build infrastructure and add employees through acquisitions and internal growth across all departments in order to accelerate and support our growth. The number of full-time employees as of December 31, 2011, was 628, as compared to 458, as of December 31, 2010 and 353 as of December 31, 2009. We will continue to make investments in our business by expanding our direct inside sales force domestically and internationally, increasing our marketing operations and programs and adding research and development personnel worldwide which will increase our operating expenses. We expect our operating expenses in future periods to continue to increase in absolute dollars and to fluctuate as a percentage of revenue as we acquire additional companies and integrate the businesses.

Sales and Marketing. Sales and marketing expenses primarily consist of personnel costs for our sales, marketing and business development employees and executives, commissions earned by our sales personnel, the cost of marketing programs such as paid search, search engine optimization and management, trade shows, webinars and the cost of business development programs. We expect to continue to hire sales personnel in the United States and in our international sales offices. In 2011, we completed the expansion of our sales offices in Singapore and Australia which has resulted in and will result in an increase in facilities and personnel costs. We also expect to continue to invest in our website, online user community site and marketing programs to drive customer downloads and support our new product launches.

Research and Development. Research and development expenses primarily consist of personnel costs for our product development employees and executives. We have devoted our development efforts primarily to expanding our product line and increasing the functionality and enhancing the ease-of-use of our software products. Since establishing our research and development center in the Czech Republic and as a result of our acquisitions, we have significantly increased our research and development employee headcount. As part of our acquisitions, we increased research and development personnel in India and the United States. We expect to continue to invest in our research and development activities by hiring engineers in the United States and in our international locations. In 2011, we completed the expansion of our development center in India which has resulted in and will result in an increase in facilities and personnel costs.

This expansion will allow us to continue our research and development growth strategy internationally.

General and Administrative. General and administrative expenses primarily consist of personnel costs for our executive, finance, legal, human resources and administrative personnel, as well as legal, accounting and other professional service fees and other corporate expenses. We expect to incur higher administrative costs in future periods as our business continues to grow both organically and through acquisitions. In addition, we intend to continue to grant equity awards to our current executives and employees and those who join us in the future through acquisitions or otherwise, which will result in additional stock-based compensation expense.

Accrued Earnout (Gain) Loss. Accrued earnout (gain) loss represents the change in the fair value of the contingent consideration obligation recorded on the acquisition date due to subsequent adjustments in the probability assumptions with respect to the likelihood of achieving the earnout criteria.

Other Income (Expense) Other income (expense) primarily consists of interest income, interest expense, foreign exchange gains (losses), government grant income and acquisition related contingent consideration fair value adjustments due to the passage of time.

Interest income represents interest received on our cash, cash equivalents and short-term investments, net of amortization of prepaid interest. Interest expense in 2010 was associated with our outstanding 32-------------------------------------------------------------------------------- Table of Contents long-term debt which was paid in full in May 2010. Foreign exchange gains (losses) relate to expenses and billing transactions denominated in currencies other than the functional currency of the associated subsidiary. Government grant income is primarily related to grants received by our Czech Republic entity for the creation of job positions and related training costs.

Income Tax Expense Income tax expense primarily consists of corporate income taxes related to profits resulting from the sale of our software offerings by our United States and Irish entities. The rate of taxation on income earned by our United States entity is higher than the rate of taxation on income earned by our Irish entity.

If our international income, as a percentage of total income, increases as we expect, then our effective income tax rate should correspondingly decline.

However, our effective tax rate may be affected by many other factors, such as changes in tax laws, regulations or rates, new interpretations of existing laws or regulations, the impact of accounting for stock-based compensation, the impact of accounting for business combinations, changes in our international structure, shifts in the amount of taxable income earned in the United States, as compared with other regions in the world, and changes in overall levels of income before tax.

We benefit from the tax credit incentives under the U.S. research and experimentation tax credit extended to taxpayers engaged in qualified research and experimental activities while carrying on a trade or business. The tax credit expired on December 31, 2011, and if not renewed under similar terms as in prior years, the result could have a material impact on our financial results. In 2011 and 2010, we received a benefit to our income tax expense from these research and development tax credits of $2.0 million and $3.0 million, respectively.

Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with United States of America generally accepted accounting principles, or GAAP, and require our management to make estimates and assumptions that affect the reported amounts and disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances; however, actual results could differ from those estimates. We believe certain accounting policies requiring significant management judgment are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management's judgment and estimates. These critical accounting policies include valuation of goodwill, intangibles, long-lived assets and contingent consideration, revenue recognition, stock-based compensation and income taxes.

Acquisitions, Goodwill and Identifiable Intangible Assets. When we acquire businesses, we allocate the purchase price to tangible assets and liabilities and identifiable intangible assets acquired. Any residual purchase price is recorded as goodwill. We must also estimate the fair value of any contingent consideration. The operating results of acquisitions are included in our consolidated financial statements from the effective date of the acquisition.

The fair value of identifiable intangible assets is based on significant judgments made by management. We typically engage third party valuation appraisal firms to assist us in determining the fair values and useful lives of the assets acquired. Such valuations and useful life determinations require us to make significant estimates and assumptions. These estimates and assumptions are based on historical experience and information obtained from management, and also include, but are not limited to, future expected cash flows earned from the intangible asset and discount rates applied in determining the present value of those cash flows. Unanticipated events and circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results.

The acquired developed product technologies recorded for each acquisition were feasible at the date of acquisition as they were being actively marketed and sold by the acquired company at the acquisition date. In addition to the acquired developed product technologies, we also record intangible assets for the acquired company's customer relationships, trademarks and non-competition covenants.

33 -------------------------------------------------------------------------------- Table of Contents An impairment of goodwill or indefinite lived intangible assets is recognized when the carrying amount of the assets exceeds their fair value. The process of evaluating the potential impairment is highly subjective and requires the application of significant judgment. For purposes of the annual impairment test, we consider our market capitalization compared with the carrying amount of our net assets on the date of the test, since we have only one reporting unit. If an event occurs that would cause us to revise our estimates and assumptions used in analyzing the value of our goodwill and other intangible assets with indefinite lives, the revision could result in a non-cash impairment charge that could have a material impact on our financial results. As of December 31, 2011 and 2010, we performed our annual review of goodwill and indefinite lived intangible assets and concluded that no impairment existed for our reporting unit during any of the periods presented. No impairment charges have been required to date.

We evaluate long-lived assets, including identifiable intangible assets and other assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends. If an event occurs that would cause us to revise our estimates and assumptions used in analyzing the value of our property and equipment or our finite-lived intangibles and other assets, that revision could result in a non-cash impairment charge that could have a material impact on our financial results. As of December 31, 2011 and 2010, there were no indicators that our long-lived assets were impaired.

Contingent Consideration. Our acquisitions may include contingent consideration payments based on future sales or product milestones of an acquired entity. We estimate the fair value of contingent consideration liabilities based on certain milestones of the acquired companies and estimated probabilities of achievement and discount the liabilities to present value using a weighted-average cost of capital. We believe our estimates and assumptions are reasonable, however, there is significant judgment involved. Changes in the fair value of contingent consideration liabilities may result from changes in discount periods, changes in the timing and amount of sales and/or other specific milestone estimates and changes in probability assumptions with respect to the likelihood of achieving the various earnout criteria. At each reporting date, the contingent consideration liability is revalued to estimated fair value and changes in fair value subsequent to the acquisitions are reflected in net income in the consolidated statements of income and could cause a material impact to, and volatility in, our operating results.

Revenue Recognition We derive substantially all of our revenue from the licensing of our software products and from the sale of maintenance agreements. We typically include one year of maintenance as part of the initial purchase price of each software offering and then sell renewals of this maintenance agreement. In accordance with current guidance, we recognize revenue for software, maintenance and other services when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is probable. Our return policy generally does not allow our customers to return software offerings.

License Revenue. We consider delivery of our software to have occurred and recognize revenue from the sale of perpetual licenses to our software when risk of loss transfers to the customer or reseller, which is generally upon electronic transfer of the license key that provides immediate availability of the product to the purchaser.

We sell licenses to our software products through our direct inside sales force and through our distributors and other resellers. Our distributors and resellers do not carry inventory of our software and we generally require them to specify the end-user of the software at the time of the order. If the distributor or reseller does not provide end-user information, then we will generally not fulfill the order. Our distributors and resellers have no rights of return or exchange for software that they purchase from us and payment for these purchases is due to us without regard to whether the distributors or resellers collect payment from their customers.

34-------------------------------------------------------------------------------- Table of Contents Because our software is generally sold with maintenance, we calculate the amount of revenue allocated to the software license by determining the fair value of the maintenance and subtracting it from the total invoice or contract amount. We establish vendor-specific objective evidence, or VSOE, of the fair value of maintenance services by the standard published list pricing for our maintenance renewals since we generally charge list prices for our maintenance renewals. If in the future we were unable to establish VSOE of fair value of the maintenance or other services we would defer all revenue over the term of the agreement and until all elements of the agreement had been delivered which could significantly impact the timing of our revenue recognition.

Maintenance and Other Revenue. We derive maintenance revenue from fees for software maintenance services which includes the maintenance portion allocated from the initial license transaction and any subsequent maintenance renewal transactions. We generally bill maintenance renewal agreements annually in advance for services to be performed over a 12-month period. Customers have the option to purchase maintenance renewals for periods longer than 12 months. We initially record the amounts to be paid under maintenance agreements as deferred revenue and recognize these amounts ratably on a daily basis over the term of the maintenance agreement. Customers with maintenance agreements are entitled to receive unspecified upgrades or enhancements to new versions of their software products on a when-and-if-available basis.

Other revenue consists primarily of training, consulting, subscription and product development services, which is recognized upon delivery of the training or consulting services to the end customer or when the development work is performed. We establish VSOE of fair value for training through the standard rates we charge for training when sold separately. Other revenue is not currently significant nor do we expect it to be significant in future periods.

Stock-Based Compensation We have granted and expect to continue to grant our employees and directors stock-based incentive awards. These awards are in the form of stock options, restricted stock and restricted stock units. We measure stock-based compensation expense for all share-based awards granted based on the estimated fair value of those awards on the date of grant. The fair values of stock option awards are estimated using a Black-Scholes valuation model.

We use various assumptions in estimating the fair value of options at the date of grant using the Black-Scholes option model including expected dividend yield, volatility, risk-free rate of return and expected life. We have not paid and do not anticipate paying cash dividends on our common stock; therefore, we assume the expected dividend yield to be zero. Since we were a private entity prior to our IPO in May 2009 with no historical data regarding the volatility of our own common stock price, we based the expected volatility on the historical and implied volatility of comparable companies from a representative industry peer group. We determined expected volatility of options granted using an average of the historical volatility measures of this peer group of companies. We based the risk-free rate of return on the average U.S. treasury yield curve for five- and seven-year terms. As allowed under current guidance, we have elected to apply the "simplified method" in developing our estimate of expected life for "plain vanilla" stock options by using the midpoint between the vesting date and contractual termination date since we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time our common stock has been publicly traded. For all dates, we granted employees options at exercise prices equal to the fair value of the underlying common stock at the time of grant, which is the closing price of our common stock as reported by the NYSE.

Income Taxes We use the liability method of accounting for income taxes as set forth in the authoritative guidance for accounting for income taxes. Under this method, we recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the respective carrying amounts and tax basis of our assets and liabilities.

35-------------------------------------------------------------------------------- Table of Contents The guidance on accounting for uncertainty in income taxes prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. At December 31, 2011 and 2010, we had $4.0 million and $1.4 million of gross unrecognized tax benefits, respectively, all of which, if recognized, would affect our effective tax rate.

We accrue interest and penalties related to unrecognized tax benefits as a component of income tax expense. As of December 31, 2011 and 2010, there was an insignificant amount accrued for interest and penalties related to unrecognized tax benefits.

In calculating our effective tax rate, we make judgments regarding certain tax positions, including the timing and amount of deductions and allocations of income among various tax jurisdictions.

The guidance requires us to identify, evaluate and measure all uncertain tax positions taken or to be taken on tax returns and to record liabilities for the amount of these positions that may not be sustained, or may only partially be sustained, upon examination by the relevant taxing authorities. Although we believe that our estimates and judgments are reasonable, actual results may differ from these estimates. Some or all of these judgments are subject to review by the taxing authorities.

We establish valuation allowances when necessary to reduce deferred tax assets to the amounts expected to be realized. On a quarterly basis, we evaluate the need for, and the adequacy of, valuation allowances based on the expected realization of our deferred tax assets. The factors used to assess the likelihood of realization include our latest forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets.

We intend either to invest our non-U.S. earnings permanently in foreign operations or to remit these earnings to our U.S. entities in a tax-free manner.

For this reason, we do not record federal income taxes on the undistributed earnings of our foreign subsidiaries.

36-------------------------------------------------------------------------------- Table of Contents Comparison of the Years Ended December 31, 2011 and 2010 Year Ended December 31, % of % of 2011 Revenue 2010 Revenue Change (in thousands) (in thousands) (in thousands) Revenue: License $ 92,254 46.5 % $ 75,603 49.6 % $ 16,651 Maintenance and other 106,104 53.5 76,790 50.4 29,314 Total revenue 198,358 100.0 152,393 100.0 45,965 Cost of revenue 11,989 6.0 7,930 5.2 4,059 Gross profit 186,369 94.0 144,463 94.8 41,906 Operating expenses: Sales and marketing 53,850 27.1 43,252 28.4 10,598 Research and development 21,332 10.8 15,731 10.3 5,601 General and administrative 28,076 14.2 23,476 15.4 4,600 Accrued earnout gain (664 ) (0.3 ) - - (664 ) Total operating expenses 102,594 51.7 82,459 54.1 20,135 Operating income 83,775 42.2 62,004 40.7 21,771 Other income (expense): Interest income 308 0.2 177 0.1 131 Interest expense - - (1,146 ) (0.8 ) 1,146 Other income 720 0.4 115 0.1 605 Total other income (expense) 1,028 0.5 (854 ) (0.6 ) 1,882 Income before income taxes 84,803 42.8 61,150 40.1 23,653 Income tax expense 22,360 11.3 16,404 10.8 5,956 Net income $ 62,443 31.5 % $ 44,746 29.4 % $ 17,697 Revenue Revenue was $198.4 million in the year ended December 31, 2011, compared to $152.4 million in the year ended December 31, 2010, an increase of $46.0 million, or 30.2%. Maintenance and other revenue increased $29.3 million due to a growing maintenance renewal customer base and an increase in new license sales which drives new maintenance revenue. We have maintained high customer retention and our customer base has continued to grow with acquisitions. License revenue increased $16.7 million due to continued growth in new license sales of our network management products and sales of our newly-developed and newly-acquired products such as those in the virtualization and log and event markets.

Our core product transaction growth increased 30.9% in 2011 compared 2010 as a result of our growth in new license sales of our network management products and the release of new stand-alone products and acquired products. As the number of core product transactions fluctuates with changes in the business or product mixes, this also affects our trailing 12-month average transaction size for new license sales. As of December 31, 2011, the trailing 12-month average transaction size for new license sales was approximately $8,600 as compared to approximately $8,300 for the trailing 12-month period as of December 31, 2010, an increase of 3.6%.

New license sales in our global commercial business increased 23.4% and new license sales in our U.S. federal government business increased 21.2% in 2011 as compared to 2010. This growth in both businesses was driven by year-over-year growth in core product transaction volume. We had three transactions in 2011 and two transactions in 2010 with the U.S. federal government that each resulted in license revenue greater than $0.5 million. Our revenue from our foreign subsidiaries was 23.7% and 22.1% of total revenue in 2011 and 2010, respectively.

37 -------------------------------------------------------------------------------- Table of Contents Cost of Revenue Cost of revenue was $12.0 million in 2011 compared to $7.9 million in 2010, an increase of $4.1 million, or 51.2%. Cost of license revenue increased by $2.2 million in 2011 compared to 2010, primarily due to the amortization of acquired product technologies associated with the Hyper9 and TriGeo acquisitions. The increase in cost of revenue was also due to a $1.9 million increase in cost of maintenance revenue related to increased headcount from the acquisition of TriGeo combined with an increase in the headcount in our international organization to support new customers added in 2011, additional product offerings from acquisitions and internal product development.

Operating Expenses Sales and Marketing. Sales and marketing expenses were $53.9 million in 2011 compared to $43.3 million in 2010, an increase of $10.6 million, or 24.5%. We increased the size of our sales management team and marketing personnel to give us the ability to scale our sales effort as we continue to grow and enter new markets. As a result of these expansions efforts, our sales and marketing personnel costs, which include stock-based compensation expense, increased by $9.9 million and consulting and contractor fees increased $0.7 million offset by a decrease of $0.3 million in marketing program costs.

Research and Development. Research and development expenses were $21.3 million in 2011 compared to $15.7 million in 2010, an increase of $5.6 million, or 35.6%. In order to support our product development strategy and the development of new stand-alone, acquired and other products, we continued to increase the size of our Czech Republic research center during 2010 and 2011. We also added research and development personnel in the United States with the acquisition of Hyper9 in January 2011 and TriGeo in July 2011. Due to this growth, our personnel costs, which include stock-based compensation expense, increased by $4.8 million in 2011 compared to 2010. Other costs such as contract services and travel expenses increased by $0.6 million.

General and Administrative. General and administrative expenses were $28.1 million in 2011 compared to $23.5 million in 2010, an increase of $4.6 million, or 19.6%. This $4.6 million increase was primarily due to an increase of $2.1 million in amortization expense related to certain acquired intangible assets, $1.5 million in acquisition related costs and a $0.7 million in professional fees.

Accrued Earnout Gain. We recorded a $0.7 million accrued earnout gain in 2011 due to the change in probability of achieving sales milestones during 2011 related to the Hyper9 accrued earnout. In February 2012, we paid approximately $3.5 million of cash upon the achievement of these sales milestones.

Other Income (Expense) Other income increased by $0.6 million in 2011 as compared to 2010 primarily due to the receipt of payment for the government grant related to job creation and related training costs in our Czech entity. Interest expense in 2011 was $0, decreasing by $1.1 million from 2010, because we paid all of the outstanding principal balance of our credit facilities in 2010.

Income Tax Expense Our income tax expense increased by $6.0 million for the year ended December 31, 2011 as compared to 2010. This increase resulted from an increase in our income before income taxes of $23.7 million when comparing the same periods. Our effective tax rate decreased from 26.8% for the year ended December 31, 2010 compared to 26.4% for the year ended December 31, 2011, which was primarily attributable to an increase in permanent U.S. income tax benefit related to the U.S. domestic production activities deduction and an increase in international earnings, which are generally taxed at lower tax rates.

38-------------------------------------------------------------------------------- Table of Contents Comparison of the Years Ended December 31, 2010 and 2009 Year Ended December 31, % of % of 2010 Revenue 2009 Revenue Change (in thousands) (in thousands) (in thousands) Revenue: License $ 75,603 49.6 % $ 62,378 53.6 % $ 13,225 Maintenance and other 76,790 50.4 54,068 46.4 22,722 Total revenue 152,393 100.0 116,446 100.0 35,947 Cost of revenue 7,930 5.2 4,860 4.2 3,070 Gross profit 144,463 94.8 111,586 95.8 32,877 Operating expenses: Sales and marketing 43,252 28.4 30,548 26.2 12,704 Research and development 15,731 10.3 11,199 9.6 4,532 General and administrative 23,476 15.4 26,038 22.4 (2,562 ) Total operating expenses 82,459 54.1 67,785 58.2 14,674 Operating income 62,004 40.7 43,801 37.6 18,203 Other income (expense): Interest income 177 0.1 267 0.2 (90 ) Interest expense (1,146 ) (0.8 ) (4,253 ) (3.7 ) 3,107 Other income (expense) 115 0.1 90 0.1 25 Total other income (expense) (854 ) (0.6 ) (3,896 ) (3.3 ) 3,042 Income before income taxes 61,150 40.1 39,905 34.3 21,245 Income tax expense 16,404 10.8 10,396 8.9 6,008 Net income $ 44,746 29.4 % $ 29,509 25.3 % $ 15,237 Revenue Revenue was $152.4 million in the year ended December 31, 2010, compared to $116.4 million in the year ended December 31, 2009, an increase of $35.9 million, or 30.9%. This increase was comprised of a $22.7 million increase in maintenance and other revenue, which resulted from a continued growing maintenance base due to new sales, new customers through acquisitions and high customer retention, and a $13.2 million increase in license revenue due to an increase in sales transaction volumes of our core enterprise-class network and IT management products and a 20.3% increase in our trailing 12-month average transaction size for new license sales. Our core product transaction growth increased 24.7% in 2010 compared to 2009. Through the year ended December 31, 2010, the trailing 12-month average transaction size for new license sales was approximately $8,300 as compared to approximately $6,900 for the 12-month period through the year ended December 31, 2009. We believe that the increase in new license sales and our average transaction size for new license sales resulted from better awareness of our products, an increase in the number of products that we sell primarily as a result of our product development and our acquisitions.

New license sales in our commercial business increased 32.3% globally while new license sales in our U.S. federal government business decreased 21.1% in 2010 compared to 2009. The decline in U.S. federal sales was primarily driven by a reduction in the value of orders received from agencies and groups associated with the Department of Defense. We had two transactions in 2010 and six transactions in 2009 with the U.S. federal government that each resulted in license revenue greater than $0.5 million. Our revenue from our foreign subsidiaries was 22.1% and 20.4% of total revenue for the years ended December 31, 2010 and 2009, respectively.

39-------------------------------------------------------------------------------- Table of Contents Cost of Revenue Cost of revenue was $7.9 million in 2010 compared to $4.9 million in 2009, an increase of $3.1 million, or 63.2%. Cost of maintenance revenue increased $1.6 million which was primarily related to increased headcount in our United States, EMEA and Asian-Pacific support organizations to support the new customers we added during 2009 and 2010. Cost of license revenue also increased by $1.4 million in 2010 compared to 2009 primarily due to the amortization of acquired product technologies associated with the Tek-Tools acquisition in January 2010.

Operating Expenses Sales and Marketing. Sales and marketing expenses were $43.3 million in 2010 compared to $30.5 million in 2009, an increase of $12.7 million, or 41.6%. Sales and marketing expenses increased in 2010 due to the expansion of our direct inside sales force in the United States, EMEA and Asian-Pacific region, an increase in marketing operations and program costs in the United States and EMEA and an increase in business development costs as we began to expand our partner relationships. As a result of these efforts, our sales and marketing personnel costs, which include stock-based compensation expense, increased by $8.5 million. Marketing program costs to drive higher levels of web traffic such as paid search, search engine optimization, search engine management, web operating costs and trade shows increased by $3.1 million. Other costs such as professional fees, subscription costs, consulting services and travel expenses increased by $1.1 million.

Research and Development. Research and development expenses were $15.7 million in 2010 compared to $11.2 million in 2009, an increase of $4.5 million, or 40.5%. In order to support our product development strategy, we continued to increase the size of our Czech Republic research center from 2009 to 2010 and also added research and development personnel in Dallas, Texas and Chennai, India in 2010 as a result of the acquisition of Tek-Tools. Due to this growth, our personnel costs, which include stock-based compensation expense, increased by $4.5 million in 2010 compared to 2009.

General and Administrative. General and administrative expenses were $23.5 million in 2010 compared to $26.0 million in 2009, a decrease of $2.6 million, or 9.8%. This decrease was due primarily to a decrease of $8.8 million in legal fees and settlement expenses associated with a claim by a former employee that was settled in December 2009 and a $0.6 million reduction in costs associated with a public offering completed in the fourth quarter of 2009, partially offset by an increase of $4.3 million in personnel costs, which include stock-based compensation expense, $1.2 million in amortization related to certain intangible assets from Tek-Tools and $0.4 million in acquisition costs related to the Tek-Tools acquisition. The decrease was also offset by an increase in other costs such as consulting, director fees, severance costs related to the retirement of our former Executive Chairman, employee meetings and other miscellaneous administrative and employee expenses. The increase in stock-based compensation expense of $1.9 million included a one-time expense of $1.4 million from the acceleration of the vesting of certain options related to the retirement of our former Executive Chairman on June 30, 2010.

Other Income (Expense) Interest expense in 2010 decreased by $3.1 million from 2009 due to principal payments made in 2009 and 2010. The outstanding principal balance under our indebtedness was comprised of a first lien note, or First Lien Note, and a second lien note, or Second Lien Note. Our outstanding principal balance on the notes was $44.1 million as of December 31, 2009. In March 2010, we prepaid $19.1 million of principal to repay all of the outstanding principal balance on the first lien note. In May 2010, we fully repaid the remaining $25.0 million of principal outstanding on the second lien note.

Income Tax Expense Our income tax expense increased by $6.0 million in 2010 compared to 2009. This increase resulted from an increase in our income before income taxes of $21.2 million during the same period. Our effective tax rate 40-------------------------------------------------------------------------------- Table of Contents increased from 26.1% in 2009 to 26.8% in 2010 primarily as a result of a reduction in permanent U.S. income tax benefits related to the U.S. domestic production activities deduction, and the percentage of our earnings that were generated by our international operations, which are generally taxed at lower corporate tax rates than in the United States, decreased slightly from 2009 to 2010.

Non-GAAP Financial Measures In addition to disclosing financial measures prepared in accordance with GAAP, this Form 10-K includes the following financial measures defined as non-GAAP financial measures by the SEC: (i) non-GAAP operating income; (ii) non-GAAP net income; (iii) non-GAAP diluted earnings per share; and (iv) free cash flow. Each of these financial measures excludes the impact of certain items and therefore has not been calculated in accordance with GAAP. In this report, these non-GAAP financial measures exclude stock-based compensation expense and related employer-paid payroll taxes; amortization of intangible assets; public offering costs; lawsuit settlement costs and related legal fees, net of reimbursements; severance costs related to the retirement of our former Executive Chairman; and acquisition related adjustments, including contingent consideration fair value adjustments due to the changes in probability assumptions of achieving the earnout criteria and due to the passage of time. Each of these non-GAAP adjustments is described in more detail below. In addition to these adjustments, management may include or exclude additional items from these or similar non-GAAP financial measures in future periods. A reconciliation of each of these non-GAAP financial measures to its most comparable GAAP financial measure is also included below.

We believe that these non-GAAP financial measures provide meaningful supplemental information regarding our operating results because they exclude certain amounts that our management and Board of Directors do not consider part of core operating results when assessing our operational performance, allocating resources, preparing annual budgets and determining employee incentive compensation. Accordingly, these non-GAAP financial measures may provide insight on the motivation and decision-making of management in operating the business.

In addition, by comparing our non-GAAP financial measures in different historical periods, our investors can evaluate our operating results without the additional variations of certain items that may not be indicative of our core operations, including stock-based compensation expense, which is a non-cash expense that is not a key measure of our operations.

While we believe that these non-GAAP financial measures provide useful supplemental information, there are limitations associated with the use of these non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP, do not reflect a comprehensive system of accounting and may not be completely comparable to similarly titled measures of other companies due to their financing and accounting methods, the book value of their assets, their capital structures and the method by which their assets were acquired.

Items such as the amortization of intangible assets, stock-based compensation expense and related employer-paid payroll taxes and acquisition related adjustments, as well as the related tax impacts of these items can have a material impact on operating and net income. As a result, these non-GAAP financial measures have limitations and should not be considered in isolation from, or as a substitute for, their most comparable GAAP measures. We compensate for these limitations by using these non-GAAP financial measures as supplements to GAAP financial measures and by reconciling the non-GAAP financial measures to their most comparable GAAP financial measure. Investors are encouraged to review the reconciliations of these non-GAAP financial measures to their most comparable GAAP financial measures below.

Non-GAAP operating income increased to $103.3 million for the year ended December 31, 2011 as compared to $77.9 million for the year ended December 31, 2010. This increase is primarily due to an increase in the corresponding GAAP operating income driven by higher sales volume for the year. Amortization of intangible assets and acquisition related adjustments, which are excluded from our non-GAAP operating income, also increased for the year ended December 31, 2011 as compared to 2010 primarily due to the increase in intangible assets and acquisition related costs resulting from the various acquisitions completed during 2011 (refer to Note 2-Acquisitions of our Notes to Consolidated Financial Statements for additional acquisition details including the intangibles acquired). These increases were slightly offset by a decrease in stock-based 41 -------------------------------------------------------------------------------- Table of Contents compensation expense for the year ended December 31, 2011 as compared to the year ended December 31, 2010, as the 2010 expense and related employer-paid payroll taxes includes a one-time stock-based compensation expense of $1.4 million from the acceleration of the vesting of certain options related to the retirement of our former Executive Chairman on June 30, 2010.

Non-GAAP net income increased to $77.2 million for the year ended December 31, 2011 as compared to $56.7 million for the year ended December 31, 2010. The increase is primarily due to increases in the corresponding GAAP net income, amortization of intangible assets and acquisition related costs, offset by a decrease in stock-based compensation expenses and related employer-paid payroll taxes as discussed above in the calculation of non-GAAP operating income. Other adjustments to non-GAAP net income include the write-off of debt issuance costs, fair value adjustments related to contingent consideration included in acquisition related costs and the tax benefits associated with the excluded items.

Non-GAAP earnings per share increased from $0.78 at December 31, 2010 to $1.04 at December 31, 2011 primarily due to the increase in non-GAAP net income as the number of shares used in the computation did not change significantly.

Free cash flow increased to $114.8 million for the year ended December 31, 2011 as compared to $90.1 million for the year ended December 31, 2010. The increase in free cash flow from 2010 to 2011 is primarily due to the increase in operating income that converted to cash flow. Excess tax benefit from stock-based compensation decreased in 2011 as compared to 2010 due to the executive exercises in 2010.

For a detailed explanation of the adjustments made to comparable GAAP financial measures, the reasons why management uses these measures and the usefulness of these measures, see items (1)-(6) below.

Non-GAAP Operating Income Year Ended December 31, (in thousands) 2011 2010 2009 GAAP operating income $ 83,775 $ 62,004 $ 43,801 Amortization of intangible assets (1) 7,170 3,170 689 Stock-based compensation expense and related employer-paid payroll taxes (2) 10,974 12,047 8,209 Public offering costs (3) - 170 720 Lawsuit settlement costs and related legal fees (reimbursements) (3) - (217 ) 8,551 Severance costs related to retirement of former Executive Chairman (3) - 208 - Acquisition related adjustments (4) 1,339 501 60 Non-GAAP operating income $ 103,258 $ 77,883 $ 62,030 Non-GAAP Net Income Year Ended December 31, (in thousands) 2011 2010 2009 GAAP net income $ 62,443 $ 44,746 $ 29,509 Amortization of intangible assets (1) 7,170 3,170 689 Stock-based compensation expense and related employer-paid payroll taxes (2) 10,974 12,047 8,209 Debt issuance costs write-off (3) - 334 428 Public offering costs (3) - 170 720 Lawsuit settlement costs and related legal fees (reimbursements) (3) - (217 ) 8,551 Severance costs related to retirement of former Executive Chairman (3) - 208 - Acquisition related adjustments (4) 1,578 758 60 Tax benefits associated with above adjustments (3) (4,970 ) (4,494 ) (5,434 ) Non-GAAP net income $ 77,195 $ 56,722 $ 42,732 42 -------------------------------------------------------------------------------- Table of Contents Non-GAAP Earnings Per Share Year Ended December 31, (in thousands, except per share data) 2011 2010 2009 Numerator: Non-GAAP net income $ 77,195 $ 56,722 $ 42,732 Denominator:Weighted average number of shares used in computing diluted earnings per share 74,413 72,862 56,824 Pro forma adjustments to reflect assumed weighted average effect of conversion of preferred stock - - 10,356 Non-GAAP weighted average shares used in computing non-GAAP diluted earnings per share 74,413 72,862 67,180 Non-GAAP diluted earnings per share (5) $ 1.04 $ 0.78 $ 0.64 Free Cash Flow Year Ended December 31, (in thousands) 2011 2010 2009 GAAP cash flows from operating activities $ 111,418 $ 66,043 $ 49,225 Excess tax benefit from stock-based compensation 6,359 26,748 8,734 Purchases of property and equipment (2,945 ) (2,740 ) (2,729 ) Free cash flow (6) $ 114,832 $ 90,051 $ 55,230 (1) Amortization of Intangible Assets. We provide non-GAAP information which excludes expenses for the amortization of intangible assets which primarily relate to purchased intangible assets associated with our acquisitions.

Because of varying fair value amounts of intangible assets, subjective impairment assumptions and the variety of useful lives, which affect the recognition of amortization expense, we believe that the exclusion of amortization expense allows for more accurate comparisons of our operating results to our peer companies. The amortization of purchased intangible assets associated with our acquisitions results in our recording expenses in our GAAP financial statements that were already expensed by the acquired company before the acquisition and for which we have not expended cash.

Accordingly, we analyze the performance of our operations in each period without regard to such expenses.

(2) Stock-Based Compensation Expense and Related Employer-Paid Payroll Taxes. We provide non-GAAP information which excludes expenses for stock-based compensation and related employer-paid payroll taxes. We believe the exclusion of these items allows for financial results that are more indicative of our continuing operations. We believe that the exclusion of stock-based compensation expense provides for a better comparison of our operating results to prior periods and to our peer companies as the calculations of stock-based compensation vary from period to period and company to company due to different valuation methodologies, subjective assumptions and the variety of award types. Employer-paid payroll taxes on stock-based compensation is dependent on our stock price and the timing of the taxable events related to the equity awards, over which our management has little control, and does not correlate to the core operation of our business. Because of these unique characteristics of stock-based compensation and the related employer-paid payroll taxes, management excludes these expenses when analyzing the organization's business performance.

(3) Other Items. We exclude certain other unplanned items which we believe are not indicative of our continuing operations and which amounts and timing are difficult to estimate in advance, including the following, when applicable: (i) write-off of debt issuance costs; (ii) public offering costs; (iii) lawsuit settlement costs and related legal fees, net of related reimbursements from insurance proceeds; 43 -------------------------------------------------------------------------------- Table of Contents (iv) severance costs related to retirement of certain executive officers; and (v) the income tax effect on our financial statements of excluding items related to our non-GAAP financial measures. Although these events are reflected in our GAAP financials, these transactions which are not indicative of our continuing operations may limit the comparability of our ongoing operations with prior and future periods. We also believe providing financial information with and without the income tax effect of excluding items related to our non-GAAP financial measures provide our management and users of the financial statements with better clarity regarding the on-going performance and future liquidity of our business. Because of these factors, we assess our operating performance both with these amounts included and excluded, and by providing this information, we believe the users of our financial statements are better able to understand the financial results of what we consider our continuing operations.

(4) Acquisition Related Adjustments. We exclude certain expense items resulting from acquisitions including the following, when applicable: (i) amortization of purchased intangible assets associated with our acquisitions (see Note 1 for further discussion); (ii) legal, accounting and advisory fees to the extent associated with acquisitions; (iii) changes in fair value of contingent consideration; (iv) costs related to integrating the acquired businesses; and (v) restructuring costs, including adjustments related to changes in estimates, related to acquisitions. We consider these adjustments, to some extent, to be unpredictable and dependent on a significant number of factors that are outside of our control. Furthermore, acquisitions result in non-continuing operating expenses, which would not otherwise have been incurred by us in the normal course of our organic business operations, with respect to each acquisition. We believe that providing non-GAAP information for acquisition related expense items in addition to the corresponding GAAP information allows the users of our financial statements to better review and understand the historic and current results of our continuing operations, and also facilitates comparisons to our historical results and results of less acquisitive peer companies, both with and without such adjustments.

(5) Non-GAAP Diluted Earnings Per Share Item. We provide non-GAAP diluted earnings per share. The non-GAAP diluted earnings per share amount was calculated based on our non-GAAP net income and the weighted-average number of shares outstanding during the reporting period. The non-GAAP diluted earnings per share for the year ended December 31, 2009 assumed the conversion of our preferred stock in May 2009 occurred as of the beginning of the indicated period.

(6) Free Cash Flow. We define free cash flow as cash flows from operating activities plus the excess tax benefit from stock-based compensation and less the purchase of property and equipment. We believe free cash flow is an important liquidity measure that reflects the cash generated by the business after the purchase of property and equipment that can then be used for, among other things, strategic acquisitions and investments in the business, stock repurchases and funding ongoing operations. Free cash flow does not represent the total increase or decrease in the cash balance for the period. The changes in free cash flow result from fluctuations in cash flows from operating activities offset by tax benefits associated with the exercises of options. For further discussion regarding cash flows from operating activities, see the discussion under the caption "Liquidity and Capital Resources" included in this Item 7.

Liquidity and Capital Resources Cash and cash equivalents and short-term investments were $152.4 million as of December 31, 2011, approximately $19.2 million of which was held as cash and cash equivalents by our international subsidiaries. As of December 31, 2011, 92% of these cash and cash equivalents held by our international subsidiaries were in Euros. We currently intend that the earnings generated by our international operations will be invested indefinitely in those operations and we do not expect to repatriate those earnings to our domestic operations. If we were to try and repatriate these earnings, we would incur a U.S. federal income tax liability that is not currently accrued in our financial statements.

Our available cash and cash equivalents are held in bank deposits, money market funds and highly liquid securities with original maturities of three months or less at December 31, 2011. We began purchasing short-term 44-------------------------------------------------------------------------------- Table of Contents investments, classified as available-for-sale securities, during 2011. These short-term investments consisted primarily of corporate bonds, municipal bonds and commercial paper held in investment accounts in the United States. Our money market mutual funds invest in high-quality, short-term securities.

Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. The balances held in our deposit accounts in the United States may exceed the Federal Deposit Insurance Corporation, or FDIC, insurance limits or may not be insured by the FDIC. While we monitor the balances in our accounts, and adjust the balances as appropriate, these balances could be impacted if the underlying depository institutions or the guarantors fail or could be subject to adverse conditions in the financial markets. We strive to maintain our cash deposits, money market funds and investments with multiple financial institutions of reputable credit and therefore, bear minimal credit risk. We actively monitor the third party depository institutions that hold our cash, cash equivalents and investments. To date, we have experienced no loss or lack of access to our invested cash, cash equivalents, and investments; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the future.

Summarized annual cash flow information is as follows (in thousands): Year Ended December 31, (in thousands) 2011 2010 2009 Net cash provided by operating activities $ 111,418 $ 66,043 $ 49,225 Net cash used in investing activities (147,045 ) (31,574 ) (3,176 ) Net cash provided by (used in) financing activities 17,936 (21,313 ) 43,120 Effect of exchange rate changes (1,605 ) (941 ) 53 Net increase (decrease) in cash and cash equivalents (19,296 ) 12,215 89,222 Operating Activities Cash provided by operating activities is comprised of net income, adjustments for non-cash operating activities and changes in operating assets and liabilities. Adjustments for non-cash (benefits) expenses were $16.5 million, $(11.9) million and $4.2 million for the years ended December 31, 2011, 2010 and 2009, respectively. These adjustments primarily consist of stock-based compensation expense, excess tax benefits related to employee stock-based awards and depreciation and amortization. We also recognized a gain on the change in the fair value of the Hyper9 acquisition accrued earnout of $0.7 million for the year ended December 31, 2011 due to an adjustment in the probability assumption of achieving the earnout criteria. In addition, non-cash expenses in 2009 included $2.1 million of expenses paid by a stockholder in connection with the settlement of our lawsuit with a former employee.

The change in cash flows relating to operating activities resulted from changes in operating assets and liabilities and is primarily driven by sales of our software offerings and maintenance renewals. The significant components of our cash flows from operating activities include the following: • Accounts receivables increased to $27.0 million at December 31, 2011 as compared to $20.3 million at December 31, 2010 resulting in an increase in operating assets and reflecting a cash outflow of $7.0 million for the year ended December 31, 2011. The increase in accounts receivable for the years ended December 31, 2010 and 2009 as compared to the respective prior year resulted in cash outflows of $5.1 million and $2.1 million, respectively. Our accounts receivable balance fluctuates from period to period depending on the timing of our sales, cash collections and changes to our allowance for doubtful accounts, which affects our cash flow from operating activities. Our accounts receivable balance represents trade receivables from customers when we have provided software licenses and/or software maintenance agreements and we have not yet received payment. We have historically had insignificant write-offs related to bad debts. The allowance for doubtful accounts was $0.2 million, $0.2 million and $0.1 million at December 31, 2011, 2010 and 2009, respectively. We use days sales outstanding, or DSO, calculated on a quarterly basis, as a measurement of the quality and status of our receivables. We 45 -------------------------------------------------------------------------------- Table of Contents define DSO as (a) accounts receivable divided by (b) total revenue for the most recent quarter, multiplied by (c) the number of days in the quarter.

Our DSO was 44.6 days at December 31, 2011.

• Deferred revenue increased to $77.1 million at December 31, 2011 as compared to $55.8 million at December 31, 2010, resulting in an increase in operating liabilities and reflecting a cash inflow of $19.1 million for the year ended December 31, 2011. Net cash provided by operating activities increased $15.3 million and $11.3 million due to an increase in deferred revenue for the years ended December 31, 2010 and 2009, respectively. The increase in deferred revenue was due primarily to the increase in sales of our software offerings and maintenance renewals.

• Changes in our income tax receivable and payable balances are also significant components of our cash flows from operating activities. The increase in our income tax payable was primarily due to our operating growth in fiscal year 2011. Net cash provided by operating activities was reduced by income tax payments of $1.0 million in 2011, was increased by a U.S. federal income tax refund of $3.3 million in 2010 and reduced by income tax payments of $5.7 million in 2009.

• Other changes in operating assets and liabilities include cash paid for interest payments of $1.3 million and $5.0 million in 2010 and 2009, respectively, along with $6.5 million in legal fees and settlement expenses, net of insurance reimbursements, paid by us in connection with the settlement of our lawsuit with a former employee in 2009.

Investing Activities Net cash used in investing activities for the year ended December 31, 2011 was primarily related to $109.5 million of cash used for acquisitions (refer to Note 2-Acquisitions of our Notes to Consolidated Financial Statements for additional details) and $34.1 million of cash used to purchase available-for-sale securities classified as short-term investments. Also during 2011, we had $4 million of proceeds from maturities of short-term investments and paid $4.0 million of cash to Tek-Tools upon the achievement of certain performance criteria related to the asset acquisition in January 2010. This contingent consideration was recorded at fair value in the first quarter of 2010 as an accrued acquisition earnout of $3.7 million and is reflected in cash flows from investing activities for the year ended December 31, 2011. The change in the fair value of the contingent consideration of $0.3 million due to the passage of time was recorded in other income (expense) in our consolidated statement of income for the year ended December 31, 2010 and is reflected in cash flows from operating activities in the consolidated statement of cash flows for the year ended December 31, 2011. Net cash used in investing activities in 2010 was primarily due to the $28.0 million of cash used in our purchase of certain assets of Tek-Tools and $2.7 million of purchases of property and equipment for operations. Cash used in investing activities in 2009 was primarily for purchase of software licenses and tools, computers and equipment, furniture and fixtures as we expanded our infrastructure and workforce.

We estimate our capital expenditures for 2012 to be approximately $4.8 million, comprised primarily of computer equipment, software, additional leasehold improvements and furniture and fixtures. The estimated capital expenditures for 2012 include costs related to the expected expansion of our Ireland, India and Czech Republic offices.

Financing Activities Net cash provided by financing activities in 2011 was primarily due to $11.9 million of proceeds from the exercise of employee stock options and the excess tax benefit related to stock-based awards of $6.4 million, which is a reduction in cash payments related to income taxes. Net cash used in financing activities in 2010 was due to a $44.1 million repayment of long-term debt partially offset by $21.0 million of proceeds from the exercise of stock options and a $26.7 million excess tax benefit related to stock-based compensation, which is a reduction in cash payments related to income taxes. The debt payments in 2010 paid off our entire outstanding principal under our First Lien Note and Second Lien Note.

46 -------------------------------------------------------------------------------- Table of Contents On August 2, 2010, our board of directors approved a share repurchase program, authorizing us to purchase up to $25.0 million of our outstanding common stock. The share repurchase program was completed in August 2010, and we repurchased and retired 1.7 million shares of our common stock for an aggregate purchase price of $25.0 million. The repurchase was authorized to reflect the confidence of management and the board of directors in our business. We believed the share repurchase program would generate a positive return to our shareholders by reducing the number of shares outstanding. Given the low rates of return on cash and short-term investments and as there was no outstanding debt at the time of the share repurchase, we believed the share repurchase program was a proper use of our available cash.

Net cash provided by financing activities in 2009 was due to the net cash proceeds from our IPO of $104.6 million, after deducting underwriter discounts and commissions but before other offering costs, $8.5 million of proceeds from the exercise of employee stock options and the excess tax benefit related to employee stock option exercises of $8.7 million. These proceeds were offset by $57.0 million in repayments of long-term debt pursuant to our First Lien Note and $1.7 million of payments for offering costs made during 2009. We also made a one-time earnout payment pursuant to an agreement with our original stockholders of $20.0 million in November 2009. This $20.0 million payment, which was treated as a dividend payment pursuant to applicable accounting rules, was reflected in our consolidated statements of changes in convertible preferred stock and stockholders' equity (deficit) as a reduction of additional paid-in capital.

We believe that our existing cash and cash equivalents and our cash flow from operations will be sufficient to fund our operations and our capital expenditures for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of spending to support product development efforts and expansion into new territories, the timing of any acquisitions to expand our business, the timing of introductions of new software products and enhancements to existing software products, and the continuing market acceptance of our software offerings. Although we are not currently a party to any material definitive agreement regarding potential investments in, or acquisitions of, complementary businesses, applications or technologies, we may enter into these types of arrangements, which could reduce our cash and cash equivalents, require us to seek additional equity or debt financing or repatriate cash generated by our international operations that would cause us to incur a U.S. federal income tax liability. Additional funds from financing arrangements may not be available on terms favorable to us or at all.

Contractual Obligations and Commitments We generally do not enter into long-term minimum purchase commitments. Our principal commitments as of December 31, 2011 consisted of operating lease obligations for our office facilities. The following table summarizes our outstanding contractual obligations as of December 31, 2011, that require us to make future cash payments: Payments Due by Period Less than 1 More than (in thousands) Total year 1-3 years 3-5 years 5 years Operating leases $ 21,811 $ 3,942 $ 7,584 $ 5,035 $ 5,250 Purchase obligations (1) 5,344 5,120 224 - - Accrued earnout (2) 3,513 3,513 - - - Total (3) $ 30,668 $ 12,575 $ 7,808 $ 5,035 $ 5,250 (1) Purchase obligations represent purchases of software license and support fees, marketing activities, accounting, legal and contractor fees, corporate health insurance costs and computer hardware and software.

(2) We acquired Hyper9 in January 2011. The purchase agreement included contingent consideration ranging from $0 to $7.0 million based on sales milestones for fiscal year 2011. In February 2012, we paid 47 -------------------------------------------------------------------------------- Table of Contents approximately $3.5 million of cash upon the achievement of these sales milestones. The payment is recorded at fair value on our consolidated balance sheet at December 31, 2011 as an accrued acquisition earnout of $3.5 million.

(3) We have excluded long-term tax liabilities of $4.0 million at December 31, 2011 related to uncertain tax positions from the amounts presented as the amounts that will be settled in cash are not known.

Off-Balance Sheet Arrangements During 2011, 2010 and 2009, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Recent Accounting Pronouncements See Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K, for a full description of recent accounting pronouncements which is incorporated herein by reference.

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Featured Whitepaper

Microsoft® Lync® in the Contact Center: Integrating with Customer Interaction Center™ to Provide a Barrierâ€free Customer Experience To implement contact center functionality, organizations using Microsoft Lync Server 2010 can follow the unified communications blueprint of open standards interoperability and integrate to a contact center solution of their choice. Customer Interaction Center (CIC) from Interactive Intelligence is a proven best of breed contact center solution that merits consideration ...

Featured Success Story

Interactive Intelligence all-in-one IP communications software suite integrated with Microsoft Lync helps Bentley save $200,000 annually.

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Contact Center Solutions Interaction Analyzer™

Interaction Analyzer™
Real-time word and phrase spotting. Alerting. Analytics. Scoring. Coaching. Watch how Interaction Analyzer turns every moment, of every past and present call, into data that lets you deliver an exceptional customer experience.