ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K. As discussed in the section entitled “Special Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ significantly from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and elsewhere in this report, particularly in the section entitled “Risk Factors” included under Part I, Item1A.
This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussion regarding our financial condition and results of operations for fiscal 2019 as compared to fiscal 2018 is included in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the SEC on February 26, 2020.
Overview
We are a leading provider of cloud communications, video meetings, collaboration, and contact center software-as-a-service (“SaaS”) solutions. We believe that our innovative, cloud-based communication and contact center solutions disrupt the large market for business communications and collaboration by providing flexible and cost-effective solutions that support mobile and distributed workforces. We enable convenient and effective communications for organizations across all their locations and employees, enabling them to be more productive and more responsive to their customers.
Our cloud-based business communications and collaboration solutions are designed to be easy to use, providing a single user identity across multiple locations and devices, including smartphones, tablets, PCs and desk phones. Our solutions can be deployed rapidly and configured and managed easily. Through our platform, we enable third-party developers and customers to integrate our solution with leading business applications to customize their own business workflows.
We have a portfolio of cloud-based offerings that are subscription based, made available at different rates varying by the specific functionalities, services, and number of users. We primarily generate revenues from the sale of subscriptions to our offerings. Our subscription plans have monthly, annual, or multi-year contractual terms. We believe that this flexibility in contract duration is important to meet the different needs of our customers. For the years ended December 31, 2020, 2019, and 2018, subscriptions revenues accounted for 90% or more of our total revenues. The remainder of our revenues has historically been primarily comprised of product revenues from the sale and rental of pre-configured phones and professional services. We do not develop, manufacture, or otherwise touch the delivery of physical phones and offer it as a convenience for a total solution to our customers in connection with subscriptions to our services. We rely on third-party providers to develop and manufacture these devices and fulfillment partners to successfully serve our customers.
We continue to invest in our direct inside sales force while also developing indirect sales channels to market our brand and our subscription offerings. Our indirect sales channels who sell our solutions consist of:
• a regional and global network of resellers;
•carriers including AT&T, Inc. (“AT&T”), TELUS Communications Company (“TELUS”), and BT Group plc (“BT”). Also, in November 2020 we entered into a strategic partnership with Vodafone Group Services Limited ("Vodafone") to deliver new cloud-based communications services. The parties will introduce a new co-branded cloud-based service that will be the Unified Communications as a Service ("UCaaS") solution for Vodafone and a Contact Center as a Service ("CCaaS") solution to Vodafone customers;
•strategic partners who market and sell our co-branded solutions directly and through their subsidiaries. Such partnerships include Avaya Holdings Corp. ("Avaya"), under which we introduced a new solution Avaya Cloud Office by RingCentral ("ACO") in March 2020; Atos SE ("Atos") and its subsidiary, Unify Software and Solutions GmbH & CO. KG ("Unify"), under which we introduced a new Unified Communications as a Service ("UCaaS") solution called Unify Office by RingCentral ("UO") in September 2020; and in July 2020, we entered into a strategic partnership with Alcatel-Lucent Enterprise ("ALE"), which includes the introduction of a new co-branded solution which will be marketed and sold as the UCaaS solution offering of ALE beginning in 2021.
Since its launch, our revenue growth has primarily been driven by our flagship RingCentral Office product offering, which has resulted in an increased number of customers, increased average subscription revenue per customer, and increased
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retention of our existing customer and user base. We define a “customer” as any party that purchases or subscribes to our products and services directly or indirectly through our channel partners. As of December 31, 2020, we had customers from a range of industries, including financial services, education, healthcare, legal services, real estate, retail, technology, insurance, construction, hospitality, and state and local government, among others. For the years ended December 31, 2020, 2019 and 2018, the vast majority of our total revenues were generated in the U.S. and Canada, although we expect the percentage of our total revenues derived outside of the U.S. and Canada to grow as we continue to expand internationally.
The growth of our business and our future success depend on many factors, including our ability to expand our customer base to larger customers, expansion of our indirect sales channels including strategic partnerships, continue to innovate, grow revenues from our existing customer base, expand our distribution channels, and scale internationally.
In December 2019, a novel strain of coronavirus (“COVID-19”) was reported and in January 2020, the World Health Organization (the "WHO") declared the outbreak a “Public Health Emergency of International Concern.” In February 2020, the WHO raised the COVID-19 threat level from high to very high at a global level and in March 2020, the WHO characterized the COVID-19 as a pandemic. The worldwide spread of COVID-19 has resulted in authorities implementing numerous measures to contain the virus, including travel bans and restrictions, quarantines, shelter-in-place orders, and business limitations and shutdowns.
During the year ended December 31, 2020, we noted contributions from new bookings as more businesses transition to RingCentral in the current work-from-anywhere environment. In the first and early part of the second quarter, we experienced higher churn rate mainly with small business customers in certain verticals. Since then we have seen stabilization in churn levels. Due to the shelter-in-place, we continue to see more customers opting for the RingCentral apps on laptops and mobile devices over traditional desktop phones which has impacted demand for physical phone devices. We also observed customer requests for extension in payment terms. To address customer hardships, we continue to engage with these customers providing them greater flexibility to manage challenges they are facing.
While our revenues and earnings are relatively predictable as a result of our subscription-based business model, the effect of the COVID-19 pandemic, may not be fully reflected in our results of operations and overall financial performance until future periods. The COVID-19 pandemic has created a global slowdown of economic activity which has and will likely continue to decrease demand for a broad variety of goods and services, while also disrupting sales channels and marketing activities for an unknown period of time until the disease is contained.
We may experience curtailed customer demand due to reduced customer spend, shortened contract duration, higher churn, lengthened payment terms, credit card declines, potential delays in professional services implementations, and reduction in demand for desktop phones, which could adversely impact our business, results of operations and overall financial performance in future periods. We may in the future continue to experience elevated churn in certain customer verticals and customer requests for extension of payment terms.
The extent of the impact of the COVID-19 pandemic on our operational and financial performance will also depend on certain developments, including the duration and spread of the outbreak, actions taken to contain the virus or its impact, impact on our partners, resellers, employees, vendors and customers, and employee or industry events, all of which are uncertain and cannot be predicted. For example, to support the health and well-being of our employees, customers, partners and communities in response to the COVID-19 pandemic, a vast majority of our employees are working remotely and we have shifted some of our customer events to virtual-only experiences, and we may deem it advisable to similarly alter, postpone or cancel entirely additional customer, employee or industry events in the future. At this point, the full extent to which the COVID-19 pandemic may impact our financial condition or results of operations is uncertain, but changes we have implemented have not affected and are not expected to affect our ability to maintain operations, including financial reporting systems, internal control over financial reporting, and disclosure controls and procedures.
Further discussion of the potential impacts of the COVID-19 pandemic on our business can be found in the section titled "Risk Factors" included in Part I, Item 1A.
Key Business Metrics
In addition to United States generally accepted accounting principles (“U.S. GAAP”) and financial measures such as total revenues, gross margin, and cash flows from operations, we regularly review a number of key business metrics to evaluate growth trends, measure our performance, and make strategic decisions. We discuss revenues and gross margin under “Results of Operations”, and cash flow from operations and free cash flows under “Liquidity and Capital Resources.” Other key business metrics are discussed below.
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Annualized Exit Monthly Recurring Subscriptions
We believe that our Annualized Exit Monthly Recurring Subscriptions (“ARR”) is a leading indicator of our anticipated subscriptions revenues. We believe that trends in revenue are important to understanding the overall health of our business, and we use these trends in order to formulate financial projections and make strategic business decisions. Our ARR equals our Monthly Recurring Subscriptions multiplied by 12. Our Monthly Recurring Subscriptions equals the monthly value of all customer recurring charges at the end of a given month. For example, our Monthly Recurring Subscriptions at December 31, 2020 was $108.3 million. As such, our ARR at December 31, 2020 was $1.3 billion compared to $960.1 million at December 31, 2019.
RingCentral Office Annualized Exit Monthly Recurring Subscriptions
We calculate our RingCentral Office Annualized Exit Monthly Recurring Subscriptions (“Office ARR”) in the same manner as we calculate our ARR, except that primarily customer subscriptions from RingCentral Office and RingCentral customer engagement solutions customers are included when determining Monthly Recurring Subscriptions for the purposes of calculating this key business metric. We believe that trends in revenue with respect to these products are important to the understanding of the overall health of our business, and we use these trends in order to formulate financial projections and make strategic business decisions. Our Office ARR at December 31, 2020 was $1.2 billion compared to $876.8 million at December 31, 2019.
Net Monthly Subscription Dollar Retention Rate
We believe that our Net Monthly Subscription Dollar Retention Rate provides insight into our ability to retain and grow subscriptions revenue, as well as our customers’ potential long-term value to us. We believe that our ability to retain our customers and expand their use of our solutions over time is a leading indicator of the stability of our revenue base and we use these trends in order to formulate financial projections and make strategic business decisions. We define our Net Monthly Subscription Dollar Retention Rate as (i) one plus (ii) the quotient of Dollar Net Change divided by Average Monthly Recurring Subscriptions.
We define Dollar Net Change as the quotient of (i) the difference of our Monthly Recurring Subscriptions at the end of a period minus our Monthly Recurring Subscriptions at the beginning of a period minus our Monthly Recurring Subscriptions at the end of the period from new customers we added during the period, all divided by (ii) the number of months in the period. We define our Average Monthly Recurring Subscriptions as the average of the Monthly Recurring Subscriptions at the beginning and end of the measurement period.
For example, if our Monthly Recurring Subscriptions were $118 at the end of a quarterly period and $100 at the beginning of the period, and $20 at the end of the period from new customers we added during the period, then the Dollar Net Change would be equal to ($0.67), or the amount equal to the difference of $118 minus $100 minus $20, all divided by three months. Our Average Monthly Recurring Subscriptions would equal $109, or the sum of $100 plus $118, divided by two. Our Net Monthly Subscription Dollar Retention Rate would then equal 99.4%, or approximately 99%, or one plus the quotient of the Dollar Net Change divided by the Average Monthly Recurring Subscriptions.
Our key business metrics for the five quarterly periods ended December 31, 2020 were as follows (dollars in millions):
Net Monthly Subscription Dollar Retention Rate >99% >99% >99% >99% >99%
Components of Results of Operations
Revenues
Our revenues for the years presented consisted of subscriptions and other revenues. Our subscriptions revenue includes all fees billed in connection with subscriptions to our solution offerings. These fees include recurring fixed plan subscription fees, variable usage-based fees for usage in excess of plan limits, recurring administrative cost recovery fees, one-time fees, and other recurring fees related to our subscriptions. We provide our subscriptions to our customers pursuant to contractual arrangements that range in duration typically from one month to five years. We provide our subscriptions to our customers
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pursuant to either “click through” online agreements for service terms up to one year or written agreements when the arrangement is expected to be one year or longer. We offer our subscriptions based on the functionalities and services selected by a customer, and generally our subscription arrangements automatically renew for additional periods at the end of the initial subscription term. We believe that this flexibility in contract duration is important to meet the different needs of our customers.
We generally bill our subscription fees in advance. We recognize subscription revenue over the term of the agreement. Amounts billed in excess of revenue recognized for the period are reported as deferred revenue on our Consolidated Balance Sheets.
We also generate revenues through sales of our subscriptions and products by resellers, strategic partners, and carrier partners. When we control the performance of the contractual obligations, we record the revenues on a gross basis and amounts retained by our resellers are recorded as sales and marketing expense. Our assumption of such control is evidenced when, among other things, we are primarily responsible for the delivery of the service or products, have inventory risk, and have discretion in establishing pricing of the arrangement.
“Other revenues” includes product revenues from the sale of pre-configured phones, phone rentals, and professional services. Product revenue is recognized when the product has been delivered to the customer. Professional services revenue is recognized as services are delivered.
Cost of Revenues and Gross Margin
Our cost of subscriptions revenue primarily consists of fees paid to third-party telecommunications providers, network operations, costs to build out and maintain data centers, including co-location fees for the right to place our servers in data centers owned by third parties, depreciation of servers and equipment, along with related utilities and maintenance costs, personnel costs associated with customer care and support of the functionality of our platform and data center operations, including share-based compensation expenses, and allocated costs of facilities and information technology.
We define subscriptions gross margins as subscriptions revenue minus the cost of subscriptions revenue expressed as a percentage of subscriptions revenue.
Cost of other revenue is comprised primarily of the cost associated with the purchase of phones, cost of professional services, and allocated costs of facilities and information technology.
Operating Expenses
We classify our operating expenses as research and development, sales and marketing, and general and administrative expenses.
Our research and development efforts are focused on developing new and expanded features for our solutions, integrations with distributors and other software platforms, and improvements to our backend architecture. Research and development expenses consist primarily of personnel costs for employees and contractors, including share-based compensation expenses, and allocated costs of facilities and information technology, software tools, and product certification. We expense research and development costs as incurred, except for certain internal-use software development costs that we capitalize. We believe that continued investment in our products is important for our future growth, and we expect our research and development expenses to continue to increase in absolute dollars for the foreseeable future, although these expenses may fluctuate as a percentage of our total revenues from period to period depending on the timing of these expenses.
Sales and marketing expenses are the largest component of our operating expenses and consist primarily of personnel costs for employees and contractors directly associated with our sales and marketing activities including share-based compensation expenses, internet advertising fees, radio and billboard advertising, public relations, commissions paid to employees, resellers and other third parties, amortization of capitalized sales commissions, trade shows, travel expenses, credit card fees, marketing and promotional activities, amortization of acquired customer relationship intangibles, and allocated costs of facilities and information technology. We expect our sales and marketing expenses to continue to increase in absolute dollars for the foreseeable future as we expand our sales and marketing efforts domestically and internationally and continue to build our brand, although these expenses may fluctuate as a percentage of our total revenues from period to period depending on the timing of these expenses.
General and administrative expenses consist primarily of personnel costs, including share-based compensation expenses, for employees and contractors engaged in infrastructure and administrative activities to support the day-to-day
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operations of our business. Other significant components of general and administrative expenses include professional service fees, allocated costs of facilities and information technology, cost of compliance with certain government-imposed taxes, the costs of legal matters, business acquisition costs, and loss contingencies. We expect our general and administrative expenses to continue to increase in absolute dollars for the foreseeable future, although these expenses may fluctuate as a percentage of our total revenues from period to period, depending on the timing of these expenses.
Results of Operations
The following tables set forth selected consolidated statements of operations data and such data as a percentage of total revenues. The historical results presented below are not necessarily indicative of the results that may be expected for any future period (in thousands):
Year ended December 31,
Revenues
Cost of revenues
Operating expenses
Other income (expense), net
Provision for (benefit from) income taxes 934 (3,333) 140
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Percentage of Total Revenues*
Year ended December 31,
Revenues
Cost of revenues
Total cost of revenues 27 26 23
Operating expenses
Research and development 16 15 15
General and administrative 17 16 15
Total operating expenses 82 79 79
Loss from operations (10) (5) (2)
Other income (expense), net
Interest expense (4) (2) (2)
Other income, net 7 1 1
Other income (expense), net 3 (1) (1)
Loss before income taxes (7) (6) (4)
Provision for (benefit from) income taxes — — —
Net loss (7 %) (6 %) (4 %)
* Percentages may not add up due to rounding.
Comparison of Fiscal Years Ended December 31, 2020, 2019, and 2018:
Revenues
Year ended December 31, Year ended December 31,
Revenues
Percentage of revenues
Subscriptions revenue. Subscriptions revenue increased by $268.5 million, or33%, during fiscal year 2020 as compared to fiscal year 2019. The increase was primarily a combination of the acquisition of new customers and upsells of seats and additional offerings to our existing customer base. This growth was primarily driven by an increase in sales to our mid-market and enterprise customers as we continue to move up market and increased sales through our direct and indirect sales channels. Although we expect to continue to add new customers and for existing customers to increase their usage of our product, we will continue to monitor the COVID-19 pandemic carefully and its impact on customer demand, contract duration, churn, payment terms, and credit card declines. Fluctuations in foreign currency exchange rates and volatility in the market, including those resulting from the COVID-19 pandemic, could also cause variability in our revenue.
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Other revenues. Other revenues are primarily comprised of product revenue from the sale of pre-configured phones, phone rentals, and professional services.
Other revenue increased by $12.3 million, or 15%, during fiscal year 2020 as compared to fiscal year 2019, primarily due to the increase in product sales and professional services resulting from the overall growth in our business. Due to shelter in place restrictions adopted in many jurisdictions in response to the COVID-19 pandemic, we continued to see a shift towards using RingCentral apps on laptops and mobile devices over traditional desktop phones and timing of professional services projects. We may see a reduction in demand for desktop phones and slower implementation services. We will continue to monitor the COVID-19 pandemic carefully and its impact on phone and professional services revenue.
Cost of Revenues and Gross Margin
Year ended December 31, Year ended December 31,
Cost of revenues
Percentage of revenues
Other 7 % 8 % 8 % 7 %
Gross margins
Subscription cost of revenues and gross margin. Cost of subscriptions revenues increased by $76.7 million, or 48%, during fiscal year 2020 as compared to fiscal year 2019. The primary drivers of the increase were third-party costs to support our solution offerings of $25.9 million, amortization of acquired intangible assets of $25.1 million, infrastructure support costs of $16.7 million, and personnel and contractor-related costs including share-based compensation expenses of $11.7 million. Gross margin decreased mainly due to timing of acquisition of intangible assets which resulted in higher amortization of acquired intangible assets of $25.1 million and timing of our equity grants which resulted in higher share-based compensation expense of $3.6 million.
The increase in headcount and other expense categories described herein was driven primarily by investments in our infrastructure and capacity to improve the availability of our subscription offerings, while also supporting the growth in new customers and increased usage of our subscriptions by our existing customer base. We expect subscription gross margin to be within a relatively similar range in the future. However, we continue to monitor the COVID-19 pandemic carefully and its impact on our customers.
Other cost of revenues and gross margin. Cost of other revenues increased by $15.9 million, or 22%, during fiscal year 2020 as compared to fiscal year 2019. This was primarily due to the increase in personnel costs including share-based compensation expense of $10.1 million and cost of product sales of $5.4 million. Other revenue gross margin fluctuated based on timing of completion of professional services projects and transaction price for product sales.
We continue to monitor the impact of the COVID-19 pandemic on timing of professional services and transaction price of product sales.
Research and Development
Year ended December 31, Year ended December 31,
Percentage of total revenues 16 % 15 % 15 % 15 %
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Research and development expenses increased by $53.1 million, or 39%, during fiscal year 2020 as compared to fiscal year 2019, primarily due to $48.0 million increase in personnel and contractor costs and $4.9 million increase in overhead costs to support our research and development efforts. The increase in personnel and contractor costs was mainly driven by approximately $30.3 million relating to headcount growth and $16.2 million share-based compensation expense.
The increases in research and development headcount and other expense categories were driven by continued investment in current and future software development projects for our applications. Given the continued emphasis and focus on product innovation, we expect research and development expenses to continue to increase in absolute dollars.
Sales and Marketing
Year ended December 31, Year ended December 31,
Percentage of total revenues 49 % 49 % 49 % 49 %
Sales and marketing expenses increased by $144.7 million, or 33%, during fiscal year 2020 as compared to fiscal year 2019, primarily due to increases in personnel and contractor costs of $73.3 million, third-party commissions of $35.2 million, advertising and marketing costs of $35.1 million, and amortization of deferred sales commission costs of $17.1 million, partially offset by a $9.9 million decrease in travel costs resulting from the impact of COVID-19 and a $6.6 million decrease in professional fees mainly due to costs associated with strategic partnerships and acquisitions in fiscal year 2019. Of the total increase in personnel and contractor costs, $45.5 million was primarily due to headcount growth and approximately $25.9 million was due to higher share-based compensation expense.
The increases in sales and marketing headcount and other expense categories were necessary to support our growth strategy to acquire new customers with a focus on larger customers, and to establish brand recognition to achieve greater penetration into the North America and international markets. Additionally, we expect sales and marketing expenses to continue to increase in absolute dollars as we continue to expand our presence in North America and international markets.
General and Administrative
Year ended December 31, Year ended December 31,
Percentage of total revenues 17 % 16 % 16 % 15 %
General and administrative expenses increased by $58.0 million, or 41%, during fiscal year 2020 as compared to fiscal year 2019, primarily due to increases in personnel and contractor costs of $51.1 million including $40.6 million due to higher share-based compensation expense, business fees and taxes of $6.4 million, overhead costs of $3.9 million, professional fees of $3.2 million, and increased allowance for doubtful accounts of $3.0 million partly driven by customer collection related matters stemming form COVID-19, partially offset by cost savings of $10.0 million including credits and decreased travel costs.
We expect general and administrative expenses to continue to increase in absolute dollars as we continue to make additional investments in processes, systems, and personnel to support our anticipated revenue growth.
Other Income (expense), net
Year ended December 31, Year ended December 31,
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nm - not meaningful
Other income (expense), net increased by $42.4 million during fiscal year 2020 as compared to fiscal year 2019.
Other income, net was higher by $71.2 million primarily due to $81.1 million net unrealized gain recognized on our long-term investments, which depends on market fluctuations, partially offset by $13.3 million loss on partial repurchase of our convertible senior notes during fiscal 2020 and decrease in interest income on our investments of $9.1 million mainly as a result of reduction in interest rates. Fiscal 2019 expense were also higher due to costs associated with strategic partnerships and acquisitions of $10.6 million, which did not recur in fiscal 2020.
Interest expense was higher by $28.8 million due to increase in the amortization of debt discount and issuance costs from our 2025 and 2026 convertible senior notes issued in the first and third quarters of 2020, respectively.
We expect interest income to further reduce in the future due to interest rate volatility in the current macroeconomic environment.
Net loss
Net loss increased by $29.4 million during fiscal year 2020, mainly due to non-cash items including $88.2 million higher share-based compensation expense primarily driven by equity awards granted to new employees and annual merit based equity awards to existing employees, $28.7 million increase in interest expense from the amortization of debt discount and issuance costs from our convertible senior notes, and $25.1 million increase in amortization of acquired intangibles, partially offset by $81.1 million net unrealized gain recognized from our long-term investments, and a decrease in acquisition-related costs of $24.0 million.
Liquidity and Capital Resources
Liquidity is a measure of our ability to access sufficient cash flows to meet the short-term and long-term cash requirements of our business operations.
As of December 31, 2020 and 2019, we had cash and cash equivalents of $639.9 million and $343.6 million, respectively. We finance our operations primarily through sales to our customers, which could be billed either on a monthly or annually one year in advance. For customers with annual or multi-year contracts and those who opt for annual invoicing, we generally invoice only one annual period in advance and revenue is deferred for such advanced billings. We also finance our operations from proceeds from issuance of convertible senior notes and proceeds from issuance of stock under our stock plans.
In March 2020, we issued $1.0 billion aggregate principal of 0% convertible senior notes due 2025 (the “2025 Notes”) in a private placement. As of December 31, 2020, the carrying value of our 2025 Notes totaled $825.0 million. In September 2020, we issued $650.0 million aggregate principal of 0% convertible senior notes due 2026 (the "2026 Notes") in a private placement. As of December 31, 2020, the carrying value of our 2026 Notes totaled $510.3 million. Our 2025 Notes and 2026 Notes contain customary financial covenants. In connection with both these offering, we used approximately $1.0 billion of the total net proceeds of $1.6 billion to repurchase a portion of the 0% convertible senior notes due 2023 (the "2023 Notes").
The 2023 Notes outstanding principal balance as of December 31, 2020 was $80.2 million, out of which $34.9 million conversion requests were outstanding as of December 31, 2020, and we received additional conversion requests of $4.1 million subsequent to December 31, 2020. We expect to pay approximately $185 million in the first quarter of 2021 to settle these outstanding conversion requests. As of the filing date, the remaining outstanding principal balance of the 2023 Notes is $45.3 million. We intend to settle this outstanding principal amount out of our cash and cash equivalents outstanding balance. For additional details, refer to Note 6 – Convertible Senior Notes of the notes to the consolidated financial statements included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. We are in compliance with all covenants under the 2026, 2025 and 2023 Notes as of December 31, 2020.
During the year ended December 31, 2020, we entered into strategic partnership agreements with ALE and Vodafone under which we paid approximately $163.7 million. We also financed approximately $4.7 million of property, equipment, and software licenses through vendor financing arrangements and paid approximately $4.5 million to purchase additional intellectual property rights.
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We believe that our operations, existing liquidity sources as well as capital resources and ability to raise cash through additional financing will satisfy our future cash requirements and obligations for at least the next 12 months. Our future capital requirements will depend on many factors, including revenue growth and costs incurred to support customer growth, acquisitions and expansions, sales and marketing, research and development, increased general and administrative expenses to support the anticipated growth in our operations, and capital equipment required to support our growing headcount and in support of our co-location data center facilities, as well as the extent of the COVID-19 pandemic and its effect on our business. Our capital expenditures in future periods are expected to grow in line with our business. We continually evaluate our capital needs and may decide to raise additional capital to fund the growth of our business for general corporate purposes through public or private equity offerings or through additional debt financing. We also may in the future make investments in or acquire businesses or technologies that could require us to seek additional equity or debt financing. Access to additional capital may not be available or on favorable terms. The uncertainty created by the changing markets and economic conditions related to the COVID-19 pandemic may also impact our customers’ ability to pay on a timely basis, which could negatively impact our operating cash flows.
The table below provides selected cash flow information for the periods indicated (in thousands):
Year ended December 31,
Net cash (used in) provided by operating activities $ (35,191) $ 64,846 $ 72,130
Net Cash (Used in) Provided by Operating Activities
Cash used in or provided by operating activities is driven by our net loss, the timing of customer collections, as well as the amount and timing of disbursements to our vendors, the amount of cash we invest in personnel, marketing, and infrastructure costs to support the anticipated growth of our business, payments under strategic arrangements, and amounts attributable to repayment of convertible notes.
Net cash used in operating activities was $35.2 million for the year ended December 31, 2020. This was driven primarily by $141.6 million paid under strategic agreements and $35.0 million attributable to debt discount on a portion of the 2023 convertible senior notes that was repaid. These were offset by $141.4 million in cash flow from operating activities during the year ended December 31, 2020. The cash flow from operating activities was driven by timing of cash receipts and prepayments from customers and carriers and cash payments for personnel related costs and to vendors.
Net cash used in operating activities for the year ended December 31, 2020, increased by $100.0 million as compared to the year ended December 31, 2019. This change was driven by payments under strategic arrangements and debt discount for a portion of the 2023 senior convertible notes that was repaid, offset with the additional cash generated from operating activities.
Net Cash Used in Investing Activities
Our primary investing activities have consisted of our long-term investments, business acquisitions and purchase of intellectual properties, and capital expenditures and internal-use software. As our business grows, we expect our capital expenditures to continue to increase.
Net cash used in investing activities was $107.7 million for the year ended December 31, 2020, primarily due to capital expenditures including personnel-related costs associated with development of internal-use software of $81.7 million and acquisition of IP of $26.0 million to complement and support our product development and enhancement initiatives.
Net cash used in investing activities for the year ended December 31, 2020 decreased by $189.1 million as compared to the year ended December 31, 2019, primarily due to $135.6 million used in 2019 to acquire our long-term investments and lower cash used in 2020 for business combinations and asset acquisitions of $91.0 million, partially offset by higher capital expenditures and internal use software investment of $37.4 million to support the growth in our business.
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Net Cash Provided by Financing Activities
Our primary financing activities have consisted of raising proceeds through the issuance of our 2025 Notes and 2026 Notes in the first and third quarters of 2020, respectively, and stock under our stock plans, offset by partial repurchase and conversion of our 2023 Notes.
Net cash provided by financing activities was approximately $437.6 million for the year ended December 31, 2020, primarily due to $1.6 billion proceeds from the issuance of our 2025 Notes and 2026 Notes, net of issuance costs, partially offset by $1.1 billion paid for the partial repurchase and conversions of our 2023 Notes and $102.7 million payments for capped calls transactions and costs. We also had proceeds from issuance of stock in connection with our stock plans of $41.2 million, which was offset with payments for taxes paid in connection with our stock plans of $36.7 million.
Net cash provided by financing activities for the year ended December 31, 2020, increased by $428.5 million as compared to the year ended December 31, 2019, primarily proceeds from the 2025 Notes and the 2026 Notes issued in 2020, partially offset by the partial repurchases and conversions of the 2023 Notes. Refer to Note 6, Convertible Senior Notes, of the notes to the consolidated financial statements included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information.
Non-GAAP Free Cash Flow
To supplement our statements of cash flows presented on a GAAP basis, we use non-GAAP measures of cash flows to analyze cash flow generated from our operations. We define free cash flow, a non-GAAP financial measure, as GAAP net cash provided by (used in) operating activities plus cash paid for strategic partnerships and repayments of convertible senior notes attributable to debt discount, reduced by purchases of property and equipment and capitalized internal-use software. We believe information regarding free cash flow provides useful information to management and investors in understanding the strength of liquidity and available cash. A limitation of the use of free cash flow is that it does not represent the total increase or decrease in our cash balance for the period. Free cash flow should not be considered in isolation or as an alternative to cash flows from operations, and should be considered alongside our other GAAP-based financial liquidity performance measures, such as net cash used in operating activities and our other GAAP financial results.
The following table presents a reconciliation of free cash flow to net cash provided by (used in) operating activities, the most directly comparable GAAP measure, for each of the periods presented (in thousands):
Year ended December 31,
Net cash (used in) provided by operating activities $ (35,191) $ 64,846 $ 72,130
Repayment of convertible senior notes attributable to debt discount 35,020 — —
Backlog
We have generally signed new customers contracts with varying length, from month-to-month to multi-year terms for our subscription services. At any point in the contract term, there can be amounts allocated to services that we have not yet contractually performed, which constitute a backlog. Until we meet our performance obligations, we do not recognize them as revenues in our consolidated financial statements. Given the variability in our contract length, we believe that backlog is not a reliable indicator of future revenues and we do not utilize backlog as a key management metric internally.
Deferred Revenue
Deferred revenue primarily consists of the unearned portion of monthly or annual invoiced fees for our subscriptions, which we recognize as revenue in accordance with our revenue recognition policy. For customers with multi-year contracts, we generally invoice for only one monthly or annual subscription period in advance. Therefore, our deferred revenue balance does not capture the full contract value of multi-year contracts. Accordingly, we believe that deferred revenue is not a reliable indicator of future revenues and we do not utilize deferred revenue as a key management metric internally.
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Contractual Obligations
The following summarizes our contractual obligations as of December 31, 2020 (in thousands):
Payments due by period
Up to1 year 1 to 3 years 3 to 5 years More than5 years Total
(1)Operating lease obligations includes operating leases of $1.1 million that have not yet commenced as of December 31, 2020.
Purchase obligations represent an estimate of open purchase orders and contractual obligations in the normal course of business for which we have not received the goods or services as of December 31, 2020. Although open purchase orders are considered enforceable and legally binding, except for our purchase orders with our inventory suppliers, the terms generally allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to the delivery of goods or performance of services. Our purchase orders with our inventory suppliers are non-cancellable. In addition, we have other obligations for goods and services that we enter into in the normal course of business. These obligations, however, are either not enforceable or legally binding, or are subject to change based on our business decisions. The aggregate of these items represents our estimate of purchase obligations.
Indemnification Obligations
Certain of our agreements with sales agents, resellers and customers include provisions for indemnification against liabilities if our products infringe a third-party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnification provisions and have not accrued any liabilities related to such obligations in the consolidated financial statements as of December 31, 2020.
Contingencies
We are and may be in the future subject to certain legal proceedings and from time to time may be involved in a variety of claims, lawsuits, investigations, and proceedings relating to contractual disputes, intellectual property rights, employment matters, regulatory compliance matters, and other matters relating to various claims that arise in the normal course of business. We record a provision for a liability when we believe that it is both probable that a liability has been incurred, and the amount can be reasonably estimated. Significant judgment is required to determine both probability and the estimated amount of loss. Such legal proceedings are inherently unpredictable and subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to be incorrect, it could have a significant impact on our results of operations, financial position, and cash flows.
Refer to Note 8 – Commitment and Contingencies of the notes to the consolidated financial statements included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information.
Off-Balance Sheet Arrangements
Through December 31, 2020, 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.
Critical Accounting Policies and Estimates
We prepare our consolidated financial statements in accordance with U.S. GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP and does not require management’s judgment in its application. In other cases, management’s judgment is required in selecting among available alternative accounting standards
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that provide for different accounting treatment for similar transactions. The preparation of consolidated financial statements also requires us to make estimates and assumptions that affect the amounts we report as assets, liabilities, revenues, costs, and expenses, and affect the related disclosures. We base our estimates on historical experience and other assumptions that we believe are reasonable under the circumstances. In many instances, we could reasonably use different accounting estimates, and in some instances changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, our actual results could differ significantly from the estimates made by our management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations, and cash flows will be affected. A summary of our significant accounting policies is included in Note 1 of the notes to the consolidated financial statements included in Part II, Item 8, which is incorporated herein by reference. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates.
Revenue Recognition
We derive our revenues from subscriptions, sale of products, and professional services. Subscriptions revenue is generally recognized over the period of the subscription contract. Subscription contracts generally allow the customers to terminate their services at any time during the first 30 days of the subscription period and are charged for the term of usage. Upon cancellation during the termination period, customers receive a pro-rata refund for any amounts paid. After the end of the termination period, the contract is non-cancellable and the customer is obligated to pay for the remaining term of the contract. For sale of products, revenue is recognized when control is transferred. For professional services, revenue is recognized as services are rendered.
Recent Accounting Pronouncements
For a summary of recent accounting pronouncements and the anticipated effects on our consolidated financial statements, see Note 1 to the consolidated financial statements included in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” of this Annual Report on Form 10-K, which is incorporated herein by reference.
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ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates and interest rates. We do not hold or issue financial instruments for trading purposes.
Foreign Currency Risk
The majority of our sales and contracts are denominated in U.S. dollars, and therefore our net revenue is not currently subject to significant foreign currency risk. As part of our international operations, we charge customers in British Pounds, European Union (“EU”) Euro, Canadian Dollars and Australian Dollars, among others. Fluctuations in foreign currency exchange rates and volatility in the market, including those resulting from the COVID-19 pandemic, will cause variability in our revenue. However, this impact has not been significant during 2020. Our operating expenses are generally denominated in the currencies of the countries in which our operations are located, which are primarily in the U.S., and to a lesser extent in Canada, Europe, and Asia-Pacific. The functional currency of our foreign subsidiaries is generally the local currency. Our consolidated results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates and may be adversely affected in the future due to changes in foreign currency exchange rates. To date, we have not entered into any hedging arrangements with respect to foreign currency risk. During fiscal 2020, a hypothetical 10% change in foreign currency exchange rates applicable to our business would not have had a material impact on our consolidated financial statements. As our international operations continue to expand, risks associated with fluctuating foreign currency rates may increase. We will continue to reassess our approach to managing these risks.
Interest Rate Risk
As of December 31, 2020, we had cash and cash equivalents of $639.9 million. We invest our cash and cash equivalents in short-term money market funds. We have experienced a decline in the interest rates associated with money market funds over the last several quarters. Declines in interest rates would reduce future interest income. During fiscal year 2020, a hypothetical 10% increase or decrease in overall interest rates would not have had a material impact on our interest income. The carrying amount of our cash equivalents reasonably approximates fair values. Due to the short-term nature of our money-market funds, we believe that exposure to changes in interest rates will not have a material impact on the fair value of our cash equivalents. Interest income may further reduce in the future due to interest rate volatility in the current macroeconomic environment.
As of December 31, 2020, we had $71.2 million, $825.0 million, $510.3 million outstanding from the 2023 Notes, 2025 Notes, and 2026 Notes (collectively the "Notes"), respectively. We carry the Notes at face value less unamortized discount on our balance sheet, and we present the fair value for required disclosure purposes only. The Notes have a zero percent fixed annual interest rate and, therefore, we have no economic exposure to changes in interest rates. The fair value of the Notes is exposed to interest rate risk. Generally, the fair value of our fixed interest rate Notes will increase as interest rates decline and decrease as interest rates increase. In addition, the fair values of the Notes are affected by our stock price. The fair value of the Notes will generally increase as our common stock price increases and will generally decrease as our common stock price decrease in value.
Market Risk
As of December 31, 2020, we had long term investments in convertible and redeemable preferred stock of $213.2 million. These equity investments are subject to market related risks that could decrease or increase the fair value of our holdings. These equity investments are adjusted to fair value based on market inputs at the balance sheet date, which are subject to market-related risks that could decrease or increase the fair value of our holdings, including the potential impacts from COVID-19. A fluctuation in the investee's stock price, volatility or a combination of both could have an adverse impact on the fair value of our investment. A hypothetical adverse stock price or volatility change of 10% could have resulted in a potential decrease of up to $16.8 million in the fair-value of our investment as of December 31, 2020.
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ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
RINGCENTRAL, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm 62
Consolidated Balance Sheets 64
Consolidated Statements of Operations 65
Consolidated Statements of Comprehensive Loss 66
Consolidated Statements of Stockholders’ Equity 67
Consolidated Statements of Cash Flows 68
Notes to Consolidated Financial Statements 69
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Board of Directors
RingCentral, Inc.:
Opinions on the Consolidated Financial Statements and Internal Control Over Financial Reporting
We have audited the accompanying consolidated balance sheets of RingCentral, Inc. and subsidiaries (the Company) as of December 31, 2020 and 2019, the related consolidated statements of operations, comprehensive loss, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes (collectively, the consolidated financial statements). We also have audited the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020 based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Change in Accounting Principle
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for leases as of January 1, 2019 due to the adoption of Financial Accounting Standards Board's Accounting Standards Codification (ASC) Topic 842, Leases.
Basis for Opinions
The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Controls Over Financial Reporting appearing in Item 9A of this Annual Report on Form 10-K. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and
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expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgment. The communication of a critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Evaluation of the Sufficiency of Audit Evidence Over Subscriptions Revenue
As discussed in Note 1 to the consolidated financial statements, and disclosed in the consolidated statements of operations, the Company recorded $1,183.7 million of total revenues for the year ended December 31, 2020, of which $1,086.3 million related to subscriptions. There are high volumes of subscription transactions processed across multiple information technology (IT) systems.
We identified the evaluation of the sufficiency of audit evidence over subscriptions revenue as a critical audit matter. This matter required especially subjective auditor judgment because of the number of IT applications involved in the subscriptions revenue recognition process. This matter also included determining the nature and extent of audit evidence obtained over subscriptions revenue, and the need to involve IT professionals to assist with the performance of certain procedures.
The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls over the Company's subscriptions revenue process, including associated IT controls. We applied auditor judgment to determine the nature and extent of procedures to be performed over subscriptions revenue, including the determination of the IT applications subject to testing. We assessed the recorded subscriptions revenue by selecting transactions and comparing the amounts recognized for consistency with underlying documentation, including contracts with customers. We also involved IT professionals with specialized skills and knowledge, who assisted in testing certain IT applications that are used by the Company in its subscriptions revenue recognition process. We evaluated the sufficiency of audit evidence obtained by assessing the results of procedures performed, including the appropriateness of such evidence.
/s/ KPMG LLP
We have served as the Company’s auditor since 2010.
San Francisco, California
February 26, 2021
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RINGCENTRAL, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value per share)
Assets
Current assets
Deferred and prepaid sales commission costs 63,726 36,589
Prepaid expenses and other current assets 46,516 25,354
Deferred and prepaid sales commission costs, non-current 667,779 462,344
Liabilities, Temporary Equity, and Stockholders' Equity
Current liabilities
Current portion of convertible senior notes, net 31,148 —
Commitments and contingencies (Note 8)
Temporary equity (Note 6) 3,787 —
Stockholders' equity
Accumulated other comprehensive income 6,806 1,948
See accompanying notes to consolidated financial statements
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RINGCENTRAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Year ended December 31,
Revenues
Cost of revenues
Operating expenses
Other income (expense), net
Provision for (benefit from) income taxes 934 (3,333) 140
Net loss per common share
Weighted-average number of shares used in computing net loss per share
See accompanying notes to consolidated financial statements
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RINGCENTRAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
Year ended December 31,
Other comprehensive income (loss)
Foreign currency translation adjustments, net 4,858 (278) (772)
See accompanying notes to consolidated financial statements
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RINGCENTRAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
Common stock
Shares Amount
Changes in comprehensive income — — — (772) — (772)
Changes in comprehensive income — — — (278) — (278)
Temporary equity reclassification (Note 6) — — (3,787) — — (3,787)
Changes in comprehensive income — — — 4,858 — 4,858
See accompanying notes to consolidated financial statements
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RINGCENTRAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Year ended December 31,
Cash flows from operating activities
Amortization of deferred and prepaid sales commission costs 47,207 30,134 19,754
Loss on early extinguishment of debt 13,284 — —
Repayment of convertible senior notes attributable to debt discount (35,020) — —
Reduction of operating lease right-of-use assets 15,712 13,256 —
Unrealized gain and other related costs on investments (80,988) 3,369 —
Foreign currency remeasurement (gain) loss (2,954) (105) 951
Tax benefit from release of valuation allowance — (3,210) —
Changes in assets and liabilities:
Prepaid expenses and other current assets (20,878) (1,575) (342)
Cash flows from investing activities
Cash paid for business combination, net of cash acquired — (27,870) (26,434)
Purchases of long-term investments — (135,557) —
Cash flows from financing activities
Payments for 2023 convertible senior notes partial repurchase (1,086,268) — —
Payments for capped calls and transaction costs (102,695) — (49,910)
Repurchase of common stock — — (15,000)
Payment for contingent consideration for business acquisition (3,648) (5,176) —
Repayment of financing obligations (1,489) (943) (741)
Cash, cash equivalents, and restricted cash
Supplemental disclosure of cash flow data:
Cash paid for income taxes, net of refunds $ 870 $ 996 $ 433
Non-cash investing and financing activities
Common stock issued for acquisition of intangible assets $ — $ 16,450 $ —
Equipment acquired under financing obligations $ 4,694 $ — $ 4,513
See accompanying notes to consolidated financial statements
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RINGCENTRAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Description of Business and Summary of Significant Accounting Policies
Description of Business
RingCentral, Inc. (the “Company”) is a provider of software-as-a-service (“SaaS”) solutions that enables businesses to communicate, collaborate and connect. The Company was incorporated in California in 1999 and was reincorporated in Delaware on September 26, 2013.
Principles of Consolidation
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and include the consolidated accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. The significant estimates made by management affect revenues, the allowance for doubtful accounts, valuation of long-term investments, deferred and prepaid sales commission costs, goodwill, useful lives of intangible assets, share-based compensation, capitalization of internally developed software, liability and equity allocation of convertible senior notes, return reserves, provision for income taxes, uncertain tax positions, loss contingencies, sales tax liabilities, and accrued liabilities. Management periodically evaluates these estimates and will make adjustments prospectively based upon the results of such periodic evaluations. Actual results m differ from these estimates.
In March 2020, the World Health Organization declared the outbreak of the novel strain of coronavirus (“COVID-19”) as a global pandemic with widespread and detrimental effect on the global economy. The extent of the impact of COVID-19 on the Company's operational and financial performance will depend on certain developments, including the duration and spread of the outbreak, impact on the Company's customers and sales cycles, and its employees, all of which are uncertain and cannot be predicted. As of the date of issuance of these financial statements, the Company is not aware of any specific event or circumstance that would require updating significant estimates or judgments or revising the carrying value of the Company's assets or liabilities as presented in the consolidated financial statements. These estimates may change as new events occur and additional information is obtained. Actual results could differ materially from these estimates.
Foreign Currency
The functional currency of the Company’s foreign subsidiaries is generally the local currency. Adjustments resulting from translating foreign functional currency financial statements into U.S. dollars are recorded as part of a separate component of stockholders’ equity and reported in the Consolidated Statements of Comprehensive Loss. Foreign currency transaction gains and losses are included in net loss for the period. All assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the exchange rate on the balance sheet date. Revenues and expenses are translated at the average exchange rate during the period. Equity transactions are translated using historical exchange rates.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents are stated at fair value.
Allowance for Doubtful Accounts
For the years ended December 31, 2020 and 2019, a portion of revenues were realized from credit card transactions while the remaining revenues generated accounts receivable. The Company determines provisions based on historical loss patterns, the number of days that billings are past due, and an evaluation of the potential risk of loss associated with delinquent accounts.
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Below is a summary of the changes in allowance for doubtful accounts for the years ended December 31, 2020, 2019 and 2018 (in thousands):
Long-Term Investments
Long-term investments consist of convertible and redeemable preferred securities in which the Company does not have a controlling interest or significant influence. These investments are recorded at fair value using both observable and unobservable inputs and the valuation requires judgment. These investments are reported at fair value in long-term investments in the Consolidated Balance Sheets. All gains and losses on these investments, realized and unrealized, are recognized in other income (expense), net in the Consolidated Statements of Operations.
Internal-Use Software Development Costs
The Company capitalizes qualifying internal-use software development costs that are incurred during the application development stage, provided that management with the relevant authority authorizes and commits to the funding of the project, it is probable the project will be completed, and the software will be used to perform the function intended. Costs related to preliminary project activities and post implementation activities are expensed as incurred. Capitalized internal-use software development costs are included in property and equipment and are amortized on a straight-line basis over their estimated useful lives.
For the years ended December 31, 2020 and 2019, the Company capitalized $41.9 million and $18.5 million, net of impairment, of internal-use software development costs, respectively. The carrying value of internal-use software development costs was $66.4 million and $35.6 million at December 31, 2020 and 2019, respectively.
Property and Equipment, net
Property and equipment, net is stated at cost, less accumulated depreciation and amortization. Depreciation and amortization is calculated on a straight-line basis over the estimated useful lives of those assets as follows:
Computer hardware and software 3 to 5 years
Internal-use software development costs 3 to 5 years
Furniture and fixtures 1 to 5 years
Leasehold improvements Shorter of the estimated lease term or useful life
The Company evaluates the recoverability of property and equipment and intangible assets for possible impairment whenever events or circumstances indicate that the carrying amount of such assets or asset groups may not be recoverable. Recoverability of these assets or asset groups is measured by comparing the carrying amounts of such assets or asset groups to the future undiscounted cash flows that such assets or asset groups are expected to generate. If this evaluation indicates that the carrying amount of the assets or asset groups is not recoverable, the carrying amount of such assets or asset groups is reduced to its estimated fair value.
Maintenance and repairs are charged to expense as incurred.
Leases
The Company determines if a contract is a lease or contains a lease at the inception of the contract and reassesses that conclusion if the contract is modified. All leases are assessed for classification as an operating lease or a finance lease. Operating lease right-of-use (“ROU”) assets are presented separately on the Company's Consolidated Balance Sheets. Operating lease liabilities are separated into a current portion, included within accrued liabilities on the Company's
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Consolidated Balance Sheets, and a non-current portion included within operating lease liabilities on the Company's Consolidated Balance Sheets. The Company does not have significant finance lease ROU assets or liabilities. ROU assets represent the Company's right to use an underlying asset for the lease term and lease liabilities represent its obligation to make lease payments arising from the lease. The Company does not obtain and control its right to use the identified asset until the lease commencement date.
The Company’s lease liabilities are recognized at the applicable lease commencement date based on the present value of the lease payments required to be paid over the lease term. Because the rate implicit in the lease is not readily determinable, the Company generally uses an incremental borrowing rate to discount the lease payments to present value. The estimated incremental borrowing rate is derived from information available at the lease commencement date. The Company factors in publicly available data for instruments with similar characteristics when calculating its incremental borrowing rates. The Company's ROU assets are also recognized at the applicable lease commencement date. The ROU asset equals the carrying amount of the related lease liability, adjusted for any lease payments made prior to lease commencement and lease incentives provided by the lessor. Variable lease payments are expensed as incurred and do not factor into the measurement of the applicable ROU asset or lease liability.
The term of the Company's leases equal the non-cancellable period of the lease, including any rent-free periods provided by the lessor, and also include options to renew or extend the lease (including by not terminating the lease) that the Company is reasonably certain to exercise. The Company establishes the term of each lease at lease commencement and reassesses that term in subsequent periods when one of the triggering events outlined in Topic 842, Leases, occurs. Operating lease cost for lease payments is recognized on a straight-line basis over the lease term.
The Company's lease contracts often include lease and non-lease components. For facility leases, the Company has elected the practical expedient offered by the standard to not separate lease from non-lease components and accounts for them as a single lease component. For the Company's other contracts that include leases, the Company accounts for the lease and non-lease components separately.
The Company has elected, for all classes of underlying assets, not to recognize ROU assets and lease liabilities for leases with a term of twelve months or less. Lease cost for short-term leases is recognized on a straight-line basis over the lease term. Additionally, for certain facility leases, the Company applies a portfolio approach, whereby it effectively accounts for the operating lease ROU assets and liabilities for multiple leases as a single unit of account because the accounting effect of doing so is not material.
On January 1, 2019, the Company adopted Topic 842 using a modified retrospective transition approach. As a result, the Company was not required to adjust its comparative periods' financial information for effects of the standard or make the new required lease disclosures for the periods before the date of adoption. The adoption of the standard did not have a material impact on the Company's consolidated statement of Operations or Cash Flows. The impact on the Company's Consolidated Balance Sheet as of January 1, 2019 was the recognition of ROU assets and lease liabilities for operating leases in the amount of $33.5 million.
Goodwill and Intangible Assets
Goodwill is tested for impairment at the reporting unit level at a minimum on an annual basis or more frequently when an event occurs or circumstances change that indicate that the carrying value may not be recoverable. Goodwill is considered impaired if the carrying value of the reporting unit exceeds its fair value. The Company conducted its annual impairment test of goodwill in the fourth quarter of 2020 and 2019 and determined that no adjustment to the carrying value of goodwill was required.
Intangible assets consist of purchased customer relationships and developed technology. Intangible assets are amortized over the period of estimated benefit using the straight-line method and estimated useful lives ranging from two to five years. No residual value is estimated for intangible assets.
Concentrations
Financial instruments that subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. Although the Company deposits its cash with multiple financial institutions, its deposits, at times, may exceed federally insured limits. The Company’s accounts receivable are primarily derived from sales by resellers and to larger direct customers. The Company maintains an allowance for doubtful accounts for estimated potential credit losses.
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As of December 31, 2020, 2019 and 2018, and for the years then ended, none of the Company’s customers accounted for more than 10% of total accounts receivable, total revenues, or subscription revenues.
During the years ended December 31, 2020, 2019 and 2018, the Company contracted a significant portion of its software development efforts from third-party vendors located in Russia and Ukraine. A cessation of services provided by these vendors could result in a disruption to the Company’s research and development efforts.
Long-lived assets by geographic location is based on the location of the legal entity that owns the asset. As of December 31, 2020 and 2019, approximately 90% and 89% of the Company’s consolidated long-lived assets, respectively, were located in the U.S. No other single country outside of the U.S. represented more than 10% of the Company’s consolidated long-lived assets as of December 31, 2020 and 2019.
Revenue Recognition
The Company derives its revenues primarily from subscriptions, sale of products, and professional services. Revenues are recognized when control of these services is transferred to the customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those services.
The Company determines revenue recognition through the following steps:
•identification of the contract, or contracts, with a customer;
•identification of the performance obligations in the contract;
•determination of the transaction price;
•allocation of the transaction price to the performance obligations in the contract; and
•recognition of revenue when, or as, the Company satisfies a performance obligation.
The Company recognizes revenues as follows:
Subscriptions revenue
Subscriptions revenue is generated from fees that provide customers access to one or more of the Company’s software applications and related services. These arrangements have contractual terms typically ranging from one month to five years and include recurring fixed plan subscription fees and variable usage-based fees for usage in excess of plan limits.
Arrangements with customers do not provide the customer with the right to take possession of the Company’s software at any time. Instead, customers are granted continuous access to the services over the contractual period. The Company transfers control evenly over the contractual period by providing stand-ready service. Accordingly, the fixed consideration related to subscription is recognized over time on a straight-line basis over the contract term beginning on the date the Company’s service is made available to the customer. The Company may offer its customer services for no consideration during the initial months. Such discounts are recognized ratably over the term of the contract.
Fees for additional minutes of usage in excess of plan limits are deemed to be variable consideration that meet the allocation exception for variable consideration as they are specific to the month that the usage occurs.
The Company’s subscription contracts typically allow the customers to terminate their services within the first 30 or 60 days and receive a refund for any amounts paid. After the end of the termination period, the contract is non-cancellable and the customer is obligated to pay for the remaining term of the contract. Accordingly, the Company considers the non-cancellable term of the contract to begin after the expiration of the termination period.
The Company records reductions to revenue for estimated sales returns and customer credits at the time the related revenue is recognized. Sales returns and customer credits are estimated based on the Company’s historical experience, current trends and the Company’s expectations regarding future experience. The Company monitors the accuracy of its sales reserve estimates by reviewing actual returns and credits and adjusts them for its future expectations to determine the adequacy of its current and future reserve needs. If actual future returns and credits differ from past experience, additional reserves may be required.
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Other revenue
Other revenue includes revenue generated from sale of pre-configured phones, professional implementation services, and phone rentals.
Phone revenue is recognized upon transfer of control to the customer which is generally upon shipment from the Company’s or its designated agents' warehouse. The amount of revenue recognized for products is adjusted for expected returns, which are estimated based on historical data.
The Company offers professional services to support implementation and deployment of its subscription services. Professional services do not result in significant customization of the product and are generally short-term in duration. The majority of the Company’s professional services contracts are on a fixed price basis and revenue is recognized when services are delivered.
Principal vs. Agent
A portion of the Company’s subscriptions and product revenues are generated through sales by resellers, strategic partners, and carrier partners. When the Company controls the performance of contractual obligations to the customer, it records these revenues at the gross amount paid by the customer with amounts retained by the resellers recognized as sales and marketing expenses. The Company assesses control of goods or services when it is primarily responsible for fulfilling the promise to provide the good or service, has inventory risk and has discretion in establishing the price.
Deferred and prepaid sales commission costs
The Company capitalizes sales commission expenses and associated payroll taxes paid to internal sales personnel and resellers, who sell the Company’s offerings. The resellers are selling agents for the Company and earn sales commissions which are directly tied to the value of the contracts that the Company enters with the end-user customers. These sales commissions are incremental costs the Company incurs to obtain contracts with its end-user customers. The Company pays sales commissions on initial contracts and contracts for increased purchases with existing customers (expansion contracts). The Company does not pay sales commissions for contract renewals.
These sales commission costs are deferred and then amortized over the expected period of benefit, which is estimated to be five years. The Company has determined the period of benefit taking into consideration the expected subscription term and expected renewal periods of its customer contracts, the duration of its relationships with its customers considering historical and expected customer retention, technology and other factors. Amortization expense is included in sales and marketing expenses in the accompanying Consolidated Statements of Operations.
Cost of Revenues
Cost of subscriptions revenue primarily consists of costs of network capacity purchased from third-party telecommunications providers, network operations, costs to build out and maintain data centers, including co-location fees for the right to place the Company’s servers in data centers owned by third-parties, depreciation of the servers and equipment, along with related utilities and maintenance costs, personnel costs associated with customer care and support of the functionality of the Company’s platform and data center operations, including share-based compensation expenses, and allocated costs of facilities and information technology. Cost of subscriptions revenue is expensed as incurred.
Cost of other revenue is comprised primarily of the cost associated with purchased phones, shipping costs, costs of professional services, and allocated costs of facilities and information technology related to the procurement, management and shipment of phones. Cost of other revenue is expensed in the period product is delivered to the customer.
Share-Based Compensation
Share-based compensation expense resulting from options, restricted stock units (“RSUs”), performance-based awards, and employee stock purchase plan (“ESPP”) rights granted is measured as the grant date fair value of the award and is generally recognized using the straight-line attribution method over the requisite service period of the award, which is generally the vesting period. The Company estimates the fair value of stock options, ESPP rights, and performance-based awards using the Black-Scholes-Merton option-pricing model. The Company estimates the fair value of RSUs as the closing market value of its Class A Common Stock on the grant date. For awards with performance-based and service-based conditions, compensation cost is recognized over the requisite service period if it is probable that the performance condition will be satisfied. The expense for
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performance-based awards is evaluated each quarter based on the achievement of the performance conditions. The effect of a change in the estimated number of performance-based awards expected to be earned is recognized in the period those estimates are revised. Compensation expense is recognized net of estimated forfeiture activity, which is based on historical forfeiture rates.
Research and Development
Research and development expenses consist primarily of third-party contractor costs, personnel costs, technology license expenses, and depreciation associated with research and development equipment. Research and development costs are expensed as incurred.
Advertising Costs
Advertising costs, which include various forms of e-commerce such as search engine marketing, search engine optimization and online display advertising, as well as more traditional forms of media advertising such as radio and billboards, are expensed as incurred and were $76.6 million, $59.9 million, and $58.3 million for the years ended December 31, 2020, 2019 and 2018, respectively.
Convertible Debt
The Company bifurcates the debt and equity (the contingently convertible feature) components of its convertible debt instruments in a manner that reflects its nonconvertible debt borrowing rate at the time of issuance. The equity components of the convertible debt instruments are recorded within stockholders’ equity with an allocated issuance discount. The debt issuance discount is amortized to interest expense in the Consolidated Statements of Operations using the effective interest method over the expected term of the convertible debt.
Income Taxes
The Company accounts for income taxes using the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period that includes the enactment date. The Company records a valuation allowance to reduce its deferred tax assets to the amount of future tax benefit that is more likely than not to be realized. As of December 31, 2020, except for deferred tax assets associated with its subsidiary in China, the Company recorded a full valuation allowance against all other net deferred tax assets due to its history of operating losses. The Company classifies interest and penalties on unrecognized tax benefits as income tax expense.
Segment Information
The Company has determined the chief executive officer is the chief operating decision maker. The Company’s chief executive officer reviews financial information presented on a consolidated basis for purposes of assessing performance and making decisions on how to allocate resources. Accordingly, the Company has determined that it operates in a single reportable segment.
Indemnification
Certain of the Company’s agreements with resellers and customers include provisions for indemnification against liabilities if its subscriptions infringe upon a third-party’s intellectual property rights. At least quarterly, the Company assesses the status of any significant matters and its potential financial statement exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount or the range of loss can be estimated, the Company accrues a liability for the estimated loss. The Company has not incurred any material costs as a result of such indemnification provisions. The Company has not accrued any material liabilities related to such obligations as of December 31, 2020 and 2019.
Recent Accounting Pronouncements Not Yet Adopted
In December 2019, the Financial Accounting Standard Board ("FASB") issued Accounting Standard Update ("ASU") No. 2019-12, Accounting Standards Update (Topic 740): Simplifying the Accounting for Income Taxes. The ASU removed certain exceptions for recognizing deferred taxes for investments, performing intraperiod allocation and calculating income
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taxes in interim periods. The ASU added guidance to reduce complexity in certain areas, including recognizing deferred taxes for goodwill and allocating taxes to members of a consolidated group. The ASU also amended the reporting requirement of taxes not based on income. The ASU is effective for calendar year-end public entities on January 1, 2021. Entities may early adopt the ASU in any interim period for which financial statements have not yet been issued (or made available for issuance). The Company has not yet adopted the new guidance. The adoption is not expected to have a material impact on the Company's consolidated financial statements.
In March 2020, the FASB issued optional guidance for a limited time to ease the potential burden in accounting for or recognizing the effects of reference rate reform, particularly, the risk of cessation of the London Interbank Offered Rate ("LIBOR") on financial reporting. The guidance provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The amendments are elective and are effective upon issuance for all entities through December 31, 2022. The Company is currently evaluating the impact of the new guidance.
In August 2020, the FASB issued ASU No. 2020-06, Accounting for Convertible Instruments and Contracts in an Entity's Own Equity, which simplifies the accounting for certain convertible instruments, amends the guidance on derivative scope exceptions for contracts in an entity's own equity, and modifies the guidance on diluted earnings per share calculations as a result of these changes. This new standard is effective for public entities for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. The amendment is to be adopted through either a fully retrospective or modified retrospective method of transition. Early adoption is permitted. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements.
Note 2. Revenues and Cost of Revenue
Disaggregation of revenue
Revenue by geographic location are based on the billing address of the customer. The following table provides information about disaggregated revenue by primary geographical markets:
Year ended December 31,
Primary geographical markets
Others 8 % 7 % 5 %
The Company derived over 90% of subscription revenues from RingCentral Office and RingCentral customer engagement solutions products for the years ended December 31, 2020 and 2019, and approximately 88% for the year ended December 31, 2018.
Deferred revenue
During the year ended December 31, 2020, the Company recognized revenue of approximately all of the $107.4 million that was included in the corresponding deferred revenue balance at the beginning of the year.
Remaining performance obligations
The typical subscription term ranges from one month to five years. Contract revenue as of December 31, 2020 that has not yet been recognized was approximately $1.3 billion. This excludes contracts with an original expected length of less than one year. Of these remaining performance obligations, the Company expects to recognize revenue of 53% of this balance over the next 12 months and 47% thereafter.
Other revenues and cost of revenues
Other revenues are primarily comprised of product revenue from the sale of pre-configured phones, professional services, and phone rentals. Product revenues from the sale of pre-configured phones were $43.3 million, $42.9 million, and $34.4 million for the years ended December 31, 2020, 2019 and 2018, respectively. Cost of product revenues were $41.4 million, $39.1 million, and $29.6 million for the years ended December 31, 2020, 2019 and 2018, respectively.
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Note 3. Financial Statement Components
Cash and cash equivalents consisted of the following (in thousands):
The Company has no restricted cash balance as of December 31, 2020 and 2019.
Accounts receivable, net consisted of the following (in thousands):
Allowance for doubtful accounts (5,184) (2,358)
Prepaid expenses and other current assets consisted of the following (in thousands):
Total prepaid expenses and other current assets $ 46,516 $ 25,354
Property and equipment, net consisted of the following (in thousands):
Internal-use software development costs 90,361 48,419
Less: accumulated depreciation and amortization (138,373) (99,047)
Total depreciation and amortization expense related to property and equipment was $39.8 million, $27.2 million, and $18.9 million for the years ended December 31, 2020, 2019 and 2018, respectively.
During the year ended December 31, 2020, the Company financed $4.7 million of property, equipment, and software licenses through vendor financing arrangements at interest rates ranging up to 3.95% to be repaid over a three-year term. As of December 31, 2020, $3.2 million of the related equipment is collateralized under the vendor financing arrangement. The financing arrangements and the assets purchased under these arrangements are non-cash investing and financing activities.
The carrying value of goodwill is as follows (in thousands):
Foreign currency translation adjustments 2,035
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The carrying values of intangible assets are as follows (in thousands):
Amortization expense from acquired intangible assets for the years ended December 31, 2020, 2019 and 2018 was $35.8 million, $10.7 million, and $4.4 million, respectively. Amortization of developed technology is included in cost of revenues expenses and amortization of customer relationships is included in sales and marketing expenses in the Consolidated Statements of Operations. As of December 31, 2020, the weighted-average amortization period for developed technology is approximately 2.8 years and for customer relationships is approximately 2.0 years.
Estimated amortization expense for acquired intangible assets for the following five fiscal years is as follows (in thousands):
Total estimated amortization expense $ 118,313
Accrued liabilities consisted of the following (in thousands):
Accrued compensation and benefits $ 43,225 $ 30,541
Accrued sales, use, and telecom related taxes 31,311 25,757
Operating lease liabilities, short-term 16,267 14,249
Deferred and Prepaid Sales Commission Costs
Amortization expense for the deferred and prepaid sales commission costs for the years ended December 31, 2020, 2019 and 2018 were $47.2 million, $30.1 million, and $19.8 million, respectively. There was no impairment loss in relation to the costs capitalized for the periods presented.
Note 4. Fair Value of Financial Instruments
The Company measures and reports certain cash equivalents, including money market funds and certificates of deposit, in addition to its long-term investments at fair value in accordance with the provisions of the authoritative accounting guidance that addresses fair value measurements. This guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available.
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The hierarchy is broken down into three levels based on the reliability of the inputs as follows:
Level 1: Observable inputs that reflect unadjusted quoted prices in active markets for identical assets or liabilities.
Level 2: Other inputs, such as quoted prices for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.
Level 3: Unobservable inputs that are supported by little or no market activity and that are based on management’s assumptions, including fair value measurements determined by using pricing models, discounted cash flow methodologies or similar techniques.
The financial assets carried at fair value were determined using the following inputs (in thousands):
Fair Value at December 31, 2020 Level 1 Level 2 Level 3
Cash equivalents:
Noncurrent assets:
Fair Value at December 31, 2019 Level 1 Level 2 Level 3
Cash equivalents:
Noncurrent assets:
The Company’s other financial instruments, including accounts receivable, accounts payable, and other current liabilities, are carried at cost, which approximates fair-value due to the relatively short maturity of those instruments.
Convertible Senior Notes
As of December 31, 2020, the fair value of the 0% convertible senior notes due 2026 (the "2026 Notes") was approximately $763.9 million. The fair value was determined based on the quoted price for the 2026 Notes in an inactive market on the last trading day of the reporting period and is considered as Level 2 in the fair value hierarchy.
As of December 31, 2020, the fair value of the 0% convertible senior notes due 2025 (the “2025 Notes”) was approximately $1.3 billion. The fair value was determined based on the quoted price for the 2025 Notes in an inactive market on the last trading day of the reporting period and is considered as Level 2 in the fair value hierarchy.
As of December 31, 2020, the fair value of the 0% convertible senior notes due 2023 (the “2023 Notes”) was approximately $381.1 million. The fair value was determined based on the quoted price for the 2023 Notes in an inactive market on the last trading day of the reporting period and is considered as Level 2 in the fair value hierarchy.
Long-Term Investments
As of December 31, 2020 and 2019, the fair value of the Company's long-term investments in convertible and redeemable preferred stock was $213.2 million and $132.2 million, respectively. The Company classifies its long-term investments as Level 3 in the fair value hierarchy based on the nature of the fair value inputs and judgment involved in the valuation process. The Company uses a lattice model to value these investments and relies on observable inputs including share-price, credit spread, and volatility. The model also incorporates judgments relating to the probability of special redemption triggers, the expected holding period of the investment and interest rates. These investments are reported at fair value in long-term investments in the Consolidated Balance Sheets. The Company's total net unrealized gain recorded in other income (expense), net, for the years ended December 31, 2020 and 2019 was $77.2 million and $6.6 million, respectively. Volatility in the global economic climate and financial markets, including the effects of COVID-19, could result in a significant change in the underlying share-price of the Company’s investees, resulting in a material change in the value of the long-term investments.
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Note 5. Business Combinations, Strategic Partnerships, and Asset Acquisitions
In November 2020, the Company entered into a strategic partnership with Vodafone Group Services Limited (“Vodafone”), a telecommunication provider in Europe and Africa. The parties intend to introduce a new co-branded cloud-based service that will be the Unified Communications as a Service ("UCaaS") solution for Vodafone and offer Contact Center as a Service (“CCaaS”) to Vodafone’s customers. In July 2020, the Company entered into a strategic partnership with Alcatel-Lucent Enterprise ("ALE"), a provider of communications, networking, and cloud solutions in Europe. The parties intend to introduce a new co-branded solution, which will be the UCaaS solution marketed and sold by ALE. In addition to the above transactions, in 2020, the Company also entered into arrangements with unrelated third parties to acquire intellectual property rights. Under these agreements, the Company paid total upfront consideration of $141.6 million in cash. These consideration represent cost to obtain contracts with customers and were included in deferred and prepaid sales commission costs on the Company's Consolidated Balance Sheets. The Company also paid $26.6 million to acquire intellectual property rights, which will be amortized over their expected useful life of approximately two years to four years.
In December 2019, the Company entered into a strategic partnership with Atos SE ("Atos") and its subsidiary, Unify Software and Solutions GmbH & CO. KG ("Unify"), which, among other things, provided for a one-time upfront consideration towards the acquisition of certain intellectual property rights and a commercial arrangement. Under the commercial agreement Unify is engaged in the marketing and sale of the Company's product, which represents advance payment for cost to obtain contracts with customers. In October 2019, the Company entered into certain agreements for a strategic partnership with Avaya Holdings Corp. (“Avaya”) and its subsidiaries, including Avaya Inc. In connection with the strategic partnership, the Company purchased $125.0 million aggregate principal amount of 3% convertible and redeemable preferred stock, with a conversion price of $16.00 per share, representing an approximately 6% position in Avaya on an as-converted basis. The Company also paid Avaya $345.0 million in the Company's Class A Common Stock, predominantly for future fees, which was capitalized and will be amortized over the expected benefit period. The transaction closed on October 31, 2019. The investment in preferred securities in which the Company does not have a controlling interest or significant influence are measured at fair value with changes recorded through other income (expense) in the Consolidated Statements of Operations. The advance payment represents prepayment for cost to obtain contracts with customers. The Company also purchased intellectual property rights, which have been capitalized as an intangible asset and will be amortized over the useful life of three years. In addition to the above transactions, in 2019, the Company also separately entered into arrangements with unrelated third parties to acquire intellectual property rights.
In connection with the above transactions, in 2019, the Company recorded in aggregate $105.5 million in acquired intangible assets relating to developed technology on the Consolidated Balance Sheets, which will be amortized over their respective useful life of three to five years. The Company also recorded $371.1 million as deferred and prepaid sales commission costs representing cost to obtain contracts with customers. The prepaid assets will be amortized over their useful life based on the pattern of benefit since they are considered to be incremental customer acquisition costs. Certain of the strategic agreements entered in 2020 and 2019 may require the parties to incur certain costs towards strategic efforts. Such net costs are recorded as cost of revenues and operating expenses in the Consolidated Statements of Operations, in the period incurred.
On January 14, 2019, the Company acquired the equity interests of Connect First, Inc. (“Connect First”), a cloud-based outbound/blended customer engagement platform for midsize and enterprise companies. The acquisition complements the Company’s current Customer Engagement portfolio to provide differentiated customer experiences.
The total purchase price of approximately $36.4 million consisted of cash of $29.3 million and $7.1 million held to cover indemnity claims made by the Company after the closing date. In connection with the acquisition, the Company granted $4.0 million in restricted stock units, which vest over four years.
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The allocation of the purchase price of the assets acquired and liabilities assumed based on their estimated fair values was as follows (in thousands):
Cash and cash equivalents $ 1,427
Other tangible assets acquired 2,266
Acquired intangible assets 13,300
Total assets acquired 41,458
Liabilities assumed (5,013)
Total consideration $ 36,445
The amortizable intangible assets have a weighted average useful life of three years. The purchase price exceeded the estimated fair value of the tangible and identifiable intangible assets and liabilities acquired and, as a result of the allocation, the Company recorded goodwill of $24.5 million, which is not deductible for tax purposes. The goodwill recognized is attributable primarily to contributions of the entity's technology to the overall corporate strategy, enhancements to the Company's contact center product offerings, and assembled workforce of the acquired business.
Note 6. Convertible Senior Notes
In March 2018, the Company issued $460.0 million aggregate principal amount of 0% convertible senior notes due 2023 in a private placement, including the exercise in full of the over-allotment options of the initial purchasers (the "2023 Notes"). The 2023 Notes will mature on March 15, 2023, unless earlier repurchased or redeemed by the Company or converted pursuant to their terms. The total net proceeds from the debt offering, after deducting initial purchase discounts and debt issuance costs, were approximately $449.5 million.
In March 2020, the Company issued $1.0 billion aggregate principal amount of 0% convertible senior notes due 2025 in a private placement to qualified institutional buyers (the "2025 Notes"). The 2025 Notes will mature on March 1, 2025, unless earlier repurchased or redeemed by the Company or converted pursuant to their terms. The total net proceeds from the debt offering, after deducting initial purchase discounts and debt issuance costs, were approximately $986.5 million.
In September 2020, the Company issued $650 million aggregate principal amount of 0% convertible senior notes due 2026 in a private placement to qualified institutional buyers (the "2026 Notes"). The 2026 Notes will mature on March 15, 2026, unless earlier repurchased or redeemed by the Company or converted pursuant to their terms. The total net proceeds from the debt offering, after deducting initial purchase discounts and debt issuance costs, were approximately $640.2 million.
The 2023 Notes, 2025 Notes and 2026 Notes (collectively, the “Notes”) are senior, unsecured obligations of the Company that do not bear regular interest, and the principal amount of the Notes do not accrete. The Notes may bear special interest under specified circumstances relating to the Company's failure to comply with its reporting obligations under the indentures governing each of the Notes (collectively, the "Notes Indentures") or if the Notes are not freely tradeable as required by each respective Notes Indenture.
Partial Repurchase of 2023 Notes
In March 2020, the Company used $509.6 million of the net proceeds from the offering of the 2025 Notes to repurchase $172.5 million aggregate principal amount of the 2023 Notes in cash through individual privately negotiated transactions (the “First Partial Repurchase of 2023 Notes”). Of the $509.6 million net proceeds, $153.7 million and $355.9 million were allocated to the debt and equity components, respectively. As of the repurchase date, the carrying value of the 2023 Notes subject to the First Partial Repurchase of 2023 Notes, net of unamortized debt discount and issuance costs, was $146.4 million. The First Partial Repurchase of 2023 Notes resulted in a $7.3 million loss on early debt extinguishment.
In September 2020, the Company used $452.6 million of the net proceeds from the offering of the 2026 Notes to repurchase $132.6 million aggregate principal amount of the 2023 Notes in cash through individual privately negotiated transactions (the “Second Partial Repurchase of 2023 Notes”). Of the $452.6 million net proceeds, $121.1 million and $331.5 million were allocated to the debt and equity components, respectively. As of the repurchase date, the carrying value of the 2023 Notes subject to the Second Partial Repurchase of 2023 Notes, net of unamortized debt discount and issuance costs, was $115.6 million. The Second Partial Repurchase of 2023 Notes resulted in a $5.5 million loss on early debt extinguishment.
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The allocation between the debt and equity components utilized an effective interest rate to determine the fair value of the liability component. The interest rate reflected the Company's incremental borrowing rate, adjusted for the Company's credit standing on nonconvertible debt with similar maturity as of each repurchase date.
Redemptions of 2023 Notes
During the year ended December 31, 2020, the Company received conversion requests of approximately $109.6 million, of which approximately $74.7 million principal amount were settled during the year. The Company recognized an immaterial loss on these conversions, representing the fair value of the liability component in excess of the net carrying amount of the converted notes on the respective settlement dates. The amount is included in other income (expense), net in the Consolidated Statement of Operations.
In relation to the remaining $34.9 million principal amount of unsettled conversion requests, as of December 31, 2020, the Company reclassified the net carrying value of the debt of $31.1 million from long-term to short-term debt and a portion of equity of approximately $3.8 million to temporary equity. The amount reclassified to temporary equity represents the difference between the principal and net carrying amount of the liability component of the 2023 Notes requested for conversion. These requests will be settled during the first quarter of fiscal 2021. In addition, from January 1, 2021 to the date of this filing, the Company has received additional conversion requests for $4.1 million principal amounts, which are expected to be settled during the quarter ending March 31, 2021.
Other Terms of the Notes
The conversion rate is subject to adjustment upon the occurrence of certain specified events but will not be adjusted for any accrued and unpaid special interest. In addition, upon the occurrence of a make-whole fundamental change or a redemption period, each as defined in the respective Notes Indentures, the Company will, in certain circumstances, increase the conversion rate by a number of additional shares for a holder that elects to convert its Notes in connection with such make-whole fundamental change or during the relevant redemption period.
The Notes will be convertible at the option of the holders at any time prior to the close of business on the business day immediately preceding December 15, 2022, December 1, 2024, and December 15, 2025, for the 2023 Notes, 2025 Notes, and 2026 Notes respectively, only under the following circumstances:
(1)during any calendar quarter commencing after June 30, 2018 for the 2023 Notes, June 30, 2020 for the 2025 Notes, and December 31, 2020 for the 2026 Notes, and only during such calendar quarter, if the last reported sale price of the Class A Common Stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
(2)during the five-business day period after any five consecutive trading day period in which, for each trading day of that period, the trading price per $1,000 principal amount of each Notes for such trading day was less than 98% of the product of the last reported sale price of the Class A Common Stock and the conversion rate for the respective Notes on each such trading day;
(3)upon the Company’s notice that it is redeeming any or all of either of the Notes, but only with respect to the Notes called for redemption, at any time prior to the close of business on the scheduled trading day immediately preceding the redemption date; or
(4)upon the occurrence of specified corporate events.
On or after December 15, 2022 for the 2023 Notes, December 1, 2024 for the 2025 Notes, and December 15, 2025 for the 2026 Notes, until the close of business on the scheduled trading day immediately preceding the maturity date, holders of the Notes may convert all or a portion of their notes regardless of the foregoing conditions.
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Upon conversion, the Company will pay or deliver, as the case may be, either cash, shares of Class A Common Stock or a combination of cash and shares of Class A Common Stock, at the Company’s election. It is the Company’s current intent to settle the principal amount of the Notes with cash.
During the three months ended December 31, 2020, the stock price condition allowing holders of the 2023 Notes to convert was met. As a result, holders have the option to convert their 2023 Notes at any time during the fiscal quarter ending March 31, 2021. During the three months ended December 31, 2020, the conditions allowing holders of the 2025 and 2026 Notes to convert were not met. The Notes may be convertible thereafter if one or more of the conversion conditions specified in the indentures are satisfied during future measurement periods.
The Company may redeem at its option, on or after September 20, 2020 for the 2023 Notes, March 5, 2022 for the 2025 Notes, and March 20, 2023 for the 2026 Notes, at a redemption price equal to 100% of the principal amount thereof, plus accrued and unpaid special interest if the last reported sale price of the Company’s Class A Common Stock has been at least 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive), including the trading day immediately preceding the date on which the Company provides notice of redemption, during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which the Company provides written notice of redemption. No sinking fund is provided for the Notes.
Upon the occurrence of a fundamental change (as defined in each respective Notes Indentures) prior to the maturity date, holders may require the Company to repurchase all or a portion of the 2023 Notes, 2025 Notes or 2026 Notes for cash at a price equal to 100% of the principal amount of the Notes to be repurchased, plus any accrued and unpaid special interest to, but excluding, the fundamental change repurchase date.
The 2026 Notes are senior unsecured obligations and will rank senior in right of payment to any of the Company’s indebtedness that is expressly subordinated in right of payment to the 2026 Notes; equal in right of payment with the Company’s existing and future liabilities that are not so subordinated, including the 2023 Notes and the 2025 Notes; effectively junior in right of payment to any of the Company’s secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness and other liabilities (including trade payables) of current or future subsidiaries of the Company.
Accounting for the Notes
In accounting for the issuance of the Notes, the Company separated the respective notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar debt instrument that does not have an associated convertible feature. The carrying amount of the equity component of the Notes representing the conversion option was determined by deducting the fair value of the liability component from the par value. The equity component is not remeasured as long as it continues to meet the conditions for equity classification. The excess of the principal amount of the liability component over its carrying amount (“debt discount”) is amortized to interest expense at an effective interest rate over the contractual terms of the note.
In accounting for the transaction costs related to the Notes, the Company allocated the total amount incurred to the liability and equity components of the notes based on the proportion of the proceeds allocated to the debt and equity components. Issuance costs attributable to the liability component recorded as additional debt discount were $8.2 million for the 2023 Notes, $10.9 million for the 2025 Notes, and $7.7 million for the 2026 Notes, and will be amortized to interest expense using the effective interest method over the contractual terms of the 2026 Notes. Issuance costs attributable to the equity component of the Notes were netted with the equity component in stockholders’ equity.
The initial net carrying amount of the equity component of the Notes were as follows (in thousands):
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The net carrying amount of the liability component of the Notes as of December 31, 2020 were as follows (in thousands):
(1)As of December 31, 2020, $31.1 million net carrying amount of the liability component of the 2023 Notes was classified as a current liability on the Consolidated Balance Sheets.
The following table sets forth the interest expense recognized related to the Notes (in thousands):
Year ended December 31,
Amortization of debt discount $ 29,460 $ — $ —
Amortization of debt issuance cost 1,457 — —
Total interest expense related to the 2025 Notes $ 30,917 $ — $ —
Amortization of debt discount $ 6,559 $ — $ —
Amortization of debt issuance cost 310 — —
Total interest expense related to the 2026 Notes $ 6,869 $ — $ —
Capped Calls
In connection with the offering of the Notes, the Company entered into privately-negotiated capped call transactions relating to each series of notes with certain counterparties (collectively the “Capped Calls”). The initial strike price of the Notes corresponds to the initial conversion price of each of the Notes. The Capped Calls are generally intended to reduce or offset the potential dilution to the Class A Common Stock upon any conversion of the Notes with such reduction or offset, as the case may be, subject to a cap based on the cap price. The Capped Calls settle in components commencing and expiring on dates specified in the table below. The Capped Calls are subject to either adjustment or termination upon the occurrence of specified extraordinary events affecting the Company, including a merger event; a tender offer; and a nationalization, insolvency or delisting involving the Company. In addition, the Capped Calls are subject to certain specified additional disruption events that may give rise to a termination of the Capped Calls, including changes in law; insolvency filings; and hedging disruptions. The Capped Call transactions are recorded in stockholders’ equity and are not accounted for as derivatives. The net cost incurred to purchase the Capped Call transactions was recorded as a reduction to additional paid-in-capital on the Company's Consolidated Balance Sheets.
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The following table below sets forth key terms and costs incurred for the Capped Calls related to each of the Notes:
Net cost incurred (in millions) $ 49.9 $ 60.9 $ 41.8
Note 7. Leases
The Company primarily leases facilities for office and datacenter space under non-cancelable operating leases for its U.S. and international locations. As of December 31, 2020, non-cancelable leases expire on various dates between 2021 and 2029.
Generally, the non-cancelable leases include one or more options to renew, with renewal terms that can extend the lease term from one to five years or more. The Company has the right to exercise or forego the lease renewal options. The lease agreements do not contain any material residual value guarantees or material restrictive covenants.
As of December 31, 2020 and 2019, the components of leases and lease costs are as follows (in thousands):
Operating leases
Operating lease right-of-use assets $ 51,115 $ 39,269
Total operating lease liabilities $ 54,989 $ 42,765
Year ended December 31,
Lease Cost
(a) Includes short-term leases and variable lease costs, which are immaterial.
The Company recognized rent expense prior to the adoption of Topic 842 on operating lease facilities of $6.9 million for the year ended December 31, 2018.
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Maturities of operating lease liabilities as of December 31, 2020 are presented in the table below (in thousands):
Year Ending December 31,
Total future minimum lease payments 62,433
Less: Imputed interest (7,444)
Present value of lease liabilities $ 54,989
Other supplemental information is as follows:
Lease Term and Discount Rate
Weighted-average remaining operating lease term (years) 4.5 4.2
Weighted-average operating lease discount rate 5 % 5 %
Year ended December 31,
Supplemental Cash Flow Information (in thousands)
Operating cash flows resulting from operating leases:
New ROU assets obtained in exchange of lease liabilities:
As of December 31, 2020, the Company has additional operating leases of approximately $1.1 million that have not yet commenced and as such, have not yet been recognized on the Company’s Consolidated Balance Sheet. These operating leases are expected to commence in the first quarter of 2021 with lease terms of up to three years.
Note 8. Commitments and Contingencies
Legal Matters