Item 1. Business.
Business Overview
Our mission is to help small- and medium-sized businesses, or SMBs, acquire, transact with, maintain and retain customers via the Internet. We offer a comprehensive suite of online marketing and reporting solutions, including ReachSearch™ (search engine marketing), ReachCast™ (Web presence), ReachDisplay™ (display advertising), ReachRetargeting™ (display retargeting), online marketing analytics, and other related products and solutions, each targeted to the SMB market. In 2013, we expect to expand our product suite to include ReachSite (a website solution) and two software-as-a-service, or SaaS, products: ReachConvert (marketing automation and lead conversion) and ReachCommerce (supporting online booking, transaction and back office processes). We deliver these solutions to SMBs through a combination of our proprietary platform, the RL Platform, and our direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies, resellers and a franchisee.
We use our RL Platform to create advertising campaigns for SMBs to target potential customers in their geographic area, optimize those campaigns in real time and track tangible results. Through a single internet advertising budget, we enable our clients to reach local customers -whether using traditional computing devices or mobile devices-across the Internet, including through all of the major search engines and leading general interest and vertically focused online publishers. In 2010, we expanded the RL Platform to include ReachCast, our full-service Web presence and social media solution, and in September 2012, we launched ReachRetargeting, a ReachDisplay product targeting local consumers who have recently searched for an SMB’s business keywords as well as those who have recently visited their website. We continue to expand the RL Platform to include additional advertising products designed specifically for the needs of our SMB clients. Empowered by the RL Platform, our IMCs, which are based in or near the cities in which our clients operate, establish a direct consultative relationship with our clients and provide our solutions to achieve their marketing objectives.
At December 31, 2012, we managed 32,500 Active Campaigns across 22,000 Active Advertisers, a substantial majority of which spend from $500 to $4,000 per month with us (see Part II, Item 6, “Selected Financial Data” for an explanation of how we define Active Campaigns and Active Advertisers). Our clients include SMBs in five primary industry verticals: healthcare, home services, professional services, automotive, and specialty services. Since inception, we have delivered to our SMB clients over 700 million geographically targeted clicks and over 100 million leads, including 50 million phone calls. At December 31, 2012, we employed 824 IMCs in North America, Australia, the United Kingdom, Germany, the Netherlands, Japan and Brazil, and worked with over 620 third-party agencies and resellers that use the RL Platform to serve their SMB clients. We continue to expand our IMC sales force both in existing and new markets. We have business development and account management resources to develop and support our third-party agencies and resellers and National Brands advertisers.
In 2013, we expect to roll-out a new suite of products. ReachSite is a new website solution product that is intended to help businesses turn more of their website visitors into leads. ReachConvert is a SaaS product that helps businesses manage their leads and convert more of them into customers. ReachConvert is currently in beta in North America. ReachCommerce, also a SaaS product, enables local businesses to take their entire booking and buying process online. The product will initially be focused on merchants in the home services vertical.
We have developed a new consumer service, ClubLocal, through which we create a direct relationship with consumers and provide home-related services by engaging third-party suppliers who perform the agreed services on our behalf. ClubLocal has been in beta in Dallas-Fort Worth since July 2012. We expect to launch in a second ClubLocal beta market, San Francisco, in 2013. The revenue from ClubLocal was immaterial in 2012.
We generate revenue by providing online advertising solutions for our clients through our ReachSearch, ReachDisplay, ReachCast and ReachRetargeting products, and our other products and services. We reported revenues of $455.4 million in 2012 and $375.2 million in 2011, representing an increase of 21.3%, Adjusted EBITDA of $23.6 million in 2012 and $15.9 million in 2011, representing an increase of 49%, a $0.2 million loss from continuing operations in 2012 and an $4.1 million loss from continuing operations in 2011, and a $0.2 million net loss in 2012 and a $10.3 million net loss in 2011. For more financial information, see our Consolidated Financial Statements, beginning on page, and see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures” for our definition of Adjusted EBITDA, why we present it and a reconciliation of our Adjusted EBITDA to loss from operations for each of the periods presented.
Industry Overview
The Local SMB Advertising and Commerce Market
SMBs serving local markets represent significant economic activity, control substantial purchasing power and address the needs of hundreds of millions of consumers. These SMBs include businesses such as lawyers, physicians, car dealers, dentists, plumbers, florists and local operations of national chains. To generate and sustain their businesses, SMBs spend money to market their services and to acquire, maintain and retain customers, and the associated expenditures are critical components of the operating budget for many SMBs, particularly given the potential value of each customer over the lifetime of the relationship. For example, a new dental patient may generate several hundred dollars in revenue during the first visit, thousands of dollars in subsequent visits and make referrals to friends and family that generate significant additional revenue. In addition to their customer acquisition efforts, increasingly SMBs are looking for platforms that enable them to transact with their customers online. These efforts to manage the entire customer experience online-from lead generation to transaction execution to overall customer management-are key to the success of SMBs.
An SMB’s owner and operator is also typically its chief marketing officer because the business is too small to justify hiring dedicated marketing personnel. Companies that operate traditional offline media formats, such as the yellow pages, newspapers, radio stations and direct mail publishers, adapted to the limited amount of time and effort that SMB owners and operators are normally able to devote to advertising and marketing by developing products, distribution and service delivery models that greatly simplified the marketing process for SMBs. The products sold by these offline media companies-namely, space in their directories and periodicals or time on the radio and television-were easy to understand (e.g., a flat $1,500 a month for a quarter page ad in the yellow pages). Because of their scale, these traditional offline media companies were able to deploy direct local sales forces that walked into the SMB’s place of business, presented a media package that gave the SMB broad customer reach through a single advertising purchase, assisted in the creation of the media advertisement for the SMB and ultimately asked the SMB to do little more than write a check. The SMB owner and operator was able to focus his or her efforts on running the business with little attention to these marketing efforts. Marketing in the offline world for an SMB was therefore relatively straightforward. There were a limited number of advertising channels, the channel owners sent dedicated personnel to visit and serve the SMB, and the SMB did not need to invest resources in managing the process.
The Digitization of Local Advertising and Local Commerce
Over the past decade, the local advertising market for SMBs and other local businesses has undergone rapid and fundamental changes. The delivery and consumption of local advertising, like all media, is becoming increasingly fragmented and digitized. Many consumers who used to search for a local business in the yellow pages or the local newspaper are now going online and searching on Google, checking reviews on Yelp and Citysearch, buying coupons on Groupon and LivingSocial, and asking their friends for their opinions through Facebook and Twitter. In addition, consumers have begun to directly book and buy local services online that traditionally were only booked or bought off-line. Existing offerings from companies such as OpenTable (finding a restaurant) as well as new offerings from companies such as ZocDoc (finding a doctor) and Uber (booking and buying car services) consolidate many of the steps of acquiring and transacting with a customer into a single simple online experience. This consumer-led digital transformation has profoundly disrupted the ways that businesses of all sizes need to acquire, transact with, maintain and retain their customers. As the Internet continues to grow and evolve, we believe that these trends will accelerate. To keep pace with this transformation, we believe that SMBs need to follow their customers and move an increasing portion of their marketing efforts and spend online.
The Local Challenge
The growth of local online advertising spend has, however, significantly lagged the increase in online media consumption. We believe that this lag is the result of two significant challenges:
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The Product Challenge: Re-create with online media the ease of purchasing and breadth of customer reach to which SMBs are accustomed with offline media. For owners and operators of SMBs, building an efficient and effective online marketing presence is a significant challenge, especially given the highly fragmented landscape of digital media publishers. In addition, SMBs want to manage the entire customer experience from lead generation to transaction execution to overall customer management through a single technology platform. While it is possible for an SMB to purchase various products that address these needs on an a la carte basis, we believe that these products do not address the fundamental needs and business realities of the SMB advertiser, which include a lack of time and resources to research and integrate the various solution providers, lack of expertise, lack of transparency into performance, and lack of economic incentive relative to the time required.
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The Distribution Challenge: Re-create the ability to sell local online advertising products to SMBs in the manner to which they are accustomed purchasing offline advertising products. Selling advertising to SMBs is difficult, and creating and sustaining a local sales force to address the SMB market requires substantial investment. The SMB market is fragmented, and SMB owners and operators are busy running their businesses and have little time to consider new marketing options. Accordingly, SMBs require a third party to work with them in developing their marketing strategy.
The ReachLocal Solution
We combine advanced, publisher-agnostic technology and an experienced, digitally sophisticated direct sales force to provide SMBs with a single, easy to use and cost-effective solution to acquire, maintain and retain customers using digital media. Our target market is SMBs that spend at least $5,000 per year on advertising.
The Product Solution
Our RL Platform addresses the needs of the SMB and re-creates the simplicity and effectiveness with which SMBs have traditionally purchased offline advertising. Our product solutions include the following key features:
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One Check: The Internet Budget. Through the simplicity of a single Internet advertising budget, the RL Platform allows us to connect SMBs to multiple online publishers. We connect the SMB to a broad range of destinations on the Internet, including:
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major search engines such as Google, Yahoo!, Bing, AOL and Ask.com;
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an extensive network of local search and directory sites such as Superpages, Citysearch, Local.com, MagicYellow and others;
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leading display advertising networks such as Yahoo!/Right Media and the Google display network; and
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leading social media sites, such as Facebook and Twitter.
The RL Platform automates connections to publicly available, self-service advertising and social media platforms through application programming interfaces, or APIs, specific to those platforms. The RL Platform also allows us to provide SMBs with access to a greater breadth of media because we are able to leverage our significant customer base to gain access to advertising inventory typically unavailable to an SMB with a modest advertising budget. By combining these features, the RL Platform allows us to offer SMBs the simplicity of a single Internet advertising budget that connects them to a diverse array of online publishers.
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Do It for Me: End-to-End Execution. The RL Platform is a proprietary, end-to-end technology platform that enables us to execute an online marketing campaign on behalf of an SMB. The RL Platform is a software-based solution that combines back-end automation and optimization technologies to manage advertising spend across a broad array of online publishers and media outlets. For advertisers interested in search engine marketing, the RL Platform automates the build-up of keyword search criteria for the leading search engines using a library of more than 20 million keywords. The RL Platform matches, sets and optimizes the bids for these keywords based on the SMB’s products and services as well as the SMB’s targeted geographic areas. For advertisers interested in display advertising, the RL Platform places display advertisements on websites selected in accordance with an SMB’s target geographic, demographic and behavioral profiles. For advertisers seeking social media and web presence solutions, the RL Platform integrates with leading social media sites, such as Facebook and Twitter.
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Do It Better Than I Can: Efficient and Optimized Buying. The RL Platform runs a set of proprietary algorithms multiple times a day to evaluate each publisher and each keyword and dynamically shifts spend to continuously optimize and improve the performance of our SMBs’ campaigns. We have run tens of thousands of online marketing campaigns for SMBs, and this scale and experience in purchasing online advertising from publishers allows us to make more efficient and effective purchasing decisions on behalf of our clients.
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Prove It: Calls, not Just Clicks. We employ a proprietary reverse proxy technology that automatically tracks campaign-generated activity, such as phone calls, e-mails and site navigation, without requiring the SMB to alter its website or maintain a separate website. SMBs can log in to the RL Platform to monitor their advertising spend on a daily basis and determine, for example, which online campaign generated which phone call. In addition, the RL Platform allows the SMB to use reverse lookup technology to see who called and provides a recording of each phone call. The ability of our RL Platform to allow SMBs to track accurately offline activity - principally phone calls - is a critical source of differentiation from available self-service online advertising platforms, which currently provide SMBs no data regarding offline activity.
Each of our products includes, through a single budget, access to multiple publishers, some of which are not available to SMBs, as well as access to our proprietary optimization and tracking technologies that dynamically adjust the publishers to which we allocate clients’ media spend in order to meet their performance objectives. In addition, powered by our RL Platform, we also offer non-media based digital marketing solutions, such as ReachCast, TotalLiveChat. In addition, in 2013, we will be offering a number of other products and services to support the online marketing and local commerce needs of our SMB clients, such as ReachSite, ReachConvert and ReachCommerce. For these reasons, while we rely on third-party publishers for the substantial majority of the media we purchase on behalf of our clients, we are not simply a reseller of media; rather, we market our products as a complete package of services intended to drive the success of our clients.
The Distribution Solution
Our distribution solution is built around a direct, locally based sales force of IMCs who, empowered by the RL Platform, engage with our clients to help them achieve their marketing objectives in the consultative manner to which SMBs are accustomed.
The key characteristics of our IMC sales force are as follows:
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Internet-Focused and Trained. Our IMCs are 100% focused on selling Internet-based advertising products. This exclusive focus is unlike the sales forces of existing offline media companies that cross-sell online and offline advertising, often with an inherent bias towards their own offline products.
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Locally Based. Our 824 IMCs are located in 60 markets in North America, Australia, the United Kingdom, Germany, Netherlands, Japan and Brazil where their clients are based, enabling them to provide the personal connection that is necessary for the IMC to develop and maintain a relationship with our clients. In our experience, our Direct Local clients, a substantial majority of which we calculate spend from $500 to $4,000 per month, require face-to-face interaction that is consistent with the way the SMB has historically purchased offline media.
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Consultative. Our IMCs are trained to consult with, educate and guide SMBs through the opportunities arising from and mechanics of purchasing online advertising.
In addition, we have a separate sales channel targeting national brands with operations in multiple local markets and select third-party agencies and resellers.
We believe that the ReachLocal solution, a combination of technology and human capital, gives our SMB clients access to technology and media that they could not access by themselves, and we prove that it works in ways they understand. We allow SMBs to write a single check while we do the rest.
The ReachLocal Advantage
We have been a pioneer in addressing the needs of SMBs seeking local Internet advertising solutions and have focused solely on this market for more than nine years.
Scale and Experience
We have run tens of thousands of online marketing campaigns for SMBs. Our scale and experience in purchasing online advertising from publishers allows us to make more efficient and effective purchasing decisions on behalf of our clients. In addition, the RL Platform enables us to connect our SMB clients to a wide array of online publishers. Our platform not only allows us to expand the reach of our publisher network, but also allows us quickly to test and identify better performing advertising options for our clients. In addition, our leadership position in the local Internet advertising market provides us with the ability to attract and retain as IMCs experienced local salespeople who understand the transformative power of the Internet.
Client Relationships
Our IMCs establish a direct relationship with SMB clients. In 2012 and 2011, we generated 79% and 78%, respectively, of our revenue through our Direct Local channel. As new online advertising opportunities emerge, such as mobile, video and social media, we believe that having a direct client relationship will enable us to offer additional products and services to our clients. We are able to leverage both our sales force and the collective purchasing power of our SMB clients for the mutual benefit of our clients and third-party publishers. We provide publishers with no or a limited sales force access to SMB clients, which, in turn, enables us to offer our SMB clients advertising opportunities that they would not be able to obtain on their own. We believe that adding more publishers will attract additional advertisers which, in turn, will attract still more publishers.
Technology
Running thousands of SMB online advertising campaigns simultaneously across multiple publishers poses significant technical challenges. While technologies exist to help larger companies manage and optimize their online marketing spend, we believe that such solutions are too expensive and too complex to scale down to the typical SMB’s monthly advertising budget. We have built our services, systems and networks for maximum scalability and flexibility to manage these types of campaigns, and we have invested heavily in automation technologies that reduce the level of human intervention required to support these campaigns. This automation is critical to our ability to scale our business and deliver moderately budgeted campaigns in a cost-effective manner. We continually strive to develop technologies that allow us to improve the match of our solutions to the demands of our SMB clients. For example, our development of our reverse proxy technology has opened up a new way for SMBs to track and understand the tangible results of their online advertising, enabling us to incorporate offline conversion events, such as phone calls, into the optimization of the client’s online marketing campaign. As we continue to gather online and offline conversion data from marketing campaigns conducted through our RL Platform, we will continue to refine our operations to increase efficiencies and generate better results for our SMB clients.
Our Strategy
We believe that we are in the early stages of a large and long-term business opportunity presented by the shift of local marketing budgets from traditional media formats to digital media formats. Our strategy for pursuing this opportunity includes the following key components:
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Continue to Expand the Reach of our IMC Sales Force. We intend to continue to increase the size of our traditional IMC sales force in selective territories, particularly internationally. In addition, starting in 2012, we began testing an inside sales force to address second and third tier markets. We believe that these markets, while smaller, still present significant opportunities for growth, and the use of an inside sales force enables us to pursue those smaller markets in a more cost effective fashion. In 2013, we intend to roll-out our inside sales efforts more broadly in North America.
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Expand Internationally. The local challenge is a global one, and we have found our product and distribution solutions to be well received in our international markets. Generally, our international IMCs are more productive than our domestic IMCs and we therefore intend to continue growing our international sales force and make other investments in service of those markets.
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Increase IMC Productivity. We intend to continue to invest in our service delivery model and our sales approach to provide our IMCs with additional capacity and tools to manage and acquire more advertisers. For example, we are in the process of organizing our sales and service organization into verticals so that we can leverage greater subject matter expertise, we continue to explore different staffing approaches to enhance the IMC’s opportunity to focus on new client acquisition, and we are deploying additional technology to make the selling process more efficient.
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Expand Media Offerings. We have developed a platform that enables us more easily to connect our SMB advertisers to a broader array of online publishers and, in the future, to reach customers through new formats such as mobile and video. Our plan has been, and continues to be, to fulfill, track and optimize an SMB’s entire digital media plan, regardless of media property or format. In addition, in 2012 we launched our ReachRetargeting product, a display advertising solution that targets consumers who have searched for a client’s keywords and those who have visited a client’s website.
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Develop Digital Marketing Software Solutions. Our current products target our clients’ needs to acquire customers through online media buying. We believe that there will be continued movement towards digital platforms in the other segments of an SMB’s marketing activities, such as marketing automation, lead conversion and customer relationship management. To address these and other needs, we plan to continue investing in the internal development or potential acquisition of products and services in these adjacent segments. For example, we recently announced the beta release of ReachConvert, a SaaS marketing automation solution designed to increase our client’s ability to track, respond to and convert leads. ReachConvert is based on the technology we acquired in the acquisition of the assets of Real Practice in 2012. We will continue to focus on expanding our relationship and utility to our clients through product innovation and new marketing solutions.
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Develop New Products Supporting Local Transactions. Our original focus was to solve the local marketing problem for SMBs by developing innovative solutions to help them generate leads from local consumers. A natural extension of those efforts is to enable the consumers to digitally book and buy from the SMB. To that end, we are developing a new SaaS product, ReachCommerce, that enables local businesses to take their entire booking and buying process online. In addition to providing a better consumer experience, ReachCommerce also digitizes the merchant’s back-office operation, including scheduling, employee and fleet management, estimating, transaction processing, invoicing, and business intelligence and reporting. ReachCommerce is expected to be released in beta in North America in 2013. The product will initially be focused on merchants in the home services vertical.
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Develop New Consumer Solution to Offer Local Services Online. We recently began testing a new consumer service, ClubLocal through which we create a direct relationship with consumers and provide home-related services by engaging third-party suppliers who perform the agreed services on our behalf. ClubLocal enables consumers to instantly book various home services via its website or mobile app. ClubLocal began testing in Dallas-Fort Worth in July 2012 and we are expecting to launch a second ClubLocal beta market in San Francisco in 2013.
Products and Services
We offer a comprehensive suite of SMB-focused online marketing and reporting solutions, including search engine marketing, display advertising, remarketing, digital presence and online marketing analytics, all of which run on our RL Platform.
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ReachSearch. Our ReachSearch product is focused on assuring that our clients’ advertisements appear prominently among the search results when local consumers enter certain keywords on leading local search sites such as Google, Yahoo! and Bing. The RL Platform is directly integrated into the advertising platforms of these and other leading search engines via APIs. In addition, as part of the ReachSearch product, our SMB clients also receive placement in the search results of our extensive network of online publishers and directory sites called the ReachLocal Search Network. This network provides additional qualified local traffic to the SMB and allows the SMB to reach potential customers across a broader range of sites.
The RL Platform automatically matches keywords for a business’ products or services through its extensive category taxonomy and keyword library, and its optimization engine dynamically adjusts keyword-level bids based on which keywords at which publishers are driving the most online leads and phone calls at the lowest price. Based on the SMB’s business and targeted geographic area, the RL Platform automatically paces the SMB’s target monthly budget and allocates and optimizes that budget across search publishers. Our ReachSearch product was introduced in 2004.
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ReachDisplay. Our ReachDisplay product is primarily focused on maximizing the exposure for an SMB that wants to broadcast a message to a specific target online audience. There are various ReachDisplay products that allow an SMB to target different demographic, vertical and behavioral customer segments. For general exposure in a specific geographic area, the ReachDisplay Awareness package provides the SMB with reach across a network of sites. For advertisers wishing to target by vertical or by specific customer behavior, we offer additional display packages. For example, the ReachDisplay Automotive package provides SMBs in the automotive vertical access to audiences visiting automotive sites as well as customers whose previous behavior indicates that they may be in the market to purchase a car. We offer more than 25 different display advertising products across a wide variety of publishing partners, including Yahoo!/Right Media, Google Display Network, Facebook and other display networks and demand-side platforms. Our ReachDisplay product was introduced in 2009 and we continue to add new publishers and options as display advertising on the Internet evolves.
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ReachCast. ReachCast was introduced in 2010 and combines a proprietary technology platform with an expert service team to help SMBs build and optimize their Web presence for the purpose of driving online search discovery, powering reputation management, and managing social media marketing. As part of the ReachCast service, each SMB is partnered with an expert Web Presence Professional, or WPP, who works directly with the business to develop a strategy to meet their specific goals, starting with a consultation and initial setup of ReachCast and presence creation across Google, Facebook, Twitter and local directories. Then, in consultation with the business, the WPP regularly creates and publishes custom content, posts to social media sites, engages with fans and followers, and monitors online reputation.
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ReachRetargeting. Our remarketing and search retargeting products allow us to target consumers who have previously visited a specific client’s website, either through a ReachSearch campaign or a ReachDisplay campaign, or who have previously searched for a client’s keywords. When the potential customer visits any other site within our remarketing network, we can remarket to the target customer on behalf of that SMB. Because many purchases from local merchants involve an extended research process, providing the SMB with the ability to stay in front of a potential customer who has expressed an initial interest can lead to sales that might not have resulted from a single advertising impression. Our remarketing product, ReachRetargeting, which we introduced in 2012, can be purchased on a standalone basis or can be bundled into the ReachSearch and ReachDisplay product lines.
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ReachConvert. ReachConvert is a SaaS product that helps businesses manage their leads and convert more of them into customers. ReachConvert notifies the business of new leads in real time via text message, email or the ReachLocal mobile app, so that the business can follow up within minutes. ReachConvert helps the business stay top of mind during the customer decision-making process by automatically sending new prospects targeted emails and sending alerts to the business’s staff reminding them to follow up on each lead. ReachConvert is currently in beta in North America.
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TotalTrack®, TotalLiveChat™, TotalVideoNow™, TotalBannerNow™. As part of our mission to provide a comprehensive suite of digital marketing solutions to SMBs, we have developed various products to address specific marketing needs, such as lead optimization, online analytics and digital creative solutions.
Distribution
We distribute our products and services directly though our sales force of IMCs, who are focused on serving SMBs in their local markets, as well as a separate sales force targeting national brands with operations in multiple local markets and select third-party agencies and resellers.
Internet Marketing Consultants
Our IMCs generally sell our services directly to our SMB clients through an in-person, consultative sales process. Over time, an individual IMC can build a valuable relationship with his or her clients by delivering measurable results via the RL Platform. Our IMCs are trained to explain the benefits of a digitally focused marketing strategy to SMBs which are generally preoccupied with operating and managing their businesses. As an IMC develops a portfolio of SMB clients, the IMC is responsible for calling on and maintaining contact with each client, working with each client to evaluate the performance of its digital campaigns and discussing available options and opportunities to extend or expand each client’s digital spend strategy. In addition, in 2012 we launched a beta inside sales force to address second and third tier markets.
Our IMCs are located in 60 markets in North America, Australia, the United Kingdom, Germany, the Netherlands, Japan and Brazil.
We make a significant investment in the hiring, training and ongoing support of our IMCs while they develop a portfolio of SMB clients. Our IMC development program divides IMCs into two groups: Underclassmen, which consists of IMCs during their first 12 months of employment; and Upperclassmen, which consists of IMCs with more than 12 months of employment. Increasing the number of our IMCs has been the principal engine for our growth. In particular, our growth is driven by the increase in the number of Upperclassmen, who are significantly more productive than our Underclassmen. Our recruitment, training and performance system is designed with the objective of increasing the number of our Upperclassmen over time and increasing the percentage of Underclassmen who become Upperclassmen.
At December 31, 2012, we had 405 Underclassmen and 419 Upperclassmen. We have created a system to identify and develop our Underclassmen into Upperclassmen, key elements of which include:
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Recruitment. We invest heavily in recruiting our sales force and have developed an in-house team of specialized recruiters. Typically, each month we hire 40-50 IMCs worldwide, with the hiring weighted towards the first 10 months of the year. IMC recruits are generally required to have at least three to five years of sales experience, preferably serving the SMB market. We generally seek experience selling online advertising and require that all IMC hires be technically proficient. Although many recruits come from traditional media companies where they have sold to the SMB market, we seek IMCs who understand the transformative power of the Internet and who have seen, first hand, the flow of advertising dollars online.
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Training. Each IMC attends a mandatory one week boot camp training session at our sales headquarters in Plano, Texas or, for international IMCs, a similar boot camp closer to their principal office locations. During the week, IMCs learn our business model and their responsibilities in it, learn the fundamentals of search engine and display marketing and social media and reputation management, and are trained on the RL Platform and our suite of products. Once an IMC returns to his or her specific office, the IMC engages in a standard onboarding process that includes hands-on instruction in prospecting SMB clients, scheduling and tracking appointments, and developing presentations for prospective clients. During the remainder of their first 12 months, Underclassmen are required to participate in ongoing training sessions that include general industry updates, RL Platform updates and presentations from Upperclassmen who provide guidance on how to sell to and serve specific SMB verticals.
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Focus on Performance. In order to track performance and underscore expectations, Underclassmen are provided a roadmap of expected performance milestones and receive constant support and counseling during this period to assist them in meeting the milestones and otherwise building a portfolio of SMB clients. We also use this support system to identify and try to remediate any problems if an IMC’s performance deviates too far from expected revenue contributions.
With each new class of IMCs, we track how the IMCs are performing relative to a standard level of revenue growth and other performance metrics for each month after their training. We do not expect all Underclassmen to become Upperclassmen, and our investment decisions anticipate the cost of attrition. We maintain data on the past and current performance of our IMCs, which we use as a basis for our hiring decisions. The performance of past and current IMCs allows us to adjust our investment model in the event there are significant changes in macroeconomic or competitive conditions.
National Brands, Agencies and Resellers
We have a separate sales force targeting national brands with operations in multiple local markets (e.g., franchise organizations) as well as a number of third-party agencies and resellers. The sales process for national brands can differ from the process employed by our IMCs and often requires an endorsement by, and potentially a direct financial contribution from, the parent entity such as a franchisor. If a local operation of one of our national brands requires face-to-face contact with a local sales representative, we are able to offer one of our IMCs to service that local operation.
In addition, we sell and provide access to our RL Platform to select third-party agencies and resellers in customer segments where they have a sales force with established relationships with their SMB client base. We currently have over 620 agencies and resellers actively selling on our RL Platform. We have a team that is responsible for identifying potential agencies and resellers, training their sales forces to sell our products and services and supporting the relationships on an ongoing basis. In addition, in 2012, we entered into our first franchise relationship, in which a third party was given the exclusive right to exploit and resell certain ReachLocal products in selected Eastern European markets under the ReachLocal name.
Customer Service
Our customer service organization is responsible for providing ongoing support to our sales forces, advertisers and resellers, including technical assistance with the use of the RL Platform, as well as providing product- and campaign-specific technical assistance and recommendations to our SMB clients.
We also field an advanced campaign management team that is responsible for supporting and optimizing the overall performance of the products on a category-by-category level. Our RL Platform has a set of administrator-only tools that is used by the campaign management team to efficiently evaluate the success of ongoing campaigns and to recommend ways for our clients to improve their performance.
With a combination of employees in each of our regional markets and, India, we have a dedicated team focused on the provisioning and review of campaigns before they are deployed. This team is responsible for reviewing the keywords that are automatically generated by the RL Platform, ensuring that the creative aspects of the campaign and editorial standards conform to best practices and overseeing the reverse proxy services for our clients. This team employs automated tools to increase the number of campaigns that can be provisioned per person, per day.
Our team of Web Presence Professionals is responsible for the delivery of the ReachCast service, which includes creating and publishing custom content, posting to social media sites, engaging with fans and followers, and monitoring online reputation.
Technology Operations
Our RL Platform is hosted in various data centers. Our primary data center hardware is co-located in El Segundo, California. We also maintain smaller regional data centers at various locations to support our domestic and international operations. We also have a business continuity and disaster recovery data center hosted in Chandler, Arizona. All facilities employ around-the-clock security personnel, video surveillance and monitoring and are serviced by onsite electrical generators and fire detection and suppression systems. All facilities also have multiple Tier 1 connections to the Internet. We continuously monitor the performance and availability of our products and have well documented procedures to respond to incidents. In addition, we utilize cloud computing providers for certain of our products and services.
We architect our applications to enable us to scale our operations quickly while reducing deployment costs. We have a highly-available, scalable infrastructure that employs hardware load-balancers, redundant interconnected network switches and firewalls, replicated databases and fault-tolerant storage devices.
Product and Technology Development
We devote a substantial portion of our resources to developing new solutions and enhancing existing solutions, conducting product testing and quality assurance testing and improving core technology. We have teams of product and engineering professionals located in various locations in the United States and India.
Intellectual Property
Our success and ability to compete is dependent in part on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing upon the proprietary rights of others. We have patent applications pending on some of our technology, but rely primarily on a combination of copyright, trade secret and trademark laws, confidentiality procedures, contractual provisions and other similar measures to protect our proprietary technology and information. Among other practices, we enter into confidentiality agreements with our employees, consultants and business partners, and we control access to and distribution of our proprietary information.
On an ongoing basis, we consider trademark registration for some of our product names, slogans and logos in the United States and in some foreign countries. ReachLocal, ReachCast and TotalTrack are registered U.S. trademarks. We have also registered ReachLocal, ReachCast and TotalTrack as trademarks in a number of international territories. Other trademarks we use are ReachSearch, ReachDisplay, ReachRetargeting, ReachConvert and ClubLocal.
We are the registrant of the Internet domain name for our websites as well as for our proxy services, in addition to the international extensions of those domains. The information on, or accessible through, our websites does not constitute part of, and is not incorporated into, this Annual Report.
Customers
We currently primarily sell to SMB advertisers, national brands, and agencies and resellers. No single advertiser, national brands, or agency or reseller represents more than 10% of our total consolidated revenue. The customers of ClubLocal are the consumers to whom the services being offered.
Competition
The market for local online advertising solutions is intensely competitive and rapidly changing, and with the introduction of new technologies and market entrants, we expect competition to intensify in the future. Many of our current and potential competitors enjoy substantial competitive advantages, such as greater name recognition, longer operating histories and larger marketing budgets, as well as substantially greater financial, technical and other resources. In addition, many of our current and potential competitors have established marketing relationships and access to larger customer bases.
Our competitors include:
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Internet Marketing Providers. We compete with large Internet marketing providers such as Google, Yahoo! and Microsoft. These providers typically offer their products and services through disparate, online-only, self-service platforms. We compete with these companies on the basis of our IMC sales force, our product offerings and our publisher-agnostic services to our clients. Although we compete against the self-service offerings of these large providers, we also have business relationships with them and we believe we are an important customer for their locally-targeted search inventory. We also believe that we provide a valuable service to these companies by connecting them to a large number of SMBs, which are generally disinclined to purchase online advertising via self-service platforms.
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Traditional, Offline Media Companies. We compete with traditional yellow page and newspaper companies with large, direct sales forces. While these traditional media companies have made investments to address the migration of advertising expenditures away from their existing print products, we believe that they face the prospect of cannibalizing their existing higher margin products that they own and the challenge of re-training and restructuring their sales forces, most of whom have only sold print products and many of whom still receive the majority of their income from selling those products. We compete with these companies on the basis of the strength and breadth of our technology platform and product offering and our focus exclusively on Internet advertising.
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Other SMB Marketing Providers. We also compete with technology companies providing online marketing platforms focused on the SMB market such as Angie’s List and Yelp, as well as newer market entrants, such as Groupon and LivingSocial, which are actively focused on new forms of online marketing solutions for SMBs and in some cases building significant direct sales forces. We compete with these companies based on our scale, technological platform, breadth of product suite, size and geographic scope of our IMCs and established publisher relationships.
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New Competitors in New Markets. We have recently launched a new consumer service, ClubLocal, through which we create a direct relationship with consumer and provide home-related services by engaging third-party suppliers who perform the agreed services on our behalf. We are also developing and launching new SaaS products, such as ReachConvert and ReachCommerce, designed to provide SMBs tools to convert leads to customers, retain customers, and transact with customers. In each case, as we enter new markets we will encounter new competitors.
Government Regulation
We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, broadband residential Internet access and the characteristics and quality of services. It is not clear how existing laws governing issues such as property ownership, sales and other taxes, libel and personal privacy apply to the Internet. Unfavorable resolution of these issues may substantially harm our business and operating results.
Employees
At December 31, 2012, we had approximately 1,900 employees worldwide. Approximately 20 of our employees in Brazil were subject to a collective bargaining agreement. None of our other employees is represented by a labor union. We believe that relations with our employees are good.
Available Information
We file reports with the Securities and Exchange Commission (the “SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any other filings required by the SEC. We make available free of charge in the investor relations section of our corporate website (http://investors.reachlocal.com) our annual report on form 10-K, quarterly reports on form 10-Q, current reports on form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. References to the Company’s corporate website address in this report are intended to be inactive textual references only, and none of the information contained on our website is part of this report or incorporated in this report by reference.
Item 1A.
Item 1A. Risk Factors.
You should carefully consider the risks described below and the other information in this Annual Report on Form 10-K.
Risks Related to Our Business
Our operations and financial results are subject to various risks and uncertainties that could adversely affect our business, financial condition, results of operations, and the trading price of our common stock.
Our current business and future prospects are difficult to evaluate. We commenced operations in late 2004 in North America, and developed a strategy for taking advantage of what we believe is a shift of local marketing budgets from traditional media formats to digital media formats. Our strategy allowed us to grow rapidly. However, our growth rate in North America has slowed and, as a result, our overall growth rate has also declined. In 2012, our North America revenues, which accounted for 72% of our 2012 revenues, grew by 13.2% versus 19.7% growth in 2011. We are expanding internationally and introducing new products to continue to grow our business, but we cannot assure you that our strategy will be successful and that our growth rate will not decline further. In particular, although our international IMCs are now considerably more productive than our North American IMCs, over time as those markets mature, international IMCs’ productivity may decline, putting further pressure on our growth rate and results of operations.
You must also consider our business and prospects in light of the risks and difficulties we encounter as a company in the rapidly evolving online marketing industry. These risks and difficulties include:
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our limited number of product offerings and the difficulties and risks associated with developing and selling new product offerings, including, in particular, software-as-a-service and consumer products;
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successfully entering new markets, domestically and internationally;
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maintaining the effectiveness of our RL Platform, and adapting our technology to new market opportunities and challenges;
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competition from existing and new competitors;
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reaching and maintaining profitability;
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continuing to attract new SMB clients, many of whom have not previously advertised online and may not understand the value to their businesses of our products and services; and
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effectively managing continued growth in our sales force, personnel and operations.
Failing to successfully address these challenges or others could significantly harm our business, financial condition, results of operations and liquidity.
We have incurred significant operating losses in the past and may incur significant operating losses in the future.
As of December 31, 2012, we had an accumulated deficit of approximately $27.1 million, and we may incur net operating losses in the future. We expect our operating expenses to increase in the future as we expand our operations. Our business strategy contemplates hiring significant numbers of additional IMCs, both in new and existing markets, as well as making substantial investments in new and existing products, which will require significant expenditures. If our revenue does not grow to offset these increased expenses, we will not be profitable. We also expect that a variety of factors, including increased competition and the maturation of our business, may continue to cause our revenue growth rate to decline in the future, and we cannot assure you that our revenue will continue to grow or will not decline. As a result, you should not consider our historical revenue growth as indicative of our future performance. Furthermore, if our operating expenses exceed our expectations, our financial performance will be adversely affected.
We purchase most of our media from Google, and our business could be adversely affected if Google takes actions that are adverse to our interests or if we fail to meet advertiser or spend targets necessary for receiving rebates from Google. Similar actions from Yahoo!, Microsoft and other media providers could adversely affect our business, though to a lesser degree.
Nearly all of our cost of revenue is for the purchase of media, and a substantial majority of the media we purchase is from Google. Google accounts for a large majority of all U.S. searches, and Google’s share in foreign markets is often even greater. As a result, we expect that our business will depend upon media purchases from Google for the foreseeable future. This dependence makes us vulnerable to actions that Google may take to change the manner in which it sells AdWords, as described below, or conducts its business on a number of levels:
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Google Can Choose to Change the Terms and Conditions Upon Which it Does Business with Us and our Advertisers. Google can act unilaterally to change the terms and conditions for our purchase of media or the purchase of Google products, and Google has done so in the past. Future changes by Google to the terms and conditions upon which we purchase media could materially and adversely affect our business.
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Competitive Risk. Google offers its products directly to SMBs through an online self-service option. Google enjoys substantial competitive advantages over us, such as substantially greater financial, technical and other resources. In addition, Google continues to launch products that are targeted directly at SMBs, which Google does not always make available to third parties. While we cannot assess at this time the effect of Google’s offering such products directly to SMBs, the prices charged by Google for direct service are lower than the prices we charge for the same media.
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Technology Risk. Our RL Platform interacts with Google through publicly available application programming interfaces, or APIs. If Google were to discontinue the availability of all or a portion of these APIs to us, we may have to change our technology, incur additional costs or discontinue certain products or services that we currently offer our clients. Any of these changes could adversely affect our ability to provide effective online marketing and reporting solutions to our clients. In addition, Google may decide to alter the amount it charges us for the right to use its APIs, which would decrease our gross margin absent any change in our pricing to our customers.
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Editorial Control. Google closely monitors the experience of end-users, and from time-to-time, its editorial personnel request that companies alter their services based on Google’s determination that aspects of such services could adversely affect the end-user experience. For example, each of our media products includes TotalTrack, a tracking service powered by our proprietary reverse proxy technology. If Google were to determine that the tracking URLs utilized by our TotalTrack service adversely affects the end-user’s experience, Google could require us to alter or suspend the way we implement our tracking solutions. Such a change would significantly decrease our ability to optimize our clients’ advertising campaigns and limit our ability to provide the level of campaign performance reporting that we currently provide to our clients.
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Rebate/Incentive Risk. Google retains broad authority with respect to its rebate programs and has, from time to time, canceled rebate programs. For example, effective December 31, 2008, Google terminated a publisher rebate provided as part of its North American Authorized AdWords Reseller program, which was the primary reason that our cost of revenue as a percentage of revenue increased from 52.8% in 2008 to 54.5% in 2010. In the second quarter of 2011, we entered into reseller agreements with Google that, among other things, provide us with certain performance bonuses if certain advertiser and spend targets, including share of retail requirements, are met. If we fail to meet those targets, and do not qualify for the rebates, our operating results would be harmed. Our reseller agreements with Google are subject to broad mutual termination rights and termination of those agreements would negatively affect our cost of revenue.
In addition, any new developments or rumors of developments regarding Google’s business practices that affect the local online advertising industry may create perceptions with our customers or investors that our ability to compete has been impaired.
The above risks also apply to other publishers from whom we purchase media, including Yahoo! and Microsoft.
We purchase a significant majority of our media from Google, Microsoft and Yahoo! in an auction marketplace. If we are unable to purchase media from any one of these companies, if prices for media significantly increase or if the manner in which the media is sold changes, our business could be adversely affected.
Our success depends on our ability to purchase media from Google, Microsoft and Yahoo! at reasonable prices so that we can provide our clients with a reasonable return on the advertising expenditures they make through us. We generally purchase this media in an auction marketplace. Increased competition or other factors may cause the cost of the media that we purchase from Google, Yahoo! and Microsoft to rise. In particular, if our expectation that local SMB advertising will increasingly migrate to the Internet is correct, the marketing budget available to bid in these auctions will increase and the price of media may increase substantially. An increase in the cost of media in these marketplaces without a corresponding increase in our media buying efficiency could result in an increase in our cost of revenue as a percentage of revenue even if our business expands. In addition, such an increase could result in an increase in the prices we must charge our clients or a decrease in our ability to fulfill our clients’ service expectations. Furthermore, the Internet search companies that operate these media marketplaces may change the operating rules or bidding procedures in ways that decrease the effectiveness of the technology that we use to optimize our purchases or otherwise prevent us from purchasing media at reasonable prices or at all. Any change in our ability to provide effective online marketing campaigns to our clients may adversely affect our ability to attract and retain clients.
The market in which we participate is intensely competitive, particularly in North America, and if we do not compete effectively, our operating results could be harmed.
The market for online marketing solutions is intensely competitive and rapidly changing, and with the emergence of new technologies and market entrants, we expect competition to intensify in the future.
Our competitors include:
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Internet Marketing Providers. We compete with large Internet marketing providers such as Google, Yahoo! and Microsoft. These providers typically offer their products and services through disparate, online-only, self-service platforms.
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Traditional, Offline Media Companies. We compete with traditional yellow page, newspaper, television and radio companies that, in many cases, have large, direct sales forces.
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Other SMB Marketing Providers. We also compete with technology companies providing online marketing platforms focused on the SMB market such as Angie’s List and Yelp, as well as newer market entrants, such as Groupon and LivingSocial, which are actively focused on new forms of online marketing solutions for SMBs and, in some cases, building significant direct sales forces. In addition, there are a number of smaller companies which provide internet marketing services and may be able to offer such services at highly competitive prices.
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New Competitors in New Markets. We have recently launched a new consumer service, ClubLocal, through which we create a direct relationship with customers and provide home-related services by engaging third-party suppliers who perform the agreed services on our behalf. We are also developing and launching new software-as-a-service, or SaaS, products designed to provide SMBs tools to convert leads to customers, retain customers, and transact with customers. In each case, as we enter new markets we will encounter new competitors.
Many of our current and potential competitors enjoy substantial competitive advantages, such as greater name recognition, longer operating histories, substantially greater financial, technical and other resources and, in some cases, the ability to combine their online marketing products with traditional offline media such as newspapers or yellow pages. These companies may use these advantages to offer products similar to ours at a lower price, develop different products to compete with our current solutions and respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or client requirements. In particular, if major Internet search companies such as Google, Yahoo! and Microsoft decide to devote greater resources to develop and market online advertising offerings directly to SMBs, greater numbers of our clients and potential clients may choose to purchase online advertising services directly from these competitors, particularly if and as the ease of their self-service models increases. In addition, many of our current and potential competitors have established marketing relationships with and access to larger client bases and are heavily investing in recruiting sales personnel, which might affect our ability to achieve our IMC hiring targets.
As the market for local online advertising increases, we expect new competitors, business models and solutions to emerge, some of which may be superior to ours. We also believe that the marketplace for online media is more transparent than other media marketplaces. Our competitors may use information available to them to price their products at a discount to the prices that we currently offer. Clients and potential clients might adopt competitive products and services in lieu of purchasing our solutions, even if our online marketing and reporting solutions are more effective than those offered by our competitors, if we are not able to differentiate our products and convince clients that our products are more effective that our competitors’ offerings. For all of these reasons, we may not be able to compete successfully against our current and potential competitors.
Our future success depends in part on our ability to effectively develop and sell additional products, services and features.
We invest in the development of new products and services with the expectation that we will be able to effectively offer them to our clients. We are developing, and may in the future develop or acquire, other products and services that address new segments of an SMB’s marketing activities. We are also developing new direct to consumer and SaaS products, which present different challenges from those we have faced in the past. Our future revenue depends in part on our ability to stay competitive with our product and service offerings. Our ability to develop and launch new products on our expected timelines, or at all, is subject to numerous risks and uncertainties, such as the difficulties of designing complex software products, achieving desired functionality and integrating the new products with our existing technology.
The sale of new or additional features, products and services, the value or utility of which may be different from our current products and services or less easily understood by our clients, may require increasingly sophisticated and costly sales efforts and increased operating expenses, as well as additional training of our IMCs and education for our SMB clients. New product launches require the investment of resources in advance of any revenue generation. If new products fail to achieve market acceptance, we may never realize a return on this investment. If these efforts are not successful, our business may suffer. Many SMBs have modest advertising budgets. Accordingly, we cannot assure you that our SMB clients will increase their aggregate spending as a result of the introduction of new products and services or that the successful introduction of new products or services will not adversely affect sales of our current products and services through cannibalization of our current products or disharmony created by consumer offerings that could be perceived as in competition with our current customers. Any such adverse impact on our current media products could also adversely affect our publisher rebates.
We may be unsuccessful in managing or growing our international operations, which could harm our business, operating results and financial condition.
We currently have international sales operations in Australia, the United Kingdom, Canada, Germany, the Netherlands Japan and Brazil, and campaign support services in India. Revenue from international operations outside North America accounted for 28.1% and 22.9% of total revenue for the years ended December 31, 2012 and 2011, respectively. Over the long term, we intend to expand our international operations to new markets and countries. We may incur losses or otherwise fail to enter new markets successfully.
Our ability to operate internationally involves various risks, including the need to invest significant resources, the possibility that returns on such investments will not be achieved in the near future and competitive environments with which we are unfamiliar. Our international operations may not prove to be successful in certain or any markets. In addition, we have incurred and expect to continue to incur significant expenses as we attempt to establish our presence in particular international markets. Our current and any future international expansion plans will require management attention and resources and may be unsuccessful. Furthermore, in many international markets, we would not be the first entrant, and greater competition may exist with stronger brand recognition than we have faced in our current markets. Different privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our business and operating results to suffer.
Our international operations may also fail to succeed due to other risks inherent in foreign operations, including:
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difficulties or delays in developing a network of clients in one or more international markets;
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legal, political or systemic restrictions on the ability of U.S. companies to market products and services or otherwise do business in foreign countries;
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different regulatory requirements, including regulation of internet services, privacy and data protection, banking and money transmitting, and selling, that may limit or prevent the offering of our products in some jurisdictions;
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international intellectual property laws that may be insufficient to protect our intellectual property or permit us to successfully defend ourselves or our intellectual property in international lawsuits;
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different employee/employer relationships and the existence of workers’ councils and labor unions, which could make it more difficult to terminate underperforming IMCs;
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difficulties in staffing and managing foreign operations;
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greater difficulty in accounts receivable collection;
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currency fluctuations or a weakening U.S. dollar, which can increase costs of international expansion;
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potential adverse tax consequences, including the difficulty of repatriating money;
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lack of infrastructure to adequately conduct electronic commerce transactions; and
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price controls or other restrictions on foreign currency.
As a result of these obstacles, we may find it impossible or prohibitively expensive to continue or expand our international operations and replicate our business model, which could harm our business, operating results and financial condition.
Failure to adequately recruit, train and retain our Internet Marketing Consultants would impede our growth and could harm our business, operating results and financial condition.
Our ability to maintain or grow revenue and achieve profitability will depend, in part, on increasing the size of our direct sales force of IMCs. We divide our IMCs into two groups: Underclassmen, who are IMCs during their first 12 months of employment, and Upperclassmen, who are IMCs with more than 12 months of employment. Generally, Upperclassmen are more productive than Underclassmen and generate revenue in excess of direct and allocable costs, while Underclassmen do not. Accordingly, we rely on the success of our Upperclassmen to fund our investment in Underclassmen. As we attempt to achieve larger scale in our business, if our Upperclassmen are not as successful as we anticipate, or if our Underclassmen do not successfully develop into productive Upperclassmen, our ability to grow revenue will suffer, our costs may increase and we may not ever become profitable. We assume a certain level of attrition when we hire new Underclassmen. We base that assumption on our historical experience and future expectations, and our assumptions may prove wrong. If our IMC attrition is greater than anticipated, our business will be harmed. In addition, as more companies seek to capitalize on the shift to online media, competition for knowledgeable and qualified online media sales personnel will increase. Moreover, employees that we hire from our competitors have in the past, and may in the future, be subject to claims of breach of noncompetition and non-solicitation obligations owed to their former employers, which could impact our ability to attract and hire high-quality candidates and potentially subject us to litigation. If we are unable to effectively recruit, train and retain IMCs, we may not be able to grow our sales force, our revenue may suffer or our costs may increase.
One of our international growth strategies is to enter new international markets through franchise or reseller arrangements, and if one or more of these relationships is unsuccessful, it could negatively impact us.
In July 2012, the Company entered into a franchise agreement with OxataSMB B.V. permitting it to operate and resell our services under the ReachLocal brand in Slovakia, Czech Republic, Hungary, Poland and Russia. At the same time, we entered into a market development loan agreement with OxataSMB pursuant to which we agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) was immediately advanced. As we expand into other international markets, in addition to entering markets directly, we may enter through a franchisee or a reseller (as we have in New Zealand). The success of such strategy will depend on a number of factors, including whether our franchisees and resellers have the experience and financial resources to be effective operators and remain aligned with us on operating, promotional and capital-intensive initiatives, and the potential impact on us if they experience operational problems or project a brand image inconsistent with our values, particularly if our contractual and other rights and remedies are limited by local law or otherwise, or are costly to exercise. Difficulties of one or more of our international franchisee or reseller arrangements could result in losses stemming from related strategic investments, delay penetration into and/or negatively affect our brand in certain international markets, and distract management and absorb product development resources.
More consumers are using devices other than personal computers to access the Internet and accessing new platforms to make search queries. If we are unable to effectively reach consumers on the Internet on behalf of our customers, our business could be adversely affected.
The number of people who access the internet through devices other than personal computers, including mobile phones and tablets has increased dramatically in the past few years. Mobile search advertising is growing very rapidly and may offer lower conversion rates for our customers, which if not offset by lower costs, may make search engine marketing less attractive for our customers. In addition, the lower resolution, functionality, and memory associated with some alternative devices may alter consumers’ use of the Internet, including of search engines and other websites where we publish advertisements on behalf of customers. For example, search queries are increasingly being undertaken via “apps” tailored to particular devices or social media platforms, which could affect our ability to deliver advertising results to our clients if we are unable to effectively reach consumers via those apps.
Our new ClubLocal service represents our entry into a new market and, as such, subjects us to new risks.
We have recently launched a new consumer service, ClubLocal, through which we create a direct relationship with customers and provide home-related services by engaging third-party suppliers who perform the agreed services on our behalf. Expanding our ClubLocal service to new markets will require substantial financial resources and establishing the ClubLocal brand with consumers is likely to require a significant investment in marketing. These increased costs may negatively impact our operating results and, if ClubLocal is unsuccessful, our financial condition.
Our new ClubLocal service is different from our other products and services, which have primarily been digital advertising products. A component of our ClubLocal service is a software service used by our third-party suppliers to administer the services on our behalf. Any errors, defects, disruptions in service or other performance problems could hurt our reputation and may damage our third-party suppliers’ businesses, which in turn would negatively affect our ability to offer the ClubLocal service. In addition, it is possible that the introduction of ClubLocal will be viewed as competitive by the purchasers of our marketing services, which could adversely affect sales of our media products and services.
ClubLocal may be subject to regulatory requirements and risks applicable to service professionals, which include management of licensing, permitting and quality of our third-party contractors. We have have sought to establish processes and procedures to manage risk and seek consumer satisfaction with the services provided by our third-party contractors. If we fail to manage these processes effectively or provide proper oversight of these services, we could suffer lost sales, fines and lawsuits, as well as damage to our reputation, which could adversely affect our business.
We may be liable to consumers for any damage we cause to their home or facility, belongings or property during the delivery of ClubLocal services, and we offer a ClubLocal Buyer Protection Plan guaranteeing ClubLocal services for up to $10,000. In addition, if a ClubLocal consumer is injured in connection with a ClubLocal service, we could be exposed to personal injury or product liability claims. Any such claims we face could result in significant refunds or payments to consumers, or could be expensive to defend and divert management’s attention. Also, any such claims and any adverse outcomes may subject us to adverse publicity, damage our reputation and competitive position and adversely affect sales of ClubLocal services and our other products.
We are introducing new SaaS products, which may not gain market acceptance or may not perform as we intend.
We are developing and launching new SaaS products designed to provide SMBs tools to convert leads to customers, retain customers, and transact with customers. The success of our new SaaS products is subject to numerous risks and uncertainties, such as the difficulties of designing complex software products, integrating the new SaaS products with our existing technology, training our IMCs to sell the new SaaS products, and gaining market acceptance. Because our SaaS products are complex and incorporate a variety of hardware and proprietary and third-party software, our SaaS products may have errors or defects that could result in unanticipated downtime for our customers and harm to our reputation and our business. Internet-based services frequently contain undetected errors when first introduced or when new versions or enhancements are released. We have from time to time found defects in our SaaS products and new errors in our SaaS products may be detected in the future. In addition, our customers may use our SaaS products in unanticipated ways that may cause a disruption in service for other customers attempting to access their data. If we acquire new technology, we may encounter difficulty in incorporating the acquired technologies into our SaaS products. Since our customers may use our SaaS products for important aspects of their business, such as scheduling, pricing, invoicing, calculation of sales taxes and transaction processing, any errors, defects, disruptions in service or other performance problems could damage our customers’ businesses and result in financial losses, which would hurt our reputation. As a result, customers could elect to not renew, or delay or withhold payment to us, we could lose future sales or customers may make warranty or other claims against us.
We depend on key personnel to operate our business, and if we are unable to retain our current personnel or hire additional personnel, our ability to develop and successfully market our business could be harmed.
We believe that our future success is highly dependent on the contributions of our executive officers, as well as our ability to attract and retain highly skilled managerial, sales, technical and finance personnel. Qualified individuals are in high demand, and we may incur significant costs to attract them. All of our U.S. officers and other U.S. employees are at-will employees, which means they may terminate their employment relationship with us at any time, and their knowledge of our business and industry would be extremely difficult to replace. If we are unable to attract and retain our executive officers and key employees, our business, operating results and financial condition will be harmed. In addition, our management team has a long history of working together, and we believe that our key executives have developed highly successful and effective working relationships. If one or more of these individuals leave, we may not be able to fully integrate new executives or replicate the current dynamic, and our operations could suffer.
Volatility or lack of performance in our stock price may also affect our ability to attract and retain our key employees. Our executive officers have become vested in a substantial amount of stock or stock options. Employees may be more likely to leave us if the shares they own or the shares underlying their options have significantly appreciated in value relative to the original purchase prices of the shares or the exercise prices of the options, or if the exercise prices of the options that they hold are significantly above the market price of our common stock.
During 2012, we realigned the roles of some of our executive management team. Those changes may not prove effective or may be disruptive to our business and could adversely affect our business and results of operations.
The impact of worldwide economic conditions, including the resulting effect on advertising budgets, may adversely affect our business, operating results and financial condition.
Our performance is subject to worldwide economic conditions and their impact on levels of advertising. In addition, as we increase our international footprint, we will become more sensitive to economic conditions outside of North America. We believe that the economic conditions remain challenging in North America and internationally, which have adversely affected our business.
To the extent that economic difficulties continue, or worldwide economic conditions materially deteriorate, our existing and potential clients may no longer consider investment in our online marketing solutions a necessity, or may elect to reduce advertising budgets. Historically, economic downturns have resulted in overall reductions in advertising spending. In particular, online marketing advertising solutions may be viewed by some of our existing and potential clients as a lower priority and may be among the first expenditures reduced as a result of unfavorable economic conditions. These developments could cause us to respond by temporarily reducing hiring or taking other measures and could have an adverse effect on our business, operating results and financial condition.
We are exposed to fluctuations in currency exchange rates.
Because we conduct a significant and growing portion of our business outside the United States but report our financial results in U.S. dollars, we face exposure to adverse movements in currency exchange rates. Our foreign operations are exposed to foreign exchange rate fluctuations as the financial results are translated from the local currency into U.S. dollars upon consolidation. If the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions will result in increased revenue, operating expenses and net income (or loss). If the U.S. dollar strengthens against foreign currencies, however, the translation of these foreign currency denominated transactions will result in decreased revenue, operating expenses and net income (or loss). As exchange rates vary, sales and other operating results, when translated, may differ materially from expectations. In addition, approximately 44% of our cash balances are denominated in currencies other than the U.S. dollar, and the value of such holdings will increase or decrease along with the weakness or strength of the U.S. dollar, respectively.
If we fail to increase the number of our clients or retain existing clients, our revenue and our business will be harmed.
Our ability to grow our business depends in large part on maintaining and expanding our client base. To do so, we must convince prospective clients of the benefits of our RL Platform and existing clients of the continuing value of our products and services. The online marketing industry is new and rapidly evolving, and many prospective clients may not be familiar with the benefits of online marketing. These businesses may generally favor using more traditional methods of local advertising, such as newspapers or print yellow pages directories. In addition, as the online media options for SMBs proliferate and our clients become more familiar with such options, we cannot assure you that we will be successful in maintaining or expanding our client base.
SMB marketing and advertising campaigns are often sporadic and difficult to predict, as they may be driven by seasonal promotions or business dynamics, evolving product and service offerings, available budgets and other factors. Some SMBs advertise only periodically, such as to promote sales or special offers. Because we need to address these business considerations of our clients, we do not require clients to enter into long-term obligations to purchase our products and services. Many do not renew their campaigns, and some cancel. We must continually add new clients both to replace clients who choose not to renew their advertising campaigns and to grow our business beyond our current client base. A client’s decision not to renew may be based on a number of factors, including dissatisfaction with our products and services, inability to continue operations and spending levels or because their campaigns were event-driven or otherwise intentionally limited in scope or duration. If our clients increasingly fail to fulfill their contracts or increasingly do not renew their advertising campaigns with us, or if we are unable to attract new clients in numbers greater than the number of clients that we lose, our client base will decrease and our business, financial condition and operating results will be adversely affected.
A significant portion of our revenue is generated by our national brands, agencies and resellers. If we are not able to maintain relationships with one or more of them, our sales may suffer and our revenue may decline.
We distribute our products and services through a separate sales force for national brands with operations in multiple local markets, as well as select third-party agencies and resellers. More generally, because national brands, agencies and resellers typically represent an aggregated group of SMB clients, if our relationship with one or more of these persons or companies were restricted or terminated, our sales would decrease and our revenue would be adversely affected, potentially materially. In addition, our strategy of distributing our products and services to our clients through our Direct Local channel and through our National Brands, Agencies and Resellers channel may result in distribution channel conflicts. Our Direct Local sales efforts may compete with our third-party agency and resellers and, to the extent different third-party agencies and resellers target the same clients, they may also come into conflict with each other. While we have certain policies in place to address these potential conflicts, there can be no assurance that these channel conflicts will not materially adversely affect our relationship with existing third-party agencies and resellers or adversely affect our ability to attract new third-party agencies and resellers. In the event that any of our relationships with existing third-party agencies and resellers are terminated or we are unable to attract new third-party agencies and resellers as a result of these distribution channel conflicts, our sales may suffer and our revenue may decline.
If SMBs increasingly opt to perform advertising tasks on their own, their demand for our products and services would decrease, negatively affecting our revenue.
Large Internet marketing providers such as Google, Yahoo! and Microsoft offer online advertising products and services through self-service platforms. As SMBs become more familiar with and experienced in interacting online, they may prefer to actively manage their own Internet presence and their demand for our products and services may decrease. We cannot predict the evolving experiences and preferences of SMBs, which may become more fully integrated into digitized modes of commerce and communication, and cannot assure you that we can develop our products and services in a manner that will suit their needs and expectations faster or more effectively than our competitors, or at all. If we are not able to do so, our results of operations would suffer.
We expect a number of factors to cause our operating results to fluctuate on a quarterly and annual basis, which may make it difficult to predict our future performance.
Our revenue and operating results could vary significantly from quarter-to-quarter and year-to-year because of a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. In addition to other risk factors discussed in this section, factors that may contribute to the variability of our quarterly and annual results include:
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unilateral actions taken by Google or other media providers;
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seasonal variations in advertising budgets and media pricing;
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seasonal variations in IMC hiring;
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the rate at which SMBs migrate their advertising spending online;
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the timing and stage of product and technology development;
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our ability to develop, introduce and manage consumer-facing products;
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the impact of fluctuations in currency exchange rates, particularly the relative strength of the US Dollar to the currencies in the countries in which we do business and its impact on our consolidated revenues and results of operations;
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the impact of worldwide economic conditions on our revenue and expenses;
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the timing of and our ability to enter new markets and manage expansion in new markets;
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our ability to appropriately set the price of non-media products;
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our ability to accurately forecast revenue and appropriately plan our expenses;
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the attraction and retention of qualified employees and key personnel;
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the effectiveness of our internal controls;
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our ability to effectively manage our growth;
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our ability to successfully manage any future acquisitions of businesses, solutions or technologies;
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interruptions in service and any related impact on our reputation;
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the effects of natural or man-made catastrophic events; and
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changes in government regulation affecting our business.
As a result of these and other factors, the results of any prior quarterly or annual periods should not be relied upon as indications of our future operating performance. In addition, our operating results may not meet the expectations of investors.
Growth may place significant demands on our management and our infrastructure.
We have experienced substantial growth in our business. This growth has placed and may continue to place significant demands on our management and our operational and financial infrastructure. As our operations grow in size, scope and complexity, we will need to improve and upgrade our systems and infrastructure to offer an increasing number of clients enhanced solutions, features and functionality. The expansion of our systems and infrastructure will require us to commit substantial financial, operational and technical resources in advance of an increase in the volume of business, with no assurance that the volume of business will increase. Continued growth could also strain our ability to maintain reliable service levels for our clients, develop and improve our operational, financial and management controls, enhance our reporting systems and procedures and recruit, train and retain highly skilled personnel. Managing our growth will require significant expenditures and allocation of valuable management resources. If we fail to maintain the necessary level of discipline and efficiency in our organization as it grows, our business, operating results and financial condition would be harmed.
Our ability to deliver reporting and tracking solutions to our clients depends upon the quality, availability, policies and prices of third-party call tracking providers, website hosting companies and domain registrars.
We rely on third parties to provide our call tracking and recording services. In certain geographies, we rely on a single call tracking provider. In the event the provider were to terminate our relationship or stop providing these services, our ability to provide our tracking services could be impaired. We may not be able to find an alternative provider in time to avoid a disruption of our services or at all, and we cannot be certain that such provider’s services would be compatible with our products without significant modifications or cost, if at all. Our proxy servers, which underlie key elements of our tracking services, require the use of various domains and IP address blocks. If domain registrars, website hosting companies or Internet service providers determined that our use of such domains and IP blocks were in violation of their terms of service or internet policies, such companies could elect to block our traffic. For example, several website hosting companies have blocked traffic from our reverse proxy servers for a group of our SMB clients, resulting in our inability to provide our full tracking services to those clients. Our ability to address or mitigate these risks may be limited. The failure of all or part of our tracking services could result in a loss of clients and associated revenue and could harm our results of operations.
We rely on bandwidth providers, data centers and other third parties for key aspects of the process of providing online marketing solutions to our clients, and any failure or interruption in the services provided by these third parties could harm our ability to operate our business and damage our reputation.
We rely on third-party vendors, including data center, software as a service, cloud computing Internet infrastructure and bandwidth providers. Any disruption in the services provided by these third-party providers or any failure of these third-party providers to handle current or higher volumes of use could significantly harm our business. Any financial or other difficulties our providers face may have negative effects on our business, the nature and extent of which we cannot predict. We exercise little control over these third-party vendors, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions and delays in service and availability for such elements. Any errors, failures, interruptions or delays experienced in connection with these third-party technologies and information services could negatively impact our relationship with our clients and adversely affect our brand and our business and could expose us to liabilities to third parties.
Client complaints or negative publicity about our customer service or other business practices could adversely affect our reputation and brand.
Client complaints or negative publicity about our technology, personnel or customer service could severely diminish confidence in and the use of our products and services. Effective customer service requires significant personnel expense, and this expense, if not managed properly, could significantly impact our operating results. Moreover, failure to provide our clients with high-quality customer experiences for any reason could substantially harm our reputation and our brand and adversely affect our efforts to develop as a trusted provider of online marketing and reporting solutions for the SMB market.
Rapid technological changes may render our online marketing and reporting solutions obsolete or decrease the attractiveness of our solutions to our clients.
To remain competitive, we must continue to enhance and improve the functionality and features of our RL Platform. The Internet, access to the Internet and the online marketing and advertising industry are rapidly changing. Our competitors are constantly developing new products and services in online marketing and advertising. As a result, we must continue to invest significant resources in order to enhance our existing products and services and introduce new products and services that clients can easily and effectively use. If competitors introduce new solutions embodying new technologies, or if new industry practices emerge, our existing technology may become obsolete. Our future success will depend on our ability to:
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enhance our existing solutions;
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develop new solutions and technologies that address the increasingly sophisticated and varied needs of our prospective clients; and
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respond to technological advances and emerging industry practices on a cost-effective and timely basis.
Developing our online marketing and reporting solutions and the underlying technology entail significant technical and business risks. We may use new technologies ineffectively, or we may fail to adapt our RL Platform and network infrastructure to client requirements or emerging industry practices. If we face material delays in introducing new or enhanced solutions, our clients may forego the use of our solutions in favor of those of our competitors.
Future acquisitions could disrupt our business and harm our financial condition and operating results.
Our success will depend, in part, on our ability to expand our offerings and markets and grow our business in response to changing technologies, client demands and competitive pressures. In some circumstances, such as our recent acquisition of the assets of RealPractice, Inc., we may determine to do so through the acquisition of complementary businesses, solutions or technologies rather than through internal development. The identification of suitable acquisition candidates can be difficult, time-consuming and costly, and we may not be able to successfully complete identified acquisitions. Furthermore, even if we successfully complete an acquisition, we may not be able to successfully assimilate and integrate the business, technologies, solutions, personnel or operations of the company that we acquired, particularly if key personnel of an acquired company decide not to work for us. We may also inherit liability for activities of the acquired company before the acquisition, including violations of laws, rules and regulations, intellectual property disputes, commercial disputes, tax liabilities and other known and unknown liabilities. In addition, we may borrow to complete an acquisition, which would increase our costs, or issue equity securities, which would dilute our stockholders’ ownership and could adversely affect the price of our common stock. Historically, we have primarily grown organically, rather than through acquisitions. As a result, we have somewhat limited experience in identifying and executing acquisition opportunities. Acquisitions may also involve the entry into geographic or business markets in which we have little or no prior experience. Consequently, we may not achieve anticipated benefits of the acquisitions which could harm our operating results.
We make strategic investments from time to time and if they are unsuccessful, it could harm our financial condition.
We have made strategic investments in the past, such as the market development loan to OxataSMB, a franchisee, and may make additional similar or different strategic investments in the future. Such investments may not prove profitable or successful for us and may result in the partial or total loss of our invested capital. In addition, strategic investments, such as with OxataSMB, may involve future commitments to provide further capital and we cannot assure you any such further investments will be desirable if, and when made, or will prove profitable over the long term.
We may require additional capital to respond to business opportunities, challenges, acquisitions or unforeseen circumstances. If capital is not available to us, our business, operating results and financial condition may be harmed.
We may require additional capital to operate or expand our business. In addition, some of our product development initiatives may require substantial additional capital resources before they begin to generate material revenue. Additional funds may not be available when we need them, on terms that are acceptable to us, or at all. Any debt financing secured by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we do not have funds available to enhance our solutions, maintain the competitiveness of our technology or pursue business opportunities, we may not be able to service our existing clients or acquire new clients, which could have an adverse effect on our business, operating results and financial condition.
Our business is subject to the risks of earthquakes, fires, floods and other natural catastrophic events and to interruption by man-made problems such as computer viruses or terrorism.
Our systems and operations are vulnerable to damage or interruption from earthquakes, fires, floods, power losses, telecommunications failures, terrorist attacks, acts of war, human errors, break-ins and similar events. For example, a significant natural disaster, such as an earthquake, fire or flood, could have a material adverse impact on our business, operating results and financial condition, and our insurance coverage will likely be insufficient to compensate us for losses that may occur. Our servers may also be vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems, which could lead to interruptions, delays, loss of critical data or the unauthorized disclosure of confidential intellectual property or client data. We may not have sufficient protection or recovery plans in certain circumstances, such as natural disasters affecting the Los Angeles area, and our business interruption insurance may be insufficient to compensate us for losses that may occur. As we rely heavily on our servers, computer and communications systems and the Internet to conduct our business and provide high quality customer service, such disruptions could negatively impact our ability to run our business, which could have an adverse affect on our operating results and financial condition.
If our security measures are breached and unauthorized access is obtained to a client’s data, our service may be perceived as not being secure and clients may curtail or stop using our service.
Our service involves the storage and transmission of clients’ proprietary information, such as credit card and bank account numbers, and security breaches could expose us to a risk of loss of this information, litigation and possible liability. Our payment services may be susceptible to credit card and other payment fraud schemes, including unauthorized use of credit cards, debit cards or bank account information, identity theft or merchant fraud.
If our security measures are breached in the future as a result of third-party action, employee error, malfeasance or otherwise, and as a result, someone obtains unauthorized access to our clients’ data, our reputation will be damaged, our business may suffer and we could incur significant liability. Because techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose sales and clients.
We are subject to a number of risks related to credit card payments we accept. If we fail to be in compliance with applicable credit card rules and regulations, we may incur additional fees, fines and ultimately, the revocation of the right to use the credit card company, which would have a material adverse effect on our business, financial condition or results of operations.
A majority of our clients’ campaigns were paid for using a credit card or debit card. For credit and debit card payments, we pay interchange and other fees, which may increase over time and raise our operating expenses and adversely affect our net income. We are also subject to payment card association operating rules, certification requirements and rules governing electronic funds transfers, which could change or be reinterpreted to make it difficult or impossible for us to comply. We believe we are compliant with the Payment Card Industry Data Security Standard, which incorporates Visa’s Cardholder Information Security Program and MasterCard’s Site Data Protection standard. However, there is no guarantee that we will maintain such compliance or that compliance will prevent illegal or improper use of our payment system. If we fail to comply with these rules or requirements, we may be subject to fines and higher transaction fees and lose our ability to accept credit and debit card payments from our clients. A failure to adequately control fraudulent credit card transactions would result in significantly higher credit card-related costs and could have a material adverse effect on our business, financial condition or results of operations.
Our revenue may be negatively affected if we are required to charge sales tax or other transaction taxes on all or a portion of our past and future sales to customers located in jurisdictions where we are currently not collecting and reporting tax.
We generally do not charge, collect or have imposed upon us sales or other transaction taxes related to the products and services we sell, except for certain corporate level taxes and transaction level taxes outside of the United States. However, many states, local jurisdictions or one or more countries may seek to impose sales or other transaction tax obligations on us in the future. A successful assertion by any state, local jurisdiction or country in which we do business that we should be collecting sales or other transaction taxes on the sale of our products or services could result in substantial tax liabilities related to past sales, create increased administrative burdens or costs, discourage clients from purchasing products or services from us, decrease our ability to compete or otherwise substantially harm our business and results of operations. The imposition of new laws requiring the collection of sales or other transaction taxes on the sale of our products or services (or the introduction of new products or services that are subject to existing transaction taxes) could create increased administrative burdens or costs, discourage clients from purchasing products or services from us, decrease our ability to compete or otherwise substantially harm our business and results of operations.
The intended tax benefits of our corporate structure and intercompany arrangements depend on the application of the tax laws of various jurisdictions and on how we operate our business.
Our corporate structure and intercompany arrangements, including the manner in which we develop and use our intellectual property and the transfer pricing of our intercompany transactions, are intended to reduce our worldwide effective tax rate. The application of the tax laws of various jurisdictions, including the United States, to our international business activities is subject to interpretation and depends on our ability to operate our business in a manner consistent with our corporate structure and intercompany arrangements. The taxing authorities of the jurisdictions in which we operate may challenge our methodologies for valuing developed technology or intercompany arrangements, including our transfer pricing, or determine that the manner in which we operate our business does not achieve the intended tax consequences, which could increase our worldwide effective tax rate and harm our financial position and results of operations.
Our corporate structure includes legal entities located in jurisdictions with income tax rates lower than the U.S. statutory tax rate. Our intercompany arrangements allocate income to such entities in accordance with arm’s-length principles and commensurate with functions performed, risks assumed and ownership of valuable corporate assets. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. statutory rate will have a beneficial impact on our worldwide effective tax rate.
Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. For example, our effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in foreign currency exchange rates or by changes in the relevant tax, accounting and other laws, regulations, principles and interpretations. As we operate in numerous taxing jurisdictions, the application of tax laws can be subject to diverging and sometimes conflicting interpretations by tax authorities of these jurisdictions. It is not uncommon for taxing authorities in different countries to have conflicting views, for instance, with respect to, among other things, the manner in which the arm’s length standard is applied for transfer pricing purposes, or with respect to the valuation of intellectual property. In addition, tax laws are dynamic and subject to change as new laws are passed and new interpretations of the law are issued or applied. In particular, there is uncertainty in relation to the U.S. tax legislation in terms of the future corporate tax rate but also in terms of the U.S. tax consequences of income derived from intellectual property related income earned overseas in low tax jurisdictions.
Our existing corporate structure and intercompany arrangements have been implemented in a manner we believe is in compliance with current prevailing tax laws. However, the tax benefits which we intend to eventually derive could be undermined if we are unable to adapt the manner in which we operate our business and due to changing tax laws.
Failure to adequately protect our intellectual property could substantially harm our business and operating results.
Because our business is heavily dependent on our intellectual property, including our proprietary technology, the protection of our intellectual property rights is crucial to the success of our business. We rely on a combination of intellectual property rights, including trade secrets, patent applications, copyrights and trademarks, as well as contractual restrictions, to safeguard our intellectual property. These afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our online marketing and reporting solutions, technology, software and functionality or obtain and use information that we consider proprietary. Moreover, policing our proprietary rights is difficult and may not always be effective. In particular, because we sell our solutions internationally, we may need to enforce our rights under the laws of countries that do not protect proprietary rights to as great an extent as do the laws of the United States.
Our proprietary technology is not currently protected by any issued patents, and policing our rights to such technology may be hindered if we are unable to obtain any patents. In addition, the type and extent of patent claims that may be issued to us in the future is uncertain, and any patents that are issued may not contain claims that permit us to stop competitors from using similar technology. In light of the costs of obtaining patent protection, at times we may choose not to protect certain innovations that later on prove to be highly important. To the extent that the various technologies underlying any patent applications are determined to be business methods, the law around these types of patents is rapidly developing, and pending changes may impact our ability to protect our technology and proprietary use thereof through patents.
We have registered ReachLocal and other trademarks as trademarks in the United States and in certain other countries. Some of our trade names are not eligible to receive trademark protection. Also, trademark protection may not be available, or sought by us, in every country in which our technology and products are available online. Competitors may adopt service names similar to ours, or purchase our trademarks and confusingly similar terms as keywords in Internet search engine advertising programs, thereby impeding our ability to build brand identity and possibly leading to client confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of the term ReachLocal or our other trademarks.
Litigation or proceedings before the U.S. Patent and Trademark Office or other governmental authorities and administrative bodies in the United States and abroad may be necessary in the future to enforce our intellectual property rights, to protect our patent rights, trade secrets and domain names and to determine the validity and scope of the proprietary rights of others. Our efforts to enforce or protect our proprietary rights may be ineffective and could result in substantial costs and diversion of resources and could substantially harm our operating results.
Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.
In order to protect our proprietary technology and processes, we rely in part on confidentiality agreements with our employees, licensees, independent contractors and other advisors. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information, and in such cases, we could not assert any trade secret rights against such parties. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.
Assertions by third parties of infringement by us of their intellectual property rights could result in significant costs and substantially harm our business and operating results.
Companies in the Internet, technology and media industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently litigate or threaten litigation based on allegations of infringement or other violations of intellectual property rights. Other parties have asserted, and may in the future assert, that we have infringed their intellectual property rights. These types of litigations may involve patent holding companies or other adverse patent owners who have no relevant product revenue, and therefore our own issued and pending patents, if any, may provide little or no deterrence. In addition, we have been and could in the future become involved in disputes over the use of keywords by our clients, to the extent such clients’ competitors allege the use of such keywords on our RL Platform violates such competitors’ trademark rights. We cannot predict whether assertions of third-party intellectual property rights or claims arising from such assertions will substantially harm our business and operating results. If we are forced to defend against any infringement claims, whether they are with or without merit or are determined in our favor, we may face costly litigation and diversion of technical and management personnel. Furthermore, an adverse outcome of a dispute may require us to pay damages, potentially including treble damages and attorneys’ fees, if we are found to have willfully infringed a party’s patent or copyright rights; cease making, licensing or using solutions that are alleged to incorporate the intellectual property of others; expend additional development resources to redesign our solutions; and enter into potentially unfavorable royalty or license agreements in order to obtain the right to use necessary technologies. Royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. Over time, we expect that we will increasingly be subject to infringement claims as the number of competitors in our industry segment grows or as our presence and visibility within the industry increases.
We could lose clients if we or our media partners fail to detect click-through or other fraud on advertisements in a manner that is acceptable to our clients.
We are exposed to the risk of fraudulent clicks or actions on our third-party publishers’ websites. We may lose clients, or in the future, we may have to refund revenue that our clients have paid to us and that was later attributed to, or suspected to be caused by, click-through fraud. Click-through fraud occurs when an individual clicks on an ad displayed on a website or an automated system is used to create such clicks with little to no intent of viewing the underlying content. If fraudulent clicks are not detected, the affected clients may become dissatisfied with our campaigns, which in turn may lead to loss of clients and the related revenue.
Our business is subject to complex and evolving U.S. and foreign laws and regulations regarding privacy, data protection, and other matters. Many of these laws and regulations are subject to change and uncertain interpretation, and could result in claims, changes to our business practices, increased cost of operations, or otherwise harm our business.
We are subject to a variety of laws and regulations in the United States and abroad that involve matters central to our business, including user privacy, rights of publicity, data protection, content, intellectual property, distribution, electronic contracts and other communications, competition, protection of minors, consumer protection, taxation, and online payment services. Foreign data protection, privacy, and other laws and regulations are often more restrictive than those in the United States. These U.S. federal and state and foreign laws and regulations are constantly evolving and can be subject to significant change. In addition, the application and interpretation of these laws and regulations are often uncertain. These laws and regulations could have a significant impact on online advertising services depending on how these laws and regulations are interpreted and enforced. It is also clear that the laws and regulations are intending to regulate behavioral targeting, the availability of which could become highly limited are eliminated entirely. Our product suite does not rely heavily on the use of behavioral targeting, but we do offer a display remarketing product, which involves showing a consumer an ad for the website of an advertiser that the consumer has previously visited.
In addition, a number of proposals are pending before federal, state, and foreign legislative and regulatory bodies that could significantly affect our business. For example, a revision to the 1995 European Union Data Protection Directive is currently being considered by European legislative bodies that may include more stringent operational requirements for data processors and significant penalties for non-compliance. Similarly, there have been a number of recent legislative proposals in the United States, at both the federal and state level, that would impose new obligations in areas such as privacy, data protection and data breach notifications. Some of the proposed changes to U.S. and European law could require that we obtain prior consent before using cookies or other tracking technologies or provide a “do not track” mechanism in certain circumstances. These existing and proposed laws and regulations can be costly to comply with and can delay or impede the development of new products, result in negative publicity, increase our operating costs, require significant management time and attention, and subject us to claims or other remedies, including fines or demands that we modify or cease existing business practices.
We process, store and use personal information and other data, which subjects us to governmental regulation and other legal obligations related to privacy. Our actual or perceived failure to comply with such obligations could harm our business.
We receive, store and process personal information and other user data, including credit card information for certain users. There are numerous federal, state and local laws around the world regarding privacy and the storing, sharing, use, processing, disclosure and protection of personal information and other user data, the scope of which are changing, subject to differing interpretations, and may be inconsistent between countries or conflict with other rules. It is possible that these obligations may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another and may conflict with other rules or our practices. Any failure or perceived failure by us to comply with our privacy policies, our privacy-related obligations to users or other third parties, or our privacy-related legal obligations, or any compromise of security that results in the unauthorized release or transfer of personally identifiable information or other user data, may result in governmental enforcement actions, litigation or negative publicity and could cause our advertisers to lose trust in us, which could have an adverse effect on our business. Additionally, if third parties with whom we work, such as our publishers or our providers of telephony services, violate applicable laws or our policies, such violations may also put our users’ information at risk and could have an adverse effect on our business.
Some of our services may utilize “open source” software, and any failure to comply with the terms of one or more of these open source licenses could negatively affect our business.
Some of our services may utilize software licensed by its authors or other third parties under so-called “open source” licenses, including, but not limited to, the GNU General Public License and the GNU Lesser General Public License. Some of those licenses may require that we make available source code for modifications or derivative works we create using the open source software, that we provide notices with our products and that we license any modifications or derivative works under an open source license or rights of further use to third parties. If we combine our proprietary software with open source software, we could be required to release the source code of our proprietary software. Although we take steps to ensure that our software engineers properly isolate our proprietary software they design from open source software components, we may not control the product development efforts of our engineers and we cannot be certain that they have not inappropriately incorporated open source software into our proprietary technologies. If an author or other third party that distributes open source software were to obtain a judgment against us based on allegations that we had not complied with the terms of any applicable open source license, we could be subject to liability for copyright infringement damages and breach of contract. In addition, we could be enjoined from selling our services that contained the open source software and required to make the source code for the open source software available, to grant third parties certain rights of further use of our software or to remove the open source software from our services, which could disrupt our distribution and sale of some of our services.
Government regulation of the Internet is evolving, and unfavorable changes could substantially harm our business and operating results.
We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet. Existing and future laws and regulations may impede the growth in use of the Internet and online services. The application of existing laws to the Internet and online services governing issues such as property ownership, sales and other taxes, libel and personal privacy has not yet been settled. Unfavorable resolution of these issues may substantially harm our business and operating results. Other laws and regulations that have been adopted, or may be adopted in the future, that may affect our business include those covering user privacy, data protection, spyware, “do not email” lists, access to high speed and broadband service, pricing, taxation, tariffs, patents, copyrights, trademarks, trade secrets, export of encryption technology, electronic contracting, click-fraud, acceptable content, search terms, lead generation, behavioral targeting, consumer protection, and quality of products and services. Any changes in regulations or laws that hinder growth of the Internet generally or that decrease the acceptance of the Internet as a communications, commercial and advertising medium could adversely affect our business. See also Part 1, Item 1A, “Risk Factors- If the technology that we currently use to target the delivery of online advertisements is restricted or becomes subject to regulation, our expenses could increase and we could lose clients.”
Risks Related to Owning Our Common Stock
Our stock price may be volatile, and the value of an investment in our common stock may decline.
Shares of our common stock were sold in our initial public offering in May 19, 2010 at a price of $13.00 per share, and our common stock has subsequently traded as high as $28.39 and as low as $6.05. An active, liquid and orderly market for our common stock may not be sustained, which could depress the trading price of our common stock. The trading price of our common stock may be subject to wide fluctuations in response to various factors, some of which are beyond our control, including:
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our operating performance and the operating performance of similar companies;
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the overall performance of the equity markets;
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the number of shares of our common stock publicly owned and available for trading;
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changes in the amounts and frequency of share repurchases;
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threatened or actual litigation;
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changes in laws or regulations relating to our solutions;
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any major change in our board of directors or management;
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publication of research reports about us or our industry or changes in recommendations or withdrawal of research coverage by securities analysts;
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large volumes of sales of our shares of common stock by existing stockholders; and
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general political and economic conditions.
In addition, the stock market in general, and the market for Internet-related companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Securities class action litigation has often been instituted against companies following periods of volatility in the overall market and in the market price of a company’s securities. This litigation, if instituted against us, could result in very substantial costs, divert our management’s attention and resources and harm our business, operating results and financial condition. In addition, the recent distress in the financial markets has also resulted in extreme volatility in security prices.
Future sales of shares of our common stock by stockholders could depress the price of our common stock.
As of December 31, 2012, approximately 69% of our common stock is held by our directors, officers and entities affiliated with our directors, including approximately 45% beneficially owned by VantagePoint Capital Partners and approximately 10% beneficially owned by Rho Ventures. In addition, these percentages may increase as we repurchase shares of our common stock pursuant to our $47 million share repurchase program, of which approximately $30 million was available for repurchase as of March 4, 2013 (see Part II, Item 5, “Common Stock Repurchases”). Such shares have not been subject to lock-up agreements since November 2010. VantagePoint and Rho Ventures were our two primary venture capital investors and have owned their shares for a considerable length of time. If VantagePoint or Rho Ventures decides to exit its investments in us, it could negatively impact the price of our common stock. During August and November of 2012, Rho Ventures sold an aggregate of 575,000 shares.
A number of members of our management team have adopted 10(b)5-1 trading plans covering approximately 1 million shares of common stock as of December 31, 2012. In addition, insiders may seek to sell shares without the adoption of trading plans. If there are substantial sales of our common stock in the public market, the trading price of our common stock could decline significantly. In addition, as of December 31, 2012, approximately 7.1 million shares subject to outstanding options under our 2004 Stock Plan and our Amended and Restated 2008 Stock Incentive Plan, are eligible for sale in the public market in the future, subject to certain legal and contractual limitations. If these additional shares are sold, or if it is perceived that they will be sold, in the public market, the price of our common stock could decline substantially.
If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our stock price and trading volume could decline.
The trading market for our common stock depends in part on the research and reports that securities or industry analysts publish about us or our business. If one or more of the analysts who cover us downgrade our stock or publish inaccurate or unfavorable research about our business, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, demand for our stock could decrease, which might cause our stock price and trading volume to decline.
Our management continues to have broad discretion over the use of the proceeds we received in our initial public offering and might not apply the proceeds in ways that increase the value of your investment.
Our management generally has broad discretion to use the net proceeds from our initial public offering, and our stockholders will be relying on the judgment of our management regarding the application of these proceeds. We have used and will continue to use the net proceeds for the acquisition of businesses, solutions and technologies that we believe are complementary to our own. If we do not invest or apply the net proceeds from the offering in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.
Investment funds managed by VantagePoint Capital Partners own a substantial amount of our stock and have significant influence over our business. In the aggregate, insiders own a majority of our outstanding stock.
As of December 31, 2012, VantagePoint Capital Partners, one of our early venture capital investors, beneficially owned approximately 45% of our outstanding common stock. As a result, VantagePoint has significant influence over the outcome of matters submitted to our stockholders for approval, including the election of directors. VantagePoint’s significant ownership also could affect the market price of our common stock by, for example, delaying, deferring or preventing a change in corporate control, impeding a merger, consolidation, takeover or other business combination involving us, or discouraging a potential acquiror from making a tender offer or otherwise attempting to obtain control of us. Alan Salzman, the Chief Executive Officer of Vantage Point, serves as a member of our board of directors.
As of December 31, 2012, our current directors and executive officers as a group beneficially own approximately 69% of our outstanding common stock (including all shares issuable with respect to options held by such holders).
Certain provisions in our charter documents and Delaware law could discourage takeover attempts and lead to management entrenchment.
Our certificate of incorporation and bylaws contain provisions that could have the effect of delaying or preventing changes in control or changes in our management without the consent of our board of directors, including, among other things:
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a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors;
•
no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates;
•
the ability of our board of directors to determine to issue shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquirer;
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the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of our board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors;
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a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders;
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the requirement that a special meeting of stockholders may be called only by the chairman of our board of directors, the Chief Executive Officer, the president (in absence of a Chief Executive Officer) or our board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors;
•
the requirement for the affirmative vote of holders of at least 662/3% of the voting power of all of the then outstanding shares of the voting stock, voting together as a single class, to amend the provisions of our certificate of incorporation relating to the issuance of preferred stock and management of our business or our bylaws, which may inhibit the ability of an acquiror from amending our certificate of incorporation or bylaws to facilitate a hostile acquisition;
•
the ability of our board of directors, by majority vote, to amend the bylaws, which may allow our board of directors to take additional actions to prevent a hostile acquisition and inhibit the ability of an acquiror from amending the bylaws to facilitate a hostile acquisition; and
•
advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us.
We are also subject to certain anti-takeover provisions under Delaware law. Under Delaware law, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, our board of directors has approved the transaction.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
We do not own any real estate. We lease 38,592 square-feet for our corporate office in Woodland Hills, California, and 66,785 square-feet for our corporate and sales offices in Plano, Texas. We also have over 60 leases for sales offices, support facilities and data centers in other locations in North America and overseas.
Item 3.
Item 3. Legal Proceedings.
From time to time, we are involved in legal proceedings arising in the ordinary course of our business. We believe that there is no litigation pending that is likely to have a material adverse effect on our results of operations and financial condition.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock has been traded on The Nasdaq Global Select Market since May 20, 2010 under the symbol “RLOC.” The following table sets forth the high and low sales prices for our common stock as reported by The Nasdaq Global Select Market for the period indicated.
As of March 5, 2013, we had approximately 41 stockholders of record of our common stock. We have never declared or paid, and do not anticipate declaring or paying, any cash dividends on our common stock. Any future determination as to the declaration and payment of dividends, if any, will be at the discretion of our board of directors and will depend on then existing conditions, including our financial condition, operating results, contractual restrictions, capital requirements, business prospects and other factors our board of directors may deem relevant.
Stock Price Performance Graph
This performance graph shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities under that Section, and shall not be deemed to be incorporated by reference into any filing of ReachLocal, Inc. under the Securities Act or the Exchange Act.
The following graph compares, for the period from May 20, 2010 through December 31, 2012, the total cumulative stockholder return on our common stock with the total cumulative return of the NASDAQ Composite Index and the RDG Internet Composite Index. The graph assumes a $100 investment at the beginning of the period in our common stock, the stocks represented in the NASDAQ Composite Index and the stocks represented in the RDG Internet Composite Index, and reinvestment of any dividends. Historical stock price performance should not be relied upon as an indication of future stock price performance:
Recent Sales of Unregistered Securities
On February 22, 2010, we agreed to issue up to 364,632 shares of common stock as partial deferred consideration for the acquisition of SMB:LIVE Corporation, and on February 22, 2011, August 22, 2011, and February 22, 2012, we issued 90,062, 93,346 and 181,224, respectively, of such shares of our common stock.
On February 8, 2011, we agreed to issue up to 21,297 shares of common stock as partial deferred consideration for the acquisition of DealOn, LLC, and on February 8, 2012 and August 8, 2012, we issued 10,649 and 5,324, respectively, of such shares of our common stock.
Use of Proceeds from Registered Securities
On May 19, 2010, our registration statement on Form S-1 (File No. 333-163905) was declared effective for our initial public offering, pursuant to which we registered the offering and sale of 3,941,103 shares of common stock, including shares from the exercise of the underwriters’ option to purchase 625,000 shares, and the associated sale of 850,564 shares of common stock by selling stockholders at a public offering price of $13.00 per share. J.P. Morgan and Merrill Lynch, Pierce, Fenner & Smith Incorporated were the joint book running managers and representatives of the underwriters.
As a result of the offering, we received net proceeds of approximately $42.0 million, after deducting underwriting discounts and commissions of approximately $3.6 million and offering expenses payable by us of approximately $5.6 million. No offering expenses were paid directly or indirectly to any of our directors or officers or their associates or to persons owning ten percent or more of our common stock or to any other affiliates. The net offering proceeds have been invested into cash and money market accounts and have been used to make acquisitions, fund product development and expand internationally.
There has been no material change in the planned use of proceeds from our initial public offering as described in our final prospectus filed with the SEC pursuant to Rule 424(b).
Common Stock Repurchases
On November 4, 2011, we announced that our Board of Directors authorized the repurchase of up to $20.0 million of our outstanding common stock. On December 13, 2012, we announced that our Board of Directors increased our share repurchase program by $6.0 million, to a total authorization of $26.0 million, and on March 4, 2013, we announced that our Board of Directors increased the total authorized repurchase amount by an additional $21.0 million, to a total authorization of $47.0 million. At December 31, 2012, we had executed repurchases of $17.4 million of our common stock under the program. From January 1, 2013 to March 5, 2013, we executed repurchases of an additional $1.5 million of our common stock under the program. Purchases may be made from time-to-time in open market or privately negotiated transactions as determined by our management. The amount and timing of the share repurchase will depend on business and market conditions, stock price, trading restrictions, acquisition activity, and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and the repurchase program may be suspended or discontinued at any time at our discretion.
Common stock repurchases during the quarter ended December 31, 2012 were as follows:
Item 6.
Item 6. Selected Financial Data.
The data set forth below are qualified in their entirety by reference to, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements, related notes and other financial information included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2012, 2011 and 2010 and the consolidated balance sheet data as of December 31, 2012 and 2011 are derived from our audited consolidated financial statements included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2009 and 2008 and the consolidated balance sheet data as of December 31, 2010, 2009 and 2008 are derived from our audited consolidated financial statements not included in this report. In addition, as a result of the winding down of the operations of Bizzy, the local recommendation engine we developed, we have reclassified and presented all Bizzy related historical financial information as “discontinued operations” in the accompanying Consolidated Balance Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. Historical results are not necessarily indicative of the results to be expected in the future.
(1)
Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line items (in thousands):
(2)
See Note 2 to our consolidated financial statements for an explanation of the method used to calculate basic and diluted net income per share of common stock.
(3)
Represents purchases of property and equipment and the amount of software development costs capitalized, in aggregate, excluding stock-based compensation and the acquisition of ReachLocal Australia in September 2009, and excluding capital expenditures related to the discontinued operations of Bizzy.
(4)
See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures” for our definition of Adjusted EBITDA, why we present it and for a reconciliation of our Adjusted EBITDA to loss from operations for the years ended December 31, 2012, 2011 and 2010.
(5)
See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures” for our definition of Underclassmen Expense.
(6)
Active Advertisers is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Advertisers by adjusting the number of Active Campaigns to combine clients with more than one Active Campaign as a single Active Advertiser. Clients with more than one location are generally reflected as multiple Active Advertisers. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Advertisers includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred.
(7)
Active Campaigns is a number we calculate to approximate the number of individual products or services we are managing under contract for Active Advertisers. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client, we consider that two Active Campaigns. Similarly, if a client purchased ReachSearch campaigns for two different products or purposes, we consider that two Active Campaigns. Numbers are rounded to the nearest hundred.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
You should read the following discussion together with Part II, Item 6, “Selected Financial Data” and our consolidated financial statements and the related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements about our business and operations. Our actual results may differ materially from those we currently anticipate as a result of many factors, including those we describe in Part I, Item 1A, “Risk Factors” and elsewhere in this Annual Report. See Part I, “Cautionary Notice Regarding Forward-Looking Statements.”
Overview
Our mission is to help small and medium-sized businesses, or SMBs, acquire, transact with, maintain and retain customers via the Internet. We offer a comprehensive suite of online marketing and reporting solutions, including ReachSearch™ (search engine marketing), ReachCast™ (Web presence), ReachDisplay™ (display advertising), ReachRetargeting™ (display retargeting), online marketing analytics, and other related products and solutions, each targeted to the SMB market. In 2013, we expect to expand our product suite to include ReachSite (website solution) and two software-as-a-service, or SaaS, products ReachConvert (marketing automation and lead conversion) and ReachCommerce (supporting online booking, transaction and back office processes). We deliver these solutions to SMBs through a combination of our proprietary platform, the RL Platform, and our direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies, resellers and a franchisee.
We use our RL Platform to create advertising campaigns for SMBs to target potential customers in their geographic area, optimize those campaigns in real time and track tangible results. Through a single Internet advertising budget, we enable our clients to reach local customers-whether using traditional computing devices or mobile devices-across the Internet, including through all of the major search engines and leading general interest and vertically focused online publishers. In 2010, we expanded the RL Platform to include ReachCast, our full-service Web presence and social media solution, and in September 2012, we launched ReachRetargeting, a ReachDisplay product targeting local consumers who have recently searched for an SMB’s business keywords as well as those who have recently visited their website. We continue to expand the RL Platform to include additional advertising products designed specifically for the needs of our SMB clients. Empowered by the RL Platform, our IMCs, which are based in or near the cities in which our clients operate, establish a direct consultative relationship with our clients and provide our solutions to achieve their marketing objectives.
We generate revenue by providing online advertising solutions for our clients through our portfolio of online marketing and advertising solutions. We sell ReachSearch, ReachDisplay and ReachRetargeting based on a package pricing model in which our clients commit to a fixed fee that includes the media; the optimization, reporting and tracking technologies of the RL Platform; and the personnel dedicated to support and manage their campaigns. We also generate revenue from digital marketing solutions for our clients that do not include the purchase of third-party media, including ReachCast, TotalTrack and TotalLiveChat. Generally, our products are sold to our clients in a single budget to simplify the purchasing process.
We offer our products and services through two primary channels. Our IMCs sell our products and services directly to SMBs, which we refer to as our Direct Local channel. We also sell our products and services through third-party agencies and resellers, and to national or regional businesses with multiple locations, such as franchisors, which we refer to as national brands. Because the sale to agencies, resellers and national brands involves negotiations with businesses that generally represent an aggregated group of SMB advertisers, we group them together as our National Brands, Agencies and Resellers channel.
In 2006, we entered our first market outside of North America through a joint venture in Australia, and in 2009, we acquired the remaining interest in the joint venture. We entered the United Kingdom and Canada in 2008, Germany and the Netherlands in 2011, and Japan and Brazil in 2012. We also serve clients in New Zealand, Slovakia, Poland and Czech Republic through our resellers, including a franchisee. In 2010, we commenced campaign management and provisioning operations in India.
Business Model
Our Direct Local channel represents the majority of our revenue. As a percentage of revenue, Direct Local revenue has increased to 79% for the year ended December 31, 2012, from 78% for the year ended December 31, 2011. Growth in Direct Local revenue is largely attributable to an increase in the number of Upperclassmen and the productivity of Upperclassmen driven by their increased tenure. Also contributing to the increase was growth in the number of international IMCs who, on average, are more productive than our IMCs in North America.
Typically, each month we hire 40-50 IMCs worldwide, with the hiring weighted towards the first ten months of the year. We refer to IMCs with 12 months or less of experience as Underclassmen. With each new class of Underclassmen, we track how they are performing relative to a standard level of revenue growth and other performance metrics for each month after their training. Understanding the performance of past and current Underclassmen allows us to adjust our investment in additional Underclassmen in the event we detect significant changes in their productivity.
We believe the key factors that affect the productivity of our IMCs are:
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IMC Tenure. As IMCs mature, they, on average, grow their advertiser base or sell additional products to existing advertisers, resulting in greater revenue productivity. In particular, Upperclassmen, those IMCs with more than 12 months of employment, are more productive than Underclassmen. As more and more IMCs mature and become Upperclassmen, as Upperclassmen become a higher percent of total IMCs, and as existing Upperclassmen mature, we expect overall IMC productivity to increase.
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Macroeconomic and Business Conditions. Macroeconomic conditions directly impact the amount of money SMBs allocate to market their business. Commencing in mid-2008, IMC productivity was significantly impacted by the economic recession as some of our SMB clients were forced to close or temporarily suspend their operations, while others curtailed their marketing expenditures in light of a contraction in consumer spending. From the end of 2009 through 2012, our IMC productivity remained higher than those levels experienced at the end of 2008. However, we believe the economic conditions remain challenging, particularly in North America. In addition, our IMCs’ productivity is affected by the amount of competition and online advertising consumption by SMBs. For example, our international IMCs have on average been more productive, which we attribute to lower levels of competition and online advertising consumption by SMBs in those markets.
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Number of Products. We believe that expanding our comprehensive suite of online marketing and reporting products and services will allow us to generate more revenue from each SMB relationship. Prior to 2009, we primarily offered a single product, ReachSearch. Since then, we launched our ReachDisplay and remarketing products in 2009, our TotalLiveChat and ReachCast products in 2010, our search retargeting and international ReachCast products in 2011, and our ReachRetargeting product in 2012.
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IMC Capacity. We continually endeavor to enhance the productivity of our IMCs. Our business model therefore contemplates additional investments in technology and support personnel to assist our IMCs in managing and maintaining existing clients in order to increase their capacity to acquire new clients. For example, we are in the process of organizing our sales and service organization into verticals so that we can leverage greater subject matter expertise, we continue to explore different staffing approaches to enhance the IMC’s opportunity to focus on new client acquisition, and we are deploying additional technology to make the selling process more efficient.
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Client Tenure. One of the most time-consuming activities for our IMCs is the process of prospecting, arranging a time to visit and obtaining the first order for our products and services from a new client. A key factor in IMC productivity is therefore the success of our efforts to continue to sell our products and services to existing clients, which requires significantly less of an IMC’s time. We believe that a measure of the success of these efforts is the percentage of our revenue generated by sales to clients with different tenures. For this purpose, on an annual basis, we divide our clients into three groups to measure their revenue contribution:
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Trial Period Clients. We characterize a client’s initial four months as the “trial period” because that is generally the minimum term for a new client’s first agreement, and we believe that four months is the shortest period in which performance of an advertising campaign can be fully assessed.
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First-Year Post-Trial Clients. We characterize a client that continues to advertise through us after its four-month trial period and for up to one year after its trial period as a First-Year Post-Trial Client.
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Long-Term Clients. We characterize clients that continue to advertise through us for more than one year after their trial period as Long-Term Clients.
The chart below presents the percentage of total revenues represented by our trial period, first-year post-trial, and long-term clients for the years ended December 31, 2010 to 2012.
Operating Metrics
We regularly review a number of other financial and operating metrics to evaluate our business, determine the allocation of resources and make decisions regarding business strategies. The following table shows certain key operating metrics for the three years ended December 31, 2012, 2011 and 2010.
(1)
See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures” for our definition of Underclassmen Expense.
(2)
See Part II, Item 6, “Selected Financial Data” for our definition of Active Advertisers.
(3)
See Part II, Item 6, “Selected Financial Data” for our definition of Active Campaigns.
Number of IMCs
Our ongoing investment in increasing the number of our IMCs has been the principal engine for our growth. Typically, each month, we hire 40-50 IMCs worldwide, with the hiring weighted towards the first ten months of the year. We refer to IMCs with 12 months or less of experience as Underclassmen. In particular, our revenue growth is driven by the increase in the number of our Upperclassmen, who are significantly more productive than our Underclassmen. As such, we believe that our ability to grow our business is highly dependent on our ability to grow the number of our Upperclassmen. Beyond our hiring practices, which determine the number of IMCs to be hired as well as the rate at which we hire them, the increase in the number of Upperclassmen depends primarily on the productivity of Underclassmen, as the majority of Underclassmen attrition has been involuntary and is based on performance relative to a standard level of revenue growth and other performance metrics determined by us. We do not expect all Underclassmen to become Upperclassmen, and our investment decisions anticipate the cost of attrition. Our revenue growth is also driven by the increase in the number of our international IMCs as our international IMCs are on average more productive than our IMCs in North America, which we attribute to lower levels of competition and lower existing online advertising consumption by SMBs in those markets. Total IMCs in 2012 increased as compared to the preceding year due to the increase in the number of Underclassmen becoming Upperclassmen. The number of Underclassmen at the end of 2012 was slightly lower than at the end of 2011 due to slightly lower IMC hiring rates in 2012. During 2012, our strategy regarding hiring and maturation of IMCs was to maintain a more constant level of IMC hiring globally-as opposed to prior years when we sought to increase our number of Underclassmen more substantially-while shifting the hiring to our newer international markets and focusing on improving Upperclassmen productivity in our more established markets.
Underclassmen Expense
Underclassmen do not, in the aggregate, make a positive contribution to operating income. Our largest operating expenses include the hiring, training and retention of Underclassmen in support of our goal of developing more Upperclassmen.
Underclassmen Expense is a number we calculate to approximate our investment in Underclassmen and is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions and other variable compensation), training and sales organization expenses, including depreciation, allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximate investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by management, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies.
We determine the amount to invest in Underclassmen based on our objectives for development of the business and the key factors affecting IMC productivity described above. The increase in Underclassmen Expense in 2012 as compared to the preceding year was primarily attributable to our international expansion, partially offset by a reduced investment in North America. Underclassmen expense slightly increased as compared to the preceding year due to increased hiring in our international markets, though the increase was offset by a reduced investment in Underclassmen recruitment in North America. The increase in Underclassmen Expense from 2011 to 2012 was lower than the increase from 2010 to 2011 as a result of our strategy to maintain a more constant level of IMC hiring globally-as opposed to prior years when we sought to increase Underclassmen hiring more substantially-while shifting the hiring to our newer international markets and focusing on improving Upperclassmen productivity in our more established markets.
Active Advertisers and Active Campaigns
We track the number of Active Advertisers and Active Campaigns to evaluate the growth, scale and diversification of our business. We also use these metrics to determine the needs and capacity of our sales forces, our support organization and other personnel and resources. Active Advertisers and Active Campaigns increased in 2012 due to an increase in the number of Upperclassmen and the productivity of Upperclassmen driven by their increased tenure, and an increase in the number of products available for our IMCs to sell.
Basis of Presentation
Discontinued Operations
As a result of the winding down of the operations of Bizzy, we have reclassified and presented all related historical financial information as “discontinued operations” in the Consolidated Balance Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. In addition, we have excluded all Bizzy-related activities from the following discussions, unless specifically referenced.
Sources of Revenue
We derive our revenue principally from the provision and sale of online advertising to our clients. Revenue includes (i) the sale of our ReachSearch, ReachDisplay, ReachRetargeting and other products based on a package pricing model in which our clients commit to a fixed fee that includes the media, optimization, reporting and tracking technologies of the RL Platform, and the personnel dedicated to support and manage their campaigns; (ii) the sale of our ReachCast, TotalTrack, TotalLiveChat, and other products and services; and (iii) set-up, management and service fees associated with these products and other services. We distribute our products and services directly through our sales force of IMCs, who are focused on serving SMBs in their local markets through an in-person, consultative process, which we refer to as our Direct Local channel, as well as a separate sales force targeting our National Brands, Agencies and Resellers channel. The sales cycle for sales to SMBs ranges from one day to over a month. Sales to our National Brands, Agencies and Resellers clients generally require several months.
We typically enter into multi-month agreements for the delivery of our ReachSearch, ReachDisplay, ReachRetargeting and ReachCast products. Under our agreements, our SMB clients typically pay, in advance, a fixed fee on a monthly basis, which includes all charges for the included technology and media services, management, third-party content and other costs and fees. We record these prepayments as deferred revenue and only record revenue for income statement purposes as we purchase media and perform other services on behalf of clients. Generally, when at least 85% of requisite purchases and other services have occurred and an additional campaign cycle remains under the agreement, we make an additional billing or automatic collection for the next campaign cycle.
Our National Brands, Agencies and Resellers clients enter into agreements of various lengths or that are indefinite. Our National Brands, Agencies and Resellers clients either pay in advance or are extended credit privileges with payment generally due in 30 to 60 days. There were $3.8 million and $3.3 million of accounts receivables related to our National Brands, Agencies and Resellers at December 31, 2012 and 2011, respectively.
Cost of Revenue
Cost of revenue consists primarily of the costs of online media acquired from third-party publishers. Media cost is classified as cost of revenue in the period in which the corresponding revenue is recognized. From time to time, publishers offer the Company rebates based upon various factors and operating rules, including the amount of media purchased. We record these rebates in the period in which they are earned as a reduction to cost of revenue and the corresponding payable to the applicable publisher, or as an other receivable, as appropriate. Cost of revenue also includes third-party telephone and information services costs, data center and third-party hosting costs, credit card processing fees, third-party content and other direct costs. Cost of revenue also includes the cost of service providers related to our ClubLocal service.
In addition, cost of revenue includes costs to initiate, operate and manage clients’ campaigns, other than costs associated with the Company’s sales force, which are reflected as selling and marketing expenses. Cost of revenue includes salaries, benefits, bonuses and stock-based compensation for the related staff, including the cost of Web Presence Professionals who are the principal service providers for the Company’s ReachCast product, and allocated overhead such as depreciation expense, rent and utilities, as well as an allocable portion of our technical operations costs. Cost of revenue also includes the amortization and impairment charges on certain acquired intangible assets.
Operating Expenses
Selling and Marketing. Selling and marketing expenses consist primarily of personnel and related expenses for our selling and marketing staff, including salaries and wages, commissions and other variable compensation, benefits, bonuses and stock-based compensation; travel and business costs; training, recruitment, marketing and promotional events; advertising; other brand building and product marketing expenses; and occupancy, technology and other direct overhead costs. A portion of the compensation for IMCs, sales management and other employees in the sales organization is based on commissions and other variable compensation. In addition, the cost of agency commissions is included in selling and marketing expenses.
Product and Technology. Product and technology expenses consist primarily of personnel and related expenses for our product development and technology staff, including salaries, benefits, bonuses and stock-based compensation, and the cost of certain third-party service providers and other expenses, including occupancy, technology and other direct overhead costs. Technology operations costs, including related personnel and third-party costs, are included in product and technology expenses. We capitalize a portion of costs for software development and, accordingly, include amortization of those costs as product and technology expenses as the RL Platform addresses all aspects of our activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back-office functions of our business.
Product and technology expenses also include the amortization of the technology obtained in acquisitions and expenses of the deferred payment obligations related to acquisitions attributable to product and technology personnel.
General and Administrative. General and administrative expenses consist primarily of personnel and related expenses for executive, legal, finance, human resources and corporate communications, including wages, benefits, bonuses and stock-based compensation, professional fees, insurance premiums and other expenses, including occupancy, technology and other direct overhead, public company costs and other corporate expenses.
Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses. We continually evaluate our estimates, judgments and assumptions based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates.
We believe that the following critical accounting policies involve our more significant judgments, assumptions and estimates and, therefore, could have the greatest potential impact on our consolidated financial statements:
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Revenue recognition
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Software development costs
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Goodwill
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Long-lived and intangible assets
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Stock-based compensation
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Variable interest entities
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Income taxes
Revenue Recognition
We recognize revenue for our services when all of the following criteria are satisfied:
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persuasive evidence of an arrangement exists;
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services have been performed;
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the selling price is fixed or determinable; and
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collectability is reasonably assured.
We recognize revenue as the cost for the third-party media is incurred, which is upon delivery of the advertising on behalf of our clients. We recognize revenue for our ReachSearch product as clicks are recorded on sponsored links on the various search engines and for our ReachDisplay and ReachRetargeting product when the display advertisements record impressions or as otherwise provided in our agreement with the applicable publisher. We recognize revenue for our ReachCast product on a straight line basis over the applicable service period for each campaign. We recognize revenue when we charge set-up, management service or other fees on a straight line basis over the term of the related campaign contract or the completion of any obligation for services, if shorter. When we receive advance payments from clients, we record these amounts as deferred revenue until the revenue is recognized. When we extend credit, we record a receivable when the revenue is recognized.
When we sell through agencies, we either receive payment in advance of services or in some cases extend credit. We pay each agency an agreed-upon commission based on the revenue we earn or cash we receive. Some agency clients that have been extended credit may offset the amount otherwise due to us by any commissions they have earned. We evaluate whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions. As we are the primary party obligated in the arrangement, subject to the credit risk, with discretion over both price and media, we recognize the gross amount of such sales as revenue and any commissions are recognized as a selling and marketing expense.
We also have a small number of resellers, including a franchisee. Resellers integrate our services, including ReachSearch, ReachDisplay and TotalTrack, into their product offerings. In most cases, the resellers integrate with our RL Platform through a custom Application Programming Interface (API). Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay us in arrears, net of commissions and other adjustments. We recognize revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as we believe that the reseller has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.
We have recently launched a new consumer service, ClubLocal, through which we create a direct relationship with consumers and provide home-related services by engaging third-party suppliers who perform the agreed services on our behalf . Revenue is recognized when services have been provided. As we are the primary obligor under the arrangements, have discretion in supplier selection, have latitude in establishing prices, and bear the credit risk, we recognize the gross amount of sales as revenue and the cost of the service provided is recorded as cost of revenue.
We offer future incentives to clients in exchange for minimum commitments. In these circumstances, we estimate the amount of the future incentives that will be earned by clients and defer a portion of the otherwise recognizable revenue. Estimates are based upon a statistical analysis of previous campaigns for which such incentives were offered. Should a client not meet its minimum commitment and no longer qualify for the incentive, we recognize the revenue previously deferred related to the estimated incentive.
We account for sales and similar taxes imposed on our services on a net basis in the consolidated statements of operations.
Software Development Costs
We capitalize costs to develop software when we have determined that the development efforts will result in new or additional functionality or new products. Costs capitalized as internal use software are amortized on a straight-line basis over the estimated three-year useful life. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred and are recorded along with amortization of capitalized software development costs as product and technology expenses within the accompanying consolidated statements of operations. We monitor our existing capitalized software and reduce its carrying value as the result of releases that render previous features or functions obsolete or otherwise reduce the value of previously capitalized costs.
Goodwill
We have total goodwill of $42.1 million as of December 31, 2012 and $41.8 million as of December 31, 2011 related to our acquired businesses. We operate in one reportable segment, in accordance with ASC 280, Segment Reporting, and have identified two reporting units-North America and Australia-for purposes of evaluating goodwill. These reporting units each constitute a business or group of businesses for which discrete financial information is available and is regularly reviewed by each segment’s management. North America’s assigned goodwill was $9.7 million as of December 31, 2012 and $9.4 million as of December 31, 2011. Australia’s assigned goodwill was $32.4 million as of December 31, 2012 and 2011. We review the carrying amounts of goodwill for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable. We perform our annual assessment of goodwill impairment as of the first day of each fourth quarter.
For the year ended December 31, 2012, we followed the amended guidance for assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, in accordance with ASC 350-20, Intangibles - Goodwill and Other. Entities are provided with the option of first performing a qualitative assessment on any of its reporting units to determine whether further quantitative impairment testing is necessary. An entity may also bypass the qualitative assessment for any reporting unit in any period and proceed directly to the quantitative impairment test. If an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing a two-step impairment test is necessary. The first step of the impairment test involves comparing the estimated fair values of each of our reporting units with their respective carrying amounts, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, including goodwill, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the estimated fair value of the reporting unit is less than its carrying amount, including goodwill, then the second step is performed to compare the carrying amount of the goodwill with its implied fair value. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess. We estimate fair value utilizing the projected discounted cash flow method and discount rate determined by management to commensurate the risk inherent in our business model.
We performed our annual assessment of goodwill impairment as of the first day of the fourth quarter of 2012 and 2011, and determined that it was more likely than not that there was no impairment of goodwill. Accordingly, no impairment of goodwill was recorded as of December 31, 2012 and 2011.
Long-Lived and Intangible Assets
We report finite-lived, acquisition-related intangible assets at fair value, net of accumulated amortization. Identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives of one or three years. Straight-line amortization is used because no other pattern over which the economic benefits will be consumed can be reliably determined.
Management reviews the carrying values of long-lived assets, including intangible assets, for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable. In our analysis of other finite lived amortizable intangible assets, we apply the guidance of ASC 350-20, Intangibles - Goodwill and Other, in determining whether any impairment conditions exist. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Intangible assets are attributable to the various developed technologies and client relationships of the businesses we have acquired. Long-lived assets to be disposed of are reported at the lower of carrying amount or estimated fair value less cost to sell.
Stock-Based Compensation
We account for stock-based compensation based on fair value. We follow the attribution method, which reduces current stock-based compensation expenses recorded by the effect of anticipated forfeitures. We estimate forfeitures based upon our historical experience.
The fair value of each award is estimated on the date of the grant and amortized over the requisite service period, which is the vesting period. We use the Black-Scholes option pricing model to estimate the fair value of stock-based awards on the date of grant. Determining the fair value of stock-based awards at the grant date under this model requires judgment, including estimating volatility, expected term and risk-free interest rate. The assumptions used in calculating the fair value of stock-based awards represent management’s estimate based on judgment and subjective future expectations. These estimates involve inherent uncertainties. If any of the assumptions used in the Black-Scholes model significantly changes, stock-based compensation for future awards may differ materially from the awards granted previously.
Variable Interest Entities
In accordance with ASC 810, Consolidations, the applicable accounting guidance for the consolidation of variable interest entities, or VIEs, we analyze our interests, including agreements, loans, guarantees, and equity investments, on a periodic basis to determine if such interests are variable interests. If variable interests are identified, then the related entity is assessed to determine if it is a VIE. Our analysis includes both quantitative and qualitative reviews. We base our quantitative analysis on the forecasted cash flows of the entity, and our qualitative analysis on the design of the entity, its organizational structure including its decision-making authority, and relevant agreements. If we determine that the entity is a VIE, we then assess if we must consolidate the VIE as its primary beneficiary. Our determination of whether we are the primary beneficiary is based upon qualitative and quantitative analyses, which assess the purpose and design of the VIE, the nature of the VIE’s risks and the risks that we absorb, the power to direct activities that most significantly impact the economic performance of the VIE, and the obligation to absorb losses or the right to receive benefits that could be significant to the VIE.
In connection with our entrance into a franchise agreement with OxataSMB on July 6, 2012, we entered into a market development loan agreement with OxataSMB pursuant to which the Company agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) has been advanced. We have determined that OxataSMB is considered a VIE, but that we are not the primary beneficiary of OxataSMB and, therefore, we did not consolidate the results of OxataSMB.
Deferred Consideration
Deferred purchase consideration that is fixed and determinable and expected to be settled in cash is accrued as a liability as of the date of the respective acquisition. Deferred purchase consideration that is fixed and determinable and expected to be settled in common stock is recorded as an increase to additional paid-in capital as of the date of acquisition. Deferred stock-based compensation issued to employees in connection with acquisitions is measured at fair value on the date of grant/acquisition and recognized over the vesting period of the instruments in accordance with our Stock-Based Compensation policy.
Common Stock Repurchase and Retirement
Common stock repurchased is retired and the excess of the cost over the par value of the common shares repurchased is charged to additional paid-in capital.
Income Taxes
We use the liability method of accounting for income taxes. Significant judgment is required in determining the consolidated provision for income taxes and evaluating our tax positions. In the ordinary course of business, there are many transactions and calculations for which the ultimate tax settlement is uncertain. As a result, we recognize tax liabilities based on estimates of whether additional taxes and interest will be due. These tax liabilities are recognized when, despite our belief that our tax return positions are supportable, we believe that it is more likely than not that those positions may not be fully sustained upon review by tax authorities.
For the periods presented, income tax expense represents income taxes imposed by state, foreign and local tax jurisdictions applicable to our activities. We are otherwise generating net operating losses in the various tax jurisdictions in which we operate. We believe that it is likely that taxes imposed by state, local and foreign jurisdictions will increase in magnitude, particularly to the extent we become profitable in certain foreign jurisdictions before the time we obtain profitability on a consolidated basis.
Due to a history of losses, we have provided a valuation allowance against our deferred tax assets as more fully described in Note 12 of the consolidated financial statements. The ability to utilize these losses, any future losses and any other tax credits or attributes may be restricted or eliminated by changes in our ownership, including potentially as a result of our public offering, changes in legislation and other rules affecting the ability to offset future taxable income with losses from prior periods. Future determinations on the need for a valuation allowance on our net deferred tax assets will be made on a quarterly basis, and our assessment at December 31, 2012 reflects a continued need for a valuation allowance.
U.S. income and foreign withholding taxes have not been recognized on the excess of the amount for financial reporting over the tax basis of investments in foreign subsidiaries in the amount of $1.1 million that are essentially permanent in duration. This amount becomes taxable upon a repatriation of assets from the subsidiary or a sale or liquidation of the subsidiary. Determination of the amount of any unrecognized deferred income tax liability on this temporary difference is not practicable because of the complexities of the hypothetical calculation.
As a result of the acquisition of SMB:LIVE on February 22, 2010, we recorded a one-time discrete deferred tax benefit of $0.7 million from intangible assets recorded on the date of acquisition.
We are required to file income tax returns in the United States and various foreign jurisdictions, which requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions. Such returns are, and from time to time, have been subject to audit by the various federal, state and foreign taxing authorities, which may disagree with our tax positions. We believe that our accruals for tax liabilities are adequate for all open audit years based on our assessment of many factors, including past experience and interpretations of tax law. We review and update our estimates in light of changing facts and circumstances, such as the closing of a tax audit, the lapse of a statute of limitations or a material change in estimate. To the extent that the final tax outcome of these matters differs from our expectations, such differences will impact income tax expense in the period in which such determination is made.
Results of Operations
Comparison of the Years Ended December 31, 2012, 2011 and 2010
(1)
Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line-items (in thousands):
Revenue
The increase in Direct Local revenue of $68.1 million in 2012 compared to 2011 was largely attributable to an increase in the number of Upperclassmen and the productivity of Upperclassmen driven by their increased tenure. Also contributing to the increase was growth in the number of international IMCs who, on average, are more productive than our IMCs in North America, which we attribute to lower levels of competition and growing online advertising demand by SMBs in those markets. Total IMCs in 2012 increased as compared to the preceding year due to the increase in the number of Underclassmen becoming Upperclassmen. The number of Underclassmen at the end of 2012 was slightly lower than at the end of 2011 due to slightly lower IMC hiring rates in 2012. During 2012, our strategy regarding hiring and maturation of IMCs was to maintain a more constant level of IMC hiring globally-as opposed to prior years when we sought to increase Underclassmen more substantially-while shifting the hiring to our newer international markets and focusing on improving Upperclassmen productivity in our more established markets. While we maintain flexibility in our IMC hiring strategy based on macroeconomic and market conditions, we anticipate that we will pursue a level of Underclassmen hires similar to 2012, while focusing on Upperclassmen productivity improvements in the near-term.
The increase in National Brands, Agencies and Resellers revenue of $12.1 million in 2012 compared to 2011 was due to an increase in revenue from our domestic and international National Brands clients of $5.6 million, and an increase in revenue of $6.4 million from our domestic and international Agencies and Resellers. These increases were primarily driven by increases in expenditures by existing National Brands clients and existing Agencies and Resellers, as well as an increase in the number of Agencies and Resellers.
The increase in Direct Local revenue of $73.6 million in 2011 compared to 2010 was largely attributable to the increase in productivity of our IMCs as a result of the increases in the number of Upperclassmen, the tenure of our Upperclassmen, and the number of international IMCs as a percentage of our total IMCs as our international IMCs are on average more productive, which we attribute to lower levels of competition and online advertising consumption by SMBs in those markets.
The increase in National Brands, Agencies and Resellers revenue of $10.0 million in 2011 compared to 2010 was primarily due to $10.4 million in higher revenue from our domestic and international National Brands clients during 2011, and $1.2 million from our international Agencies and Resellers, which we attribute to greater success in these portions of the channel. This increase was offset in part by a decrease of $1.7 million in revenue from North American Agencies and Resellers during 2011, which was due to a decrease in spending from advertisers who advertised with us in both 2010 and 2011, and a decrease in the number of agencies advertising with us, partially offset by an increase in revenue from new agencies.
Cost of Revenue
The decrease in our cost of revenue as a percentage of revenue in 2012 compared to 2011 was primarily due to an increase in publisher rebates, partially offset by the change in our geographic, product and service mix. As we enter new markets, the initial sales focus is on our ReachSearch product, which affects our product and service mix and has a higher cost of revenue than our other products. Publisher rebates as a percentage of revenue increased to 4.6% of revenue in 2012 from 3.2% in 2011.
The decrease in our cost of revenue as a percentage of revenue in 2011 compared to 2010 was primarily due to changes in geographic, product and service mix, including increased international sales and sales of ReachCast and ReachDisplay, improved media buying efficiencies introduced in late 2010 related to our core products, an increase in publisher and vendor rebates, and economies of scale in our operations and service infrastructure. Publisher rebates as a percentage of revenue increased to 3.2% of revenue in 2011 from 1.9% in 2010, due to more favorable rebate terms, primarily from our reseller agreements with Google.
Our cost of revenue as a percentage of revenue will be affected in the future by the mix and relative amount of media we purchase to fulfill service requirements, the availability and amount of publisher rebates, the mix of products and services we offer, our media buying efficiency, and the costs of support and delivery.
Operating Expenses
Over the past several years, we have significantly increased the scope of our operations. We intend to continue to increase our sales force, product offerings and the infrastructure to support them. In growing our business, particularly in international markets, and in developing new products and solutions, we are incurring expenses to support our long-term growth plans, acknowledging that these investments may put pressure on near-term periodic operating results and increase our operating expenses as a percentage of revenue.
Selling and Marketing
The increase in selling and marketing salaries, benefits and other costs in absolute dollars in 2012 compared to 2011 was primarily due to an increase in our IMC headcount and related recruiting, training and facilities costs, as well as increased advertising costs, including for ClubLocal. The slight decrease in these costs as a percentage of revenue was primarily due to increased productivity and operational scale in our established markets, partially offset by expenses related to our entrance into new international markets and new product initiatives, including for ClubLocal.
The increase in commission expense in absolute dollars for 2012 compared to 2011 was due to increased sales. As a percentage of revenue, commission expense was slightly lower compared to the prior year. Commission expense includes commissions and other variable compensation. We do not expect continued decreases in commission expense as a percentage of revenue due to an expected higher percentage of Upperclassmen, who generally earn higher commission rates based on increased productivity.
Underclassmen expense slightly increased as compared to the preceding year due to increased hiring in our international markets, though the increase was offset by a reduced investment in Underclassmen recruitment in North America. The increase in Underclassmen Expense from 2011 to 2012 was lower than the increase from 2010 to 2011 as a result of our strategy to maintain a more constant level of IMC hiring globally - as opposed to prior years where we were aggressively ramping up Underclassmen hiring - while shifting the hiring to emerging international markets and focusing on improving Upperclassmen productivity in our more established markets.
The increase in selling and marketing salaries, benefits and other costs in absolute dollars in 2011 compared to 2010 was primarily due to an increase in our IMC headcount and related recruiting, training and facilities costs. The increase as a percentage of revenue in 2011 compared to 2010 was due primarily to the entrance into new international markets, partially offset by economies of scale in our established markets.
The increase in commission expense in absolute dollars for 2011 compared to 2010 was due to increased sales. As a percentage of revenue, commission expense decreased due to a higher percentage of revenue from our Direct Local channel, for which we pay lower commission rates.
The increase in Underclassmen Expense in 2011 compared to 2010 was primarily due to increased IMC hiring, particularly in international markets.
Product and Technology
The increase in product and technology expenses in absolute dollars in 2012 compared to 2011 was primarily attributable to $1.6 million of increased salaries and compensation expense as a result of increased headcount related to the ongoing development of the RL Platform and new product initiatives, and $1.6 million of increased amortization expense related to previously capitalized software development costs and acquired intangibles. The increase as a percentage of revenue was primarily attributable to increased salaries and compensation expense as a result of increased headcount related to the ongoing development of the RL Platform and new product initiatives, including ClubLocal.
The changes in the amount of capitalized software development costs in both absolute dollars and as a percentage of revenues in 2012 compared to 2011 were primarily due to an increase in capitalizable projects, including those relating to our new product initiatives.
The increase in product and technology expenses in both absolute dollars and as a percentage of revenue in 2011 compared to 2010 was primarily attributable to $3.5 million of increased salaries and compensation expense as a result of increased headcount related to the ongoing development of the RL Platform, including ReachCast, and $2.1 million of increased amortization expense related to previously capitalized software development costs.
Capitalized software development costs were essentially flat between 2011 and 2010.
General and Administrative
The increase in general and administrative expenses in absolute dollars in 2012 compared to 2011 was primarily due to $6.8 million of increased employee and facilities costs to support the growth of the business, including our international expansion, and $0.7 million of increased stock-based compensation expense, partially offset by $0.5 million of decreased professional fees, which consist of tax, consulting, audit and legal fees.
The increase in general and administrative expenses in absolute dollars and as a percentage of revenue in 2011 compared to 2010 was primarily due to $2.9 million of increased employee costs to support the growth of the business, $2.3 million of increased tax, consulting and legal professional fees, including costs to support our Sarbanes-Oxley compliance efforts and our international expansion initiatives, $2.2 million of increased stock-based compensation expense, and $1.8 million of increased facilities and related costs supporting the growth of the business and the requirements associated with being a public company.
We expect general and administrative expenses to increase in absolute dollars as we continue to add personnel and incur additional professional fees and other expenses to support our continued domestic and international growth.
Other Income, Net
Other income, net decreased in 2012 compared to 2011 due to foreign exchange rate fluctuations and lower interest rates on invested balances. Other income, net primarily consists of interest income resulting from invested balances.
The increase in other income in both absolute dollars and as a percentage of revenue in 2011 compared to 2010 was attributable to an increase in interest income resulting from higher invested balances.
Provision for (Benefit from) Income Taxes
The income tax provision of $1.2 million and $0.7 million for 2012 and 2011, respectively, relates to federal, state and foreign income taxes, including the deferred tax impact of prior business combinations. The income tax benefit of $0.5 million for 2010 was primarily attributable to the acquisition of SMB:LIVE, in which we recorded one-time discrete tax benefit of $0.7 million, which was partially offset by state, local and foreign income taxes of $0.2 million.
Loss from Discontinued Operations
On November 1, 2011, we announced that we would wind down the operations of Bizzy and determined that Bizzy would be considered a discontinued operation as of the third quarter of 2011. In connection with this decision, we recorded a charge of $4.0 million in 2011 to reflect the impairment of capitalized software development costs, personnel and severance costs, operating losses, facilities and other costs.
Non-GAAP Financial Measures
In addition to our GAAP results discussed above, we believe Adjusted EBITDA and Underclassmen Expense are useful to investors in evaluating our operating performance. For the years ended December 31, 2012, 2011 and 2010, our Adjusted EBITDA and Underclassmen Expense were as follows:
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Adjusted EBITDA. We define Adjusted EBITDA as net income (loss) from continuing operations before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, stock-based compensation, the effects of accounting for business combinations (including any impairment of acquired intangibles and, in the case of the acquisition of SMB:LIVE, the deferred cash consideration), and amounts included in other non-operating income or expense.
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Underclassmen Expense. We define Underclassmen Expense as our investment in Underclassmen, which is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions and other variable compensation), training and sales organization expenses including depreciation allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximated investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by the company, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies.
Our management uses Adjusted EBITDA because (i) it is a key basis upon which our management assesses our operating performance; (ii) it may be a factor in the evaluation of the performance of our management in determining compensation; (iii) we use it, in conjunction with GAAP measures such as revenue and income (loss) from operations, for operational decision-making purposes; and (iv) we believe it is one of the primary metrics investors use in evaluating Internet marketing companies.
Our management believes that Adjusted EBITDA permits an assessment of our operating performance, in addition to our performance based on our GAAP results that is useful in assessing the progress of the business. By excluding (i) the effects of accounting for business combinations and associated acquisition and integration costs, which obscure the measurable performance of the business operations; (ii) depreciation and amortization and other non-operating income and expense, each of which may vary from period to period without any correlation to underlying operating performance; and (iii) stock-based compensation, which is a non-cash expense, we believe that we are able to gain a fuller view of the operating performance of the business. We provide information relating to our Adjusted EBITDA so that investors have the same data that we employ in assessing our overall operations. We believe that trends in our Adjusted EBITDA are a valuable indicator of operating performance on a consolidated basis and of our ability to produce operating cash flow to fund working capital needs, capital expenditures and investments in Underclassmen.
In addition, our management believes that Adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:
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Adjusted EBITDA does not reflect our cash expenditures for capital equipment or other contractual commitments;
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Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect capital expenditure requirements for such replacements;
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Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;
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Adjusted EBITDA does not consider the potentially dilutive impact of issuing equity-based compensation to our management team and employees;
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Adjusted EBITDA does not reflect the potentially significant interest expense or the cash requirements necessary to service interest or principal payments on indebtedness we may incur in the future;
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Adjusted EBITDA does not reflect income and expense items that relate to our financing and investing activities, any of which could significantly affect our results of operations or be a significant use of cash;
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Adjusted EBITDA does not reflect certain tax payments that may represent a reduction in cash available to us; and
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Other companies, including companies in our industry, calculate Adjusted EBITDA measures differently, which reduces its usefulness as a comparative measure.
Adjusted EBITDA is not intended to replace operating income (loss), net income (loss) and other measures of financial performance reported in accordance with GAAP. Rather, Adjusted EBITDA is a measure of operating performance that you may consider in addition to those measures. Because of these limitations, Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results, including cash flows provided by operating activities, and using total Adjusted EBITDA as a supplemental financial measure.
The following table presents a reconciliation of Adjusted EBITDA to our loss from operations for each of the periods indicated:
Liquidity and Capital Resources
At December 31, 2012 and 2011, we had cash and cash equivalents of $92.3 million and short-term investments of $3.1 million. Cash and cash equivalents consist of cash, money market accounts and certificates of deposit. Short term investments consist of certificates of deposit with original maturities in excess of three months but less than 12 months. To date, we have experienced no loss of our invested cash, cash equivalents or short-term investments. We cannot, however, provide any assurances that access to our invested cash, cash equivalents and short-term investments will not be impacted by adverse conditions in the financial markets. At December 31, 2012, we had no long-term indebtedness for borrowed money and are not subject to any restrictive bank covenants. At December 31, 2012, we had $1.2 million in restricted certificates of deposit to secure letters of credit issued to landlords and others.
At December 31, 2012 and 2011, we did not have contractual or purchase commitments for capital expenditures that were not reflected on our balance sheet as a liability. In addition, at December 31, 2012, we had significant internal product and technology resources working on projects that met the criteria for capitalization as software development costs and others that did not, although none of the projects in process were long-term projects (greater than one year). The amount capitalized for such projects in future periods will be evaluated by management and will impact the portion of costs for those internal resources that reduces net cash provided by operating activities and the portion of such costs used in investing activities. Funding for the committed capital expenditures, including software development costs, is expected to be provided by operating cash flows.
We have financed our operations, our expansion of our IMC sales force and the extension of our Direct Local channel into new territories through cash provided by operations. Deferred revenue arising from prepayment by the great majority of our clients and vendor trade financing, principally for the purchase of media, are major components of our cash flow from operations, and the cash provided by deferred revenue and accounts payable has increased as our business has continued to grow. In general, to the extent our revenue from our Direct Local channel continues to grow, we would expect both the amount of deferred revenue from customer prepayments and the amount of vendor financing for purchased media to increase, which, subject to offset from changes in other operating costs, cash demands or vendor terms, would result in an increase in net cash provided by operations. Should revenue from the Direct Local channel decrease, the amount of deferred revenue and vendor financing would likely decrease, which, subject to changes in other accounts, would cause net cash provided by operations to be reduced.
Although we expect that cash flow from operations and our existing cash balances will be sufficient to continue funding our expansion activities, these investments, including investments in developing new products and services for our clients, could require us to seek additional equity or debt financing, and that financing may not be available on terms favorable to us or at all. In addition, we intend to continue to increase our investment in Underclassmen and in the development of new products and services for our clients, which could require significant capital and entail non-capitalized expenses that could decrease our income from operations.
Operating Activities
Our cash flow from operating activities for 2012 resulted primarily from adjustments for non-cash expenses and increases in operating liabilities. Our loss from continuing operations, net of income taxes, of $0.2 million, was more than offset by non-cash depreciation and amortization of $13.8 million, and non-cash stock-based compensation of $9.5 million. Cash flow from operating activities also reflected increases in accounts payable and accrued expenses of $12.9 million due to growth of the business and the fluctuation in timing of payments to certain vendors, including the normalization of rebates receivable, and increases in deferred revenue, rent and other liabilities of $7.7 million due to the growth of our business.
Our cash flow from operating activities for 2011 resulted primarily from adjustments for non-cash expenses and increases in operating liabilities. Our loss from continuing operations of $4.1 million was offset by non-cash depreciation and amortization of $10.3 million, and non-cash stock-based compensation of $8.5 million. The loss was also offset by increases in accounts payable and accrued expenses of $7.1 million, reflecting a return to more normalized accounts payable levels as compared to 2010 due to the change in timing of payments to certain vendors, and $5.5 million of increases in deferred revenue and deferred payment obligations, both due to the growth of our business. The increases were partially offset by an increase in other receivables and prepaid expenses of $5.7 million, primarily related to an increase in vendor rebates of $6.3 million.
Our cash flow from operating activities for 2010 resulted primarily from changes in our operating assets and liabilities, with accounts payable and accrued liabilities increasing $11.2 million and deferred revenue and rent increasing $7.9 million, both due to the growth of our business. We had a net loss in 2010 of $8.6 million, which included non-cash depreciation and amortization of $6.3 million and non-cash stock-based compensation of $5.9 million.
Investing Activities
Our primary investing activities have consisted of purchases of property and equipment, capitalized software development costs, short-term investments, and business acquisitions. Our purchases of property and equipment and capitalization of software costs increased by $3.9 million year-over-year from in 2012 from 2011 reflecting our increased investment in our products, technology, facilities, and in newer markets. Purchases of property and equipment and capitalization of software costs will vary from period to period due to the timing of the expansion of our operations and our software development efforts. We expect to continue to use capital for acquisitions, purchases of property and equipment, and development of software.
On June 29, 2012, we entered into a market development loan agreement with OxataSMB pursuant to which we agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) has been advanced. In addition, during 2012, we made acquisition related payments of $4.2 million, consisting of payments on deferred obligations related to the DealOn and SMB:LIVE acquisitions totaling $1.6 million, and payment for the RealPractice acquisition of $2.6 million. We have remaining obligations totaling $0.8 million related to these acquisitions. We also purchased certificates of deposits and short-term investments of $9.1 million, offset by maturities aggregating $6.6 million.
On February 8, 2011, we acquired DealOn for up to approximately $9.7 million in cash and stock. On the closing date, we paid $5.8 million in cash and issued 82,878 shares of our common stock. The balance of the purchase price was estimated to total up to $1.5 million, payable in cash, and 22,095 common shares of our stock, payable in three installments, with 50% (10,649 shares of common stock) paid in February 2012, 25% paid August 2012 and 25% paid February 2013.
In 2010, we invested $2.8 million, net of cash acquired, in the purchase of SMB:LIVE. The terms of our purchase agreement required us to make additional payments in 2011 of $0.4 million and in 2012 of $0.6 million. In 2009, we acquired the remaining interest of ReachLocal Australia and invested $8.9 million in net cash. Of this investment, $3.1 million was paid, net of cash acquired, in 2009 and the balance of $5.8 million was paid in conjunction with our initial public offering in 2010.
Financing Activities
During 2012, our financing activities primarily consisted of using $11.0 million of cash to settle the purchase of shares of our common stock pursuant to our share repurchase program, partially offset by $1.8 million in proceeds from exercise of stock options. Our cash flow used in financing activities for 2011 resulted primarily from settlements of repurchases of our common stock of $6.5 million, partially offset by $5.5 million in proceeds from the exercise of stock options. In May 2010, we received $43.0 million in proceeds, after deducting underwriting discounts and commissions and estimated offering costs payable by us, from the sale of shares of common stock in connection with our initial public offering.
Future cash flows from financing activities may also be affected by our repurchases of our common stock. On November 4, 2011, we announced that our Board of Directors authorized the repurchase of up to $20.0 million of our outstanding common stock. On December 13, 2012, we announced that our Board of Directors increased the total authorized repurchase amount to $26.0 million, and on March 4, 2013, we announced that our Board of Directors increased the total authorized repurchase amount by an additional $21.0 million, to a total authorization of $47.0 million. At December 31, 2012, we had executed repurchases of $17.4 million of our common stock under the program. From January 1, 2013 to March 5, 2013, we executed repurchases of an additional $1.5 million of our common stock under the program. Purchases may be made from time-to-time in open market or privately negotiated transactions as determined by our management. The amount and timing of the share repurchase will depend on business and market conditions, stock price, trading restrictions, acquisition activity, and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and the repurchase program may be suspended or discontinued at any time at our discretion.
Balance Sheet Arrangements
At December 31, 2012, we did not have any off-balance sheet arrangements.
Contractual Obligations
At December 31, 2012, the remaining deferred payment obligation under the DealOn acquisition agreement included approximately $0.4 million in cash and 5,324 shares of our common stock, both of which were paid on February 8, 2013. The remaining deferred payment obligation related to the RealPractice acquisition was $0.3 million.
We lease our primary office space in Woodland Hills, California; Plano, Texas; and other locations under various cancelable and non-cancelable operating leases that will expire between 2012 and 2021. We have no debt obligations. All property and equipment have been purchased for cash, and we have no capital lease obligations recorded in the financial statements. We have a long-term purchase obligation outstanding with a vendor, of which $1.4 million is due within a year, and $3.5 million is due between 1 to 3 years.
As of December 31, 2012, future minimum payments under non-cancelable operating leases are as follows (in thousands):
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We are exposed to market risk in the ordinary course of our business. These risks primarily include interest rate, foreign exchange and inflation risks.
Interest Rate Fluctuation Risk
We do not have any long-term indebtedness for borrowed money. Our investments include cash, cash equivalents and short-term investments. Cash and cash equivalents and short-term investments consist of cash, money market accounts and certificates of deposit. The primary objective of our investment activities is to preserve principal while maximizing income without significantly increasing risk. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to a fluctuation in interest rates, which may affect our interest income and the fair market value of our investments. Due to the short-term nature of our investment portfolio, we do not believe an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio, and therefore we do not expect our operating results or cash flows to be materially affected to any degree by a sudden change in market interest rates.
Foreign Currency Exchange Risk
We have foreign currency risks related to our investments, revenue and operating expenses denominated in currencies other than the U.S. dollar, principally the Australian dollar, the British pound sterling, the Canadian dollar, the euro, the Japanese yen, the Indian rupee, and the Brazilian real. For the year ended December 31, 2012, a 10% strengthening of the U.S. dollar relative to these foreign currencies would have resulted in a decrease in revenue of $14.1 million, but an increase in operating income of $0.9 million. A 10% weakening of the U.S. dollar relative to these foreign currencies, however, would have resulted in an increase in revenue of $14.1 million, but a decrease in operating income of $0.9 million. We currently do not hedge or otherwise manage our currency exposure. As our international operations expand to more countries and mature, our risks associated with fluctuations in currency rates will become greater, and we will continue to reassess our approach to managing this risk. In addition, currency fluctuations or a weakening U.S. dollar can increase the costs of our international expansion.
Inflation Risk
We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Please refer to Item 15 - Exhibits and Financial Statement Schedules.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
(a)
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e) as of December 31, 2012. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
(b)
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on criteria established in the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2012.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. A control system no matter how well designed and operated, can provide only reasonable assurance with respect to financial statement preparation and presentation. 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.
Grant Thornton LLP, an independent registered public accounting firm, has audited the effectiveness of our internal control over financial reporting as of December 31, 2012, as stated in their report, which is included in Item 8 of this Annual Report on Form 10-K.
(c)
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders.
We have adopted a code of business conduct and ethics applicable to our directors, officers (including our principal executive officer and principal financial officer) and employees. The Code of Business Conduct and Ethics is available on the investor relations section of our website at www.reachlocal.com under “Corporate Governance.”
We intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from , a provision of this Code of Business Conduct and Ethics by posting such information on our website, at the address and location specified above and, to the extent required by the listing standards of The NASDAQ Stock Market, by filing a Current Report on Form 8-K with the SEC, disclosing such information.
Item 11.
Item 11. Executive Compensation.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders.
Item 14.
Item 14. Principal Accountant Fees and Services.
The information required by this item is incorporated herein by reference to our Proxy Statement for our 2013 Annual Meeting of Stockholders.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
We have filed the following documents as part of this Annual Report on Form 10-K:
PAGE F - 1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
ReachLocal, Inc.
We have audited the accompanying consolidated balance sheets of ReachLocal, Inc. (a Delaware corporation) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ReachLocal, Inc. as of December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 11, 2013 expressed an unqualified opinion thereon.
/s/ GRANT THORNTON LLP
Irvine, California
March 11, 2013
PAGE F - 2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
ReachLocal, Inc.
We have audited the internal control over financial reporting of ReachLocal, Inc. (a Delaware corporation) (the “Company”) as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible 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 Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
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 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.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company as of and for the year ended December 31, 2012, and our report dated March 11, 2013 expressed an unqualified opinion on those consolidated financial statements.
/s/ GRANT THORNTON LLP
Irvine, California
March 11, 2013
PAGE F - 3
REACHLOCAL, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
See notes to consolidated financial statements.
PAGE F - 4
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
See notes to consolidated financial statements.
PAGE F - 5
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
See notes to consolidated financial statements.
PAGE F - 6
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
PAGE F - 7
See notes to consolidated financial statements.
PAGE F - 8
REACHLOCAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See notes to consolidated financial statements.
PAGE F - 9
REACHLOCAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Description of Business
ReachLocal, Inc. (the “Company”) was incorporated in the state of Delaware in August 2003. The Company’s operations are located in North America, Australia, the United Kingdom, the Netherlands, Germany, Japan, Brazil and India. The Company’s mission is to help small- and medium-sized businesses (“SMBs”) acquire, transact with, maintain and retain customers via the Internet. The Company offers a comprehensive suite of online marketing solutions, including search engine marketing (ReachSearch™), Web presence (ReachCast™), display advertising (ReachDisplay™), display retargeting (ReachRetargeting™), online marketing analytics (TotalTrack®), and assisted chat service (TotalLiveChat™), each targeted to the SMB market. The Company delivers this suite of services to SMBs through a combination of its proprietary technology platform, the RL Platform, its direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies and resellers.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of ReachLocal, Inc. and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Discontinued Operations
As a result of winding down and closing the operations of Bizzy, effective November 2011, the Company has reclassified and presented all related historical financial information as “discontinued operations” in the accompanying Consolidated Balance Sheets, Statements of Operations and Cash Flows. In addition, all Bizzy-related activities have been excluded from the notes unless specifically referenced.
Reclassifications and Adjustments
Certain prior period amounts have been reclassified to conform to the current period presentation and certain immaterial adjustments have been recorded in prior periods as further described in Note 11, “Stock-Based Compensation-Adjustment to Historical Stock-Based Compensation Expense”.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. These estimates are based on information available as of the date of the financial statements. Therefore, actual results could differ from those estimates.
Foreign Currency Translation
The Company’s operations are conducted in several countries around the world, and the financial statements of its foreign subsidiaries are reported in the applicable foreign currencies (functional currencies). Financial information is translated from the applicable functional currency to the U.S. dollar, the reporting currency, for inclusion in the Company’s consolidated financial statements. Income, expenses, and cash flows are translated at average exchange rates prevailing during the period, and assets and liabilities are translated at exchange rates in effect at the balance sheet date. Resulting translation adjustments are included as a component of accumulated other comprehensive income (loss), net in stockholders’ equity. Foreign currency translation adjustments are generally not adjusted for income taxes as they are primarily related to indefinite investments in foreign subsidiaries. Foreign exchange transaction gains and losses are included in other income (expense), net in the accompanying consolidated statements of operations. Exchange gains and losses on intercompany balances that are considered permanently invested are also included as a component of accumulated other comprehensive loss in stockholders’ equity.
PAGE F - 10
Foreign currency translation adjustments included in other comprehensive income (loss), were $(1.2) million, $(0.3) million and $0.1 million for the years ended December 31, 2012, 2011 and 2010, respectively. For the years ended December 31, 2012, 2011 and 2010, the Company recorded immaterial amounts of other income (loss) from foreign exchange transactions.
Cash and Cash Equivalents
The Company reports all highly liquid short-term investments with original maturities of three months or less at the time of purchase as cash equivalents. As of December 31, 2012 and 2011, cash equivalents consist of demand deposits and money market accounts. Cash equivalents are stated at cost, which approximates fair value.
Short-Term Investments
The Company classifies short-term investments when the original maturity is less than one year, or when the Company intends to sell the investment within one year. As of December 31, 2012 and 2011, short-term investments consisted of certificates of deposit. All of the short-term investments are classified as available-for-sale.
Financial Instruments
For certain of the Company’s financial instruments, including cash and cash equivalents, short-term investments, accounts receivable, loan receivable, accounts payable and other accrued liabilities, the carrying amounts approximate fair value due to their short maturities.
Restricted Cash
Restricted cash represents certificates of deposit held at financial institutions, which are pledged as collateral for letters of credit related to lease commitments. The restrictions will lapse when the letters of credit expire at the end of the respective lease terms in 2021. As of December 31, 2012 and 2011, the Company had restricted certificates of deposit in the amounts of $1.2 million and $1.3 million, respectively. Restricted certificates of deposit are classified as non-current assets.
Concentrations of Credit Risk
Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of cash and cash equivalents, restricted cash, short-term investments and accounts receivable. The Company holds its cash and cash equivalents, short-term investments and restricted cash with major financial institutions around the world.
Cash and cash equivalents and certificates of deposit are deposited with a limited number of financial institutions in the United States, Canada, Australia, United Kingdom, India, the Netherlands, Germany, Japan and Brazil. The balances held at any one financial institution are generally in excess of Federal Deposit Insurance Corporation insurance limits or, in foreign territories, local insurance limits. To date, the Company has not experienced any loss or lack of access to cash in its operating accounts. However, the Company can provide no assurances that access to its cash and cash equivalents will not be impacted by adverse conditions in the financial markets. As of December 31, 2012, domestic bank balances in excess of insured limits were $44.1 million. The Company had $27.8 million in excess of insured limits in foreign bank accounts as of December 31, 2012.
The Company’s customers are dispersed both geographically and across a broad range of industries. Receivables are generated primarily through agencies and resellers. Management performs ongoing evaluation of trade receivables for collectability and provides an allowance for potentially uncollectible accounts. The following table summarizes the change in the Company’s allowance for doubtful accounts for each of the three years ended December 31, 2012, 2011 and 2010 (in thousands):
As of December 31, 2012, no client accounted for 10% or more of the total accounts receivable balance. As of December 31, 2011, one client accounted for 20% of the total accounts receivable balance.
PAGE F - 11
In 2012, 2011, and 2010, no client accounted for 10% or more of the Company’s total revenue.
During 2012, 2011, and 2010, the Company’s cost of revenue was primarily for the purchase of media and the media the Company purchased was primarily from Google, Yahoo! and Bing.
Other receivables and prepaid expenses included $5.9 million and $7.3 million of non-trade receivables from media vendors at December 31, 2012 and 2011, respectively.
Property and Equipment
Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful life of the assets or, where applicable and if shorter, over the lease term. Upon retirement or sale, the cost of assets disposed of and the related accumulated depreciation are eliminated from the accounts and any resulting gain or loss is credited or charged to operations. Repairs and maintenance costs are expensed as incurred.
Estimated useful lives of assets are as follows:
Software Development Costs
The Company capitalizes costs to develop software when management has determined that the development efforts will result in new or additional functionality or new products. Costs capitalized as internal use software are amortized on a straight-line basis over the estimated three-year useful life. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred and are recorded along with amortization of capitalized software development costs as product and technology expenses within the accompanying consolidated statements of operations. We monitor our existing capitalized software and reduce its carrying value as the result of releases that render previous features or functions obsolete or otherwise reduce the value of previously capitalized costs.
Goodwill
The Company’s total goodwill of $42.1 million as of December 31, 2012, and $41.8 million as of December 31, 2011, is related to our acquired businesses. The increase in goodwill of $0.3 million in 2012 was related to the RealPractice, Inc. acquisition. See Note 4, “Acquisitions”, for further details. The Company operates in one reportable segment, in accordance with ASC 280, Segment Reporting, and has identified two reporting units-North America and Australia-for purposes of evaluating goodwill. These reporting units each constitute a business or group of businesses for which discrete financial information is available and is regularly reviewed by segment management. North America’s assigned goodwill was $9.7 million as of December 31, 2012 and $9.4 million as of December 31, 2011. Australia’s assigned goodwill was $32.4 million as of December 31, 2012 and 2011. The Company reviews the carrying amounts of goodwill for possible impairment whenever events or changes in circumstances indicate that the related carrying amount may not be recoverable. The Company performs its annual assessment of goodwill impairment as of the first day of each fourth quarter.
For the years ended December 31, 2012 and 2011, the Company followed the amended guidance for assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, in accordance with ASC 350-20, Intangibles - Goodwill and Other. Entities are provided with the option of first performing a qualitative assessment on any of its reporting units to determine whether further quantitative impairment testing is necessary. An entity may also bypass the qualitative assessment for any reporting unit in any period and proceed directly to the quantitative impairment test. If an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing a two-step impairment test is necessary. The first step of the impairment test involves comparing the estimated fair values of each of our reporting units with their respective carrying amounts, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, including goodwill, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the estimated fair value of the reporting unit is less than its carrying amount, including goodwill, then the second step is performed to compare the carrying amount of the goodwill with its implied fair value. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess. The Company estimates fair value utilizing the projected discounted cash flow method and a discount rate determined by the Company to commensurate with the risk inherent in its business model.
PAGE F - 12
The Company performed its annual assessment of goodwill impairment as of the first day of the fourth quarter of 2012 and 2011, and determined that it was more likely than not that there was no impairment of goodwill and accordingly, no impairment of goodwill was recorded.
Long-Lived and Intangible Assets
At December 31, 2012 and 2011, the Company had $2.4 million and $2.0 million, respectively, of intangible assets resulting from acquisitions. The Company reports finite-lived, acquisition-related intangible assets at fair value, net of accumulated amortization. Identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives of three years, or one year, in the case of certain customer relationships. Straight-line amortization is used because no other pattern over which the economic benefits will be consumed can be reliably determined.
The Company reviews the carrying values of long-lived assets, including intangible assets, for possible impairment whenever events or changes in circumstances indicate that the related carrying amount may not be recoverable. In its analysis of other finite lived amortizable intangible assets, the Company applies the guidance of ASC 350-20, Intangibles - Goodwill and Other, in determining whether any impairment conditions exist. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Intangible assets are attributable to the various developed technologies and client relationships of the businesses the Company has acquired. Long-lived assets to be disposed of are reported at the lower of carrying amount or estimated fair value less cost to sell.
Leases
The Company leases various facilities under agreements accounted for as operating leases. For leases that contain escalation or rent concessions provisions, management recognizes rent expense during the lease term on a straight-line basis over the term of the lease. The difference between rent paid and straight-line rent expense is recorded as a deferred rent liability in the accompanying consolidated balance sheets.
Revenue Recognition
The Company recognizes revenue for its services when all of the following criteria are satisfied:
•
persuasive evidence of an arrangement exists;
•
services have been performed;
•
the selling price is fixed or determinable; and
•
collectability is reasonably assured.
The Company recognizes revenue as the cost for the third-party media is incurred, which is upon delivery of the advertising on behalf of its clients. The Company recognizes revenue for its ReachSearch product as clicks are recorded on sponsored links on the various search engines and for its ReachDisplay and ReachRetargeting product when the display advertisements record impressions or as otherwise provided in its agreement with the applicable publisher. The Company recognizes revenue for its ReachCast product on a straight line basis over the applicable service period for each campaign. The Company recognizes revenue when it charges set-up, management service or other fees on a straight line basis over the term of the related campaign contract or the completion of any obligation for services, if shorter. When the Company receives advance payments from clients, management records these amounts as deferred revenue until the revenue is recognized. When the Company extends credit, management records a receivable when the revenue is recognized.
When the Company sells through agencies, it either receives payment in advance of services or in some cases extends credit. The Company pays each agency an agreed-upon commission based on the revenue it earns or cash it receives. Some agency clients who have been extended credit may offset the amount otherwise due to the Company by any commissions they have earned. Management evaluates whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions. As the Company is the primary party obligated in the arrangement, subject to the credit risk, with discretion over both price and media, management recognizes the gross amount of such sales as revenue and any commissions are recognized as a selling and marketing expense.
PAGE F - 13
The Company also has a small number of resellers, including a franchisee. Resellers integrate the Company’s services, including ReachSearch, ReachDisplay, and TotalTrack, into their product offerings. In most cases, the resellers integrate with the Company’s RL Platform through a custom Application Programming Interface (API). Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay the Company in arrears, net of commissions and other adjustments. Management recognizes revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as management believes that the reseller has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.
The Company recently launched a new consumer service, ClubLocal, through which it creates a direct relationship with customers and provides home-related services by engaging third-party suppliers who perform the agreed services on its behalf. Revenue is recognized when services have been provided. As the Company is the primary obligor under the arrangements, has discretion in supplier selection, has latitude in establishing prices, and bears the credit risk, the Company recognizes the gross amount of sales as revenue and the cost of the service provided is recorded as cost of revenue.
The Company offers future incentives to clients in exchange for minimum commitments. In these circumstances, management estimates the amount of the future incentives that will be earned by clients and defers a portion of the otherwise recognizable revenue. Estimates are based upon a statistical analysis of previous campaigns for which such incentives were offered. Should a client not meet its minimum commitment and no longer qualify for the incentive, management recognizes the revenue previously deferred related to the estimated incentive.
The Company accounts for sales and similar taxes imposed on its services on a net basis in the consolidated statements of operations.
Cost of Revenue
Cost of revenue consists primarily of the cost of media acquired from third-party publishers. Media cost is classified as cost of revenue in the corresponding period in which revenue is recognized. From time to time, publishers offer the Company rebates based upon various factors and operating rules, including the amount of media purchased. Management records these rebates in the period in which they are earned as a reduction to cost of revenue and the corresponding payable to the applicable publisher, or as an other receivable, as appropriate. Cost of revenue also includes third-party telephone and information services costs, data center and third-party hosting costs, credit card processing fees, third-party content and other direct costs. In addition, cost of revenue includes costs to initiate, operate and manage clients’ campaigns, other than costs associated with the Company’s sales force, which are reflected as selling and marketing expenses. Cost of revenue includes salaries, benefits, bonuses and stock-based compensation for the related staff, including the cost of Web Presence Professionals who are the principal service providers for the Company’s ReachCast product, and allocated overhead such as depreciation expense, rent and utilities, as well as an allocable portion of the Company’s technical operations costs, and the cost of service providers related to ClubLocal.
Selling and Marketing Expenses
Selling and marketing expenses consist primarily of personnel and related expenses for selling and marketing staff, including salaries and wages, commissions and other variable compensation, benefits, bonuses and stock-based compensation; travel and business costs; training, recruitment, marketing and promotional events; advertising; other brand building and product marketing expenses; and occupancy, technology and other direct overhead costs. A portion of the compensation for IMCs, sales management and other employees in the sales organization is based on commissions and other variable compensation. In addition, the cost of agency commissions is included in selling and marketing expenses.
Product and Technology Expenses
Product and technology expenses consist primarily of personnel and related expenses for product development and technology staff, including salaries, benefits, bonuses and stock-based compensation, and the cost of certain third-party service providers and other expenses, including occupancy, technology and other direct overhead costs. Technology operations costs, including related personnel and third-party costs, are included in product and technology expenses. The Company capitalizes a portion of its software development costs (Note 6) and, accordingly, includes amortization of those costs as costs of product and technology, as the RL Platform and the Company’s other systems address all aspects of the Company’s activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back-office functions of the business. Product and technology expenses also include the amortization of the technology obtained in acquisitions and the expenses of deferred payment obligations related to product and technology personnel.
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General and Administrative Expenses
General and administrative expenses consist primarily of personnel and related expenses for executive, legal, finance, human resources and corporate communications, including wages, benefits, bonuses and stock-based compensation, professional fees, insurance premiums and other expenses, including occupancy, technology and other direct overhead, public company costs and other corporate expenses.
Advertising Expenses
The Company expenses advertising as incurred. Advertising expense was $2.9 million, $1.3 million and $1.6 million for the years ended December 31, 2012, 2011 and 2010, respectively, and was recorded in sales and marketing expense in the Consolidated Statements of Operations.
Stock-Based Compensation
The Company accounts for stock-based compensation based on fair value. The Company follows the attribution method, which reduces current stock-based compensation expenses recorded by the effect of anticipated forfeitures. Management estimates forfeitures based upon its historical experience.
The fair value of each award is estimated on the date of the grant and amortized over the requisite service period, which is the vesting period. The Company uses the Black-Scholes option pricing model to estimate the fair value of stock-based awards on the date of grant. Determining the fair value of stock-based awards at the grant date under this model requires judgment, including estimating volatility, expected term and risk-free interest rate. The assumptions used in calculating the fair value of stock-based awards represent management’s estimate based on judgment and subjective future expectations. These estimates involve inherent uncertainties. If any of the assumptions used in the Black-Scholes model significantly changes, stock-based compensation for future awards may differ materially from the awards granted previously.
Variable Interest Entities
In accordance with ASC 810, Consolidations, the applicable accounting guidance for the consolidation of variable interest entities (“VIE”), the Company analyzes its interests, including agreements, loans, guarantees, and equity investments, on a periodic basis to determine if such interests are variable interests. If variable interests are identified, then the related entity is assessed to determine if it is a VIE. The Company’s analysis includes both quantitative and qualitative reviews. The Company bases its quantitative analysis on the forecasted cash flows of the entity, and its qualitative analysis on the design of the entity, its organizational structure including its decision-making authority, and relevant agreements. If the Company determines that the entity is a VIE, the Company then assesses if it must consolidate the VIE as its primary beneficiary. The Company’s determination of whether it is the primary beneficiary is based upon qualitative and quantitative analyses, which assess the purpose and design of the VIE, the nature of the VIE’s risks and the risks that the Company absorbs, the power to direct activities that most significantly impact the economic performance of the VIE, and the obligation to absorb losses or the right to receive benefits that could be significant to the VIE. See Note 8, “Variable Interest Entities”, for more information.
Loan Receivable
Loan receivable is recorded at carrying value, net of potential allowance for losses. Losses on the receivables are recorded when probable and estimable. The Company routinely evaluates the receivable for potential collection issues that might indicate an impairment. Changes in such estimates can significantly affect the allowance and provision for losses. It is possible that the Company will experience losses that are different from its current estimates. Write-offs are deducted from the allowance for losses when the Company judges the principal to be uncollectible. Any subsequent recoveries are added to the allowance at the time cash is received on a written-off balance. See Note 8, “Variable Interest Entities”, for more information. Interest income on the loan receivable is accrued on a monthly basis over the life of the loan.
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Deferred Consideration
Deferred purchase consideration that is fixed and determinable and expected to be settled in cash is accrued as a liability as of the date of the respective acquisition. Deferred purchase consideration that is fixed and determinable and expected to be settled in common stock is recorded as an increase to additional paid-in capital as of the date of acquisition. Deferred stock-based compensation issued to employees in connection with acquisitions is measured at fair value on the date of grant/acquisition and recognized over the vesting period of the instruments in accordance with the Company’s Stock-Based Compensation policy.
Common Stock Repurchase and Retirement
Common stock repurchased is retired and the excess of the cost over the par value of the common shares repurchased is charged to accumulated deficit.
Net Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and potential dilutive shares outstanding during the period, to the extent such shares are dilutive. Potential dilutive shares are composed of incremental common shares issuable upon the exercise of stock options, warrants and unvested restricted shares using the treasury stock method and convertible preferred stock under the if-converted method, where such conversions are dilutive. The Company was in a net loss position for the years ended December 31, 2012, 2011 and 2010, and therefore the number of diluted shares was equal to the number of basic shares for each of these periods.
The following potentially dilutive securities have been excluded from the calculation of diluted net loss per common share as they would be anti-dilutive for the periods below (in thousands):
Income Taxes
The Company records income taxes using the asset and liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in its financial statements or tax returns. In estimating future tax consequences, all expected future events other than enactments or changes in the tax law or rates are considered. Valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized.
The Company records tax benefits for income tax positions only if it is “more-likely-than-not” to be sustained based solely on its technical merits as of the reporting date. Management considers many factors when evaluating and estimating tax positions and tax benefits, which may require periodic adjustments and which may differ from actual outcomes. The Company follows a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. The Company’s policy is to recognize interest and penalties related to tax in income tax expense.
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3. Fair Value of Financial Instruments
The Company applies the fair value hierarchy for financial instruments. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy is based on three levels of inputs, of which the first two are considered observable and the last is considered unobservable, that are used to measure fair value:
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Level 1-Quoted prices in active markets for identical assets or liabilities.
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Level 2-Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
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Level 3-Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The following table summarizes the basis used to measure certain of the Company’s financial assets that are carried at fair value (in thousands):
The following table provides information about assets not carried at fair value in the Company’s Consolidated Balance Sheets (in thousands).
The OxataSMB B.V. (“OxataSMB”) loan receivable is not actively traded and its fair value is estimated based on valuation methodologies using current market interest rate data adjusted for inherent credit risk. See Note 8 for further information on the loan receivable.
4. Acquisitions
Acquisition of RealPractice
On July 3, 2012, the Company acquired certain technology, advertisers and hired certain employees of RealPractice, Inc. (“RealPractice”). RealPractice provides the Company with a platform for building a marketing automation and lead conversion.
At closing, the Company paid $2.6 million in cash of the estimated $2.9 million purchase price. The remaining amount of $0.3 million is payable in cash on the 18-month anniversary of the closing date, subject to adjustment on January 3, 2014. The Company also issued 150,292 restricted stock units to the hired employees, which are accounted for as stock-based compensation over the period in which they are earned.
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The Company recorded acquired assets and liabilities at their respective fair values. The following table summarizes the fair value of acquired assets and liabilities (in thousands):
Intangible assets acquired from RealPractice included customer relationships of $0.1 million and technology of $2.5 million, which are amortized over one and three years, their respective estimated useful lives, using the straight line method.
Acquisition costs in connection with the RealPractice acquisition was immaterial for the year ended December 30, 2012.
Acquisition of DealOn
On February 8, 2011, the Company acquired all of the outstanding member interests of DealOn, LLC (“DealOn”) for consideration of up to approximately $9.6 million in cash and stock. DealOn was a deal commerce company that operated in the United States and provided the Company with a deal commerce platform.
On the closing date, the Company paid $5.8 million in cash and issued 82,878 shares of its common stock, valued at $1.9 million based on fair value of the Company’s stock on the acquisition date. The balance of the purchase price of $2.0 million (the “DealOn Deferred Consideration”) was payable in cash of $1.5 million and in 21,297 shares of the Company’s common stock, and was subject to adjustment under the terms of the acquisition agreement.
For purposes of determining the Company’s acquisition consideration, management discounted the DealOn Deferred Consideration to its then present value, or $1.9 million, and recorded this amount at the time of acquisition. The Company has accrued interest on the deferred consideration originally recorded. The Company recorded the acquired assets and liabilities at their respective fair values. The following table summarizes the fair value of assets and liabilities acquired (in thousands):
During 2011, the Company recorded a $0.8 million impairment charge to intangible assets related to customer relationships acquired in the DealOn acquisition. This impairment is recorded in Cost of Revenue and resulted from a diminution in value attributable to a change in the Company’s business strategy for ReachDeals and the elimination of its dedicated deal sales force. Revenue from the acquired legacy products and services are immaterial for the years ended December 31, 2012 and 2011, respectively.
The intangible assets acquired from DealOn included customer relationships of $1.2 million, developed technology of $0.6 million, and trademarks of $0.3 million.
In connection with the DealOn acquisition, the Company incurred approximately $0.4 million in costs that are reflected in general and administrative expense in the accompanying Consolidated Statements of Operations for the year ended December 31, 2011.
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Acquisition of SMB:LIVE
On February 22, 2010, the Company acquired all of the issued and outstanding common stock of SMB:LIVE Corporation (“SMB:LIVE”) for consideration of approximately $8.5 million in cash and stock. SMB:LIVE is a provider of data syndication and social media monitoring products and services to SMBs. With the technology acquired through the SMB:LIVE acquisition, the Company developed a digital presence and reputation management solution (ReachCast) designed to enable an SMB to publish multi-media content from a single interface to a business profile page hosted by the Company as well as to local directory sites, search engines and social media sites, including Twitter and Facebook. The solution also provides automated monitoring of local review sites, social media sites, and local blogs for references to the SMB or comments related to the SMB’s business to provide an SMB with feedback, alerts and analytics to assist it in managing its online reputation.
On the closing date, the Company paid $2.8 million in cash as part of the purchase price. The balance of the consideration of $5.7 million was paid in cash and stock of the Company in 2012 and 2011. The Company recognized the deferred consideration as compensation expense over the period in which it was earned.
The Company recorded the assets and liabilities acquired at their respective fair values. The following table summarizes the fair value of assets and liabilities acquired (in thousands):
The intangible assets acquired consist of SMB:LIVE’s developed technology.
In connection with the acquisition, the Company incurred approximately $0.3 million in costs that are reflected in general and administrative expense in the accompanying Consolidated Statement of Operations for the year ended December 31, 2010.
The results of operations of acquired entities for the periods post-acquisition were included in the consolidated statements of operations and were immaterial for the years ended December 31, 2012, 2011 and 2010. The pro-forma financial statements for the above acquisitions have not been shown as the results of operations of the acquired companies have been immaterial for the years ended December 31, 2012, 2011 and 2010.
Deferred Consideration
In connection with the RealPractice acquisition, we are obligated to pay an additional $0.3 million in cash on January 3, 2014, subject to adjustment.
Pursuant to the terms of its 2011 acquisition of DealOn, on February 8, 2012, the Company made a deferred payment in the amount of $0.5 million, net of the working capital adjustment and certain other adjustments, and issued 10,649 shares of its common stock. On August 8, 2012, the Company made a deferred payment in the amount of $0.4 million and issued 5,324 shares of its common stock. On February 8, 2013, the Company made the final deferred payment in connection with the DealOn acquisition in the amount of $0.4 million and issued 5,324 shares of its common stock.
As part of the consideration paid to acquire SMB:LIVE, on February 22, 2012, the Company paid $0.6 million in cash and issued 181,224 shares of its common stock. The February 22, 2012 payment represented the final payment of deferred consideration in connection with the SMB:LIVE acquisition.
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Intangible Assets
As of December 31, 2012, intangible assets from acquisitions included developed technology of $2.4 million (net of accumulated amortization of $2.9 million) amortized over three years, and customer relationships of $25,000 (net of accumulated amortization of $25,000) amortized over one year. As of December 31, 2011, intangible assets from acquisitions included developed technology of $1.4 million (net of accumulated amortization of $1.8 million) amortized over three years, and customer relationships of $0.7 million (net of accumulated amortization of $2.1 million) amortized over one year. Based on the current amount of intangibles subject to amortization, the estimated amortization expense over the remaining lives are as follows (in thousands):
For the years ended December 31, 2012, 2011 and 2010, amortization expense related to acquired intangibles was $2.2 million, $2.3 million and $1.4 million, respectively.
5. Property and Equipment
Property and equipment consisted of the following (in thousands):
Depreciation expense for property and equipment was $5.1 million, $3.2 million and $2.3 million for the years ended December 31, 2012, 2011 and 2010, respectively.
6. Software Development Costs
Capitalized software development costs consisted of the following (in thousands):
The Company recorded amortization expense of $6.5 million, $4.7 million and $2.6 million for the years ended December 31, 2012, 2011 and 2010, respectively. As of December 31, 2012 and 2011, $3.3 million and $1.2 million, respectively, of capitalized software development costs are related to projects still in development and are not being amortized.
7. Current Liabilities
Accrued expenses consisted of the following (in thousands):
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Deferred revenue and other current liabilities consisted of the following (in thousands):
8. Variable Interest Entities
On July 6, 2012, the Company completed a transaction with OxataSMB, in which the Company entered into a franchise agreement with OxataSMB permitting it to operate and resell the Company’s services under the ReachLocal brand in Slovakia, Czech Republic, Hungary, Poland and Russia. Pursuant to the franchise agreement, OxataSMB will receive access to the RL platform, training, marketing and branding materials, media purchasing, campaign management and provisioning, sourcing of telephony, and technical support. The Company does not anticipate OxataSMB will pursue activities other than as a franchisee. In addition, the Company entered into a market development loan agreement with OxataSMB pursuant to which the Company agreed to provide financing to OxataSMB of up to €2.9 million ($3.7 million), of which €1.45 million ($1.9 million) has been advanced. The ability to draw down the remaining loan amount is dependent on OxataSMB achieving certain milestones by June 29, 2013, subject to a six-month extension at the Company’s option. The loan has a two-year term and accrues interest at 4% per annum, but does not require principal or interest payments for two years, and can be extended for an additional 24 months based on achievement of certain milestones. Prior to advance of the loan, OxataSMB had €1.45 million ($1.9 million) of contributed capital. As of December 31, 2012, OxataSMB had assets of less than $4 million and its results of operations since inception were not significant. In addition, the Company has an option to buy OxataSMB at an independently-determined fair value at the end of the initial loan term, subject to extension.
OxataSMB is considered a VIE with respect to the Company because OxataSMB may not have sufficient equity to finance its activities without additional financial support depending on its performance. At December 31, 2012, the Company was not the primary beneficiary of OxataSMB because it does not have: (1) the power to direct the activities that most significantly impact OxataSMB’s economic performance or (2) the obligation to absorb losses of OxataSMB or the right to receive benefits from OxataSMB that could potentially be significant. Therefore, the Company did not consolidate the results of OxataSMB and transactions with OxataSMB results were accounted for similarly to the Company’s resellers. The loan receivable is included in “Other assets” in the accompanying Consolidated Balance Sheet. As of December 31, 2012, the Company’s maximum exposure to loss related to the unconsolidated VIE consisted of its loan and accumulated interest receivable of $2.0 million and its contingent commitment to provide €1.45 million ($1.9 million) of additional debt financing. No allowance for loan losses has been recorded against the loan receivable.
9. Commitments and Contingencies
The Company leases office facilities under operating lease agreements that expire at various dates through 2021. The terms of the majority of the Company’s lease agreements provide for rental payments on a graduated basis. The Company recognizes rent expense on a straight-line basis over the lease term.
Rental expense, principally for leased office space under operating lease commitments, was $11.4 million, $9.7 million and $6.4 million for the years ended December 31, 2012, 2011 and 2010, respectively.
As of December 31, 2012, future minimum payments under cancelable and non-cancelable operating leases are as follows (in thousands):
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Letters of Credit and Restricted Certificates of Deposit
As of December 31, 2012 and 2011, the Company maintained letters of credit totaling $1.2 million and $1.3 million, respectively, to secure its obligations under facility operating lease agreements. The letters of credit are collateralized by restricted certificates of deposit and automatically renew for successive one-year periods over the duration of the lease term. As of December 31, 2012 and 2011, the Company was required to maintain cash reserve balances of at least $1.2 million and $1.3 million, respectively, to secure these letters of credit. These amounts were classified as restricted certificates of deposit in the accompanying Consolidated Balance Sheets.
Litigation
The Company is subject to various legal proceedings and claims arising in the ordinary course of business. Although occasional adverse decisions or settlements may occur, management believes that the final disposition of such matters will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.
10. Stockholder’s Equity
Initial Public Offering
On May 19, 2010, the Company issued 3,941,103 shares of common stock, including shares from the exercise of the underwriters’ option to purchase 625,000 shares, at a price of $13.00 per share, raising proceeds to the Company of $42.0 million, net of underwriting discounts and commissions and offering costs.
Convertible Preferred Stock
Upon the completion of the initial public offering in 2010, all of the then outstanding shares of convertible preferred stock were converted to 16,712,120 shares of common stock with a par value of $0.00001 per share.
Warrants
In November 2009, the Company issued a warrant to a consultant to purchase up to 15,000 shares of common stock at an exercise price of $10.91 per share, which expires in November 2014.
Common Stock Repurchases
On November 4, 2011, the Company announced that its Board of Directors authorized the repurchase of up to $20.0 million of the Company’s outstanding common stock. On December 13, 2012, the Company announced the Board of Directors increased the total authorized repurchase amount by $6.0 million, to a total authorization of $26.0 million, and on March 4, 2013, the Company announced that its Board of Directors increased the total authorized repurchase amount by an additional $21.0 million, to a total authorization of $47.0 million. At December 31, 2012, the Company had executed repurchases of 2.0 million shares of its common stock under the program for an aggregate of $17.4 million, of which $11.0 million or 1.1 million shares were repurchased during the year ended December 31, 2012. From January 1, 2013 to March 5, 2013, the Company executed repurchases of an additional $1.5 million of its common stock under the program. Purchases may be made from time-to-time in open market or privately negotiated transactions as determined by the Company’s management. The amount and timing of the share repurchase will depend on business and market conditions, stock price, trading restrictions, acquisition activity, and other factors. The share repurchase program does not obligate the Company to acquire any particular amount of common stock, and the repurchase program may be suspended or discontinued at any time at the Company’s discretion.
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Shares Reserved For Future Issuance
The following table shows the number of shares of common stock reserved for future issuance as of December 31, 2012 (in thousands):
11. Stock-Based Compensation
Stock Option Exchange
On May 29, 2012, the Company commenced an offer to exchange options to purchase shares of its common stock with an exercise price equal to or greater than $10.91 per share or, for the Company’s executive officers subject to Section 16 of the Securities Exchange Act of 1934, as amended (“executive officers”), $16.71 per share, for replacement options to purchase a lesser number of shares of common stock having an exercise price equal to the fair market value of the Company’s common stock on the replacement grant date, or for replacement options issued to the Company’s executive officers, an exercise price equal to the greater of the fair market value of the Company’s common stock on the replacement grant date or $13 per share.
The stock option exchange closed on June 25, 2012. All exchanged options were cancelled at that time and immediately thereafter, the Company granted replacement options under the Amended and Restated ReachLocal 2008 Stock Incentive Plan. Employees other than executive officers received options covering an aggregate of 158,752 shares, each with an exercise price of $10.56, which was the closing price of the Company’s common stock on the NASDAQ Global Select Market on June 25, 2012, and executive officers received options covering an aggregate of 396,998 shares, each with an exercise price of $13.00. After cancelling exchanged options to purchase an aggregate of 834,875 shares and granting replacement options to purchase an aggregate of 555,750 shares, the Company’s total number of shares subject to outstanding stock options was reduced by 279,125 shares.
The fair value of the replacement options granted was measured as the total of the unrecognized compensation cost of the original options exchanged plus any incremental compensation cost of the replacement options. The incremental compensation cost of the replacement options was measured as the excess of the fair value of the replacement options over the fair value of the exchanged options immediately before cancellation. The total remaining unrecognized compensation expense related to the exchanged options and the incremental compensation cost of the replacement options will be recognized over the four-year vesting period of the replacement options. The incremental compensation expense of the replacement options was immaterial.
Stock Option Plans
On April 21, 2004, the Company adopted the 2004 Stock Plan (the “2004 Plan”), as amended. Grants under the 2004 Plan may be incentive stock options or nonqualified stock options or awards. The 2004 Plan is administered by the Company’s board of directors, which has the authority to designate participants and determine the number and type of awards to be granted, the time at which awards are exercisable, the method of payment and any other terms or conditions of the awards. The vesting of these awards vary subject to the participant’s period of future service, or otherwise at the discretion of the Company’s board of directors. The majority of awards vest over four years and have a term of 10 years. There were no shares available for grant under the 2004 Plan as of December 31, 2012 and 2011.
On July 1, 2008, the Company adopted the 2008 Stock Incentive Plan (the “2008 Plan”) and retired the 2004 Plan. Options outstanding under the 2004 Plan are unaffected by the retirement of the 2004 Plan. The aggregate number of shares of the Company’s common stock available for issuance pursuant to awards granted under the 2008 Plan is equal to the sum of (x) 5,471,350 plus (y) any shares of the Company’s common stock subject to awards under the 2004 Plan that terminate, expire or lapse for any reason or are settled in cash after the date the 2008 Plan originally became effective, and (z) an annual increase in shares on the first day of each year beginning in 2011 and ending in 2018. The annual increase will be equal to the lesser of (A) 2,500,000 shares (as adjusted for stock splits, stock combinations, stock dividends and similar matters), (B) 4.5% of the Company’s common stock outstanding on the last day of the prior year or (C) such smaller number of shares as may be determined by the Board. The 2008 Plan is administered by the Company’s Compensation Committee, which has the authority to designate participants and determine the number and type of awards to be granted, the time at which awards are exercisable, the method of payment and any other terms or conditions of the awards. The vesting of these awards vary subject to the participant’s period of future service, or otherwise at the discretion of the Compensation Committee. The majority of awards issued under the 2008 Plan vest over four years and have a term of seven years. There were 732,197 and 686,103 shares available for grant under the 2008 Plan as of December 31, 2012 and 2011, respectively. On January 1, 2013, an additional 1,266,925 shares were added to the pool under the evergreen provision.
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Stock Options
The following table summarizes stock option activity (in thousands, except years and per share amounts):
The assumptions utilized for purposes of the Black-Scholes pricing model are summarized as follows:
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Volatility-As the Company has limited trading history for its common stock, the expected stock price volatility was estimated by taking a combination of 1) the median historic price volatility for industry peers based on daily price observations over a period equivalent to the expected term of the stock option grants and 2) the Company’s own historic price volatility based on daily price observations since May 2010. Industry peers consist of several public companies in the technology industry similar in size, stage of life cycle and financial leverage. Management did not rely on implied volatilities of traded options in its industry peers’ common stock because the volume of activity was relatively low.
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Expected term-The expected term was estimated using the simplified method allowed under Securities and Exchange Commission Staff Accounting Bulletin No. 107, Share-Based Payment. Management uses this method because it has limited historical data to estimate future terms and it is unable to obtain objective, measurable and comparative historical data of comparable companies.
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Risk free rate-The risk free interest rate is based on the yields of U.S. Treasury securities with maturities similar to the expected term of the options for each option group.
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Dividend yield-The Company has never declared or paid any cash dividends and does not presently plan to pay cash dividends in the foreseeable future. Consequently, management used an expected dividend yield of zero.
In addition, management estimates the forfeiture rate based on its historical experience with forfeitures and reviews estimated forfeiture rates each period-end, and makes changes as factors affecting the forfeiture rate calculations and assumptions change.
The following table summarizes the weighted average assumptions used to estimate the fair value of stock options granted during the years ended December 31, 2012, 2011 and 2010.
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The aggregate intrinsic value of stock options exercised during the years ended December 31, 2012, 2011 and 2010 were $1.9 million, $14.2 million and $6.7 million, respectively. The total fair value of shares vested during the years ended December 31, 2012, 2011 and 2010 were $2.0 million, $6.1 million and $3.7 million, respectively.
The options outstanding and vested and exercisable as of December 31, 2012 have been segregated into ranges for additional disclosure as follows (number of options in thousands):
Restricted Stock and Restricted Stock Units
The Company may issue restricted stock and restricted stock units in conjunction with acquisitions and long-term employee incentive programs. These shares of restricted stock and restricted stock units have vesting periods of 4 years. Stock-based compensation expense related to restricted stock units was $1.7 million, $0.7 million and $0.6 million for the years ended December 31, 2012, 2011, and 2010, respectively.
The following table summarizes restricted stock awards and restricted stock unit awards (in thousands, except per share amounts):
Stock-based compensation expense
In conjunction with the Company’s stock option plan and restricted shares and reserved shares issued in connection with SMB:LIVE, the Company records stock-based compensation expense net of capitalized stock-based compensation in association with software development costs. The following table summarizes stock-based compensation (in thousands):
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Stock-based compensation, net of capitalization, is included in the accompanying consolidated statements of operations, within the following captions (in thousands):
As of December 31, 2012, there was $19.9 million of unrecognized stock-based compensation related to restricted stock, restricted stock units and outstanding stock options, net of estimated forfeitures. This amount is expected to be recognized over a weighted average period of 1.6 years. Future stock-based compensation expense for these awards may differ in the event actual forfeitures deviate from management’s estimates.
Adjustment to Historical Stock-Based Compensation Expense
In conjunction with the transition to an integrated stock-based compensation tracking and reporting system, immaterial adjustments relating to the impact of forfeitures on the computation of stock-based compensation expense were identified. As a result, stock-based compensation expense was understated by $0.2 million in 2011, $0.3 million in 2010, and $0.2 million in 2009 and prior periods. Based on an analysis of qualitative and quantitative factors, management has concluded that these adjustments were not material to any historical period, although the cumulative impact of correcting for the adjustments in 2012 would have been material to the current period. As a result, the affected balances have been revised in the accompanying consolidated financial statements as adjustments to additional paid-in capital and accumulated deficit as of December 31, 2009, and stock-based compensation expense for the years ended December 31, 2011 and 2010.
12. Income Taxes
The components of income (loss) from continuing operations before income taxes were (in thousands):
The provision for income taxes for the years ended December 31, 2012, 2011 and 2010, consists primarily of state and foreign income taxes payable in the various jurisdictions in which the Company operates. In 2010, the Company recorded a one-time $0.7 million discrete deferred tax benefit related to the acquisition of SMB:LIVE.
Significant components of the provision for (benefit from) for income taxes are as follows (in thousands):
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Income taxes payable as of December 31, 2012 and 2011 amounted to $0.5 million and $0.6 million, respectively, and were classified within “Accrued expenses” in the accompanying Consolidated Balance Sheets.
The provision for income taxes differs from the amount computed by applying the federal statutory income tax rate to income before income taxes as follows (in thousands):
The components of deferred income tax assets and liabilities are as follows (in thousands):
Net deferred tax liabilities are included in “Deferred rent and other liabilities” in the accompanying Consolidated Balance Sheets.
The following table summarizes the Company’s net operating loss carry-forwards as of December 31, 2012:
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The federal NOL carryforwards per the income tax returns filed included unrecognized tax benefits taken in prior years. According to the application of ASC 740, they are larger than the NOLs for which a deferred tax asset is recognized for financial statement purposes.
The Company evaluates its deferred tax assets on a quarterly basis to determine if a valuation allowance against its net deferred tax assets is required. Realization of the Company’s deferred tax assets is dependent primarily on the generation of future taxable income. In considering the need for a valuation allowance, the Company considers its historical, as well as, future projected taxable income, along with other positive and negative evidence in assessing the realizability of its deferred tax assets. Due to the Company’s history of cumulative losses, the Company recorded a valuation allowance of $6.4 million and $10.4 million in 2012 and 2011, respectively. In 2012, the net valuation allowance decreased by $4.0 million, primarily due to the utilization of net operating losses in certain US and foreign jurisdictions. In 2011 and 2010, the net valuation allowance increased by $3.0 million and $2.7 million, respectively, due in part to the generation of additional deferred tax assets associated with net operating losses in certain US and foreign jurisdictions.
U.S. income and foreign withholding taxes have not been recognized on the excess of the amount for financial reporting over the tax basis of investments in foreign subsidiaries in the amount of $1.1 million that are essentially permanent in duration. This amount becomes taxable upon a repatriation of assets from a subsidiary or a sale or liquidation of a subsidiary. Determination of the amount of any unrecognized deferred income tax liability on this temporary difference is not practicable because of the complexities of the hypothetical calculation.
At December 31, 2012, the Company had gross unrecognized tax benefits of approximately $2.1 million. Of this total, approximately $0.1 million would affect the Company’s effective tax rate if recognized. The Company classifies liabilities for unrecognized tax benefits for which it does not anticipate payment or receipt of cash within one year in non-current other liabilities.
A reconciliation of the beginning and ending amounts of gross unrecognized tax benefits is as follows (in thousands):
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. Related to the unrecognized tax benefits noted above, the Company accrued no additional interest or penalties during 2012 and in total, as of December 31, 2012, has recognized a liability for interest and penalties of $ 0.1 million.
The Company files income tax returns in the U.S. federal jurisdiction and in various state and foreign jurisdictions. The Company’s income tax returns since inception are open to examination by federal, state, and foreign tax authorities.
The Company does not expect significant changes to the unrecognized tax benefits in the next 12 months.
13. 401(k) Plan
In February 2007, the Company established a defined contribution savings plan under Section 401(k) of the Internal Revenue Code. The plan is available to all full-time employees and allows participants to defer a portion of their annual compensation on a pre-tax basis. The Company may contribute to the plan at the discretion of its board of directors. No contributions have been made to the plan during the years ended December 31, 2012, 2011 and 2010.
14. Segment Information
The Company operates in one operating segment. The Company’s chief operating decision maker (“CODM”) manages the Company’s operations on a consolidated basis for purposes of evaluating financial performance and allocating resources.
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Revenue by geographic region with respect to the Direct Local channel and National Brands is based on the physical location of the sales office, and with respect to Agencies and Resellers, is based on the physical location of the agency or reseller. The following summarizes revenue by geographic region (in thousands):
The results of the Australia geographic region have been included in the Company’s consolidated financial statements and include revenues of $72.6 million, $56.2 million, and $32.7 million in 2012, 2011 and 2010, respectively. Long-lived assets of the Australia geographic region were $1.7 million and $2.4 million at December 31, 2012 and 2011, respectively.
15. Discontinued Operations
On November 1, 2011, the Company announced that it would wind down the operations of Bizzy and determined that Bizzy would be considered a discontinued operation as of the third quarter of 2011. In connection with this decision, the Company recorded a charge of $4.0 million in 2011 to reflect the impairment of capitalized software development costs, personnel and severance costs, operating losses, facilities and other costs. As of December 31, 2012, liabilities from discontinued operations are expected to be settled over the next year.
16. Quarterly Information (Unaudited)
The following table sets forth unaudited quarterly financial data for the four quarters of each of 2012 and 2011. As a result of the winding down of the operations of Bizzy, management has reclassified and presented all related historical financial information as “discontinued operations” in the following Consolidated Statements of Operations. As more fully discussed in Note 11, stock-based compensation expense for the quarter ended December 31, 2011 was adjusted for the impact of historical forfeitures.
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EXHIBIT INDEX
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*
Indicates management contract or compensatory plan, contract or arrangement.
**
XBRL (Extensible Business Reporting Language) information is furnished and not filed herewith, is not a part of a registration statement or Prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, as of March 11, 2013.
POWER OF ATTORNEY
Each person whose individual signature appears below hereby authorizes and appoints Zorik Gordon and Ross G. Landsbaum, and each of them, with full power of substitution and resubstitution and full power to act without the other, as his or her true and lawful attorney-in-fact and agent to act in his or her name, place and stead and to execute in the name and on behalf of each person, individually and in each capacity stated below, solely for the purposes of filing any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing, ratifying and confirming all that said attorneys-in-fact and agents or any of them or their or his substitute or substitutes may lawfully do or cause to be done by virtue thereof solely for the purposes stated therein.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities as of March 11, 2013.
Signature
Title
Date
/s/ Zorik Gordon
Chief Executive Officer, Director
March 11, 2013
Zorik Gordon
(Principal Executive Officer)
/s/ Ross G. Landsbaum
Chief Financial Officer
March 11, 2013
Ross G. Landsbaum
(Principal Financial Officer)
/s/ David Day
Senior Vice President, Corporate Controller and Chief
March 11, 2013
David Day
Accounting Officer (Principal Accounting Officer)
/s/ Nathan Hanks
President, Director
March 11, 2013
Nathan Hanks
/s/ David Carlick
Director
March 11, 2013
David Carlick
/s/ Robert Dykes
Director
March 11, 2013
Robert Dykes
/s/ James Geiger
Director
March 11, 2013
James Geiger
/s/ Habib Kairouz
Director
March 11, 2013
Habib Kairouz
/s/ Alan Salzman
Director
March 11, 2013
Alan Salzman
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