Table of Contents

 

 

 

**UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C.  20549**

 

**FORM 10-Q/A**

**(Amendment No. 1)**

** **

**(Mark One)**

** **

**x****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2013.**

 

**or**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from** **             to              **

 

**Commission File Number:  000-53205**

 

**Diligent Board Member Services, Inc.**(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                   | ** ** | **26-1189601**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

**1385 Broadway, 19th Floor**

**New York, NY 10018**

(Address of principal executive offices)(Zip Code)

 

**(212) 741-8181**

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  o Yes x No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  o Yes x No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check One)

 

| o Large   accelerated filer |   | x Accelerated   filer         |
|-----------------------------|--------|-------------------------------|
|                        |   |                          |
| o Non-accelerated   filer   |   | o Smaller   Reporting Company |

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No

 

**THE NUMBER OF SHARES OF THE REGISTRANT’S COMMON STOCK OUTSTANDING AS OF MAY 11, 2014 WAS 86,556,610.**

 

 

 

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** **

**AMENDMENT EXPLANATORY NOTE**

 

Diligent Board Member Services, Inc. is filing this Amendment No. 1 on Form 10-Q/A (“Amendment No. 1”) to its Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013 (the “Original Filing”), filed with the Securities and Exchange Commission (the “SEC”) on May 19, 2014, to amend certain clerical omissions from the Original Filing.  This Amendment No. 1 is being filed solely to include completed dates on the signature page to the Original Filing and completed dates on Exhibits 31.1, 31.2, 32.1 and 32.2 filed therewith, which were inadvertently omitted from the Original Filing.

** **

**EXPLANATORY NOTE**

 

On August 5, 2013 in the U.S., Diligent Board Member Services, Inc. (“we,” “us,” “our,” “Diligent” or the “Company”) announced that our historical financial statements for the fiscal years ended December 31, 2012, 2011 and 2010, and our interim financial statements for the fiscal quarter ended March 31, 2013, would be restated due to errors discovered in our revenue recognition review, and that our financial statements previously filed with the U.S. Securities and Exchange Commission (the “SEC”) for such periods, including interim periods within such fiscal years, should no longer be relied upon.  In addition, on January 28, 2014 in the U.S., we determined that due to an additional error in our historical financial statements relating to the accounting treatment of a note receivable from our predecessor entity, our historical financial statements previously filed with the SEC for the fiscal years ended December 31, 2009, 2008 and 2007, including interim periods within such fiscal years, should no longer be relied upon.  The fiscal years and interim periods affected by such announcements are referred to as the “Affected Periods”. For more information regarding the restatement, refer to Note 2, “Restatement of previously issued financial statements due to correction of errors” in Part I, Item 1and Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

 

On April 7, 2014, we filed with the SEC Amendment No. 2 to the Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31, 2012 (the “10-K Amendment”) and Amendment No. 1 to the Company’s Quarterly Report on Form 10-Q/A for the quarterly period ended March 31, 2013 (the “10-Q Amendment”).  The 10-K Amendment and the 10-Q Amendment contain restated financial information for the fiscal years ended December 31, 2012 and 2011, the quarterly periods within such fiscal years and the quarterly period ended March 31, 2013.  Other than the 10-K Amendment and the 10-Q Amendment, we have not filed amendments to (i) our Quarterly Reports on Form 10-Q previously filed with the SEC for the interim periods in the Affected Periods, or (ii) our Annual Reports on Form 10-K previously filed with the SEC for the fiscal years included in the Affected Periods (collectively, the “Affected Reports”). Accordingly, investors should rely only on the financial information and other disclosures regarding the Affected Periods in the 10-K Amendment and the 10-Q Amendment, and not on the Affected Reports or any reports, sales update press releases, or similar communications relating to the Affected Periods.

 

As disclosed in Item 9A of the 10-K Amendment, management concluded that as of December 31, 2012, our internal controls over financial reporting were not effective due to material weaknesses in our control environment, control activities and information and communication relative to stock option grants and stock issuances.  In addition, we lacked a sufficient complement of trained finance, accounting and tax personnel and did not establish adequate accounting and financial reporting policies and procedures as a general matter.  In particular, there were material weaknesses in our financial reporting control environment and the design, establishment, maintenance and communication of effective controls relating to revenue recognition, income taxes and certain transactions with our predecessor entity.  In addition, our accounting and financial reporting processes were dependent on the maintenance of spreadsheets that had become inadequate to ensure accurate and timely financial reporting given the growth of the Company and the volume of transactions. Management also evaluated the effectiveness of our disclosure controls and procedures and concluded that our disclosure controls and procedures were not effective as of December 31, 2012.  Information relating to the identified material weaknesses in internal control over financial reporting, and related remedial measures, as well as additional information relating to the restatement, is contained in the 10-K Amendment.

 

In connection with the preparation of this Quarterly Report on Form 10-Q, management evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2013 and determined that our disclosure controls and procedures were ineffective as of such date.  We continue to evaluate the sufficiency of our planned remedial measures and to dedicate substantial resources to our remediation efforts. The disclosed material weaknesses cannot be considered fully remediated until the applicable controls are implemented, operate for a sufficient period of time and management has concluded, through testing, that these controls are operating effectively.

 

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** **

**CONTENTS**

 
| ** **                                 | ** **                                                                                   | **PAGE**   |
|--------------------------------------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** **                                                                                   | ** ** |
| Forward   Looking Statements               | ii                                                                                           |
|                                       |                                                                                         |       |
| PART I   — Financial Information |                                                                                         |
|                                       |                                                                                         |       |
| Item 1.                                    | Condensed   Consolidated Financial Statements (Unaudited)                                    | 1          |
| Item 2.                                    | Management’s   Discussion and Analysis of Financial Condition and Results of Operations | 21         |
| Item 3.                                    | Quantitative   and Qualitative Disclosures About Market Risk                                 | 35         |
| Item 4.                                    | Controls and   Procedures                                                                    | 36         |
|                                       |                                                                                         |       |
| PART II   — Other Information    |                                                                                         |
|                                       |                                                                                         |       |
| Item 1.                                    | Legal Proceedings                                                                            | 37         |
| Item 1A.                                   | Risk Factors                                                                                 | 37         |
| Item 2.                                    | Unregistered   Sales of Equity Securities and Use of Proceeds                                | 37         |
| Item 3.                                    | Defaults   Upon Senior Securities                                                            | 37         |
| Item 4.                                    | Mine Safety   Disclosures                                                                    | 37         |
| Item 5.                                    | Other   Information                                                                          | 37         |
| Item   6.                                  | Exhibits                                                                                     | 37         |
|                                       |                                                                                         |       |
| SIGNATURES                                 |                                                                                         | 39         |

 

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** **

**FORWARD LOOKING STATEMENTS**

 

This document contains forward-looking statements within the meaning of the safe harbor provision of the Securities Litigation Reform Act of 1995. Terms such as “expect,” “believe,” “continue,” and “intend,” as well as similar comments, are forward-looking in nature.   There are numerous risks and uncertainties that could cause actual results and the timing of events to differ materially from those anticipated by the forward-looking statements in this Quarterly Report on Form 10-Q. Such risks and uncertainties may give rise to future claims and increase our exposure to contingent liabilities. These risks and uncertainties arise from the following issues (among other factors):

 

·                  We have had to restate certain of our historical financial statements and as a result have not been able to  timely file periodic  reports with the New Zealand Stock Exchange (the NZSX) or the SEC;

·                  As of December 31, 2012 and December 31, 2013, we identified material weaknesses in our internal controls over financial reporting and concluded that our disclosure controls were not effective; we must address the material weaknesses in our internal controls and our disclosure controls, which otherwise may impede our ability to produce timely and accurate financial statements and periodic reports;

·                  Our Special Committee investigation identified a number of instances in which we were not, or may not have been, in compliance with applicable New Zealand and US regulatory obligations;

·                  We face the risk of litigation or governmental investigations or proceedings relating to the restatement or the  matters covered by the Special Committee investigation;

·                  Certain of our past stock issuances and stock option grants may expose us to potential contingent liabilities, including potential rescission rights;

·                  We are subject to New Zealand Stock Exchange Listing Rules and compliance with securities and financial reporting laws and regulations in the US and New Zealand and face higher costs and compliance risks than a typical US public company due to the need to comply with these dual regulatory regimes;

·                   If our security measures are breached and unauthorized access is obtained to a client’s data or our data or our IT systems, our services may be perceived as not being secure, clients may curtail or stop using our services and we may incur significant legal and financial exposure and liabilities.

·                  Our business is highly competitive and we face the risk of declining customer renewals or upgrades;

·                  If we do not successfully develop or introduce new product offerings, or enhancements to our existing Diligent Boardbooks offering, or keep pace with technological changes that impact the use of our product offerings, we may lose existing customers or fail to attract new customers; and

·                  We may fail to manage our growth effectively.

 

We also refer you to Part I, Item 1A, “Risk Factors” in the 10-K Amendment for an extended discussion of the risks confronting our business. The forward-looking statements in this Quarterly Report on Form 10-Q should be considered in the context of these risk factors.  The Company makes no commitment to revise or update any forward-looking statements in order to reflect events or circumstances after the date any such statement is made, except as otherwise required by the federal securities laws or the NZSX Listing Rules.

 

EMERGING GROWTH COMPANY

 

We are an emerging growth company under the JOBS Act.  We shall continue to be deemed an emerging growth company until the earliest of:

 

(a)  the last day of the fiscal year during which we have total annual gross revenues of $1,000,000,000 (as such amount is indexed for inflation every 5 years by the Commission to reflect the change in the Consumer Price Index for All Urban Consumers published by the Bureau of Labor Statistics, setting the threshold to the nearest 1,000,000) or more;

(b)  the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement in the U.S.;

(c)  the date on which we have, during the previous 3-year period, issued more than $1,000,000,000 in non-convertible debt; or

 

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(d) the date on which we are deemed to be a large accelerated filer, as defined in section 240.12b-2 of title 17, Code of Federal Regulation, or any successor thereto.

 

As an emerging growth company we are exempt from Section 404(b) of Sarbanes Oxley, which requires the independent registered public accounting firm to attest to and report on the assessment on the effectiveness of the internal control structure and procedures for financial reporting.  In addition,  we may choose to take advantage of exemptions from various reporting requirements applicable to other public companies but not to “emerging growth companies,” including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements.  We are also exempt from Section 14A (a) and (b) of the Securities Exchange Act of 1934 which require shareholder approval of executive compensation and golden parachutes.

 

Section 107 of the JOBS Act also provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards.  However, we are choosing to opt out of any extended transition period, and as a result we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for publicly reporting companies.  Section 107 provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

 

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** **

**PART I—FINANCIAL INFORMATION**

 

Item 1. Condensed Consolidated Financial Statements.

 

**Diligent Board Member Services, Inc.**

**Condensed Consolidated Balance Sheets**

**(Unaudited)**

**(in thousands, except share and per share amounts)**

 
| ** **                                                                                                                                                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                             | ** ** | **2013**               | ** ** | **2012**              | ** ** |
| **A   S S E T S**                                                                                                                                                      |       |                   |       |                  |       |
| **Current   assets:**                                                                                                                                                  |       |                   |       |                  |       |
| Cash and cash   equivalents                                                                                                                                            |       | $                      | 36,369     |                  | $          | 33,311 |   |
| Short-term   investments                                                                                                                                               |       | 10,999                 |       | 103                   |       |
| Accounts   receivable, net                                                                                                                                             |       | 2,225                  |       | 1,542                 |       |
| Deferred   commissions                                                                                                                                                 |       | 1,833                  |       | 2,081                 |       |
| Prepaid expenses   and other current assets                                                                                                                            |       | 1,334                  |       | 899                   |       |
| Deferred tax   assets                                                                                                                                                  |       | 3,095                  |       | 3,939                 |       |
| Income tax   receivable                                                                                                                                                |       | 511                    |       | —                |       |
| **Total   current assets**                                                                                                                                             | ** ** | **56,366**             | ** ** | **41,875**            | ** ** |
|                                                                                                                                                                   |       |                   |       |                  |       |
| Property and   equipment, net                                                                                                                                          |       | 6,867                  |       | 3,913                 |       |
| Deferred tax   assets                                                                                                                                                  |       | 3,590                  |       | 1,532                 |       |
| Security   deposits                                                                                                                                                    |       | 674                    |       | 225                   |       |
| Other   non-current assets                                                                                                                                             |       | —                 |       | 167                   |       |
| **Total   assets**                                                                                                                                                     | ** ** | **$**                  | **67,497** | ** **            | **$**      | **47,712** | ** ** |
| ** **                                                                                                                                                             | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES,   REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Current   liabilities:**                                                                                                                                             | ** ** | ** **             | ** ** | ** **            | ** ** |
| Accounts payable                                                                                                                                                       |       | $                      | 1,093      |                  | $          | 222 |   |
| Accrued expenses   and other liabilities                                                                                                                               |       | 8,038                  |       | 4,964                 |       |
| Income taxes   payable                                                                                                                                                 |       | —                 |       | 1,391                 |       |
| Deferred revenue                                                                                                                                                       |       | 23,187                 |       | 16,972                |       |
| Obligations   under capital leases                                                                                                                                     |       | 847                    |       | 702                   |       |
| **Total   current liabilities**                                                                                                                                        | ** ** | **33,165**             | ** ** | **24,251**            | ** ** |
|                                                                                                                                                                   |       |                   |       |                  |       |
| **Non-current   liabilities:**                                                                                                                                         | ** ** | ** **             |       |                  |       |
| Deferred   revenue, less current portion                                                                                                                               |       | 9,719                  |       | 6,964                 |       |
| Obligations   under capital leases, less current portion                                                                                                               |       | 976                    |       | 237                   |       |
| Deferred tax   liabilities                                                                                                                                             |       | —                 |       | 31                    |       |
| Other   non-current liabilities                                                                                                                                        |       | 587                    |       | 272                   |       |
| **Total   non-current liabilities**                                                                                                                                    | ** ** | **11,282**             | ** ** | **7,504**             | ** ** |
| **Total   liabilities**                                                                                                                                                | ** ** | **44,447**             | ** ** | **31,755**            | ** ** |
| **Commitments   and contingencies**                                                                                                                                    | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Redeemable preferred stock:**                                                                                                                                        |       |                   |       |                  |       |
| Series A convertible redeemable preferred stock, $.001 par   value, 50,000,000 shares authorized 32,667,123 shares issued and outstanding   (liquidation value $5,170) | ** ** | **3,254**              | ** ** | **3,233**             | ** ** |
| **Stockholders'   equity:**                                                                                                                                            | ** ** | ** **             |       |                  |       |
| Common Stock,   $.001 par value, 250,000,000 shares authorized, 83,776,155 and 83,586,155 shares   issued and outstanding                                              |       | 84                     |       | 84                    |       |
| Additional   paid-in capital                                                                                                                                           |       | 27,602                 |       | 26,052                |       |
| Accumulated   deficit                                                                                                                                                  |       | (7,869                 | )          | (13,480               | )          |
| Accumulated other comprehensive (loss) income                                                                                                                          |       | (21                    | )          | 68                    |       |
| **Total   stockholders' equity**                                                                                                                                       | ** ** | **19,796**             | ** ** | **12,724**            | ** ** |
| **Total   liabilities, redeemable preferred stock and stockholders' equity**                                                                                           | ** ** | **$**                  | **67,497** | ** **            | **$**      | **47,712** | ** ** |

 

See accompanying notes to condensed consolidated financial statements

 

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D**iligent Board Member Services, Inc.**

**Condensed Consolidated Statements of Income**

**(Unaudited)**

**(in thousands, except per share amounts)**

 
| ** **                                                   | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2013**                                                 | ** ** | **2012**                                                | ** ** | **2013** | ** ** | **2012** | ** ** |
| ** **                                                   | ** ** | ** **                                               | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Revenues                                                     |       | $                                                        | 17,235     |                                                    | $          | 10,831 |   | $ | 46,573 |   | $ | 26,777 |   |
| Cost of revenues   (excluding depreciation and amortization) |       | 3,244                                                    |       | 2,476                                                   |       | 9,017 |   | 6,821 |   |
| **Gross   profit**                                           |       | 13,991                                                   |       | 8,355                                                   |       | 37,556 |   | 19,956 |   |
|                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| **Operating   expenses:**                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Selling and   marketing                                      |       | 2,473                                                    |       | 2,324                                                   |       | 7,089 |   | 6,318 |   |
| General and   administrative                                 |       | 5,371                                                    |       | 2,162                                                   |       | 13,664 |   | 6,563 |   |
| Research and   development                                   |       | 1,209                                                    |       | 576                                                     |       | 3,088 |   | 1,630 |   |
| Depreciation and   amortization                              |       | 515                                                      |       | 334                                                     |       | 1,130 |   | 822 |   |
| Investigations   and restatement                             |       | 939                                                      |       | —                                                  |       | 3,282 |   | — |   |
| **Total   operating expenses**                               |       | 10,507                                                   |       | 5,396                                                   |       | 28,253 |   | 15,333 |   |
|                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| **Operating   income**                                       |       | 3,484                                                    |       | 2,959                                                   |       | 9,303 |   | 4,623 |   |
|                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| **Other   income (expense), net:**                           |       |                                                     |       |                                                    |       |   |   |   |   |
| Interest income   (expense), net                             |       | (24                                                      | )          | 22                                                      |       | (58 | ) | 111 |   |
| Foreign exchange   transaction (loss) gain                   |       | 32                                                       |       | 39                                                      |       | (149 | ) | 24 |   |
| **Total   other income (expense), net**                      |       | 8                                                        |       | 61                                                      |       | (207 | ) | 135 |   |
|                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| **Income   before (benefit) provision for income taxes**     |       | 3,492                                                    |       | 3,020                                                   |       | 9,096 |   | 4,758 |   |
| Income tax   expense (benefit)                               |       | 1,339                                                    |       | (4,062                                                  | )          | 3,485 |   | (3,640 | ) |
| **Net   income**                                             |       | $                                                        | 2,153      |                                                    | $          | 7,082 |   | $ | 5,611 |   | $ | 8,398 |   |
|                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Accrued preferrred   stock dividends                         |       | (89                                                      | )          | (89                                                     | )          | (270 | ) | (270 | ) |
| **Net   income attributable to common stockholders**         | ** ** | **$**                                                    | **2,064**  | ** **                                              | **$**      | **6,993** | ** ** | **$** | **5,341** | ** ** | **$** | **8,128** | ** ** |
|                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Earnings per   share:                                        |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                        |       | $                                                        | 0.02       |                                                    | $          | 0.06 |   | $ | 0.05 |   | $ | 0.07 |   |
| Diluted                                                      |       | $                                                        | 0.02       |                                                    | $          | 0.06 |   | $ | 0.04 |   | $ | 0.07 |   |
| Weighted average shares outstanding:                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                        |       | 116,443                                                  |       | 114,735                                                 |       | 116,422 |   | 114,585 |   |
| Diluted                                                      |       | 121,744                                                  |       | 119,973                                                 |       | 121,863 |   | 120,246 |   |

 

See accompanying notes to condensed consolidated financial statements

 

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**Diligent Board Member Services, Inc.**

**Condensed Consolidated Statements of Comprehensive Income**

**(Unaudited)**

**(in thousands)**

 
| ** **                              | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                              | ** ** | **2013**                                                 | ** ** | **2012**                                                | ** ** | **2013** | ** ** | **2012** | ** ** |
| ** **                              | ** ** | **(As restated)**                                        | ** ** | **(As restated)**                                       | ** ** |
| Net income                              |       | $                                                        | 2,153      |                                                    | $          | 7,082 |   | $ | 5,611 |   | $ | 8,398 |   |
| Other comprehensive income (loss) :     |       |                                                     |       |                                                    |       |   |   |   |   |
| Foreign exchange translation adjustment |       | 55                                                       |       | 33                                                      |       | (89 | ) | 58 |   |
| Comprehensive income                    |       | $                                                        | 2,208      |                                                    | $          | 7,115 |   | $ | 5,522 |   | $ | 8,456 |   |

 

See accompanying notes to condensed consolidated financial statements 

 

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D**iligent Board Member Services, Inc.**

**Condensed Consolidated Statement of Changes in Stockholders’ Equity**

**Nine months Ended September 30, 2013**

**(Unaudited)**

**(in thousands)**

 
| ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **      | ** ** | **Accumulated**        | ** **  | ** **        | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|----------------|------------|-----------------|------------|------------------------|-------------|-------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **      | ** ** | **Other**              | ** **  | **Total**         | ** ** |
| ** **                                           | ** ** | **Common** | ** ** | **Common** | ** ** | **Paid-in-**   | ** ** | **Accumulated** | ** ** | **Comprehensive**      | ** **  | **Stockholders'** | ** ** |
| ** **                                           | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit**     | ** ** | **Income (Loss)** | ** **  | **Equity**        | ** ** |
| **Balance at January 1, 2013**                       | ** ** | **83,586** | ** ** | **$**      | **84**     | ** **     | **$**      | **26,052**      | ** ** | **$**                  | **(13,480** | **)**             | **$**      | **68** | ** ** | **12,724** | ** ** |
| Net income                                           |       |       |       |       |       |           |       | 5,611           |       |                   |        | 5,611             |       |
| Other comprehensive loss                             |       |       |       |       |       |           |       |            |       | (89                    | )           | (89               | )          |
| **Total comprehensive income**                       |       |       |       |       |       |           |       |            |       |                   | ** **  | **5,522**         | ** ** |
| Capital contributions                                |       |       |       |       |       | 240            |       |            |       |                   |        | 240               |       |
| Share-based compensation                             |       |       |       |       |       | 1,225          |       |            |       |                   |        | 1,225             |       |
| Excess tax benefits - stock compensation             |       |       |       |       |       | 302            |       |            |       |                   |        | 302               |       |
| Exercise of stock options                            |       | 190        |       | —     |       | 74             |       |            |       |                   |        | 74                |       |
| Amortization of preferred stock offering costs       |       |       |       |       |       | (21            | )          |            |       |                   |        | (21               | )          |
| Accrued preferred stock dividend ($.00825 per share) |       |       |       |       |       | (270           | )          |            |       |                   |        | (270              | )          |
| **Balance at September 30, 2013**                    | ** ** | **83,776** | ** ** | **$**      | **84**     | ** **     | **$**      | **27,602**      | ** ** | **$**                  | **(7,869**  | **)**             | **$**      | **(21** | **)** | **$** | **19,796** | ** ** |
|                                                      |            |            |            |            |            |                |            |                 |            |                        |             |                   |            |  |  |  |  |  |

** **

See accompanying notes to condensed consolidated financial statements

 

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**Diligent Board Member Services, Inc.**

**Condensed Consolidated Statements of Cash Flows**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                  | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2013**                                                | ** ** | **2012** | ** ** |
| ** **                                                                                  | ** ** | ** **                                              | ** ** | **(As restated)** | ** ** |
| **Cash flows from operating activities:**                               | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Net income                                                                                  |       | $                                                       | 5,611      |   | $ | 8,398 |   |
| **Adjustments   to reconcile net income to net cash provided by operating activities:**     |       |                                                    |       |   |   |
| Deferred taxes                                                                              |       | (1,245                                                  | )          | (4,806 | ) |
| Excess tax   benefits realized from share-based compensation                                |       | (302                                                    | )          | — |   |
| Depreciation and   amortization                                                             |       | 1,130                                                   |       | 822 |   |
| Share-based   compensation                                                                  |       | 1,225                                                   |       | 1,030 |   |
| Allowance for   doubtful accounts                                                           |       | —                                                  |       | 50 |   |
| **Changes   in operating assets and liabilities:**                                          |       |                                                    |       |   |   |
| Accounts   receivable                                                                       |       | (684                                                    | )          | (239 | ) |
| Deferred   commissions                                                                      |       | 248                                                     |       | (122 | ) |
| Prepaid expenses   and other assets                                                         |       | (268                                                    | )          | (92 | ) |
| Security   deposits                                                                         |       | 13                                                      |       | (136 | ) |
| Accounts payable   and accrued expenses                                                     |       | 3,490                                                   |       | 183 |   |
| Income taxes   payable                                                                      |       | (1,600                                                  | )          | 964 |   |
| Deferred revenue                                                                            |       | 8,970                                                   |       | 8,703 |   |
| Other   non-current liabilities                                                             |       | 424                                                     |       | — |   |
| Other                                                                                       |       | 50                                                      |       | 90 |   |
| **Net   cash provided by operating activities**                                             |       | 17,062                                                  |       | 14,845 |   |
| **Cash   flows from investing activities:**                                                 |       |                                                    |       |   |   |
| Purchases of   short-term investments                                                       |       | (10,999                                                 | )          | — |   |
| Proceeds from   maturity of short-term investments                                          |       | 103                                                     |       | — |   |
| Restricted cash   - security deposit                                                        |       | (462                                                    | )          | — |   |
| Purchases of   property and equipment                                                       |       | (2,282                                                  | )          | (1,153 | ) |
| **Net   cash used in investing activities**                                                 |       | (13,640                                                 | )          | (1,153 | ) |
| **Cash   flows from financing activities:**                                                 |       |                                                    |       |   |   |
| Repayment of   note receivable from shareholder                                             |       | —                                                  |       | 3,072 |   |
| Payment of   preferred stock dividend                                                       |       | (120                                                    | )          | (120 | ) |
| Proceeds from   exercise of stock options and purchases of shares under stock purchase plan |       | 74                                                      |       | 134 |   |
| Excess tax   benefits realized from share-based compensation                                |       | 302                                                     |       | — |   |
| Repayments of   obligations under capital leases                                            |       | (418                                                    | )          | (162 | ) |
| Payments of obligations under software licensing agreements                                 |       | (109                                                    | )          | (109 | ) |
| **Net   cash (used in) provided by financing activities**                                   |       | (271                                                    | )          | 2,815 |   |
| Effect of   exchange rates on cash and cash equivalents                                     |       | (93                                                     | )          | 59 |   |
| **Net   increase in cash and cash equivalents**                                             |       | 3,058                                                   |       | 16,566 |   |
| **Cash   and cash equivalents at beginning of period**                                      |       | 33,311                                                  |       | 8,931 |   |
| **Cash   and cash equivalents at end of period**                                            |       | $                                                       | 36,369     |   | $ | 25,497 |   |
|                                                                                        |       |                                                    |       |   |   |
| **Supplemental disclosure of cash flow   information:**                                     |       |                                                    |       |   |   |
| Cash paid during the period for :                                                           |       |                                                    |       |   |   |
| Interest                                                                                    |       | $                                                       | 67         |   | $ | 15 |   |
| Income taxes                                                                                |       | $                                                       | 5,558      |   | $ | 142 |   |
| **Supplemental disclosure of noncash investing   and financing activities:**                |       |                                                    |       |   |   |
| Tender of common stock in lieu of interest payment on note   receivable from shareholder    |       | $                                                       | —     |   | $ | 200 |   |
| Capital contribution in lieu of preferred stock dividend                                    |       | $                                                       | 240        |   | $ | 240 |   |
| Property and equipment acquired under capital leases                                        |       | $                                                       | 1,306      |   | $ | 1,024 |   |
| Accounts payable for property and equipment                                                 |       | $                                                       | 545        |   | $ | — |   |

 

See accompanying notes to condensed consolidated financial statements

 

5

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Table of Contents

 

Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

**1)****                                    ****Organization and nature of the business**

 

Diligent Board Member Services, Inc. (“Diligent” or the “Company”) is a global leader in web-based portals for Boards of Directors.  The Company develops and sells an online software application called Diligent Boardbooks®, a web-based portal that board members, management and administrative staff use to compile, update, review and archive board materials during and after board meetings.  Diligent provides clients with subscription-based access to the software and also provides associated services including securely hosting the clients’ data, and customer service and support for the application.

 

The Company was incorporated in the State of Delaware on September 27, 2007 and is listed on the New Zealand Stock Exchange (“NZSX”).  On December 12, 2007, the Company completed an offshore public offering in connection with its listing on the NZSX.  The Company’s corporate headquarters are located in New York, New York.

 

The Company has a wholly-owned subsidiary located in New Zealand, Diligent Board Member Services NZ Limited (“DBMS NZ”), which provides research and development services for the Company.  The Company has a wholly-owned subsidiary in the United Kingdom, Diligent Boardbooks Limited (“DBL”) and a wholly-owned subsidiary in Australia, Diligent Board Services Australia Pty Ltd. (“DBA”), which provide sales, marketing and customer support services in their respective regions.  The Company’s Singapore subsidiary, Diligent APAC Board Services Pte. Ltd.  (“APAC”) provides sales support in the Asia-Pacific region.  At the end of 2012, Diligent formed a subsidiary in Hong Kong to support its Asia-Pacific sales and marketing, which has had no operations to date.

 

The Company’s condensed consolidated financial statements are presented in U.S. dollars, which is the Company’s functional and reporting currency.

 

**2)****                                    ****Restatement of Condensed Consolidated Financial Statements**

 

On April 7, 2014, Diligent filed Amendment No. 2 to the Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31, 2012 (the “10-K Amendment”) and Amendment No. 1 to the Company’s Quarterly Report on Form 10-Q/A for the three months ended March 31, 2013 (the “10-Q Amendment”) with the SEC.   The 10-K Amendment and the 10-Q Amendment contain restated financial information for the fiscal years ended December 31, 2012 and 2011, the quarterly periods within such fiscal years and the quarterly period ended March 31, 2013.    Each of the errors identified in the restatement are discussed in more detail below, and tables are included illustrating the impact of those errors on the Company’s previously issued interim condensed consolidated financial statements for the three and nine months ended September 30, 2012.

 

We have concluded that revenue recognition of our subscription fees for our Diligent Boardbooks service should commence on the date the service is made available to the customer, as determined by the date the customer has full access to the product.  Our historical practice was to consider the contract date to be the service commencement date, and to begin revenue recognition as of the beginning of the month in which the contract date falls. We have corrected recognition of revenue to prorate revenue on a daily basis starting on the date at which access is provided, which is generally later than the contract date.  Additionally, we have concluded that installation fees charged for initial set-up of our product and training should be recognized ratably over the expected life of the customer relationship, which is estimated to be nine years, rather than over the initial contract period, generally one year, as had been our historical practice.  The effect of correcting these two errors was to reduce previously reported revenue and increase previously reported deferred revenue by $1.0 million and $3.4 million for the three and nine months ended September 30, 2012, respectively.

 

The Company previously recorded sales commissions earned by account managers by recognizing them immediately in the period earned. In order to more appropriately match expenses with the related revenue and to be consistent with how the Company recognizes commissions for its sales staff, the

 

6

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Table of Contents

 

Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

Company has changed the method of recognizing commission expense for account management personnel, by amortizing commissions over the related contract period, generally twelve months. The effect of correcting this error decreases commissions by $172 thousand and $420 thousand for the three and nine months ended September 30, 2012, respectively. In addition, the Company historically netted deferred commissions against accrued expense. They are now presented as a separate line item on the condensed consolidated balance sheet as “Deferred Commissions”.

 

The Company has historically not collected state sales tax on the sale of its subscription service. The Company has determined that it should have collected sales tax in certain states and may also have exposure in several other states, accordingly, the Company has recorded a provision of $117.5 thousand and $352.5 thousand in general and administrative costs and accrued expense for the three and nine months ended September 30, 2012, respectively. The resulting cumulative provision as of September 30, 2013 related to the uncollected sales tax is $1.3 million. We intend to start collecting and remitting sales tax in certain states in 2014.

 

In addition, we made corrections to accrued liabilities to record expenses in the proper periods, corrected the recording of the capital contribution for the waiver of the preferred stock dividends and made other adjustments and presentation corrections discovered in connection with the restatement.

 

The changes in the Company’s income before provision for income taxes resulting from the adjustments discussed in the above paragraphs also impacted the provision for income taxes throughout each of the periods subject to restatement.  In addition, we made corrections to our provision for income taxes for each of the periods subject to the restatement to correct for errors in the calculation of our NOL limitation under Section 382 of the Internal Revenue Code, state tax apportionment factors, uncertain tax positions and other tax matters.  Accordingly, throughout each of the periods subject to restatement, we have restated our income tax provision and related deferred tax assets and liabilities.

 

The basic earnings per share calculation has been corrected as the weighted average shares outstanding used to compute basic earnings per share has historically excluded the convertible preferred stock outstanding.  The preferred stockholders are entitled to participate on an “as converted” basis in any dividend on the Company’s common stock, and as such are considered participating securities to which earnings should be allocated.  The preferred stock should have been considered in the calculation of earnings per share using the two-class method in periods in which the Company had net income.

 

Additionally, we have corrected the accounting for an equipment and software lease that was entered into in the first quarter of 2013 but initially recorded in the fourth quarter of 2012, and an internal use software license arrangement entered into in the third quarter of 2011.

 

The following is a reconciliation of the previously reported condensed consolidated statements of income and statement of cash flow amounts to the restated amounts.

 

7

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Table of Contents

 

Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

**Condensed Consolidated Statement of Income**

(in thousands, except per share amounts)

**Three Months Ended September 30, 2012**

 
| ** **                                                   | ** ** | **As**         | ** ** | ** **      | ** ** | ** **   | ** ** |
|--------------------------------------------------------------|------------|----------------|------------|-----------------|------------|--------------|------------|
| ** **                                                   | ** ** | **Previously** | ** ** | ** **      | ** ** | **As**       | ** ** |
| ** **                                                   | ** ** | **Reported**   | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|                                                         |       |           |       |            |       |         |       |
| Revenues                                                     |       | $              | 11,830     |            | $          | (999         | )          | $ | 10,831 |   |
| Cost of revenues (excluding depreciation and   amortization) |       | 2,648          |       | (172            | )          | 2,476        |       |
| **Gross profit**                                             |       | 9,182          |       | (827            | )          | 8,355        |       |
|                                                         |       |           |       |            |       |         |       |
| **Operating expenses:**                                      |       |           |       |            |       |         |       |
| Selling and marketing                                        |       | 2,276          |       | 48              |       | 2,324        |       |
| General and administrative                                   |       | 2,045          |       | 117             |       | 2,162        |       |
| Research and development                                     |       | 576            |       | —          |       | 576          |       |
| Depreciation and amortization                                |       | 337            |       | (3              | )          | 334          |       |
| **Total operating expenses**                                 |       | 5,234          |       | 162             |       | 5,396        |       |
| **Operating income**                                         |       | 3,948          |       | (989            | )          | 2,959        |       |
|                                                         |       |           |       |            |       |         |       |
| **Other income, net:**                                       |       |           |       |            |       |         |       |
| Interest income, net                                         |       | 26             |       | (4              | )          | 22           |       |
| Foreign exchange transaction gain                            |       | 39             |       | —          |       | 39           |       |
| **Total other income, net**                                  |       | 65             |       | (4              | )          | 61           |       |
|                                                         |       |           |       |            |       |         |       |
| **Income before (benefit) for   income taxes**               |       | 4,013          |       | (993            | )          | 3,020        |       |
| Income tax benefit                                           |       | 1,110          |       | (5,172          | )          | (4,062       | )          |
| **Net income**                                               |       | $              | 2,903      |            | $          | 4,179        |       | $ | 7,082 |   |
|                                                         |       |           |       |            |       |         |       |
| Accrued preferred stock dividends                            |       | (89            | )          | —          |       | (89          | )          |
| **Net income attributable to common   stockholders**         | ** ** | **$**          | **2,814**  | ** **      | **$**      | **4,179**    | ** ** | **$** | **6,993** | ** ** |
|                                                         |       |           |       |            |       |         |       |
| Net income per share:                                        |       |           |       |            |       |         |       |
| Basic                                                        |       | $              | 0.03       |            | $          | 0.03         |       | $ | 0.06 |   |
| Diluted                                                      |       | $              | 0.02       |            | $          | 0.04         |       | $ | 0.06 |   |
| Weighted average shares outstanding:                         |       |           |       |            |       |         |       |
| Basic                                                        |       | 82,068         |       | 32,667          |       | 114,735      |       |
| Diluted                                                      |       | 119,977        |       | (4              | )          | 119,973      |       |

 

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Table of Contents

 

Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

**Condensed Consolidated Statement of Income**

(in thousands, except per share amounts)

**Nine Months Ended September 30, 2012**

 
| ** **                                                   | ** ** | **As**         | ** ** | ** **      | ** ** | ** **   | ** ** |
|--------------------------------------------------------------|------------|----------------|------------|-----------------|------------|--------------|------------|
| ** **                                                   | ** ** | **Previously** | ** ** | ** **      | ** ** | **As**       | ** ** |
| ** **                                                   | ** ** | **Reported**   | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|                                                         |       |           |       |            |       |         |       |
| Revenues                                                     |       | $              | 30,163     |            | $          | (3,386       | )          | $ | 26,777 |   |
| Cost of revenues (excluding depreciation and   amortization) |       | 7,241          |       | (420            | )          | 6,821        |       |
| **Gross profit**                                             |       | 22,922         |       | (2,966          | )          | 19,956       |       |
|                                                         |       |           |       |            |       |         |       |
| **Operating expenses:**                                      |       |           |       |            |       |         |       |
| Selling and marketing                                        |       | 6,294          |       | 24              |       | 6,318        |       |
| General and administrative                                   |       | 6,161          |       | 402             |       | 6,563        |       |
| Research and development                                     |       | 1,630          |       | —          |       | 1,630        |       |
| Depreciation and amortization                                |       | 833            |       | (11             | )          | 822          |       |
| **Total operating expenses**                                 |       | 14,918         |       | 415             |       | 15,333       |       |
| **Operating income**                                         |       | 8,004          |       | (3,381          | )          | 4,623        |       |
|                                                         |       |           |       |            |       |         |       |
| **Other income, net:**                                       |       |           |       |            |       |         |       |
| Interest income, net                                         |       | 127            |       | (16             | )          | 111          |       |
| Foreign exchange transaction gain                            |       | 24             |       | —          |       | 24           |       |
| **Total other income, net**                                  |       | 151            |       | (16             | )          | 135          |       |
|                                                         |       |           |       |            |       |         |       |
| **Income before (benefit) for   income taxes**               |       | 8,155          |       | (3,397          | )          | 4,758        |       |
| Income tax (benefit) expense                                 |       | 1,894          |       | (5,534          | )          | (3,640       | )          |
| **Net income**                                               |       | $              | 6,261      |            | $          | 2,137        |       | $ | 8,398 |   |
|                                                         |       |           |       |            |       |         |       |
| Accrued preferred stock dividends                            |       | (270           | )          | —          |       | (270         | )          |
| **Net income attributable to common   stockholders**         | ** ** | **$**          | **5,991**  | ** **      | **$**      | **2,137**    | ** ** | **$** | **8,128** | ** ** |
|                                                         |       |           |       |            |       |         |       |
| Net income per share:                                        |       |           |       |            |       |         |       |
| Basic                                                        |       | $              | 0.07       |            | $          | 0.00         |       | $ | 0.07 |   |
| Diluted                                                      |       | $              | 0.05       |            | $          | 0.02         |       | $ | 0.07 |   |
| Weighted average shares outstanding:                         |       |           |       |            |       |         |       |
| Basic                                                        |       | 81,918         |       | 32,667          |       | 114,585      |       |
| Diluted                                                      |       | 119,590        |       | 656             |       | 120,246      |       |

 

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Table of Contents

 

Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

**Condensed Consolidated Statement of Cash Flows**

(in thousands)

**Nine Months Ended September 30, 2012**

 
| ** **                                                                                 | ** ** | **As Previously** | ** ** | ** **      | ** ** | **As**       | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                                 | ** ** | **Reported**           | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
| ** **                                                                                 | ** ** | ** **             | ** ** | ** **      | ** ** | ** **   | ** ** |
| **Cash flows from operating   activities:**                                                |       |                   |       |            |       |         |       |
| Net income                                                                                 |       | 6,261                  |       | 2,137           |       | 8,398        |       |
| **Adjustments to reconcile net   income to net cash provided by operating activities:**    |       |                   |       |            |       |         |       |
| Deferred taxes                                                                             |       | (293                   | )          | (4,513          | )          | (4,806       | )          |
| Depreciation and amortization                                                              |       | 833                    |       | (11             | )          | 822          |       |
| Share-based compensation                                                                   |       | 1,030                  |       | —          |       | 1,030        |       |
| Allowance for doubtful accounts                                                            |       | —                 |       | 50              |       | 50           |       |
| **Changes in operating assets and   liabilities:**                                         |       |                   |       |            |       |         |       |
| Accounts receivable                                                                        |       | (858                   | )          | 619             |       | (239         | )          |
| Deferred commissions                                                                       |       | —                 |       | (122            | )          | (122         | )          |
| Prepaid expenses and other assets                                                          |       | (122                   | )          | 30              |       | (92          | )          |
| Security deposits                                                                          |       | (136                   | )          | —          |       | (136         | )          |
| Accounts payable and accrued expenses                                                      |       | 103                    |       | 80              |       | 183          |       |
| Income taxes payable                                                                       |       | 2,019                  |       | (1,055          | )          | 964          |       |
| Deferred revenue                                                                           |       | 5,934                  |       | 2,769           |       | 8,703        |       |
| Other                                                                                      |       | 74                     |       | 16              |       | 90           |       |
| **Net cash provided by operating   activities**                                            |       | 14,845                 |       | —          |       | 14,845       |       |
| **Cash flows from investing   activities:**                                                |       |                   |       |            |       |         |       |
| Purchases of property and equipment                                                        |       | (1,153                 | )          | —          |       | (1,153       | )          |
| **Net cash used in investing   activities**                                                |       | (1,153                 | )          | —          |       | (1,153       | )          |
| **Cash flows from financing   activities:**                                                |       |                   |       |            |       |         |       |
| Repayment of note receivable from shareholder                                              |       | 3,072                  |       | —          |       | 3,072        |       |
| Payment of preferred stock dividend                                                        |       | (120                   | )          | —          |       | (120         | )          |
| Proceeds from exercise of stock options and purchase   of shares under stock purchase plan |       | 134                    |       | —          |       | 134          |       |
| Repayments of obligations under capital leases                                             |       | (162                   | )          | —          |       | (162         | )          |
| Payments of obligations under software licensing   agreements                              |       | (109                   | )          | —          |       | (109         | )          |
| **Net cash used in financing   activities**                                                |       | 2,815                  |       | —          |       | 2,815        |       |
| Effect of exchange rates on cash and cash   equivalents                                    |       | 59                     |       | —          |       | 59           |       |
| **Net increase in cash and cash   equivalents**                                            |       | 16,566                 |       | —          |       | 16,566       |       |
| **Cash and cash equivalents at   beginning of period**                                     |       | 8,931                  |       | —          |       | 8,931        |       |
| **Cash and cash equivalents at end   of period**                                           |       | 25,497                 |       | —          |       | 25,497       |       |
|                                                                                       |       |                   |       |            |       |         |       |
| **Supplemental disclosure of cash   flow information:**                                    |       |                   |       |            |       |         |       |
| Cash paid during the period for :                                                          |       |                   |       |            |       |         |       |
| Interest                                                                                   |       | $                      | 15         |            | $          | —       |       | $ | 15 |   |
| Income taxes                                                                               |       | $                      | 142        |            | $          | —       |       | $ | 142 |   |
| **Supplemental disclosure of   noncash investing and financing activities:**               |       |                   |       |            |       |         |       |
| Tender of common stock in lieu of interest payment   on note receivable from shareholder   |       | $                      | 200        |            | $          | —       |       | $ | 200 |   |
| Property and equipment acquired under capital   lease agreements                           |       | $                      | 1,024      |            | $          | —       |       | $ | 1,024 |   |
| Capital contributions in lieu of preferred stock   dividend                                |       | —                 |       | $               | 240        |         | $          | 240 |   |

 

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Table of Contents

 

Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

**3)****                                    ****Investigations and restatement**

 

***Special Committee***

 

In December 2012, the Board of Directors of the Company appointed a Special Committee of independent directors to examine certain of Diligent’s past stock issuances and stock option grants that may not have been issued in compliance with the relevant stock option and incentive plans. The Special Committee’s members were not on the Board at the time of the issuance of such grants, were not involved in their issue, and are not the recipients of any option grants. The Special Committee was delegated broad powers from the Board to take all such action in respect of the issuances as it deemed necessary and advisable.

 

The Special Committee, assisted by attorneys in the U.S. and New Zealand, conducted a thorough review and analysis of all stock issuances and stock option grants during the relevant period.  As discussed in Notes 8 and 10, the Special Committee found that three option awards exceeded the applicable plan caps on the number of shares covered by an award issued to a single recipient in a particular year. The Special Committee was delegated the authority to develop appropriate alternative compensation packages for the affected employees.  These awards were determined by the Board to be reasonable compensation at the time, and were an important incentive component of the employees’ compensation packages.

 

As part of its work, the Special Committee also reviewed the Company’s compliance with applicable regulations, including U.S. and New Zealand securities regulations and the NZSX Listing Rules. The Special Committee identified a number of instances where it appears that Diligent was not, or may not have been, in compliance with its U.S. and New Zealand regulatory obligations.

 

The Special Committee determined that these instances of non-compliance were inadvertent and attributable in part to the constrained resources of Diligent in a period of financial difficulty in the years following its listing on NZSX, and the complex regulatory and compliance obligations across multiple jurisdictions with differing regulations and requirements. It has recommended, and the Board fully endorsed, that the Company work with its regulators to resolve these issues. In September 2013 the NZ Markets Disciplinary Tribunal approved a settlement reached by the Company and the New Zealand Stock Exchange regarding the previously disclosed breaches of the NZSX Listing Rules by the Company. The settlement provided for the payment of fines and costs by the Company, consisting of NZ $15 thousand as a penalty to the NZX Discipline Fund and NZ $4 thousand towards the costs of NZXR.

 

Costs for the Special Committee for the nine months ended September 30, 2013 were $2.3 million. An additional $0.3 million incurred in the fourth quarter of 2012.  Included in Special Committee expenses are professional fees incurred for legal, accounting and compensation consultants, NZX penalties and compensation paid to Special Committee members. During the second quarter of 2013, the Special Committee was disbanded and the Company is in the process of implementing the recommendations of the Special Committee to remediate the compliance and internal control weaknesses identified.

 

***Audit Committee Investigation***

 

On July 2, 2013 the Audit Committee of the Board of Directors engaged outside company counsel to investigate the accounting errors that gave rise to the need to restate the Company’s financial statements, as well as other historical accounting practices impacting the timing of recognition of revenue. In connection with the investigation, it was determined that the Company included in its financial results certain customer agreements that, while having an effective date within a quarter, had not been signed by all parties within the quarter, as would be required to commence revenue recognition under US GAAP. The early inclusion of such contracts did not have a material impact on previously reported revenue for fiscal quarters including the first quarter of 2010 through the first quarter of 2013. The Audit Committee

 

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Table of Contents

 

Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

investigation resulted in no finding of intentional misconduct or fraud.  Costs of the investigation for the three and nine months ended September 30, 2013 were $0.2 million with additional costs to be incurred in the fourth quarter of 2013 and consisted of legal fees.

 

***Restatement and Re-audit Engagements***

 

In August, 2013, the Company announced that its historical financial statements for the years ended December 31, 2012, 2011 and 2010 and the quarter ended March 31, 2013 would be restated due to revenue recognition errors. The Company completed the restatement process in April of 2014. Costs for the restatement and re-audits incurred during the three and nine months ended September 30, 2013 were $0.8 million, with additional costs to be incurred in the fourth quarter of 2013 and the first quarter of 2014.  These costs are comprised of professional fees incurred for accounting, auditing and consulting services and restatement bonuses.

 

**4)****                                    ****Significant accounting policies**

 

**Basis of presentation****—**The accompanying interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information pursuant to the rules and regulations of the SEC.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to SEC rules. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the 10-K Amendment.

 

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial statements.  The results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of the results to be expected for the full year.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions made by management include the deferral and recognition of revenue, the fair value of share-based compensation, accounting for income taxes, including the realization of deferred tax assets and uncertain tax positions, and the useful lives of tangible and intangible assets. Actual results could differ from those estimates.

 

**Principles of consolidation** — The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All significant intercompany balances and transactions have been eliminated.

 

**Cash and cash equivalents** — The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.  The Company invests its excess cash primarily in bank and money market funds of major financial institutions.  Accordingly, its cash equivalents are subject to minimal credit and market risk.

 

**Short-term investments** — Short-term investments consist of U.S. treasury bills with original maturities of more than three years at the time of purchase and term deposits which are short-term investments with banks, with maturities greater than three months at inception.

 

**Fair value of financial instruments** — The fair value of the Company’s accounts receivable, accounts payable and accrued expenses and other liabilities approximates book value due to their short term settlements.

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

**Revenue recognition** — The Company derives its revenues primarily from subscription fees and installation fees, including training. The Company sells subscriptions to its cloud-based application that are generally one year in length. Its arrangements do not include a general right of return and automatically renew unless the Company is notified 30 days prior to the expiration of the initial term. The Company’s subscription agreements do not provide the customer the right to take possession of the software that supports the application. Installation fees consist of the configuration of the Company’s service and training of its customers.

 

Revenue recognition commences when all of the following conditions are met:

 

·  There is persuasive evidence of the arrangement;

 

·  The service has been made available to the customer;

 

·  The fee is fixed or determinable; and

 

·  The collectability of the fees is reasonably assured.

 

In October 2009, the Financial Accounting Standards Board, or FASB, ratified authoritative accounting guidance regarding revenue recognition for arrangements with multiple deliverables effective for fiscal periods beginning on or after June 15, 2010. The guidance affects the determination of separate units of accounting in arrangements with multiple deliverables. To qualify as a separate unit of accounting, the delivered item must have value to the customer on a standalone basis. The Company has determined that the installation fee does not have standalone value, so accordingly, it accounts for its arrangements as a single unit of accounting.

 

Revenue from the Company’s subscription service is recognized on a daily basis over the subscription term as the services are delivered. The service is considered delivered, and hence revenue recognition commences, when the customer has access to the Diligent Boardbooks product. Revenue is recorded ratably through the end of the contract period, which is generally twelve months from the contract date.

 

Installation fees paid by customers in connection with the subscription service are deferred and are recognized ratably over the expected life of the customer relationships, generally nine years. In estimating the expected customer relationship period, the Company looked to guidance on the determination of the useful life of an intangible asset for the appropriate factors to be considered in estimating expected customer life and specifically focused on its customer renewal rate. The Company’s customer contracts contain a standard “autorenew” feature which provides for one-year renewals unless either party provides written notice of termination. In addition, the Company’s renewal history with its customers has been and remains at very high rates. As a result, the Company believes that its customers will renew numerous times during their tenure with the Company and consequently have a very low annual attrition rate. After considering these factors, the Company determined that a nine year estimated customer life was appropriate.

 

**Deferred Revenue****—**Deferred revenue represents installation and subscription fees for which cash has been received but for which the Company has not yet delivered its services or the criteria for the recognition of revenue have not yet been met.  Deferred revenues presented in the consolidated balance sheet do not include amounts receivable (both billed and unbilled) for executed subscription agreements for which the Company has not yet received payment.  Accordingly, the deferred revenue balance does not represent the total contract value of annual, non-cancelable subscription agreements.

 

Long term deferred revenue consists of installation fees that will be recognized over the estimated life of the customer relationship, generally nine years.  Installation fees expected to be recognized within the next 12 months of the balance sheet date are included in the current portion of deferred revenue.

 

**Accounts receivable** — The Company generally invoices its customers on an annual or quarterly basis.  Accounts receivable represents amounts due from our customers for which revenue has been recognized.    A provision for doubtful accounts is recorded based on management’s assessment of amounts considered uncollectable for specific customers based on age of the receivable, history of payments and other relevant 

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

information.  At each of September 30, 2013 and December 31, 2012, the Company has recorded a provision for doubtful accounts of $100 thousand.

 

**Research and development****—** Research and development expenses are incurred as the Company upgrades and maintains the Diligent Boardbooks software, and develops product enhancements.  Such expenses include compensation and employee benefits of engineering and testing personnel, materials, travel and direct costs associated with the design and required testing of the product line.  The Company does not allocate indirect overhead to research and development. Direct development costs related to software enhancements that add functionality have been expensed as incurred as the Company has not historically maintained sufficiently detailed records of its development efforts to be able to capitalize such costs.

 

**Share-based compensation****— -** The Company measures the cost of employee services received in exchange for an equity-based award using the fair value of the award on the date of the grant, and recognizes the cost over the period that the award recipient is required to provide services to the Company in exchange for the award. The fair value of restricted stock units are estimated using the market price of the Company’s common stock at the date of the grant and we recognize compensation expense for the portion of the award that is expected to vest.

 

The Company measures compensation cost for awards granted to non-employees based on the fair value of the award at the measurement date, which is the date performance is satisfied or services are rendered by the non-employee.

 

**Earnings per share** - Basic earnings per share is computed by dividing the net income attributable to common stockholders, after deducting accrued preferred stock dividends, by the weighted average number of common and preferred shares outstanding for the period. The preferred stockholders are entitled to participate on an “as converted” basis in any dividends paid on the Company’s common stock, and as such are considered participating securities to which earnings should be allocated using the two-class method.

 

Diluted earnings per share reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised, settled or converted into common stock, unless the effect is anti-dilutive. Stock options and employee share awards are included as potential dilutive securities for the applicable periods, except that 360 thousand stock options have been excluded for the three and nine months ended September 30, 2013, respectively because their effect is antidilutive.

 

The computation of shares used in calculating basic and diluted earnings per common share are as follows:

 
| ** **                                            | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                            | ** ** | **2013**                                                 | ** ** | **2012**                                                | ** ** | **2013** | ** ** | **2012** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                                  | ** ** |
| Basic weighted average common shares outstanding      |       | 83,776                                                   |       | 82,068                                                  |       | 83,755 |   | 81,918 |   |
| Basic weighted average preferred shares   outstanding |       | 32,667                                                   |       | 32,667                                                  |       | 32,667 |   | 32,667 |   |
| Basic weighted average shares outstanding             |       | 116,443                                                  |       | 114,735                                                 |       | 116,422 |   | 114,585 |   |
| Dilutive effect of stock options                      |       | 5,218                                                    |       | 5,238                                                   |       | 5,404 |   | 5,661 |   |
| Dilutive effect of restricted stock units             |       | 83                                                       |       | —                                                  |       | 37 |   | — |   |
| Dilutive weighted average shares outstanding          |       | 121,744                                                  |       | 119,973                                                 |       | 121,863 |   | 120,246 |   |

 

**Recent accounting pronouncements** — In February 2013, the FASB issued ASU 2013-02, “Comprehensive Income”, which requires disclosure of significant amounts reclassified out of accumulated other comprehensive income by component and their corresponding effect on the respective line items of net income. This guidance was effective for the Company as of January 1, 2013 and did not have a material impact on the Company’s consolidated financial statements.

 

From time to time, new accounting pronouncements are issued by the FASB and are adopted by the Company as of the specified effective date. Unless otherwise discussed, the impact of other recently

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

issued accounting pronouncements are not expected to have a material impact on the consolidated financial position, results of operations, and cash flows, or do not apply to the Company’s operations.

 

**5)****                                ****Obligations Under Capital Leases**

 

During the first quarter of 2013 the Company entered into two capital leases for computer equipment which mature in February 2016.  The leases have a total obligation of $1.3 million and bear interest rates of 5.449% and 3.804%, with monthly payments of $28 thousand and $14 thousand, respectively.

 

**6)****                                   ****Fair Value of Financial Instruments**

 

The fair value of a financial instrument is the amount at which the instrument could be exchanged in an orderly transaction between market participants. As of September 30, 2013 and December 31, 2012, the carrying amounts of cash and cash equivalents, accounts receivables, accounts payable and accrued expenses and other liabilities approximated fair value due to the short-term nature of these instruments. ASC 820, Fair Value Measurements and Disclosures, establishes a fair value hierarchy for input into valuation techniques as follows:

 

i.                                          Level 1 input - unadjusted quoted prices in active markets for identical instrument; 

 

ii.                                       Level 2 input - observable market data for the same or similar instrument but not Level 1, including quoted prices for identical or similar assets or liabilities in markets that are active or 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; and 

 

iii.                                    Level 3 input - unobservable inputs developed using management’s assumptions about the inputs used for pricing the asset or liability.

 

Level 2 inputs were utilized to determine the fair value of the Company’s investments in U.S. treasury bills, U.S treasury money market funds, and term deposits.  Due to the short-term nature of these investments, which mature between 90 days and 365 days, amortized cost is used to estimate the fair value.

 

At September 30, 2013, cash equivalents include investments in U.S. treasury bill of $6 million and U.S. treasury money markets of $18 million, which are carried at cost, which approximates fair value. The fair value of money market funds was determined by reference to quoted market prices.   At September 30, 2013, short-term investments include investments in U.S. treasury bills of $11 million, which are carried at cost which approximates fair value.

 

At December 31, 2012, cash equivalents include investments in U.S. treasury bills of $11 million and U.S. treasury money market funds of $13 million.  At December 31, 2012, the Company had a term deposit, included in short-term investments, with a New Zealand bank with an initial term of 365 days. The term deposit in the amount of NZ$125 thousand (US$103 thousand) bore interest at 4.4% and matured March 15, 2013.

 

**7)****                                    ****Redeemable Preferred Stock**

 

On March 11, 2009, the Company issued 30 million shares of Series A Preferred Stock at $0.10 per share in a private offering, for aggregate gross proceeds of $3.0 million.  Expenses relating to the preferred stock issuance were $139 thousand.

 

The carrying value of the Preferred Stock at September 30, 2013 and December 31, 2012 is as follows:

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 
| ** **                                        | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **2013**                | ** ** | **2012**              | ** ** |
| ** **                                        | ** ** | **(in thousands)** | ** ** |
| Gross proceeds                                    |       | $                       | 3,000      |                  | $          | 3,000 |   |
| Less: Issuance costs                              |       | (139                    | )          | (139                  | )          |
|                                              |       | 2,861                   |       | 2,861                 |       |
| Dividends paid by issuance of paid-in-kind shares |       | 267                     |       | 267                   |       |
| Cumulative amortization of issuance costs         |       | 126                     |       | 105                   |       |
| Carrying value                                    |       | $                       | 3,254      |                  | $          | 3,233 |   |

 

The Preferred Stock carries a fixed, cumulative, dividend of 11% per annum (adjusted for stock splits, consolidation, etc).  The dividend, which is due on the first business day of each calendar year for the prior year, may (at the Company’s option) be paid either in cash or in kind by the issuance of additional Preferred Stock (paid-in-kind Shares), to be issued at the same issue price as the Series A Preferred Stock of $0.10 per share.  The 11% annual dividend on the Preferred Stock will have preference over the declaration or payment of any dividends on the Company’s common stock.  In addition to the 11% preferred dividend, the holders of the Preferred Stock will also be entitled to participate pro rata in any dividend paid on the Company’s common stock.

 

In 2013, the Company anticipates that accumulated unpaid dividends will be paid in cash on the Series A Preferred Stock.  Accordingly, preferred stock dividends of $270 thousand for the nine months ended September 30, 2013 are included in accrued expenses.

 

Spring Street Partners, L.P., a holder of the Series A Preferred Stock, waived its right to the preferred stock dividend payable on January 3, 2013 of $240 thousand.  This was recorded as a capital contribution in 2013 when waived. The founder and managing partner of Spring Street Partners, L.P. is also the Chairman of the Board of Directors of the Company and the holder of 4.2 million shares of common stock of the Company.

 

Spring Street Partners, L.P., waived its right to the preferred stock dividend payable on January 4, 2012 of $240 thousand.  This was recorded as a capital contribution in 2012 when waived.

 

**8)****                                    ****Stock option and incentive plan**

 

As discussed in Note 3, in December of 2012 the Company’s Board of Directors authorized a Special Committee of independent directors to conduct a review of certain of the Company’s past stock issuances and stock option grants to determine whether they were in accordance with the relevant incentive plans.  The Special Committee found that three option awards exceeded the applicable plan caps on the number of shares covered by an award issued to a single recipient in a particular year. Specifically, a 2009 award to the chief executive officer exceeded the cap in the 2007 Plan by 1.6 million shares, a 2011 award to the chief executive officer exceeded the cap in the 2010 Plan by 2.5 million shares, and a 2011 award to another employee exceeded the cap in the 2010 Plan by 250 thousand shares.

 

In May 2013, the Company and the Company’s CEO entered into a Replacement Grant Agreement providing for the cancellation of certain stock options and the issuance of a replacement award, which was to become effective upon the occurrence of certain future events.

 

On May 3, 2013, the Board of Directors adopted the Diligent Board Member Services, Inc. 2013 Incentive Plan (the “Plan”), which was approved by the Company’s stockholders in June 2013.  An aggregate of 8.5 million shares of the Company’s common stock may be issued pursuant to the Plan to employees, directors and consultants of the Company and its affiliates. Of the shares available under the Plan, 4.1 million will be utilized in connection with the replacement incentive awards issued in accordance with the CEO Substitute Remuneration Package (see Note 11, Subsequent events).  Upon approval of the

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

2013 Plan the Company discontinued the use of the Company’s 2007 Stock Option and Incentive Plan and the 2010 Stock Option and Incentive Plan.

 

Awards under the Plan may be made in the form of stock options (which may constitute incentive stock options or nonqualified stock options), share appreciation rights, restricted shares, restricted share units, performance awards, bonus shares and other awards.  In addition, certain awards under the Plan may be denominated or settled in cash, including performance awards.

 

The Board and the Company’s stockholders have approved a remuneration package for non-executive directors for the 2013 and subsequent fiscal years (the “New Remuneration Package”). The New Remuneration Package consists of both a cash component, designed to compensate members for their service on the Board and its Committees, and an equity component. The total value of the New Remuneration Package for standard board service is $130 thousand per annum, $50 thousand of which will be payable in cash.

 

The Company’s non-executive directors, other than the chairman of the Board, will receive a stock grant for 2013 service with a total value of $80 thousand, which will be paid to such non-executive directors in equal installments at the end of each quarter of the calendar year. As of September 30, 2013 no shares have been issued to the non-executive directors as their issuance has been deferred until the earlier of the date on which the Company files a Registration Statement on Form S-8 with the Securities and Exchange Commission and March 15, 2014. On March 14, 2014, the Company issued 86.5 thousand restricted shares to its directors based on the volume weighted average trading price of the Company’s common stock on its primary trading market for the 20 trading days immediately prior to such date. The grant for 2013 service was pro-rated for any director who served on the Board for less than the full calendar year.

 

On June 12, 2013, the Company entered into an agreement with respect to the options for 250 thousand shares issued to the other employee in excess of the applicable plan cap, providing for the cancellation of the 250 thousand options, the extension of the vesting schedule for the remaining nonvested options over a four and a half year period, and the issuance of 150 thousand Restricted Stock Units, with graded vesting over four and a half years.  The modification of this award resulted in additional expense of $66 thousand, which will be recognized on a graded basis through December 2017.

 

The information below includes the stock options subject to cancellation because they are outstanding at September 30, 2013 (see Note 11, Subsequent events).

 

A summary of stock option activity for the quarter ended September 30, 2013 is as follows:

 
| ** **                             | ** ** | **Options**             | ** ** | **Weighted   average   exercise price** | ** ** | **Weighted average   remaining   contractual term** | ** ** |
|----------------------------------------|------------|-------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                             | ** ** | **(in thousands)** | ** ** | ** **                                   | ** ** | ** **                                                    | ** ** |
| Outstanding at January 1, 2013    |       | 8,318                   |       | $                                            | 0.85       |                                                          | 7.82 years |   |
| Granted                                |       | 360                     |       | 6.20                                         |       |                                                          |       |
| Exercised                              |       | (190                    | )          | 0.39                                         |       |                                                          |       |
| Cancelled                              |       | (250                    | )          | 0.46                                         |       |                                                          |       |
| Forfeited                              |       | —                  |       |                                         |       |                                                          |       |
| Outstanding at September 30, 2013 |       | 8,238                   |       | 1.10                                         |       | 7.19 years                                                    |       |
| Exercisable at September 30, 2013 |       | 3,753                   |       | 0.23                                         |       | 6.05 years                                                    |       |
|                                        |            |                         |            |                                              |            |                                                               |            |  |

 

**Restricted Stock Units** — As noted above, in June 2013, the Company agreed to issue 150,000 Restricted Stock Units (“RSUs”) as replacement compensation for the 250,000 stock options issued to an

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

employee of the Company in excess of the 2010 Plan cap.  In June 2013, the shareholders of the Company approved the 2013 Plan, under which the Company had agreed to issue 164,000 RSUs to two officers, which vest 25% per year over the next four years, as long as the officers remain in the employ of the Company on each vesting date.  The fair market value of the stock on the date of grant of the RSUs was $5.38 per share.  A summary of RSU activity is as follows:

 
| ** **                        | ** ** | **Restricted Stock Units   (in thousands)** | ** ** | **Weighted Average Grant Date   Fair Value Per Share** | ** ** |
|-----------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| Nonvested January 1, 2013    |       | —                                                     |       | —                                                                               |       |
| Granted                           |       | 314                                                        |       | $                                                                                    | 5.38       |   |
| Vested                            |       | —                                                     |       | —                                                                               |       |
| Forfeited                         |       | —                                                     |       | —                                                                               |       |
| Nonvested September 30, 2013 |       | 314                                                        |       | $                                                                                    | 5.38       |   |

 

The Company estimates the fair value of the RSUs as of the grant date utilizing the closing price of our common stock on that date.

 

For the three and nine months ended September 30, 2013 the Company recognized aggregate share-based compensation expense related to stock option and RSUs of $556 thousand and $1.2 million, respectively. Total share-based compensation expense recognized for the three and nine months ended September 30, 2012 was $433 thousand and $1.0 million, respectively. At September 30, 2013 there was $3.8 million of unrecognized share-based compensation expense which includes $3 million for stock options and $816 thousand for RSUs that will be recognized over the next 4.25 years.  Such amount does not include any impact of the CEO Substitute Remuneration Package.

 

**9)****                                    ****Income taxes**

 

Income tax expense is provided on an interim basis based upon management’s estimate of the annual effective tax rate.  The income tax provision for both the three and nine months ended September 30, 2013 provides income taxes at an effective rate of 38%.  The Company recorded a net income tax benefit for the three and nine months ended September 30, 2012, resulting in effective tax rates of (135)% and (77)%, respectively.  Due to a history of tax losses, resulting in a cumulative loss position, the Company had recorded a full valuation allowance against all of its U.S. net deferred tax assets at December 31, 2011.  In the third quarter of 2012, management determined that the Company was no longer in a cumulative loss position and it was more likely than not that the Company’s net deferred tax assets would be realized through future taxable income.  Accordingly the Company released the valuation allowance previously provided.  This resulted in a deferred tax benefit for the quarter and nine months ended September 30, 2012 which exceeded the current tax provision, resulting in a net tax benefit.

 

Section 382 of the U.S. Internal Revenue Code generally imposes an annual limitation on the amount of net operating loss carryforwards that can be used to offset taxable income when a corporation has undergone significant changes in stock ownership.  During the second quarter of 2012, the Company completed its Section 382 study and determined that, due to changes in stock ownership in prior years, certain of its net operating loss carryforwards would be limited.  This limitation resulted in $5.3 million of net operating loss carryforwards being available to offset taxable income in 2012. Beginning in 2013, the Company’s annual net operating loss carryforward is subject to a limitation of approximately $350 thousand to offset expected taxable income until expiration of the carryforwards.  Based on this limitation, the Company expects that approximately $4.9 million of its total net operating loss will expire unutilized in 2029.  A full valuation allowance had previously been provided on the related deferred tax asset, and therefore the deferred tax asset and valuation allowance relating to the net operating loss carryforwards expected to expire unutilized were written off during 2012.

 

The Company and its subsidiaries are subject to regular audits by federal, state and foreign tax authorities.  These audits may result in additional tax liabilities.  The Company’s U.S. federal and state income tax returns for the tax years 2010 and forward are open for examination by the taxing jurisdictions. The Company’s foreign income tax returns are open for examination by the local taxing jurisdictions for the following years: New Zealand — 2009 and forward; U.K. — 2010 and forward; Australia — 2012.

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

**10)****                             ****Contingencies**

 

**Sales tax risk -**States and some local taxing jurisdictions have differing rules and regulations governing sales and use taxes, and these rules and regulations are subject to varying interpretations that may change over time. In particular, the applicability of sales taxes to our subscription services in various jurisdictions is unclear. The Company has recorded a provision related to uncollected sales tax of $183 thousand and $549 thousand in general and administrative costs and accrued expense for the three and nine months ended September 30, 2013, respectively.  The resulting cumulative provisions as of September 30, 2013, related to uncollected sales tax is $1.3 million. It is possible that we could face sales tax audits and that our liability for these taxes could exceed our estimates as state tax authorities could still assert that we are obligated to collect additional amounts as taxes from our customers and remit those taxes to those authorities. We could also be subject to audits with respect to states and international jurisdictions for which we have not accrued tax liabilities. A successful assertion that we should be collecting additional sales or other taxes on our services in jurisdictions where we have not historically done so and do not accrue for sales taxes could result in substantial tax liabilities for past sales, discourage customers from purchasing our application or otherwise harm our business and operating results.

 

**11)****                             ****Subsequent events**

 

*CEO Substitute Remuneration Package.*

 

On December 23, 2013, the Company and the Company’s chief executive officer entered into an Amendment to Replacement Grant Agreement which finalized the terms of the incentive compensation package provided to the Company’s CEO in substitution for certain awards that would be cancelled, as described in Note 8.

 

Under the terms of the Amendment to Replacement Grant Agreement, on December 23, 2013 (the “Grant Date”) the CEO’s fully vested option to purchase 2.4 million shares of the Company’s common stock for an exercise price of US$0.14 per share was cancelled to the extent it was in excess of the applicable plan cap, consisting of 1.6 million of such shares.  In exchange for the cancellation of the relevant portion of the award, the CEO received:

 

·                  An option to purchase 1.6 million shares of common stock having an exercise price of US$2.79, which was the Company’s closing price per share expressed in U.S. dollars on the last trading day on the NZSX immediately prior to the Grant Date (the “Exercise Price”) of December 23, 2013.  The option vested on December 31, 2013, and will have a term of ten years from the Grant Date.

 

·                  A performance cash award of US$4.2 million, determined based on 1.6 million multiplied by the excess of the Exercise Price of US$2.79 over US$0.14.   The CEO’s right to receive such cash award is contingent on the Company achieving revenue growth of at least 7% during the twelve month period ended June 30, 2014 and his continued employment through such date.  Any cash award, once earned, will be paid in three equal annual installments in 2014, 2015 and 2016, or, if earlier, upon a change in control of the Company or the CEO’s separation from service.  Any payment due on any installment date will be proportionally reduced if the sum of the Company’s stock price plus dividends for a measurement period prior to each payment date falls below 75% of the Exercise Price.

 

In addition, the CEO held an option to purchase 3 million shares of the Company’s common stock for an exercise price of US$0.82 per share, which remains subject to vesting.  Under the terms of the Amendment to Replacement Grant Agreement, the Company cancelled the portion of such option in excess of the applicable plan cap, consisting of 2.5 million of such shares. In exchange for the cancellation of the relevant portion of the award, the CEO received:

 

·                  Performance share units for 2.25 million shares of common stock contingent on the Company achieving revenue growth of at least 7% during the twelve month period ended June 30, 2014.  For purposes of clarification, performance share units in this context are units of common stock issued

 

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

to the CEO upon satisfaction of the performance criteria outlined herein.  Once earned, the award will vest in four equal installments based on continued employment, commencing June 30, 2015, with full vesting occurring on June 30, 2018.  The delivery dates for the vested performance shares will be 50% in 2018 and 50% in 2019 or, if earlier, on a change in control of the Company or the CEO’s separation from service.

 

·                  Performance share units for up to 250 thousand shares of common stock contingent on the Company achieving either at least 15% fully diluted EPS growth (adjusted to exclude stock-based compensation expense and extraordinary items) or 15% total stockholder return (“TSR”) growth in four one-year measurement periods beginning April 1, 2013.  TSR growth will be measured based on the Company’s stock price performance during the 20 trading days prior to the relevant measurement date.  Performance share units for 62.5 thousand shares of common stock will be earned in each year for which the applicable target is met, with the additional opportunity to earn such shares at the end of the four year performance period if the cumulative fully diluted EPS growth or TSR growth meet the cumulative performance target.  The delivery dates for the vested performance shares will be in 2018 or, if earlier, upon a change in control of the Company or the CEO’s separation from service.

 

The vesting of the options, performance cash award and performance stock units described above will be subject to certain acceleration provisions in the event of a change in control of the Company, upon death or disability or if the CEO is terminated without cause or resigns for good reason.

 

The Company expects to record compensation expense of $2.9 million in the second half of 2013 relating to the replacement award of which $1.0 million was recognized in the third quarter.  The replacement award is expected to result in compensation cost of $3.1 million in 2014, $0.7 million in 2015, $0.4 million in 2016, $0.2 million in 2017 and $0.1 million in 2018.

 

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**Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations**

 

*The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the “Explanatory Note” at the beginning of this report and our condensed consolidated financial statements and related notes that appear elsewhere in this Quarterly Report on Form 10-Q. This discussion contains a number of forward-looking statements, all of which are based on our current expectations and all of which could be affected by uncertainties and risks. Our actual results may differ materially from the results contemplated in these forward-looking statements as a result of many factors including, but not limited to, those described under “Risk Factors” in Part I, Item 1A of the 10-K Amendment.*

 

**Restatement**

 

The following management’s discussion and analysis reflects the restatement of our condensed consolidated statements of income and comprehensive income for the three and nine months ended September 30, 2012 and our statement of cash flows for the nine months ended September 30, 2012 as described in Part I, Item 1 of this Form 10-Q.

 

We have made the following corrections to our historical financial statements in connection with the restatement:

 

·                  We have concluded that revenue recognition of our subscription fees for our Diligent Boardbooks service should not commence until the date the service is made available to the customer, as determined by the date the customer has full access to the product.  Our historical practice was to consider the contract date to be the service commencement date, and to begin revenue recognition as of the beginning of the month in which the contract date falls. We have corrected recognition of revenue to prorate revenue on a daily basis starting on the date at which access is provided, which is generally later than the contract date.  Additionally, we have concluded that installation fees charged for initial set-up of our product and training should be recognized ratably over the expected life of the customer relationship, which is estimated to be nine years, rather than over the initial contract period, generally one year, as had been our historical practice.  The effect of correcting these two errors was to reduce previously reported revenue and increase previously reported deferred revenue by $1.0 million and $3.4 million for the three and nine months ended September 30, 2012, respectively.

 

·                  The Company previously recorded sales commissions earned by account managers by recognizing them immediately in the period earned. In order to more appropriately match expenses with the related revenue and to be consistent with how the Company recognizes commissions for its sales staff, the Company has changed the method of  recognizing commission expense for account management personnel, by amortizing  commissions over the related contract period, generally twelve months. The effect of correcting this error decreases commissions by $172.4 thousand and $419.8 thousand for the three and nine months ended September 30, 2012, respectively. In addition, the Company historically netted deferred commissions against accrued expense. They are now presented as a separate line item on the condensed consolidated balance sheet as “Deferred Commissions”.

 

·                  The Company has historically not collected state sales tax on the sale of its subscription service. The Company has determined that it should have collected sales tax in certain states and may also have exposure in several other states, accordingly, the Company has recorded a provision of $117.5 thousand and $352.5 thousand in general and administrative costs and accrued expenses for the three and nine months ended September 30, 2012, respectively. The resulting cumulative provision as of September 30, 2013 related to the uncollected sales tax is $1.3 million. We intend to start collecting and remitting sales tax in certain states in 2014.

 

·                  In addition, we made corrections to accrued liabilities to record expenses in the proper periods, corrected the recording of the capital contribution for the waiver of the preferred stock dividends and made other adjustments and presentation corrections discovered in connection with the restatement.

 

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·                  The changes in the Company’s income before provision for income taxes resulting from the adjustments discussed in the above paragraphs also impacted the provision for income taxes throughout each of the periods subject to restatement.  In addition, we made corrections to our provision for income taxes for each of the periods subject to the restatement to correct for errors in the calculation of our NOL limitation under Section 382 of the Internal Revenue Code, state tax apportionment factors, uncertain tax positions and other tax matters. Accordingly, throughout each of the periods subject to restatement, we have restated our provision for income tax and related deferred tax assets and liabilities.

 

·                  The basic earnings per share calculation has been corrected as the weighted average shares outstanding used to compute basic earnings per share has historically excluded the convertible preferred stock outstanding.  The preferred stockholders are entitled to participate on an “as converted” basis in any dividend on the Company’s common stock, and as such are considered participating securities to which earnings should be allocated.  The preferred stock should have been considered in the calculation of earnings per share in all periods in which the Company had net income.

 

·                  Additionally, we have corrected the accounting for an equipment and software lease that was entered into in the first quarter of 2013 but initially recorded in the fourth quarter of 2012, and an internal use software license arrangement entered into in the third quarter of 2011.

 

In general, the restatement had the effect of shifting revenue and profits from the periods covered by this Quarterly Report on Form 10-Q to future periods. The restatement does not call into question the existence of our total previously reported revenue but does change the time period over which such previously reported amounts will be recognized as revenue.

 

The following discussion and analysis of our financial condition and results of operations incorporates the restated amounts.  See Note 2, “Restatement of condensed consolidated financial statements” of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 for a detailed discussion of the effect of the restatement.

 

**Overview**

 

The Company develops and makes available an online software application called Diligent Boardbooks®, a web-based portal that board members, management and administrative staff use to compile, update, review and archive board materials before, during and after board meetings. The Company provides clients with subscription-based access to its software and also provides associated services including securely hosting the client’s data, and customer service and support for the application.

 

Our goal is to help companies streamline the creation and delivery of board materials through an easy-to-use and secure online software platform. Key elements of our strategy include:

 

·                  Strengthening the existing product and offering new functionality,

·                  Further building our existing client base through geographic expansion and new client acquisition,

·                  Deepening relationships with existing client base, and

·                  Minimizing client cancellations by offering superior customer service and support.

 

The Company uses the Software-as-a-Service (“SaaS”) model to distribute its Diligent Boardbooks application to the market and maintain the security and integrity of its clients’ data. Under this model, the Company offers annual renewable subscriptions for client access to its Diligent Boardbooks product which is hosted on the Company’s secure servers, and offers a complete suite of related services including training, support, data migration and data security/backup.

 

The SaaS model allows the Company to differentiate itself through technological innovation and client service while the subscription billing approach results in a predictable and recurring revenue stream. This SaaS model 

 

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also allows clients to retain control over access to the application while outsourcing to the Company the support activities, such as managing the IT infrastructure and maintaining the software.

 

The Company’s SaaS model addresses several difficulties found in the traditional software model and offers the following critical advantages for our company:

 

·**                 ****Highly scalable operations.**Because our clients’ boards do not ordinarily meet on a daily or monthly basis, our system has the capability to support many more Boards without absorbing increased costs associated with customer growth.

 

·**                 ****Better revenue visibility.**By offering renewable annual subscriptions instead of one-time perpetual licenses, the Company has much better revenue foresight. This high revenue visibility allows the Company to undertake much better planning and budgeting, with significant advantages for corporate strategy and profitability.

 

·**                 ****Lower cost of development.**The Company has developed an application that is cost-effectively shared across thousands of end users. This is considerably less expensive than developing all the permutations (databases, operating systems, etc.) needed by clients who want to run the software on their own premises.  These economies allow the Company to spend resources on developing increased functionalities for its Diligent Boardbooks application instead of on creating multiple versions of the same code.

 

·**                 ****Longer corporate life.**The SaaS model has a long tail of recurring revenue that reduces investment risk, simplifies corporate planning and leads to extended corporate life.

 

·**                 ****Optimal expense planning.**Because of the recurring nature of the SaaS model our revenue is more predictable and that allows the Company to better plan expenses.

 

We began developing components of the Diligent Boardbooks system starting in 1998, culminating in the roll-out of an international sales force in 2007.

 

On December 12, 2007 we completed an offshore offering of 24,000,000 shares of our common stock in conjunction with a listing of our stock on the New Zealand Stock Exchange under the symbol “DIL.”  As a result, the Company is subject to the regulation and reporting requirements imposed by the New Zealand Stock Exchange.  While our common stock trades on a periodic basis on the over-the counter bulletin board (“OTCBB”), there is no established public trading market for our common stock in the United States.  However, because the Company is a U.S. company incorporated in Delaware with over 500 shareholders, it is also treated as a public company in the U.S. subject to the reporting and regulatory requirements of the SEC and the Securities Exchange Act of 1934.  We are subject to the Listing Rules of the New Zealand Stock Exchange, New Zealand securities and financial reporting laws and United States securities laws and regulations applicable to a U.S. public company not listed on a U.S. national securities exchange.  Our need to comply with both New Zealand and U.S. regulatory regimes increases the focus we must place on compliance as well as the cost of compliance.

 

**Critical Accounting Policies and Estimates**

 

The 10-K Amendment contains an updated description of our critical accounting policies after giving effect to our revenue recognition review and restatement of the 2012 financial statements.  There have been no material changes to our critical accounting policies as described in the 10-K Amendment.

 

**Revenue Recognition -**The Company derives its revenues primarily from subscription fees and installation fees, including training. The Company sells subscriptions to its cloud-based application that are generally one year in length. Its arrangements do not include a general right of return and automatically renew unless the Company is notified 30 days prior to the expiration of the subscription term. The Company’s subscription agreements do not provide the customer the right to take possession of the software that supports the application. Installation fees consist of the configuration of the Company’s service and training of its customers.

 

Revenue recognition commences when all of the following conditions are met:

 

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·              There is persuasive evidence of the arrangement;

·              The service has been made available to the customer;

·              The fee is fixed or determinable; and

·              The collectability of the fees is reasonably assured.

 

In October 2009, the Financial Accounting Standards Board, or FASB, ratified authoritative accounting guidance regarding revenue recognition for arrangements with multiple deliverables effective for fiscal periods beginning on or after June 15, 2010. The guidance affects the determination of separate units of accounting in arrangements with multiple deliverables. To qualify as a separate unit of accounting, the delivered item must have value to the customer on a standalone basis. The Company has determined that the installation fee does not have standalone value, so accordingly it accounts for its arrangements as a single unit of accounting.

 

Revenue from our subscription service is recognized on a daily basis over the subscription term as the services are delivered. The service is considered delivered, and hence revenue recognition commences, when the customer has access to the Diligent Boardbooks product. Revenue is recorded ratably through the end of the subscription term, which is generally twelve months from the date of the contract.

 

Installation fees paid by customers in connection with the subscription service are deferred and are recognized ratably over the expected life of the customer relationships, generally nine years. In estimating the expected customer relationship period, the Company looked to guidance on the determination of the useful life of an intangible asset for the appropriate factors to be considered in estimating expected customer life and specifically focused on its customer renewal rate. The Company’s customer contracts contain a standard “autorenew” feature which provides for one-year renewals unless either party provides written notice of termination. In addition, the Company’s renewal history with its customers has been and remains at very high rates. As a result, the Company believes that its customers will renew numerous times during their tenure with the Company and consequently have a very low annual attrition rate. After considering these factors, the Company determined that a nine year estimated customer life was appropriate.

 

**Deferred Revenue****—**Deferred revenue represents installation and subscription fees for which cash has been received but for which the Company has not yet delivered its services or the criteria for the recognition of revenue have not yet been met.  Deferred revenues presented in the consolidated balance sheet do not include amounts receivable (both billed and unbilled) for executed subscription agreements for which the Company has not yet received payment.  Accordingly, the deferred revenue balance does not represent the total contract value of annual, non-cancelable subscription agreements.

 

Long term deferred revenue consists of installation fees that will be recognized over the estimated life of the customer relationship, generally nine years.  Installation fees expected to be recognized within the next 12 months of the balance sheet date are included in the current portion of deferred revenue.

 

The Company also discloses gross deferred revenue which consists of deferred revenue and  installation and subscription fees which have been billed to the customer pursuant to an executed subscription agreement, but for which payment has not yet been received and the criteria for the recognition of revenue has not yet been met.  As a result of our subscription-based model and historically high renewal rates, at the end of any period, we generally have subscription contracts in place for a high percentage of our total revenues for the next 12 months and therefore we believe it is useful to the users of our condensed consolidated financial statements to disclose gross deferred revenues.

 

**Accounts receivable** — The Company generally invoices its customers on an annual or quarterly basis.  Accounts receivable represents amounts due from our customers for which revenue has been recognized.  A provision for doubtful accounts is recorded based on management’s assessment of amounts considered uncollectable for specific customers based on age of the receivable, history of payments and other relevant information.  At each of September 30, 2013 and December 31, 2012, the Company has recorded a provision for doubtful accounts of $100 thousand.  The Company also discloses gross accounts receivable which consists of billings to customers for installation and subscription fees.

 

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The reconciliation of gross accounts receivable and deferred revenue to net accounts receivable and deferred revenue at September 30, 2013, is as follows:

 
| ** **                              | ** ** | **Gross**               | ** ** | **Adjustment (1)** | ** ** | **Net** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-------------------------|------------|---------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Accounts receivable, net                |       | $                       | 17,770     |                    | $          | (15,545 | )          | $ | 2,225 |   |
|                                    |       |                    |       |                    |       |    |       |
| Deferred revenue - current              |       | $                       | 38,732     |                    | $          | (15,545 | )          | $ | 23,187 |   |
| Deferred revenue - less current portion |       | $                       | 9,719      |                    | $          | —  |       | $ | 9,719 |   |
| Total deferred revenue                  |       | $                       | 48,451     |                    | $          | (15,545 | )          | $ | 32,906 |   |

 

The reconciliation of gross accounts receivable and deferred revenue to net accounts receivable and deferred revenue at December 31, 2012, is as follows:

 
| ** **                              | ** ** | **Gross**               | ** ** | **Adjustment (1)** | ** ** | **Net** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-------------------------|------------|---------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Accounts receivable, net                |       | $                       | 12,299     |                    | $          | (10,757 | )          | $ | 1,542 |   |
|                                    |       |                    |       |                    |       |    |       |
| Deferred revenue - current              |       | $                       | 27,729     |                    | $          | (10,757 | )          | $ | 16,972 |   |
| Deferred revenue - less current portion |       | $                       | 6,964      |                    | $          | —  |       | $ | 6,964 |   |
| Total deferred revenue                  |       | $                       | 34,693     |                    | $          | (10,757 | )          | $ | 23,936 |   |

 

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(1) Represents installation and subscription fees which have been billed to customers but for which payment has not been received and the criteria for revenue recognition has not been met.

 

**Cost of Revenues and Operating Expenses**

 

*Cost of Revenues (exclusive of depreciation and amortization).* Cost of revenues consists of direct expenses related to account management, customer support and IT services. We do not allocate depreciation, amortization or indirect overhead to cost of revenues.

 

*Selling and Marketing.* Selling and marketing expenses are comprised of sales commissions, salaries for sales and marketing employees, and direct advertising expenses, including mailings and travel. We do not allocate indirect overhead to selling and marketing.

 

*General and Administrative.* General and administrative expenses consist of compensation and related expenses for executive, finance, accounting, administrative and legal, personnel, professional fees, other corporate expenses and costs such as office space and utilities.

 

*Research and Development.* Research and development expenses are incurred as we upgrade and maintain our software, and develop product enhancements. Such expenses include compensation and employee benefits of engineering and testing personnel, materials, travel and direct costs associated with the design and required testing of our product line. We do not allocate indirect overhead to research and development. Direct development costs related to software enhancements that add functionality are permitted to be capitalized and amortized over their useful lives, however we have not historically maintained sufficient detail records of our development efforts to be able to capitalize such costs.

 

*Investigations and Restatement.*The Company’s Board of Directors authorized and empowered a Special Committee of independent directors to conduct a review of the Company’s past stock issuances and stock option grants to determine if they were in accordance with the relevant incentive plans. Included in investigations and restatement are the expenses relating to the Special Committee investigation, including professional fees incurred for legal, accounting and compensation consultants and compensation to be paid to Special Committee members. Investigation and restatement costs also include the costs of our Audit Committee’s investigation of the accounting errors that gave rise to the need to restate the Company’s financial statements and the costs related to the restatement of our financial statements and re-audits of the years ended December 31, 2012, 2011 and 2010, which are comprised of legal, accounting and consulting fees.

 

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*Share-Based Compensation.*  Share-based compensation consists of stock, stock options and other share-based compensation awards issued to employees and contractors for services rendered. The Company measures the cost of employee services received in exchange for an equity-based award using the fair value of the award on the date of the grant, and recognizes the cost over the period that the award recipient is required to provide services to the Company in exchange for the award.  The fair value of restricted stock units are estimated using the market price of the Company’s common stock at the date of the grant and we recognize compensation expense for the portion of the award that is expected to vest.

 

The Company measures compensation cost for awards granted to non-employees based on the fair value of the award at the measurement date, which is the date performance is satisfied or services are rendered by the non-employee.

 

**Results of Operations for the Three Months Ended September 30, 2013 and 2012**

 
| ** ** | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** ** | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| Revenues   |       | $                                                        | 17,235     |                | $          | 10,831         |       | $ | 6,404 |   | 59 | % |
|            |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

The growth in total revenues of 59% for the third quarter of 2013 when compared with the third quarter of 2012 is primarily the result of the increase in new subscription agreements, as well as our client retention rate of 97% for the trailing twelve months ended September 30, 2013. The Company has continued to add subscription agreements each quarter since inception.  At September 30, 2013, the total number of client agreements (net of cancellations) was 2,305, compared with 1,808 at December 31, 2012, and 1,615 at September 30, 2012.  A net of 122 new subscription agreements were added during the third quarter of 2013, compared with 168 added in the third quarter of 2012.  The growth rate in new sales decreased in North America and Asia/Pacific and increased in EMEA (Europe, Middle East and Africa), with North America accounting for 64% of the dollar value of new subscriptions added in the third quarter, EMEA (Europe, Middle East and Africa) accounting for 21% and the remaining 15% from Asia/Pacific. Additionally, upgrades from existing customers, which represents the increase during the period in the value of existing agreements, decreased 17% over the third quarter of 2012, based on the dollar value added to existing annual contracts.

 

The Company recognizes subscription revenue ratably over the contract period, which is generally twelve months.  Accordingly, the full impact of the growth in subscription agreements will be recognized over the next twelve months.

 

**Cost of Revenues and Operating Expenses**

 
| ** **                                                    | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                                                    | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| Cost of Revenues    (excluding depreciation and amortization) |       | $                                                        | 3,244      |                | $          | 2,476          |       | $ | 768 |   | 31 | % |
| *% of Revenues*                                               | * *   | *19*                                                     | *%*        | *23*                | *%*        |           |       |   |   |
|                                                               |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

Cost of revenues is comprised of account management, customer support and information technology services.  The increase in costs of revenues is predominantly due to the increase in headcount to service the Company’s larger client base. Worldwide, employee salaries and incentive pay increased by $0.6 million, consisting of $0.2 million in account management, $0.1 million in customer support and $0.2 million in IT services.   Hosting costs increased by $0.2 million due to the increase in capacity of our existing centers.

 

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Cost of revenues increased at a lower rate than revenues, resulting in an increase in the gross profit margin to 81% for the third quarter of 2013, compared with 77% for the third quarter of 2012.

 
| ** **            | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|-----------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **            | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| Selling and Marketing |       | $                                                        | 2,473      |                | $          | 2,324          |       | $ | 149 |   | 6 | % |
| *% of Revenues*       | * *   | *14*                                                     | *%*        | *21*                | *%*        |           |       |   |   |
|                       |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

Selling and marketing expenses consist of $1.5 million of selling expense and $1.0 million of marketing expense. The net increase is comprised of a decrease in selling expenses of $0.5 million, offset by an increase in marketing expenses of $0.6 million.  The decrease in selling expense is primarily a result of a decrease in U.S. sales commissions, as our new sales in the U.S. have declined.

 

The increase in marketing expenses of $0.6 million consists of $0.4 million in the U.S. and $0.1 million in the U.K. and $0.1 million in Australia.  The Company has significantly increased its marketing initiatives in both the U.S. and the U.K.  The Company expects to further increase its marketing expense during the remainder of 2013.

 
| ** **                 | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|----------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                 | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| General and Administrative |       | $                                                        | 5,371      |                | $          | 2,162          |       | $ | 3,209 |   | 148 | % |
| *% of Revenues*            | * *   | *31*                                                     | *%*        | *20*                | *%*        |           |       |   |   |
|                            |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

The increase in general and administrative expenses of $3.2 million is comprised of an increase of $3.2 million in the U.S., a decrease of $0.1 million in the U.K. and an increase of $0.1 million in New Zealand.  The U.S. increase consists of $1.7 million relating to salaries for the Company’s executive officers and employees.  Within this increase is the accrual for the CEO’s performance cash award of $1.0 million (see Notes 3, 8 and 10).  Other increases include $0.4 million in professional fees resulting from increased compliance costs as a result of remediation measures taken to correct certain inadvertent regulatory non-compliance discussed further in Part I, Item 4 of this Quarterly Report on Form 10-Q; MIS (management information systems) expenses of $0.1 million; Directors fees and expenses of $0.1 million, due to the expansion of the Board of Directors; Occupancy and related costs of $0.3 million; Recruiting fees of $0.1 million and ERP (Enterprise Resource Planning) implementation costs of $0.4 million.

 

We anticipate that general and administrative expenses will increase going forward due to the implementation of remedial measures to improve our internal controls and compliance with applicable regulatory requirements, as discussed in Part I, Item 4 of this Quarterly Report on Form 10-Q, and as a result of the modification of the incentive compensation package for the Company’s CEO, as discussed further in Notes 3, 8 and 10 of the condensed consolidated financial statements.

 

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| ** **               | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|--------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **               | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| Research and Development |       | $                                                        | 1,209      |                | $          | 576            |       | $ | 633 |   | 110 | % |
| *% of Revenues*          | * *   | *7*                                                      | *%*        | *5*                 | *%*        |           |       |   |   |
|                          |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

The increase in research and development expenses is primarily due to increased staffing.  In the third quarter of 2013, the Company had an additional seven people in research and development, the majority being added to the New Zealand team for product upgrades and enhancements. The Company maintains a small research and development department at its New York headquarters, which also had an increase in headcount.  Worldwide, labor costs in the third quarter of 2013 were $0.4 million higher than the third quarter of 2012.  The remaining increase of $0.2 million is as a result of employing outside consultants.

 

The Company expects to increase its investment in research and development over the remainder of 2013.

 
| ** **                    | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|-------------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                    | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                    | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| Depreciation and Amortization |       | $                                                        | 515        |                | $          | 334            |       | $ | 181 |   | 54 | % |
| *% of Revenues*               | * *   | *3*                                                      | *%*        | *3*                 | *%*        |           |       |   |   |
|                               |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

The increase in depreciation and amortization is attributable to the net increase in property and equipment, consisting principally of computer equipment and computer software.

 
| ** **                     | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                     | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                     | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| Investigations and restatement |       | $                                                        | 939        |                | $          | —         |       | $ | 939 |   | N/A |   |
| *% of Revenues*                | * *   | *5*                                                      | *%*        |                |       |           |       |   |   |
|                                |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

The Company incurred cost of $757 thousand related to the restatement and re-audits of it’s historical financial statements for the years ended December 31, 2012, 2011 and 2010 and $182 thousand related to the Audit Committee Investigation (see Note 3 to the condensed consolidated financial statements for a description of these activities).

 
| ** **                     | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                     | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                     | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** | ** **     | ** ** |
| Interest Income (Expense), net |       | $                                                        | (24        | )                   | $          | 22             |       | $ | (46 | ) | -209 | % |
| *% of Revenues*                | * *   | *-0.1*                                                   | *%*        | *0.2*               | *%*        |           |       |   |   |
|                                |            |                                                          |            |                     |            |                |            |  |  |  |  |  |

 

Interest income, net, includes interest on the Company’s cash and cash equivalents and short-term investments which are interest-bearing, offset by interest expense on capital lease obligations.  In 2012, it also includes interest income on a note receivable from our predecessor entity and shareholder, which was repaid in August of 2012. The decrease in net interest income (expense) is attributable to the decrease in interest income due to the repayment of the note in 2012.  This decrease more than exceeded the increase in interest earned on the 

 

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Company’s cash held in interest-bearing securities. Additionally, interest expense on the Company’s capital lease obligations increased as a result of the addition of new leases in 2013.

 
| ** **                   | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** |
|------------------------------|------------|----------------------------------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** |
| ** **                   | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** |
| Foreign Exchange (Loss) Gain |       | $                                                        | 32         |                | $          | 39 |   | $ | (7 | ) |
| *% of Revenues*              | * *   | *0.2*                                                    | *%*        | *0.4*               | *%*        |   |   |
|                              |            |                                                          |            |                     |            |  |  |  |  |  |

 

The Company’s U.S. and foreign operations have transactions with clients and suppliers denominated in currencies other than their functional currencies, and the U.S. parent company has transactions with its foreign subsidiaries in the subsidiaries’ functional currencies which create foreign currency intercompany receivables and payables.  Additionally, the U.S. parent company maintains a portion of its cash balances in foreign currencies, primarily the Canadian dollar (CAD), the New Zealand dollar (NZ$), the British Pound (GBP) and the Australian dollar (AUD).  Foreign exchange transaction gains and losses arise on the settlement of foreign currency transactions at amounts different from the recorded amounts, and the measurement of the unrealized foreign currency gains and losses in the related assets and liabilities at the end of the period.   The net gain or loss is an accumulation of the effects of the foregoing transactions.  The gain in the third quarter of 2013 is due to weakening of the U.S. dollar against the GBP which caused gains on the settlement of intercompany receivables and on cash held in GBP.

 
| ** **         | ** ** | **Three months ended September 30,** | ** ** | **Increase /** | ** ** |
|--------------------|------------|----------------------------------------------------------|------------|---------------------|------------|
| ** **         | ** ** | **2013**                                                 | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** |
| ** **         | ** ** | **(in thousands)**                                  | ** ** | ** **          | ** ** |
| Income Tax Expense |       | $                                                        | 1,339      |                | $          | (4,062 | ) | $ | 5,401 |   |
| Effective Tax Rate | * *   | *38*                                                     | *%*        | *-135.0*            | *%*        |   |   |
|                    |            |                                                          |            |                     |            |  |  |  |  |  |

 

Income tax expense increased significantly when compared to the comparable 2012 quarter, as the Company has become profitable and is now subject to tax in multiple jurisdictions.  The overall effective tax rate of 38% for the third quarter of 2013 is lower than the combined U.S. statutory rate for federal, state and local taxes due to lower tax rates in foreign jurisdictions. The income tax benefit of $4.1 million recorded in the third quarter of 2012 is a result of the release of the valuation allowance against the Company’s U.S. net deferred tax assets of $4.9 million in the third quarter of 2012, offset by current tax expense of $0.8 million.  Due to a history of tax losses, resulting in a cumulative loss position, the Company had recorded a full valuation allowance against all of its U.S. net deferred tax assets at June 30, 2012.  In the third quarter of 2012, management determined that the Company was no longer in a cumulative loss position and it was more likely than not that the Company’s net deferred tax assets would be realized through future taxable income.  Accordingly, the Company released the valuation allowance previously provided.  This resulted in a deferred tax benefit which exceeded the current tax provision, resulting in a net tax benefit for the quarter ended September 30, 2012.

 

**Results of Operations for the Nine Months Ended September 30, 2013 and 2012**

 
| ** ** | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** ** | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| Revenues   |       | $                                                       | 46,573     |                | $          | 26,777         |       | $ | 19,796 |   | 74 | % |
|            |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

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The growth in total revenues of 74% for the nine months of 2013 when compared with the nine months of 2012 is primarily the result of the increase in new subscription agreements, as well as our client retention rate of 97% for the trailing twelve months ended September 30, 2013. The Company has continued to add subscription agreements each quarter since inception.  At September 30, 2013, the total number of client agreements (net of cancellations) was 2,305, compared with 1,808 at December 31, 2012, and 1,615 at September 30, 2012.  A net of 497 new subscription agreements were added through the third quarter of 2013, compared with 589 added through the third quarter of 2012.  The growth rate in new sales decreased in North America and Asia/Pacific and increased in EMEA (Europe, Middle East and Africa), with North America accounting for 67% of the dollar value of new subscriptions added through the third quarter, EMEA (Europe, Middle East and Africa) accounting for 20% and the remaining 13% from Asia/Pacific. Additionally, upgrades from existing customers, which represents the increase during the period in the value of existing agreements, increased 14% over the third quarter of 2012, based on the dollar value added to existing annual contracts.

 

The Company recognizes subscription revenue ratably over the contract period, which is generally twelve months.  Accordingly, the full impact of the growth in subscription agreements will be recognized over the next twelve months.

 

**Cost of Revenues and Operating Expenses**

 
| ** **                                                    | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                                                    | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| Cost of Revenues    (excluding depreciation and amortization) |       | $                                                       | 9,017      |                | $          | 6,821          |       | $ | 2,196 |   | 32 | % |
| *% of Revenues*                                               | * *   | *19*                                                    | *%*        | *25*                | *%*        |           |       |   |   |
|                                                               |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

Cost of revenues is comprised of account management, customer support and information technology services.  The increase in costs of revenues is predominantly due to the increase in headcount to service the Company’s larger client base. Worldwide, employee salaries and incentive pay increased by $1.9 million, consisting of $1.0 million in account management, $0.3 million in customer support and $0.6 million in IT services.   Hosting costs increased by $0.5 million due to the opening of an additional hosting center and the increase in capacity at our existing centers.  These increases were offset by a decrease due to the transfer of MIS related costs to general and administrative expenses of $0.3 million. Included within these increases are higher costs in the U.K. of $0.2 million and Australia of $0.1 million, as a result of the increase in European account management, customer support and information technology services staff and the commencement of operations in Australia in 2012 and continued growth in 2013.

 

Cost of revenues increased at a lower rate than revenues, resulting in an increase in the gross profit margin to 81% in the nine months of 2013, compared with 75% in the nine months of 2012.

 
| ** **            | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **            | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| Selling and Marketing |       | $                                                       | 7,089      |                | $          | 6,318          |       | $ | 771 |   | 12 | % |
| *% of Revenues*       | * *   | *15*                                                    | *%*        | *24*                | *%*        |           |       |   |   |
|                       |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

Selling and marketing expenses consist of $4.6 million of selling expense and $2.5 million of marketing expense. The net increase is comprised of a decrease in selling expenses of $0.8 million, offset by an increase in marketing expenses of $1.6 million.  The decrease in selling expense is primarily a result of a decrease in U.S. sales commissions, as our new sales in the U.S. have declined.

 

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The increase in marketing expenses of $1.6 million consists of $0.9 million in the U.S. and $0.6 million in the U.K. and $0.1 million in Australia. The Company has significantly increased its marketing initiatives in both the U.S. and the U.K.  The Company expects to further increase its marketing expense during the remainder of 2013.

 
| ** **                 | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|----------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                 | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| General and Administrative |       | $                                                       | 13,664     |                | $          | 6,563          |       | $ | 7,101 |   | 108 | % |
| *% of Revenues*            | * *   | *29*                                                    | *%*        | *25*                | *%*        |           |       |   |   |
|                            |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

The increase in general and administrative expenses of $7.1 million is comprised of increases of $6.5 million in the U.S., $0.3 million in the U.K., $0.2 million in New Zealand and $0.1 million in Australia.  The U.S. increase consists of $1.6 million relating to salaries for the Company’s executive officers and employees.  Within this increase is the accrual for the CEO’s performance cash award of $1.0 million (see Notes 3, 8 and 10).  Other increases include:  an increase of $2.2 million in professional fees resulting from increased compliance costs as a result of remediation measures taken to correct certain inadvertent regulatory non-compliance discussed further in Part I, Item 4 of this Quarterly Report on Form 10-Q. Other increases include: MIS expenses of $0.4 million; share-based compensation of $0.2 million; Directors fees and expenses of $0.4 million, due to the expansion of the Board of Directors; Occupancy and related costs of $0.5 million; Recruiting fees of $0.3 million and costs associated with ERP implementation of $0.9 million.

 

The increase in the U.K. is due to the expansion of the Company’s European operations, and consists principally of an increase in employee costs, including salaries and bonuses and additional support staff. The increase in Australia is due to the commencement of operations during 2012 and continued growth in 2013, and the New Zealand increase is a result of an increase in salaries, occupancy and recruiting expenses.

 

We anticipate that general and administrative expenses will increase going forward due to the implementation of remedial measures to improve our internal controls and compliance with applicable regulatory requirements as discussed in Part I, Item 4 of this Quarterly Report on Form 10-Q, and as a result of the modification of the incentive compensation package for the Company’s CEO, as discussed further in Notes 3, 8 and 11 of the condensed consolidated financial statements.

 

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| ** **               | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|--------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **               | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| Research and Development |       | $                                                       | 3,088      |                | $          | 1,630          |       | $ | 1,458 |   | 89 | % |
| *% of Revenues*          | * *   | *7*                                                     | *%*        | *6*                 | *%*        |           |       |   |   |
|                          |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

The increase in research and development expenses is primarily due to increased staffing.  During the nine months of 2013, the Company had an additional seven people in research and development, the majority being added to the New Zealand team for product upgrades and enhancements. The Company maintains a small research and development department at its New York headquarters, which also had an increase in headcount.  Worldwide, labor costs during the first nine months of 2013 were $1.0 million higher than the first nine months of 2012.    An increase of $0.3 million is as a result of employing outside consultants.  The remaining increase of $0.1 million is due to travel and recruiting.

 

The Company expects to increase its investment in research and development over the remainder of 2013.

 
| ** **                    | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                    | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                    | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| Depreciation and Amortization |       | $                                                       | 1,130      |                | $          | 822            |       | $ | 308 |   | 37 | % |
| *% of Revenues*               | * *   | *2*                                                     | *%*        | *3*                 | *%*        |           |       |   |   |
|                               |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

The increase in depreciation and amortization is attributable to the net increase in property and equipment, consisting principally of computer equipment and computer software.

 
| ** **                     | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|--------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                     | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                     | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| Investigations and restatement |       | $                                                       | 3,282      |                | $          | —         |       | $ | 3,282 |   | N/A |   |
| *% of Revenues*                | * *   | *7*                                                     | *%*        |                |       |           |       |   |   |
|                                |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

The Company’s Board of Directors authorized and empowered a Special Committee of independent directors to conduct a review of the Company’s past stock issuances and stock option grants to determine if they were in accordance with the relevant incentive plans. As a result of the review, the Special Committee identified a number of instances of inadvertent non-compliance with applicable regulations, and determined that certain executive’s options were inadvertently issued in excess of applicable plan caps.  The Company incurred expenses of $2.3 million related to the Special Committee in the first two quarters of 2013.  These expenses included professional fees incurred for legal, accounting and compensation consultants, NZSX penalties and compensation paid to Special Committee members.  During the second quarter of 2013, the Special Committee was disbanded and the Company is in the process of implementing the recommendations of the Special Committee to remediate the compliance and internal control weaknesses identified. Additionally, the Company incurred cost of $757 thousand in the third quarter related to the restatement and re-audits of our historical financial statements for the years ended December 31, 2012, 2011 and 2010 and $182 thousand related to the Audit Committee Investigation (see Note 3 of the condensed consolidated financial statements for a description of these activities).

 
| ** **                     | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** | ** **     | ** ** |
|--------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                     | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                     | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** | ** **     | ** ** |
| Interest Income (Expense), net |       | $                                                       | (58        | )                   | $          | 111            |       | $ | (169 | ) | -152 | % |
| *% of Revenues*                | * *   | *-0.1*                                                  | *%*        | *0.4*               | *%*        |           |       |   |   |
|                                |            |                                                         |            |                     |            |                |            |  |  |  |  |  |

 

Interest income, net, includes interest on the Company’s cash and cash equivalents and short-term investments which are interest-bearing, offset by interest expense on capital lease obligations.  In 2012, it also includes interest income on a note receivable from our predecessor entity and shareholder, which was repaid in August of 2012. The decrease in net interest income (expense) is attributable to the decrease in interest income due to the repayment of the note in 2012.  This decrease more than exceeded the increase in interest earned on the 

 

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Company’s cash held in interest-bearing securities. Additionally, interest expense on the Company’s capital lease obligations increased as a result of the addition of new leases in 2013.

 
| ** **                   | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** |
|------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** |
| ** **                   | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** |
| Foreign Exchange (Loss) Gain |       | $                                                       | (149       | )                   | $          | 24 |   | $ | (173 | ) |
| *% of Revenues*              | * *   | *-0.3*                                                  | *%*        | *0.1*               | *%*        |   |   |
|                              |            |                                                         |            |                     |            |  |  |  |  |  |

 

The Company’s U.S. and foreign operations have transactions with clients and suppliers denominated in currencies other than their functional currencies, and the U.S. parent company has transactions with its foreign subsidiaries in the subsidiaries’ functional currencies which create foreign currency intercompany receivables and payables.  Additionally, the U.S. parent company maintains a portion of its cash balances in foreign currencies, primarily the Canadian dollar (CAD), the New Zealand dollar (NZ$), the British Pound (GBP) and the Australian dollar (AUD).  Foreign exchange transaction gains and losses arise on the settlement of foreign currency transactions at amounts different from the recorded amounts, and the measurement of the unrealized foreign currency gains and losses in the related assets and liabilities at the end of the period.   The net gain or loss is an accumulation of the effects of the foregoing transactions.  The loss through the nine months of 2013 is due to strengthening of the U.S. dollar against the GBP which caused losses on the settlement of intercompany receivables and on cash held in GBP.

 
| ** **                   | ** ** | **Nine months ended September 30,** | ** ** | **Increase /** | ** ** |
|------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **2013**                                                | ** ** | **2012**            | ** ** | **(Decrease)** | ** ** |
| ** **                   | ** ** | **(in thousands)**                                 | ** ** | ** **          | ** ** |
| Income Tax (Benefit) Expense |       | $                                                       | 3,485      |                | $          | (3,640 | ) | $ | 7,125 |   |
| Effective Tax Rate           | * *   | *38.3*                                                  | *%*        | *-77.0*             | *%*        |   |   |
|                              |            |                                                         |            |                     |            |  |  |  |  |  |

 

The overall effective tax rate of 38% for the first three quarters of 2013 is lower than the combined U.S. statutory rate for federal, state and local taxes due to lower tax rates in foreign jurisdictions. The income tax benefit of $3.6 million recorded in the nine months of 2012 is a result of the release of the valuation allowance against the Company’s U.S. net deferred tax assets of $4.9 million, offset by current tax expense.  Due to a history of tax losses, resulting in a cumulative loss position, the Company had recorded a full valuation allowance against all of its U.S. net deferred tax assets at June 30, 2012.  In the third quarter of 2012, management determined that the Company was no longer in a cumulative loss position and it was more likely than not that the Company’s net deferred tax assets would be realized through future taxable income.  Accordingly, the Company released the valuation allowance previously provided.  This resulted in a deferred tax benefit which exceeded the current tax provision, resulting in a net tax benefit for the nine months ended September 30, 2012.

 

**Liquidity and Capital Resources**

 

At September 30, 2013, the Company’s sources of liquidity consist of cash and cash equivalents and short-term investments of approximately $47.4 million.

 

In the early stages of the Company’s history, its primary source of liquidity was the cash received from common and preferred stock issuances.  Through the third quarter of 2010, the Company’s cash flow from operations was negative and it relied on capital infusions to sustain and grow the business, and combined with cost containment activity.  By the third quarter of 2010, the Company began generating positive cash flows from operations and 2010 marked the first year since inception of the Company that Diligent generated positive cash flow from operations.  The Company has continued to generate positive cash flows each subsequent quarter.  Additionally, in August 2012, the Company received $3.1 million in cash from the repayment of the note receivable from its predecessor entity which

 

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was due October 1, 2012. The Company has no long-term debt, except for obligations under capital leases and software licensing agreements and, thus far, its financing costs have consisted principally of the annual dividend on the preferred stock and repayments of capital lease and software licensing obligations.

 

On April 15, 2013, the Company announced that the Board of Directors approved a term sheet for an incentive compensation package to be provided to the Company’s chief executive officer in substitution for certain awards that would be cancelled, subject to stockholder approval of the terms of the substitute incentive compensation package and a new incentive plan.  On May 3, 2013, in order to effectuate the substitute incentive compensation provided for in the term sheet, the chief executive officer and the Company entered into a definitive Replacement Grant Agreement and certain agreed upon ancillary award agreements related thereto.  In June 2013, the substitute remuneration package was approved by the Company’s stockholders and on December 23, 2013 the chief executive officer and the Company entered into an amendment to the Replacement Grant Agreement which fixed the terms of the incentive compensation package.  In addition to stock options and performance shares, the amended Replacement Grant Agreement includes a performance fixed cash award of $4.2 million, which is earned if the Company achieves a specified growth in revenue over the performance period from July 1, 2013 through June 30, 2014.  Once earned, the award is payable in three installments of $1.4 million each, with the first payment due in the third quarter of 2014 and the remaining two payments due March 30, 3015 and March 30, 2016.  The Company considers it likely that the performance target will be met.

 

In order to minimize credit and market risk, the Company has invested $35 million of its cash in short-term U.S. treasury instruments, through the direct purchase of treasury bills and through a U.S. treasury money market fund.  The remainder of our cash is held in various financial institutions by the parent company and its subsidiaries based on our projected cash needs. To minimize our foreign currency exposure, we maintain funds in foreign currency bank accounts, based on projected foreign currency expenditures.

 

**Cash flows**

 
| ** **                  | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------|------------|---------------------------------------------------------|------------|
| ** **                  | ** ** | **2013**                                                | ** ** | **2012** | ** ** |
| Cash provided by (used in): |       |                                                    |       |   |   |
| Operating activities        |       | $                                                       | 17,062     |   | $ | 14,845 |   |
| Investing activities        |       | $                                                       | (13,640    | ) | $ | (1,153 | ) |
| Financing activities        |       | $                                                       | (271       | ) | $ | 2,815 |   |

 

**Net Cash Flows from Operating Activities**

 

Cash provided by operating activities for the nine months ended September 30, 2013 increased compared with the nine months ended September 30, 2012, primarily due to an increase in the amount of cash provided by the growth in deferred revenue compared to the prior year and an increase in accounts payable and accrued expenses.

 

**Net Cash Flows from Investing Activities**

 

Cash used in investing activities in the first nine months of 2013 consists of purchases of computer equipment, software and leasehold improvements of $2.3 million, and net purchases of short-term investments of $10.9 million and a security deposit of $462 thousand.

 

**Net Cash Flows from Financing Activities**

 

During the first nine months of 2013, the Company recognized a $0.3 million excess tax benefit from the exercise of stock options, which is recorded directly to equity as additional paid-in-capital, and the receipt of $0.1 million in cash from the exercise of stock options.  This was offset by the dividend paid on the Company’s preferred

 

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stock, as well as payments under capital lease and software licensing obligations.  In 2012, cash inflows included the repayment of the note receivable from the Company’s predecessor entity of $3.1 million and $0.1 million in cash from the exercise of stock options offset by cash outflows from dividends paid on preferred stock and repayments of capital leases and software licensing agreements.

 

**Recent Accounting Pronouncements**

 

See Note 4 to the condensed consolidated financial statements at Item 1 of this Form 10-Q.

 

Item 3.**  Quantitative and Qualitative Disclosures About Market Risk.**

 

**Foreign currency exchange risk**

 

The Company’s wholly-owned subsidiaries, DBL, DBMS NZ and DBA, utilize the British Pound Sterling (GBP), New Zealand Dollar (NZ$) and Australian Dollar (AUD), respectively, as their functional currencies.  Assets and liabilities of these subsidiaries are translated to U.S. dollars at exchange rates in effect at the balance sheet dates, with the resulting translation adjustments directly recorded to a separate component of accumulated other comprehensive income or loss.  Prior to the fourth quarter of 2012, the Company’s Singapore subsidiary used the Singapore dollar as its functional currency.  Effective October 1, 2012, the Company changed the functional currency to the U.S. dollar.  The Company believes that the growth in this subsidiary’s U.S. dollar denominated revenues and expenses indicated a change in the economic facts and circumstances that justified the change in the functional currency.  The effects of the change in functional currency were not significant to the Company’s consolidated financial statements.

 

Transactions in foreign currencies are reported at the rates of exchange at the transaction date.  Assets and liabilities are translated at the rates of exchange in effect at the balance sheet date.  All differences are recorded in results of operations.

 

From time to time, the Company uses foreign currency option contracts or foreign currency forward contracts that are not designated as hedging instruments to manage exposure to fluctuations in foreign currency.  The Company uses these instruments as economic hedges and not for speculative or trading purposes.  The fair value of the foreign currency contracts represents the amount the Company would receive or pay to terminate the contract at the reporting date, and is recorded in other assets or liabilities, depending on whether the net amount is a gain or loss.  During the nine months ended September 30, 2013 and 2012, the Company did not enter into any foreign currency contracts.

 

***Interest Rate Sensitivity***

 

We had cash, cash equivalents and short-term investments totaling $47.4 million at September 30, 2013.  This amount was invested primarily in money market funds and government securities. The cash, cash equivalents and short-term marketable securities are held for general corporate purposes including possible acquisitions of, or investments in, services or technologies, working capital and capital expenditures. Our investments are made for capital preservation purposes. We do not enter into investments for trading or speculative purposes.

 

Our cash equivalents and our portfolio of marketable securities are subject to market risk due to changes in interest rates. Fixed rate securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectation due to changes in interest rates or we may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. However because we classify our debt securities as “available for sale,” no gains or losses are recognized due to changes in interest rates unless such securities are sold prior to maturity or declines in fair value are determined to be other-than-temporary. Our fixed-income portfolio is subject to interest rate risk.

 

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**Item 4. Controls and Procedures.**

 

**Introduction**

 

As disclosed in Item 9A of the 10-K Amendment, management concluded that as of December 31, 2012, our internal controls over financial reporting were not effective due to material weaknesses in our control environment, control activities and information and communication relative to stock option grants and stock issuances.   In addition, we lacked a sufficient complement of trained finance, accounting and tax personnel and did not establish adequate accounting and financial reporting policies and procedures as a general matter.  In particular, there were material weaknesses in our financial reporting control environment and the design, establishment, maintenance and communication of effective controls relating to revenue recognition, income taxes and certain transactions with our predecessor entity. In addition, our accounting and financial reporting processes were dependent on the maintenance of spreadsheets that had become inadequate to ensure accurate and timely financial reporting given the growth of the Company and the volume of transactions.  Management also evaluated the effectiveness of our disclosure controls and procedures and concluded that our disclosure controls and procedures were not effective as of December 31, 2012.  Information relating to the identified material weaknesses in internal control over financial reporting, and related remedial measures, as well as additional information relating to the restatement, is contained in the 10-K Amendment.

 

*(a)**        **Evaluation of disclosure controls and procedures (As revised)*

 

Disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act are controls and other procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified by the rules and forms promulgated by the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management, including the chief executive officer and the chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

 

In connection with the preparation of this Form 10-Q, the Company evaluated, as of September 30, 2013, under the supervision of and with participation from the Company’s management, including our Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures. Based upon such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, because of the material weaknesses in the Company’s internal control over financial reporting described in the 10-K Amendment, which material weaknesses have not been fully remediated as of September 30, 2013, the Company’s disclosure controls and procedures were not effective as of September 30, 2013.

 

*(b)**        **Changes in Internal Controls.*

 

As disclosed in Item 9A of the 10-K Amendment, the Company determined that as of December 31, 2012, the Company had material weaknesses in internal controls over financial reporting and that the Company is committed to improving its overall control environment and financial reporting processes. During the fiscal quarter ended September 30, 2013, the Company implemented several of the remedial and other actions described in the 10-K Amendment relating to the improvement of our internal controls and governance.

 

·                  The Company hired a new Controller in September 2013. Our new Controller has significant experience in revenue recognition with an emphasis in the software and SaaS industries and public reporting experience.

 

·                  The Company implemented, maintained and monitored compliance with written revenue recognition policies in accordance with GAAP, which will be regularly communicated to all accounting, sales and legal personnel.

 

Our remediation efforts are ongoing and have not been completed.  For further information about our planned remedial measures, please see Item 9A “Controls and Procedures” included in the Form 10-K Amendment.

 

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Additional remediation measures may be required, which may require additional implementation time.  We will continue to assess the effectiveness of our remediation efforts in connection with our evaluations of internal control over financial reporting. Prior to the completion of our remedial measures, there remains risk that the processes and procedures on which we currently rely will fail to be sufficiently effective, which could result in material misstatement of our financial position or results of operations and require a restatement. Moreover, because of the inherent limitations in all control systems, no evaluation of controls—even where we conclude the controls are operating effectively—can provide absolute assurance that all control issues, including instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, our control systems, as we develop them, may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

 

**PART II—OTHER INFORMATION**

 

**Item 1. Legal Proceedings. **On September 6, 2013 New Zealand Daylight Time, the Company issued an announcement relating to the approval by the NZ Markets Disciplinary Tribunal of a settlement reached by the Company and the New Zealand Stock Exchange regarding the previously disclosed breaches of the NZSX Listing Rules by the Company. The settlement provided for the payment of fines and costs by the Company, consisting of NZ $15 thousand as a penalty to the NZX Discipline Fund and NZ$4 thousand towards the costs of NZX Regulation.

 

**PART II—OTHER INFORMATION**

 

**Item 1A. Risk Factors.**

 

*An investment in our common stock is subject to risks inherent in our business. There have been no material changes to the risk factors previously disclosed in Part I, Item 1A. of our Form 10-K Amendment. Before making an investment decision, you should carefully consider the risks and uncertainties described in the Company’s 10-K Amendment together with all of the other information included in this report and in our other public filings. In addition to the risks and uncertainties described in the 10-K Amendment, other risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition and results of operations. If any of the risks and uncertainties described in the 10-K Amendment, or if any other risks and uncertainties, actually occurs, our business, financial condition or operating results could be harmed substantially, which could cause the market price of our stock to decline, perhaps significantly.*

 

**Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds.**

 

None

 

**Item 3.   Defaults Upon Senior Securities. **Not applicable.

 

**Item 4.   Mine Safety Disclosures. **Not applicable.

 

**Item 5.   Other Information. **Not applicable.

 

**Item 6. Exhibits.**

 

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| **Exhibit********Numbers** | ** ** | **Exhibits**                                                                            |
|----------------------------|------------|-----------------------------------------------------------------------------------------|
|                       |       |                                                                                    |
| 31.1                       |       | CEO   Certification pursuant to Rule 13a-14(a)                                     |
|                       |       |                                                                                    |
| 31.2                       |       | CFO   Certification pursuant to Rule 13a-14(a)                                     |
|                       |       |                                                                                    |
| 32.1                       |       | CEO   Certification furnished pursuant to Rule 13a-14(b) and 18 U.S.C.   1350 |
|                       |       |                                                                                    |
| 32.2                       |       | CFO   Certification furnished pursuant to Rule 13a-14(b) and 18 U.S.C.   1350 |

 

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**SIGNATURES**

 

Pursuant to the requirements 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.

 
| ** ** | ** **     | **DILIGENT BOARD MEMBER SERVICES, INC.** |
|------------|----------------|-----------------------------------------------|
|       |           |                                          |
|       |           |                                          |
| Dated:     | May   19, 2014 |                                          | By: | /s/   Alessandro Sodi |
|       |           |                                          |   | Alessandro   Sodi, Chief Executive Officer (Principal Executive Officer) |
|       |           |                                          |
| Dated:     | May   19, 2014 |                                          | By: | /s/   Carl Blandino |
|       |           |                                          |   | Carl   Blandino, Chief Financial Officer (Principal Financial Officer) |

 

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