UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K




x
              ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
                For
      the fiscal year ended December 31, 2008ORo
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
                For
      the transition period
      from                                        
               
  toCommission
      file number: 001-33517




Data
Domain, Inc.


(Exact
name of registrant as specified in its charter)







Delaware
                94-3412175(State
      or other jurisdiction of incorporation or organization)
                (IRS
      Employer Identification No.)2421
      Mission College Blvd., Santa Clara, CA
                95054(Address
      of principal executive offices)
                (Zip
      Code)Registrant’s
      telephone number, including area code
                (408)
      980-4800Securities
      registered pursuant to Section 12(b) of the Act:Title
      of each class
                Name
      of each exchange on which registeredCommon
      Stock, par value $.0001 per share
                NASDAQ
      Global Select Market





Securities registered pursuant to
Section 12(g) of the Act: None


Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.    Yes   ̈    No  x


Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the
Act.    Yes   ̈    No  x


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.    Yes  x    No   ̈


Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§ 229.405) is not contained herein, and will not be contained,
to the best of registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.     ̈


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 the definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check
one):


Large
      accelerated filer  ̈
            Accelerated
      filer þ
            Non
      accelerated filer  ̈
            Smaller
      reporting company  ̈





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




The
aggregate market value of the common stock held by non-affiliates of the
registrant, based upon the closing price of such common stock on June 30,
2008, the last business day of the registrant’s most recently completed second
fiscal quarter, asreported by The NASDAQ
Global Select Market, was approximately $680,579,610. Shares of common
stock held by each executive officer and director of the registrant and by
eachperson who owns
10% or more of the registrant’s outstanding common stock have been excluded in
that such persons may be deemed to be affiliates. This determination of
affiliate status is not necessarily a conclusive determination for other
purposes.




The
number of outstanding shares of the registrant’s common stock as of March 11,
2009, was 61,017,402.




DOCUMENTS
INCORPORATED BY REFERENCE




Portions
of the definitive proxy statement for registrant’s 2009 Annual Meeting of
Stockholders to be held June 11, 2009 are incorporated by reference into
Part III of this Annual Report on Form 10-K.


1




Table
of Contents




PagePart IItem
      1.
              Business
              3Item
      1A.
              Risk
      Factors
              8Item
      1B.
              Unresolved
      Staff
      Comments
              18Item
      2.
              Properties
              18Item
      3.
              Legal
      Proceedings
              18Item
      4.
              Submission
      of Matters to a Vote of Security
      Holders
              18Item
      4A.
              Executive
      Officers of the
      Registrant
              18Part
      IIItem
      5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
              19Item
      6.
              Selected
      Financial
      Data
              21Item
      7.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              22Item
      7A.
              Quantitative
      and Qualitative Disclosures About Market
      Risk
              32Item
      8.
              Financial
      Statements and Supplementary
      Data
              33Item
      9.
              Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
              62Item 9A
              Controls
      and
      Procedures
              62Item
      9B.
              Other
      Information
              62Part
      IIIItem
      10.
              Directors,
      Executive Officers and Corporate
      Governance
              62Item
      11.
              Executive
      Compensation
              62Item
      12.
              Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
              62Item
      13.
              Certain
      Relationships and Related Transactions, and Director
      Independence
              62Item
      14.
              Principal
      Accounting Fees and
      Services
              62Part
      IVItem
      15.
              Exhibits
      and Financial Statement
      Schedules
              62Signatures
              65






2


FORWARD
LOOKING STATEMENTS




This
Annual Report on Form 10-K contains forward-looking statements that involve
risks and uncertainties. The statements contained in this document that are not
purely historical are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, including, without limitation statements
regarding our expectations, beliefs, intentions or strategies regarding
anticipated trends and challenges in our business and the markets in which we
operate, our expected future financial performance, our ability to manage growth
and expansion into international markets and our ability to compete in our
industry. We may identify these statements by the use of words such as
“anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,”
“may,” “might,” “plan,” “potential,” “predict,” “project,” “should,” “will,”
“would” and other similar expressions. All forward-looking statements included
in this report are based on information available to us on the date hereof, and
we assume no obligation to update any such forward-looking statements, except as
may otherwise be required by law.




Our
actual results could differ materially from those anticipated in these
forward-looking statements as a result of certain factors, including those set
forth in the “Risk Factors” section located in Item 1A of this report. In
evaluating our business, current and prospective investors should consider
carefully these factors in addition to the other information set forth in this
document.




Part
I




Item 1.
            Business




Corporate
Information




Data
Domain, Inc., or Data Domain, was incorporated in Delaware in October 2001. Our
executive offices are located at 2421 Mission College Blvd, Santa Clara, CA
95054, and our telephone number is (408) 980-4800. Our website address is
www.datadomain.com.
Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and
Current Reports on Form 8-K, as well as any amendments to these reports, are
available through our website as soon as reasonably practicable after they are
electronically filed with or furnished to the Securities and Exchange
Commission, or SEC. Information contained or referenced on our website is not
incorporated by reference and does not form a part of this Annual Report on Form
10-K.





Overview







Data
Domain is a leading provider of storage solutions for backup and archive
applications based on deduplication technology.  Data Domain deduplication
storage systems are designed to deliver reliable, efficient, and cost-effective
solutions that enable enterprises of all sizes to manage, retain and
protect their data.





We
believe offering a simple-to-manage deduplication storage product family
supporting both high throughput for backup/restore and adaptability to other
nearline applications, such as archiving, provides the application independent,
consolidative infrastructure required for enterprise data protection storage. In
addition to our storage systems, we provide global product support as
well as software updates to customers that purchase a support and services
contract, and we offer professional services.







Our
products and services are designed to meet the demands of data protection for
enterprise backup and archive applications.  To this end, we work with
leading application providers such as Symantec Corporation and F5 Networks to
help ensure reliable, high performance joint deployments.  To meet the
needs of backup applications and disaster recovery, our systems must have high
throughput to meet backup windows and sophisticated wide area network, or WAN,
replication options.  To meet the needs of file archiving, our products
must support many millions of files and offer specialized features such as
deduplicated snapshots and governance-oriented file locking.  For both
requirements, we believe the simplifying nature of our inline deduplication
technology and plug-in appliances makes our products cost effective and easy to
manage.







We
shipped the world’s first inline deduplication storage appliance in 2004. Since
then, we have brought to market many significant innovations and industry firsts
in deduplication storage and data management. We have grown to over
800 employees as of February 2009, with operations in over 25 countries
around the world.





Data
Domain Products







Data
Domain offers a family of products to meet the backup and nearline storage needs
of enterprises of all sizes as they seek to reduce costs, simplify data
management and enhance their return on existing information technology, or IT,
infrastructure assets.







Data
Domain Operating System (DD OS) Software









Our
systems are based on our operating system, or DD OS, which is optimized for data
protection and disaster recovery and supports network attached storage, or NAS,
virtual tape library, or VTL, and Symantec NetBackup OpenStorage, or OST,
environments.   DD OS is designed to address protection storage
requirements with lower operating costs, ease of use, high performance,
reliability and compatibility with all leading enterprise backup and archiving
applications for seamless integration into existing IT
infrastructures.










Systems






We offer
a family of deduplication storage systems for backup, archive and other nearline
applications. Our systems are modular and scalable and can be purchased in a
variety of configurations of storage capacity and performance.  Our DD500
and DD600 series of fabric-attached enterprise storage systems are designed to
consolidate backup and archive data in central locations using standard
connection fabrics: Ethernet (1 and 10 GB) and FibreChannel.  Our systems
are designed for high-performance data access for datacenters as well as remote
office backup and disaster protection. All of our systems run the highly
efficient DD OS. Customers can augment the storage capacity of our higher end
systems with expansion storage.  Our systems also can be combined together
in an array configuration to reach higher levels of capacity and throughput.
 For customers that want to utilize their existing excess storage capacity,
we offer versions of our systems without internal storage.


3





Software
Options







In
addition to DD OS, which comes standard with all Data Domain systems and
includes support for the Network File System (NFS) and Common Internet File
System (CIFS) access protocols, additional software options are available. These
include:







•
            Data Domain Virtual Tape
      Library (VTL) Software, which allows our systems to accept
      input from a Storage Array Network (SAN) fabric;•
            Data Domain OpenStorage (OST)
      Software, a custom interface for Symantec backup products,
      allowing greater speed and manageability;•
            Data Domain Retention
      Lock, providing additional file level locking support to
      support data archival compliance and governance requirements;
      and•
            Data Domain Replicator
      Software, which provides a variety of options for keeping
      pairs of systems synchronized across Wide Area Networks for disaster
      protection and multi-site
coordination.









Data
Domain Services







Our
customers demand reliability of their storage infrastructure to ensure the
successful, ongoing operation of their businesses. Data Domain services are
designed with this in mind. We provide professional services, global support
solutions and customer education and training to help customers effectively
manage their backup and archive data.


Technology









The core
elements of our technology and system architecture include:







•
                Global CompressionTM—Our
      technology combines high performance deduplication with traditional data
      compression techniques. This approach identifies segments of data within
      an incoming data stream that are duplicates of segments already stored and
      instead of storing an additional redundant copy of these segments, stores
      only references to the previously stored segments. Traditional compression
      techniques then compress the remaining segments before the data is stored
      to disk. Our deduplication technology is more effective than traditional
      data compression techniques alone because it compares new incoming data
      with a much larger history of previously stored data. When used to
      deduplicate a single data set over 20 weeks of regular backup storage
      events, our appliances are designed to achieve a range of data compression
      of approximately 10x to 30x. The actual range of data compression obtained
      by our customers depends on the frequency of full backup events, the
      length of time backup data is retained and the redundancy of the backup
      data.•
                High-speed,
      Inline Deduplication—Our
      Stream-Informed Segment Layout, or SISL, technology performs deduplication
      at high speed with very few disk drives. Deduplication processes require
      comparison of new data to a very large amount of previously stored data.
      Typically, this comparison requires many disk accesses to compare incoming
      new data to old data, a process that is relatively slow, expensive
      to provide and/or difficult to manage. Our appliances utilize
      proprietary technology to perform deduplication inline, or prior to
      storing to disk, at high speed. SISL completes a substantial portion of
      the deduplication process while using a small amount of random access
      memory, or RAM, thereby minimizing the need for access to disk and
      increasing the speed of the backup and restore processes. Because SISL is
      CPU-centric in its design, our products’ throughput increases with
      improvements in CPU technology. Our current highest performance product,
      the DD690, is more than 10x faster than our first generation products from
      2004, and it uses the same class of Intel-based controller. Also, because
      our technology filters redundant segments before writing to disk, and
      replicates backup data shortly after writing, copies of data at remote
      sites can be kept up-to-date.•
                Data
      Invulnerability Architecture—Our technology provides advanced
      levels of data protection that are designed to ensure that backup data is
      accurate and recoverable. Most disk-based storage systems have been
      optimized for rapid transaction processing. However, our appliances are
      designed to be the storage of last resort. Our appliances incorporate
      end-to-end data consistency, integrity verification and error correction
      technologies at the file system level. For example, after every backup
      event, our technology confirms that all data written is consistent and
      accurate. Additionally, our appliances can sustain multiple simultaneous
      disk failures without data loss, a significant benefit over many VTL
      products that can lose data when more than one disk in an array fails. We
      have introduced point-in-time snapshots that can allow images which have
      been deleted by operator error to be recovered.•
                Replication—Our
      Replicator software transfers deduplicated and compressed information over
      a network during the backup process. This process can be employed in a
      variety of common network types and requires less bandwidth, time and cost
      than traditional replication methods, making WAN vaulting economically and
      operationally feasible.•
                Nearline
      and Archive—Our file system software includes technologies and
      features developed to support nearline and archive applications. 
      Such applications accumulate large numbers of objects over long periods of
      time and reach object totals that surpass the capabilities of conventional
      file systems.  The directory structure in the DD OS file system is
      stored in a custom database that has the potential to scale to billions of
      objects and so accommodate the needs of archive applications.  Larger
      Data Domain systems today already support tens of millions of
      objects.  The file system also supports a Retention
      Lock capability that allows the user  or application to lock a
      file to ensure that it is not modified or deleted.  This capability
      ensures the integrity of the archived data against program or operator
      error and users attempting to tamper with files via the data access
      protocols.


•
            Adaptable
      Design—Each of our appliances incorporates industry standard
      components, which simplifies the procurement, assembly and support of our
      appliances. Furthermore, our appliances are easy to install, are
      compatible with the leading backup and archive software applications and
      file virtualization systems and work with both Ethernet and Fibre
      Channel-based networks


4





Customer
Support




We offer
tiered customer support programs through the sale of support and services
contracts. Customers that purchase a support and services contract are granted
rights to accelerated shipment of replacement parts, onsite hardware repair and
support, and software updates and maintenance releases that become available
during the support period. Our support and services contracts are typically
offered for periods of one to three years. We offer product support to all of
our customers, including those customers who purchase our appliances through our
channel partners.




Substantially
all of our support personnel are based in Santa Clara, California, and the
Research Triangle Park area in Raleigh, North Carolina. Customer support
personnel are available 24 hours per day, seven days per week. Our appliances
include an active monitoring system that automatically notifies us of support
problems we detect, enabling us to address customer problems more quickly. In
addition, some of our international channel partners offer primary support for
the appliances they sell to customers. We also subcontract with a third party,
Glasshouse, Inc., or Glasshouse, to provide onsite hardware repair and
replacement services for the substantial majority of our customers that have
purchased a support and services contract from us. For each such covered
customer, we purchase a support contract from Glasshouse. Our master agreement
with Glasshouse has a three-year term ending in June 2010, except that after the
initial 12 months, which ended in June 2008, either party may terminate the
agreement by providing the other party with 90 days’ prior written
notice.





Principal
Markets and Distribution Channels and Marketing







We market
and sell our products in numerous countries throughout the world.  Our
diversified customer base represents a number of large segments and vertical
markets. We focus primarily on the enterprise backup storage and WAN replication
markets, offering a variety of systems for datacenters and remote offices. We
have also expanded into the nearline and archive markets, bringing us into parts
of the data center in which we have not previously competed.







We employ
a multi-channel distribution strategy, selling products and services to end
users through channel partners and our direct sales force. Our channel partners
include value-added resellers, system integrators and distributors. We have over
450 channel partners that help market and sell our appliances, typically with
the assistance of our direct sales force. Our direct sales force is responsible
for managing and overseeing indirect sales within our geographic territories,
including North America, Europe, Asia-Pacific and Japan. This joint sales
approach combines the benefit of our having relationships with substantially all
of our customer accounts with the reach and relationships of our channel
partners, especially internationally. We intend to expand these channel partner
relationships in the future to further extend our distribution
coverage.





We focus
our marketing efforts on communicating product advantages, generating qualified
leads for our direct sales force and channel partners and increasing brand
awareness. We rely on a variety of marketing efforts, including tradeshows,
advertising, public relations, industry research and our website. In addition,
we work closely with a number of technology partners, including some of the
leading suppliers of storage infrastructure products, on co-marketing and
lead-generation activities in an effort to broaden our marketing
reach.




Customers




As of
December 31, 2008, the total number of customers that had purchased our
appliances since inception was approximately 2,900 customers worldwide from a
variety of industries, including defense, education, entertainment, finance,
government, healthcare, technology, legal, media and retail. During the years
ended December 31, 2008, 2007 and 2006, no single customer accounted for
10% or more of our total revenue. See Note 11 of “Notes to Consolidated
Financial Statements” for more information regarding the geographic distribution
of our customers.




Backlog




We
believe that because of industry conditions, customers are reluctant to enter
into long-term contracts. Accordingly, new order volumes for our products
fluctuate significantly. We typically accept and ship orders within a few days.
In addition, customers may reschedule or cancel orders with little or no
penalty. For these reasons, we do not believe that our order backlog as of any
particular date is a reliable indicator of actual sales for any succeeding
period.




Product
Warranty




Upon
shipment of products to our customers, we provide for the estimated cost to
repair or replace products that may be returned under warranty. Our warranty
period is typically 12 months from the date of shipment to the customer for
hardware and 90 days for software.




Research
and Development




Continued
investment in research and development is critical to our business. We have
assembled a team of skilled engineers with extensive experience in the fields of
computing, storage, network system design, internet routing protocols and
embedded software. These individuals have extensive prior experience with many
leading digital storage and computer data networking companies. We have invested
significant time and financial resources in the development of our storage
appliances and our Global Compression technology. Our research and development
activities take place at our corporate headquarters in Santa Clara, California,
a facility in Princeton, New Jersey that opened in 2007 and a facility in the
Research Triangle Park area in Raleigh, North Carolina that opened in 2008. We
intend to dedicate significant research and development resources to continue to
improve the performance and features of our deduplication storage solution and
to expand our product offerings to address other segments of the enterprise
storage market.




Research
and development expenses were $41.0 million, $23.5 million and $10.4 million for
the years ended December 31, 2008, 2007 and 2006,
respectively.






5




Manufacturing




We
outsource the manufacturing, assembly, testing, packaging and shipping of our
appliances to Flextronics International, or Flextronics. We rely on Flextronics
to procure a majority of the components for our appliances. We work closely with
Flextronics in an effort to ensure that we have a supply of components
sufficient to satisfy our product delivery schedule and to oversee the
manufacturing process and quality control.




We
provide purchase orders for finished goods inventory to Flextronics on a monthly
basis. The product mix and volume of the order is adjusted each month based on
anticipated demand and actual sales and shipments in prior periods. Because
different configurations of our appliances use industry standard components,
Flextronics is more easily able to respond to changes in our product mix without
significant delay or increased costs. Flextronics is currently our only contract
manufacturer, and our agreement with Flextronics has a one-year term that is
subject to automatic extensions in one-year increments absent notice of
termination by either party.  This agreement is terminable at any time
by either party with 90 days’ notice.




We
purchase our capacity expansion shelves from Xyratex Technology Limited pursuant
to an agreement that has a three-year term ending in March 2010, subject to
early termination by either party under certain circumstances.




Availability
of Raw Materials and Components




Our
production processes require raw materials and components that meet exacting
standards, including a few that are customized for us. We generally have a few
sources of supply of components, a number of which we acquire from only a single
source on which we are dependent. Various factors could reduce the availability
of raw materials and components such as memory, microprocessors, disk
drives, shelving and other materials.  Shortages of supply may occur
from time to time and lead times for the supply of raw materials and
components may be extended.  If our supply of raw materials and components
is interrupted, or lead times are extended, our results of operations could be
harmed.




Competition




The
market for our products is highly competitive and is driven by rapidly changing
technology. In addition to competing with traditional providers of tape-based
storage systems, such as Sun Microsystems, Inc., or Sun Microsystems, and
Quantum Corporation, we compete with other established storage companies such as
EMC Corporation, or EMC, and NetApp, Inc., or NetApp, and to a lesser extent
Hitachi Data Systems Corporation, or HDS, Hewlett-Packard Company, or HP, and
International Business Machines Corporation, or IBM, that offer a variety of
different protection storage products and products that address classes of
nearline applications. Some of our competitors sell, or have announced plans to
sell, deduplication storage products that compete directly with our appliances.
We also compete with a number of emerging hardware and software companies that
may become more significant competitors in the future. In addition, at the
low-end of our product line, we may compete with WAN acceleration and backup
software providers that incorporate deduplication capabilities in their
products.







We
believe the principal factors on which our products compete are as
follows:


•
            product
      features and enhancements, including ease of implementation and use,
      performance, scalability, reliability, replication and multi-protocol
      support;•
            product
      pricing and total cost of ownership;•
            product
      interoperability with customer networks and backup
    software;•
            global
      sales and distribution capability;•
            ability
      to take advantage of improvements in industry standard components;
      and•
            customer
      support and services.







We
believe that our technologies, which enable enterprises to dramatically compress
data in their protection storage environments, store data cost effectively and
with high reliability, use existing networks for data recovery and accomplish
each of the foregoing with minimal disruption to existing storage
infrastructures, provide us with significant competitive advantages. In
addition, our appliances have been purchased by approximately 2,900 customers
since inception, which represent a significant installed base of existing
customers and provide us with a significant number of reference accounts, better
enabling us to market and sell additional appliances and other product offerings
to new customers. However, many of our current and potential competitors have
longer operating histories, greater name recognition, larger customer bases and
significantly greater financial, technical, sales and marketing and other
resources than we have. Our competitors may offer to sell their products at more
attractive prices than we offer, and potential customers may prefer to purchase
from their existing vendors rather than a new vendor regardless of product
performance or features. Some of our competitors have also entered into
relationships with original equipment manufacturers, or OEMs, that could provide
those competitors with sales, marketing, distribution and other
advantages.




6




Intellectual
Property




Our
future success as a company will depend in part upon our ability to protect our
core technology and intellectual property. To accomplish this, we rely on a
combination of intellectual property rights, including patents, trade secrets,
copyrights and trademarks, as well as customary contractual protections. Our
registered trademark in the United States is Data Domain.




Our
issued patents will begin to expire in 2023. We have also entered into a
non-exclusive patent cross-license agreement with Quantum Corporation, or
Quantum, that provides each party and its controlled affiliates with a license
to certain patents held by the other party. As a result of this patent
cross-license agreement, we have a license to Quantum’s significant portfolio of
current and future patents that are or may be issued or applied for (or
otherwise entitled to a priority date) on or prior to January 1, 2012 and
that relate to or are useful with respect to data transmission and/or data
storage, excluding claims specific to tape or tape-based systems. Under the
terms of the agreement, Quantum and its controlled affiliates have a license to
our current and future patents that relate to or are useful with respect to data
transmission or data storage and that are or may be issued or applied for (or
otherwise entitled to a priority date) on or prior to January 1,
2012.




The
effect of the cross-license is that Data Domain and Quantum can implement their
respective products without threat of lawsuit from the other company for patent
infringement of the covered patents. The license agreement does not include
a transfer of any products, software, code, know-how or trade secrets. It
is not a joint development agreement or an OEM agreement. Neither party is
entitled to any products implemented by the other party or any features of the
other party’s products. There are no deliberately common components between
Data Domain and Quantum products. Quantum and Data Domain do not collaborate on
the development of any products.




United
States patent filings are intended to provide the holder with a right to exclude
others from making, using, selling or importing in the United States the
inventions covered by the claims of granted patents. We do not know whether any
of our pending patent applications will result in the issuance of patents or
whether the examination process will require us to narrow our claims. Our issued
United States patents, and any future patents that may be issued, may be
contested, circumvented or invalidated, and we may not be able to prevent third
parties from infringing these patents. In addition, as a result of our
cross-license agreement with Quantum, we will not be able to assert our existing
patent rights and many or all of our future patent rights against Quantum or its
controlled affiliates for the foreseeable future, and Quantum has certain rights
to assign this license to an acquirer of Quantum.





In
addition to the foregoing protections, we generally control access to and use of
our proprietary software and other confidential information through the use of
internal and external controls, including contractual protections with
employees, contractors, customers and partners, and our software is protected by
United States and international copyright laws.




Although
we rely on patent, copyright, trade secret, trademark and other intellectual
property laws to protect our technology, we also believe that factors such as
the technological and creative skills of our personnel, new product
developments, frequent product enhancements and reliable product support and
services are essential to establishing and maintaining a technology leadership
position. We cannot be sure that others will not develop technologies that are
similar or superior to our technology.




Protecting
against the unauthorized use of our patents, trademarks and other proprietary
rights is expensive, difficult and, in some cases, impossible. Litigation may be
necessary in the future to enforce or defend our intellectual property rights,
to protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. Such litigation could be costly and divert
management resources, either of which could harm our business. Furthermore, many
of our current and potential competitors have the ability to dedicate
substantially greater resources to enforce their intellectual property rights
than we do. Accordingly, despite our efforts, we may not be able to prevent
third parties from infringing upon or misappropriating our intellectual
property.




Employees




As of
December 31, 2008, we had 777 employees in offices around the world, of
which 636 were in the United States. Of the total employees, 434 were
engaged in sales and marketing, 182 in research and development and 161 in
general and administration, support and services and operations. None of
our employees is represented by a labor union, and we consider current employee
relations to be good.






7




Item 1A.
            Risk
      Factors




Set forth
below are risks and uncertainties that could cause actual results to differ
materially from the results contemplated by the forward-looking statements
contained in this Form 10-K. Because of the following factors, as well as other
variables affecting our operating results, past financial performance should not
be considered as a reliable indicator of future performance and investors should
not use historical trends to anticipate results or trends in future
periods.









Risks
Related to Our Business and Industry








Recent
turmoil in the financial markets and the global economic recession has adversely
affected and may continue to adversely affect our industry, business and gross
margins.







The U.S.
and world economic markets are undergoing a recession, and the future economic
environment may continue to be significantly less favorable than that of recent
years. Our business depends on the overall demand for information technology, in
particular for deduplication storage appliances for backup storage and
network-based disaster recovery. Information technology spending has
historically declined with worsening general economic and market conditions and
we believe the current recession has already caused our customers to
significantly reduce or delay their information technology purchases and
that these reductions and delays have negatively impacted demand for our
products and services and our business.  If the U.S. and global
recession continues to worsen, and the U.S. and world economies remain depressed
for an extended period of time, or if our customers believe such a downturn will
continue for the foreseeable future or become more severe, then our customers
may continue to significantly reduce their information technology
budgets and may decrease their demand for our products and
services.




As a result
of this economic slowdown and the continued tightening of credit markets, our
customers may be delayed in obtaining, or may not be able to obtain, necessary
financing for their purchases of our products. A lack of liquidity in the
capital markets or the continued global recession may cause our customers to
delay or cancel their purchases, increase the time they take to pay or default
on their payment obligations. Currency fluctuations relating to the financial
crisis could also negatively affect our international customers’ ability or
desire to purchase our products. In addition, continued weakness in the economy
could cause some of our resellers and other customers to become illiquid, delay
payments or adversely affect our collection on their accounts, any of which
would result in a higher level of bad debt expense. In February 2009, one of our
resellers filed for Chapter 11 bankruptcy.  As of December 31,
2008, we had a trade receivable of $1.1 million, from this reseller, for
which we have not recorded an allowance.  As part of the
bankruptcy proceeding, a primary investor in this reseller
has agreed to purchase the assets and assume certain liabilities of
this reseller in its efforts to recapitalize the reseller.  Specifically,
this investor  has filed a statement with the bankruptcy court of its
intention to assume the $1.1 million liability payable to us.  This
asset purchase agreement is subject to the final approval of the bankruptcy
court, and if the asset purchase is not completed, all or a portion of this
amount due us may be uncollectible and require a recognition of bad debt
expense.  We have continued to ship product to this reseller in the first
quarter of 2009 upon the receipt of cash prior to shipment.


The
global economic recession may not only cause our customers to significantly
reduce or delay their information technology budgets, which would
negatively impact demand for our products and services, but may also result
in:






•
            increased
      price competition for our products, not only from our competitors, but
      also as a result of our customer’s or potential customer’s utilization of
      inventoried or underutilized products, which could put additional pressure
      on our near term gross profits;




•
            risk
      of excess or obsolete inventories;




•
            excess
      manufacturing capacity and higher associated overhead costs as a
      percentage of revenue; and




•
            more
      limited ability to accurately forecast our business and future financial
      performance.





The
lack of liquidity and economic slowdown may also adversely affect our suppliers,
including those on whom we are dependent as sole source suppliers, and their
liquidity, and the availability of, and/or terms and conditions on which we
purchase their products and services. Any of these events could limit our
ability to obtain necessary products and services, including components for our
products, contract manufacturing services from our contract manufacturer, and
break-fix services from our break-fix services supplier, and could adversely
impact our supply chain or the delivery schedule to our customers. This also
could require us to purchase more expensive components, or re-design systems, or
find new suppliers of manufacturing or break-fix services, any of which could
increase the cost of our systems and support and delay the manufacturing and
delivery of our systems or negatively impact the performance or quality of our
products and services. Such events would likely negatively impact our business
and gross margins and harm our reputation and our customer
relationships.




As a
result of the recession, we may face new risks that we have not yet identified.
In addition, a number of the risks associated with our business, which are
disclosed in these risk factors, may increase in likelihood, magnitude or
duration.






8





We
face significant competition and expect this competition to intensify, which
could prevent us from increasing our revenue, reduce our gross margins and
result in the loss of market share.





The
market for our products is highly competitive and we expect competition to
intensify in the future. Other companies have introduced and may in the future
introduce new products in the same markets we serve or intend to enter. New
competitive offerings have been recently announced or introduced in our
marketplace by our competitors EMC, HP and IBM, and we anticipate additional
offerings by our competitors may be announced or introduced in 2009. Competition
in the past has resulted in pricing pressure on our products and services, and
we anticipate that pricing pressure will increase in the future. Competition has
in some instances resulted in a negative impact on the length of our sales
cycle, and we may experience longer sales cycles in future periods due to
increased competition. In particular, if a large number of orders, or a large
dollar value order, is delayed or cancelled, our financial results may be
harmed. Competition may result in reduced gross margins for our appliances,
increased sales and marketing expenses and a failure to increase, or the loss
of, market share.





Competitive
products may have better performance, lower prices and broader acceptance than
our appliances. Many of our current or potential competitors have longer
operating histories, greater name recognition, larger customer bases and
significantly greater financial, technical, sales, marketing and other resources
than we have. Potential customers may prefer to purchase from their existing
vendors rather than a new vendor regardless of product performance or features.
In addition, our competitors may be able to bundle products and services that we
do not offer together with products that compete with ours at a combined price
that is more attractive than the price we charge for our appliances. Currently,
we face competition from traditional providers of tape-based storage systems
such as Sun Microsystems and Quantum Corporation as well as a number of
established storage companies that offer a variety of different disk-based
storage products, including EMC and NetApp and, to a lesser extent, HDS, HP
and IBM. Some of our competitors sell, or have announced plans to sell,
deduplication storage products that compete directly with our appliances, and
additional competitors may introduce deduplication storage products in the
future. Pursuant to a cross-license agreement with Quantum, we have licensed our
current, and certain future, patents relating to data storage or data
transmission, which could assist Quantum in competing with us. We also compete
with a number of emerging hardware and software companies that may become more
significant competitors in the future. In addition, at the low-end of our
product line, we may compete with WAN acceleration and backup software providers
that incorporate deduplication capabilities in their products.





We expect
increased competition from other established and emerging companies if our
market continues to develop and expand. Some of our channel partners currently
market products and services that compete with our appliances. If these channel
partners cease to distribute our appliances for
competitive reasons, our sales may decrease or not grow as quickly. In addition,
some of our competitors have made acquisitions or entered into partnerships or
other strategic relationships with one another to offer a more comprehensive
solution than they individually are able to offer. We believe additional
consolidation or partnerships are likely to occur in the future as companies
attempt to strengthen or maintain their market positions in an evolving
industry. The companies resulting from these consolidations or partnerships
could significantly change the competitive landscape and adversely affect our
ability to compete effectively. Some of our competitors have also entered into
relationships with original equipment manufacturers, or OEMs, that could provide
those competitors with sales, marketing, distribution and other
advantages.




We
derive all of our revenue from sales of a single line of systems and related
customer support and services, and if demand for these systems does not continue
to grow, our business, results of operations and financial condition would be
harmed.
 
 We derive
all of our revenue from sales of a single line of deduplication storage systems
and associated customer support and services. As a result, we are vulnerable to
fluctuations in demand for these systems, whether as a result of competing
technologies and products, the impact of the continuing weakening of U.S. and
global economic conditions, decreases or delays in corporate spending for
information technologies, product obsolescence, lack of customer acceptance,
technological change, customer budgetary constraints or other factors. If demand
for our systems does not continue to grow, our business, results of operations
and financial condition would be harmed.





With
the recent volatility in the capital markets, there is a risk that we could
suffer a loss of principal in our cash and cash equivalents and short-term
investments and suffer a reduction in our interest or return on
investments.





We invest
our cash and cash equivalents and short-term investments pursuant to our
investment policy in cash, money market funds, commercial paper, corporate bonds
and U.S. government agency securities, and we actively manage our portfolio
with an objective of capital preservation.
Certain of these investments are subject to general credit, liquidity, market
and interest rate risks, which may be exacerbated by the continuing
deterioration of global economic conditions. To date, we have determined that
any declines in the market value of our
short-term investments have been temporary. There could be future declines in
the value of our short-term investments, which we may determine to be
other-than-temporary. These market risks associated with our investment
portfolio may have a negative adverse effect on our results of operations,
liquidity and financial condition.




Our short-term
investments portfolio has a relatively short duration consistent with our policy
of principle preservation. As a consequence, our interest income is
significantly affected from period to period by the level of short term interest
rates in effect during each period.  During the fourth
quarter of 2008, these rates were under significant downward pressure, and it is
likely we will experience a significant diminution in interest income during the
first quarter of 2009, and until short-term interest rates
increase.




At
December 31, 2008, we had $31.0 million of principal in auction-rate
securities, valued at $26.1 million. In January 2008, these securities, which
consist of AAA-rated, taxable municipal debt obligations, had auctioned
successfully. On February 14, 2008, the majority of these auction-rate
securities failed to auction, causing access to these funds to be restricted,
and each auction since then has failed. An auction failure means that the
parties wishing to sell securities could not. As of December 31, 2008, we
classified these auction-rate
securities as long-term investments, and have reclassified these securities from
available-for-sale to trading, which resulted in a recognized loss of $4.9
million          in our Statement
of Operations. In November 2008, we signed a broad-based settlement proposal from UBS
AG, or UBS, in which we have the right to sell the securities back to affiliates
of UBS (the "put option") at par value during the period from June 30, 2010 to
July 2, 2012 if liquidity does not return to the auction-rate securities market
sooner. The affiliates of UBS will retain the right to sell our auction-rate
securities on our behalf, without prior notification, at any time prior to July
2, 2012 as long as we receive par value from such sale.  We will
continue to monitor these investments going forward.





We expect
to exercise our right, or put option, to sell our auction-rate securities under
the UBS agreement. The put option was valued at $4.8 million and recorded in
long-term investments with a corresponding credit to other income (expense),
net. However, if we do not exercise the put option before July 2, 2012, this put
option will expire and UBS will have no further rights or obligations to buy our
auction-rate securities. As long as we hold our auction-rate securities, they
will continue to accrue interest as determined by the auction process or the
terms specified in the auction-rate securities if the auction process
fails.




9





We
experience quarterly fluctuations in our operating results due to a number of
factors, which make our future results difficult to predict and could cause our
operating results to fall below expectations or our guidance.





Our
quarterly operating results may fluctuate due to a variety of factors, many of
which are outside of our control. As a result, comparing our operating results
on a period-to-period basis may not be meaningful. You should not rely on our
past results as an indication of our future performance. If our revenue or
operating results fall below the expectations of investors or securities
analysts, or below any guidance we may provide to the market, the price of our
common stock could decline substantially.





In
addition to other risk factors listed in this “Risk Factors” section, factors
that may affect our quarterly operating results include:





·
            fluctuations
      in demand for our appliances;·
            fluctuations
      in sales cycles and prices for our appliances, particularly for large
      orders which tend to have a longer sales cycle;·
            reductions
      in customers’ budgets for information technology purchases and delays in
      their purchasing cycles;·
            the
      timing of recognizing revenue in any given quarter as a result of revenue
      recognition rules;·
            our
      ability to develop, introduce and ship in a timely manner new products and
      product enhancements that meet customer requirements;·
            the
      timing of product releases or upgrades by us or by our
      competitors;·
            our
      ability to hire additional sales personnel and the length of time required
      for any such additional personnel to generate significant
      revenue;·
            any
      lack of availability of, delay in the availability of, or quality problems
      with, any components we acquire from third-party suppliers, particularly
      any components we acquire from a third-party that is our sole source of
      supply for the components;·
            any
      significant changes in the competitive dynamics of our market, including
      new entrants or substantial discounting of products;·
            our
      ability to control costs, including our operating expenses and the costs
      of the components we purchase;·
            our
      experience with product reliability and associated warranty claims;
      and·
            general
      economic conditions in our domestic and international
    markets.





In
addition, we may experience seasonality in the sales of our appliances. We
believe our rapid growth and limited operating history may have masked the
nature or magnitude of seasonal or cyclical factors that might have influenced
our business to date. Seasonal variations in our sales may lead to significant
fluctuations in our quarterly operating results.





Our
international sales and operations subject us to additional risks that may harm
our operating results.





In the
year ended December 31, 2008, we derived approximately 23% of our revenue
from international customers. We have sales personnel in numerous countries
worldwide. We expect to continue to add personnel in additional countries. Our
international operations subject us to a variety of risks,
including:





·
            the
      difficulty of managing and staffing international offices and the
      increased travel, infrastructure and legal compliance costs associated
      with multiple international locations;·
            the
      management of our relationships with channel partners outside the United
      States, whose sales and lead generation activities are very important to
      our international operations;·
            difficulties
      in enforcing contracts and collecting accounts receivable, and longer
      payment cycles, especially in emerging markets;·
            tariffs
      and trade barriers and other regulatory limitations on our ability to sell
      our appliances in certain foreign markets;·
            increased
      exposure to foreign currency exchange rate risk;·
            increased
      exposure to possible violations of, or non-compliance with, the Foreign
      Corrupt Practices Act;·
            increased
      exposure to possible violations of U.S. laws regulating the export of our
      products, and to other U.S. and foreign laws affecting the conduct of
      business globally such as product certification, environmental and waste
      management and data privacy laws;·
            reduced
      protection for intellectual property rights in some countries;
      and·
            political
      and economic instability.








Sales to
international customers may also result in greater shipping costs and additional
expenses to conform our appliances to the requirements of local laws or local
product specifications. As we
continue to expand our business internationally, our success will depend, in
large part, on our ability to anticipate and effectively manage these and other
risks associated with our international operations. Our failure to manage any of
these risks successfully could harm our international operations, reduce or
delay our international sales, and result in fines and penalties.




Changes
in our provision for income taxes or adverse outcomes resulting from
examinations of our income tax returns could adversely affect our
results.
  If
our international revenues do not grow in absolute dollars and as a percentage
of total revenues, then our effective tax rate will not meet our planning
objectives and our profitability will be negatively impacted. Our provision for
income taxes is also subject to volatility and could be adversely affected by
changes in the valuation of our deferred tax assets and liabilities; by
expiration of or lapses in the R&D tax credit laws; by transfer pricing
adjustments; by tax effects of nondeductible compensation; or by changes in tax
laws, regulations, accounting principles, including accounting for uncertain tax
positions or interpretations thereof. Significant judgment is required to
determine the recognition and measurement attribute prescribed in Financial
Interpretation No. 48, Accounting for Uncertainty in Income
Taxes-an interpretation of FASB Statement No. 109, or FIN 48. In
addition, FIN 48 applies to all income tax positions, including the potential
recovery of previously paid taxes, which if settled unfavorably could adversely
impact our provision for income taxes or additional paid-in capital. We
anticipate future audits from various tax authorities. We regularly assess the
likelihood of adverse outcomes resulting from these examinations to determine
the adequacy of our provision for income taxes. There can be no assurance that
the outcomes from these future potential audits may result in an adverse effect
on our operating results and financial condition.
 
 In
addition, the recent turmoil in the financial markets, global recession, and
change in U.S. federal administration could result in changes to the U.S. tax
code and/or changes in the tax law and regulations applicable to Data Domain in
the various jurisdiction around the world in which we operate with the effect of
causing our effective tax rate to not meet our planning objectives and our
profitability to be negatively impacted.
  10
  We
are exposed to fluctuations in currency exchange rates that could negatively
impact our financial results and cash flows.
  Because
a portion of our business is conducted outside the United States, we face
exposure to adverse movements in foreign currency exchange rates. These
exposures may change over time as business practices evolve, and they could have
a material adverse impact on our financial results and cash flows. Historically,
our primary exposures have related to nondollar-denominated sales in Europe, UK,
Canada, and Australia and nondollar-denominated operating expenses in Europe,
Japan, Australia and Asia. Additionally, we have exposures for operating
expenses to emerging market currencies, which can have extreme currency
volatility. An increase in the value of the dollar could increase the real cost
to our customers of our products in those markets outside the United States
where we sell in dollars and other currencies, and a weakened dollar could
increase the cost of local operating expenses.




We
have a history of losses and we may not be able to sustain profitability in the
future.





For the
years ended December 31, 2008, 2007 and 2006, we recorded net income of
approximately $21.6 million and net losses of $3.7 million and $4.0 million,
respectively. As of December 31, 2008, our accumulated deficit was approximately
$18.7 million, and despite the fact we achieved profitability in fiscal 2008, we
might incur additional losses in future periods. We expect to make significant
expenditures related to the development of our business, including expenditures
to hire additional personnel relating to sales and marketing and product
development. In addition, we will continue to incur significant legal,
accounting and other expenses that we did not incur as a private company. Our
operating expenses are largely based on anticipated revenue trends, which could
be negatively impacted by deteriorating global economic conditions, and a high
percentage of our expenses are, and will continue to be, fixed in the short
term. As a result, a delay in generating or recognizing revenue could cause
significant variations in our operating results from quarter to quarter and
annually and could result in substantial operating losses. Our revenue growth
trends in prior periods are not likely to be sustainable, and we may not
generate sufficient revenue to maintain profitability. We may incur significant
losses in the future for a number of reasons, including those discussed in other
risk factors and factors that we cannot foresee.  If we are not able
to sustain profitability in the future, all or a portion of our net deferred
tax assets may not be considered realizable, which could increase future
income tax expense if we are required to establish a valuation allowance
against our net deferred tax assets.




Our
sales are difficult to predict, even in the near term, and a substantial portion
of our quarterly sales typically occurs during the last several weeks of the
quarter.





A
substantial portion of our quarterly sales typically occurs during the last
several weeks of the quarter, which we believe largely reflects customer buying
patterns of products similar to ours and other products in the technology
industry generally. In addition, a significant portion of our sales in any
quarter is not forecast at the start of the quarter and is generated by sales
activity initiated within the quarter. Similarly, we have little visibility at
the start of any quarter as to which existing customers, if any, will make
additional purchases and when any additional purchases may occur, if at all. As
a result, our quarterly operating results are difficult to predict even in the
near-term.




The
market we serve is emerging and the purchase of our appliances by new customers
may involve material changes to established purchasing patterns and policies.
Our sales efforts involve educating potential customers about the uses and
benefits of our appliances, including their technical capabilities and potential
cost savings. Potential customers may undertake a significant evaluation process
that has in the past resulted in a longer sales cycle. In addition, our sales
cycle may be extended if potential customers decide to re-evaluate other aspects
of their backup storage infrastructure at the same time they are considering a
purchase of our appliances. We spend substantial time, money and other resources
in our sales process without any assurance that our efforts will produce any
sales. In addition, customer purchases are frequently subject to budget
constraints, which could be negatively impacted by deteriorating global economic
conditions, multiple approvals and unplanned administrative, processing and
other delays. If sales expected from a specific customer for a particular
quarter are not realized in that quarter, or at all, our business may
suffer.


We
have a limited operating history and compete in a new and rapidly evolving
market, which makes our future operating results difficult to
predict.





We were
incorporated in October 2001 and first shipped our appliances in February 2004.
We have a limited operating history in an industry characterized by rapid
technological change, changing customer needs, evolving industry standards and
frequent introductions of new products and services. As we encounter rapidly
changing customer requirements and increasing competitive pressures, we likely
will be required to reposition our product and service offerings and introduce
new products and services. We may not be successful in doing so in a timely and
appropriately responsive manner, or at all. Furthermore, because we compete in
an early stage market, many of our target customers have not purchased products
similar to ours and might not have a specific budget for the purchase of our
appliances. Historically, enterprises have relied on non-deduplication,
tape-based technologies for backup and recovery, and we might not succeed in
generating increased demand for our products. All of these factors make it
difficult to predict our future operating results, which may impair our ability
to manage our business and investors’ ability to assess our
prospects.


If
we lose key personnel or are unable to attract and retain qualified personnel on
a cost-effective basis, our business would be harmed.





Our
success is substantially dependent upon the performance of our senior management
and key technical and sales personnel. Our management and employees can
terminate their employment at any time, and the loss of the services of one or
more of our executive officers or other key employees could harm our business.
Our success also is substantially dependent upon our ability to attract
additional personnel for all areas of our organization, particularly in our
sales and research and development departments. Our dependence on attracting and
retaining qualified personnel is particularly significant as we attempt to grow
our organization. Competition for qualified personnel in our industry is
intense, and we may not be successful in attracting and retaining such personnel
on a timely basis, on competitive terms, or at all. If we are unable to attract
and retain the necessary technical, sales and other personnel on a
cost-effective basis, our business would be harmed.


We
rely on channel partners to sell our appliances, and disruptions to, or our
failure to develop and manage our channel partners would harm our
business.
 
 Our
future success is dependent upon establishing and maintaining successful
relationships with a large number of channel partners. A substantial majority of
our revenue is generated by sales through our channel partners, and we expect
channel sales to continue to make up a significant portion of our total revenue
in the future, particularly outside the United States. In the years ended
December 31, 2008, 2007 and 2006, approximately 84%, 86% and 85%,
respectively, of our revenue was generated by sales through our channel
partners. Accordingly, our revenue depends in large part on the effective sales
and lead generation activities of these channel partners.
  Recruiting
and retaining qualified channel partners and training them in our technology and
product offerings requires significant time and resources. In order to develop
and expand our distribution channel, we must continue to scale and improve our
processes and procedures that support our channel, including investment in
systems and training. Those processes and procedures may become increasingly
complex and difficult to manage as we grow our organization. We have no minimum
purchase commitments from any of our channel partners, and our contracts with
these channel partners do not prohibit them from offering products or services
that compete with ours. Our competitors may provide incentives to existing and
potential channel partners to favor their products or to prevent or reduce sales
of our appliances. Our channel partners may choose not to offer our appliances
exclusively or at all. Establishing relationships with channel partners who have
a history of selling our competitors’ products may also prove to be difficult.
In addition, some of our channel partners are also competitors. Our failure to
establish and maintain successful relationships with channel partners would
seriously harm our business and operating results. The weak economic situation
will place additional pressures on this channel model, since we may experience
the failure of one or more of our resellers, potentially resulting in our
inability to collect outstanding receivables from such resellers, and
necessitating additional efforts on our part to replace such resellers in order
to maintain access to the various markets around the globe




If
we fail to manage growth effectively, our business would be
harmed.





We have
expanded our operations significantly since inception and anticipate that
further expansion of our operations and headcount will be required. For
example, our headcount increased from 435 employees as of December 31, 2007 to
777 employees as of December 31, 2008. Our growth has placed, and any
future growth will place, significant demands on our management,
infrastructure and other resources.  To manage any future growth, we
will need to hire, train, integrate and retain a large number of highly
skilled and motivated employees. We  will also need to continue to improve
our financial and management controls and reporting systems and procedures. We
implemented new enterprise resource planning software for our finance and
inventory management processes in October 2007, and we may in the future upgrade
other finance, sales and inventory management systems. We could encounter delays
or difficulties in implementing any of these systems. If we do not effectively
hire, train, integrate and retain sufficient highly qualified personnel to
support any future growth, and if we do not effectively manage the
associated increases in expenses, our business, results of operations and
financial condition would be harmed.





Our
financial results would suffer if demand for deduplication storage appliances
does not continue to grow.





Our
products are disk-based deduplication storage appliances for backup and
network-based disaster recovery. Deduplication is a relatively new and emerging
technology. Historically, enterprises have relied on non-deduplication
tape-based technologies for backup and recovery. A reduction in demand for
deduplication storage appliances for backup storage or network-based disaster
recovery could be caused by, among other things, weakening economic conditions,
decreases in information technology spending, lack of customer acceptance or
competing technologies and products. Our future financial results would suffer
if the demand for deduplication storage appliances does not continue to
grow.




11





If
we fail to predict accurately our manufacturing and component requirements, we
could incur additional costs or experience manufacturing delays which would harm
our business.





Our
agreement with our contract manufacturer, Flextronics, does not provide for
specific quantities or inventory levels for our appliances or the components
used in our appliances. Instead, we provide purchase orders to Flextronics on a
monthly basis. If we overestimate our manufacturing needs, Flextronics may
assess charges or we may have liabilities for excess or obsolete
inventory.  Conversely, because lead times for required materials and
components vary significantly and depend on factors such as the specific
supplier, contract terms and demand for the particular component at any given
time, if we underestimate our requirements, Flextronics may have inadequate
materials and components required to produce our appliances. In that event, the
manufacturing of our appliances could be interrupted, shipments could be delayed
and revenue could be deferred or lost. Flextronics generally carries very little
inventory of components for our appliances, and we rely on suppliers to deliver
necessary components to Flextronics in a timely manner based on forecasts
provided to the suppliers.




Any
shortages in components used in our appliances could delay shipment of our
appliances or increase our product
 costs,
which could harm our business.


We may experience shortages in
components that we use in our appliances, and we may not accurately predict the
availability of and demand for such components. We rely on Flextronics to
procure a majority of the components used in our appliances. As a result, any
disruption in Flextronics’s ability to timely procure necessary components in
the quantities required, or at reasonable prices, could result in a delay in the
shipment of our appliances. Due to technological, pricing or business reasons,
some of the components used in our appliances are available only from a single
or limited source of supply. Flextronics generally carries very little inventory
of components for our appliances, and we rely on suppliers to deliver necessary
components to Flextronics in a timely manner based on forecasts provided to the
suppliers.





Our
capacity expansion shelves and the chassis for our DD 690 appliance are
currently supplied exclusively by a single vendor, Xyratex Technology Limited,
or Xyratex. Neither our agreement with Xyratex, nor any agreement between
Flextronics and Xyratex, provides for specific quantities or inventory levels of
expansion shelves or the DD 690 chassis. Instead, Flextronics provides purchase
orders to Xyratex on a monthly basis based on purchase orders we place with
Flextronics and our forecasts.  If Flextronics is unable to acquire
the expansion shelves or DD 690 chassis from Xyratex for whatever reason, the
manufacturing of our expansion shelves and DD 690 appliance could be interrupted
and shipments could be delayed and revenue could be deferred or lost. Our
agreement with Xyratex for expansion shelves has a three-year term ending in
March 2010, subject to early termination by either party under certain
circumstances.





Our
appliances depend on NVRAM cards that currently are only available from a single
vendor, Curtiss-Wright Corporation. Neither we nor Flextronics has an agreement
with Curtiss-Wright Corporation providing for specific quantities or inventory
levels of NVRAM cards.  We or Flextronics order NVRAM cards under a
standard purchase order arrangement with Curtiss-Wright Corporation or its
distributor.





Our
appliances depend on DiskOnModule (DOM) flash memory devices that are only
available from a single vendor, PQI Corporation.  Neither we nor
Flextronics has an agreement with PQI Corporation providing for specific
quantities or inventory levels of NVRAM cards.  We or Flextronics
order the PQI DOM under a standard purchase order arrangement with PQI
Corporation or its distributor.




Our
appliances depend on microprocessors that are only available from a single
vendor, Intel Corporation, and certain of our products rely on motherboards that
are only available from Intel.  Neither we nor Flextronics has an
agreement with Intel providing for specific quantities or inventory levels of
these components.  We or Flextronics order these components under a
standard purchase order arrangement with Intel or its
distributor.




We
acquire the chassis used in our appliances other than the DD 690 from a single
vendor, Super Micro Computer, Inc., or Super Micro.  Neither we nor
Flextronics has an agreement with Super Micro providing for specific quantities
or inventory levels of chassis.  We or Flextronics order chassis under a
standard purchase order arrangement with Super Micro or its


distributor.





Significant
time and effort would be required to locate new vendors for any of the foregoing
components, if available at all, to qualify replacement components or to develop
our appliances using alternative suppliers. The unavailability of any of these
or other necessary components could delay or prevent us from shipping our
appliances. Component suppliers may be vulnerable to pressure from large
purchasers of their products, who may be competitors of ours, to allocate
available component supplies to them. The
global recession may also adversely affect our suppliers, including those on
whom we are dependent as sole source suppliers, and their liquidity, and the
availability of, and/or terms and conditions on which we purchase, their
products and services. In addition, increased demand generally by third
parties for the components we use in our appliances may lead to decreased
availability and higher prices for those components. Further, we are dependent
in some instances upon these sole source suppliers for support of their
products, and for new product introductions, and we are subject to their end of
life practices, including timing of product end of life, post end of life
support, and last time buy notice, availability and pricing.




If
we experience shortages in components that we use in our appliances, or do not
accurately predict the availability of and demand for such components, or if new
product introductions by our suppliers do not meet our expectations for timing,
availability, functionality/performance, quality or price, then our business and
gross margins could be negatively impacted, and our reputation and customer
relationships could be harmed.
  12


We
are dependent on a single contract manufacturer and changes to that relationship
may result in delays or disruptions that could harm our business.





We rely
on a single independent contract manufacturer, Flextronics, to manufacture and
assemble our appliances. We currently have an agreement in place with
Flextronics that is subject to automatic extensions in one-year increments
absent notice of termination by us or Flextronics. However, either party can
terminate the agreement for any reason at any time with at least 90 days’
advance written notice. We may not be able to effectively manage our
relationship with Flextronics, and Flextronics may not meet our future
requirements for timely delivery. Our orders represent only a small percentage
of the overall orders received by Flextronics from its customers. As a result,
fulfilling our orders may not be considered a priority by Flextronics in the
event it is constrained in its ability to fulfill all of its customer
obligations in a timely manner. Although the services required to manufacture
and assemble our appliances may be readily available from a number of other
established contract manufacturers, it would be time consuming and costly to
qualify and implement a new contract manufacturer relationship. Although we have
a contingency plan in place with Flextronics in the event that its capacity at
the location used to manufacture and assemble our appliances is reduced or
temporarily eliminated, any event that disrupts the manufacturing and assembly
process could harm our business. If Flextronics suffers an interruption in its
business, or experiences delays, disruptions or quality control problems in its
manufacturing operations, or if we have to change or add additional contract
manufacturers, our ability to manufacture and ship appliances to our customers
would be delayed and our business would suffer.






We
rely on a single third party to provide onsite hardware and repair and
replacement services to a substantial majority of our customers, and any
disruption to the availability of those services or their quality could harm our
business.
 
 We
subcontract with a third party, Glasshouse, Inc., or Glasshouse, to provide
onsite hardware repair and replacement services for the substantial majority of
our customers that have purchased a support and services contract from us. For
each such covered customer, we purchase a support contract from Glasshouse. Our
master agreement with Glasshouse has a three-year term ending in June 2010,
except that after the initial 12 months, which ended in June 2008, either party
may terminate the agreement by providing the other party with 90 days’ prior
written notice. We may not be able to effectively manage our relationship with
Glasshouse, and Glasshouse may not meet our future requirements for high
quality, timely delivery of services. Although the break fix services performed
by Glasshouse may be readily available from a number of other established
suppliers, it could be time consuming and costly to qualify and implement a new
supplier. If Glasshouse suffers an interruption in its business, or experiences
delays, disruptions or quality control problems in its services, or if we have
to change or add additional service providers, our ability to deliver high
quality and timely break fix services to our customers could be delayed and our
business and gross margins could be negatively impacted, and our reputation and
customer relationships could be harmed.
 
 If
we do not successfully anticipate market needs and develop products and product
enhancements that meet those needs, or if those products do not gain market
acceptance, our business will suffer.
 
 The
market in which we currently operate is rapidly developing. We may not be able
to anticipate future market needs or be able to develop new products or product
enhancements to meet such needs, either in a timely manner or at all. Our
business depends upon the introduction of successive new generations of products
with improved performance, capacity and functionality. We anticipate that for
future product introductions we will be required to establish new relationships
with original design manufacturers (ODMs) and other suppliers on whom we will be
dependent for design services, component supplies, manufacturing and
support.  Establishing new suppliers can be time consuming and costly,
and new designs and new suppliers present risks of delay, costs,
functionality/performance, quality and availability. If we fail to introduce
successive new generations of products with improved the performance, capacity
and functionality, and/or fail to successfully establish relationships with
(ODMs) and other suppliers on whom we will be dependent for achieving our
objectives, then our business and gross margins could be negatively impacted. We
also may not be able to develop our products in a manner that enables us to
successfully address the needs of other parts of the enterprise storage market.
For example, we have recently introduced products for classes of applications
other than backup and disaster recovery. These nearline classes of applications,
such as archival storage and fixed-content data storage, manage largely static
files and benefit from the fast storage and retrieval of disk-based systems, but
do not require the performance characteristics of primary storage. Our failure
to extend our deduplication technology into these nearline applications,
particularly if our competitors are able to do so, could harm our business. In
addition, any new products or product enhancements that we introduce may not
achieve any significant degree of market acceptance or be accepted into our
sales channel by our channel partners, which would harm our
business.


If
we fail to offer high quality customer support and services, our business would
suffer.





Once our
appliances are deployed within our customers’ networks, our customers depend on
our support organization to resolve any issues relating to our appliances. A
high level of customer support and services is important for the successful
marketing and sale of our appliances. If we or our channel partners do not help
our customers quickly resolve post-deployment issues and provide effective
ongoing support, our ability to sell our appliances to existing customers would
suffer and our reputation with potential customers would be harmed. Some of our
international channel partners offer primary support for the appliances they
sell to customers, and we rely on third parties to provide onsite hardware
repair and replacement services for most of our customers. If the third parties
fail to provide timely and effective services, our business could be harmed. As
we expand our sales, we will be required to hire and train additional support
personnel. In addition, as we expand our operations internationally, our support
organization will face additional challenges including those associated with
delivering support, training and documentation in languages other than English.
If we fail to maintain high quality customer support or to grow our support
organization to match any future sales growth, our business
will suffer.





If
we elect to discount our support and services pricing to attract or retain
customers, we may be required to defer a portion of our revenue to future
periods.





If we
elect to discount our support and services pricing or otherwise introduce
significant variability in our support and services arrangements, this
variability may require us to defer the recognition of revenue from sales of our
appliances. We recognize revenue for our appliances using the residual method as
allowed by the American Institute of Certified Public Accountants, or AICPA,
Statement of Position No. 98-9,Modification of SOP No. 97-2,
Software RevenueRecognition, with Respect to Certain
Transactions, or SOP 98-9. Under this method, in order to recognize
product revenue upon shipment, we must establish sufficient evidence, which is
referred to as vendor specific objective evidence, or VSOE, of fair value of our
undelivered support and services. We have established VSOE of fair value of our
support and services based on the price charged when support and services are
sold separately. If we are required to change the pricing of support and
services through discounting, or otherwise introduce variability in the pricing
of support and services on certain transactions to attract or retain customers,
we may be unable to maintain VSOE of the fair value of support and services for
similar types of transactions. As a result, we could be required to defer all
revenue for these transactions and recognize revenue ratably over the term of
the related support and services contracts, which is typically one to three
years. If this were to occur, our revenue would decline and our operating
results would be negatively impacted.


13




Our
appliances handle mission-critical data for our customers and are highly
technical in nature. If customer data is lost or corrupted, or our appliances
contain software errors or hardware defects, we could have product liability
exposure and our reputation and business could be harmed.





Our
appliances are involved in storing and replicating mission-critical data for our
customers. The process of storing and replicating that data is highly technical
and complex. If any data is lost or corrupted in connection with the use of our
appliances, our reputation could be seriously harmed and market acceptance of
our appliances could suffer. In addition, our appliances have contained and may
in the future contain software errors, hardware defects or security
vulnerabilities. We rely on our suppliers to deliver high quality components for
use in our products and we have limited or no control over our suppliers’
product development and production processes. Some software errors or defects in
the hardware components of our appliances may only be discovered after an
appliance has been installed and used by customers. In April 2007, we initiated
a field replacement program to replace a circuit board used in some of our
appliances. To date, these circuit boards have experienced failures in less than
1% of the appliances that we believe are potentially affected. All of the
circuit boards that have failed were manufactured by fabricators that are no
longer supplying parts for use in our appliances. Through the replacement
program, we are offering to replace the potentially affected circuit boards with
circuit boards manufactured by a particular fabricator. We accrued estimated
warranty costs of $1.2 million in the first quarter of 2007 for this replacement
program. We accrued an additional $450,000 in the third quarter of  2007 to
expand this program for additional circuit boards used in some of our
appliances. During the second quarter of  2008, we recorded an additional
charge of $25,000 as we revised our estimate of the costs of the replacement
program. These estimates were based on the number of circuit boards we expect to
replace under the program, the anticipated cost of replacement and refurbishment
and other associated costs. As of December 31, 2008, we had incurred
approximately $1.6 million of costs associated with these field replacement
programs and $68,000 remained in accrued liabilities to cover future costs for
the units potentially affected. Although we believe our estimates and judgments
for the replacement program are reasonable, if the problem is more extensive
than we currently believe or the actual costs of the program otherwise exceed
our estimate, our operating results will be negatively impacted. Any such
errors, defects or security vulnerabilities discovered in our appliances after
commercial release could result in loss of revenue, loss of customers, increased
service and warranty cost, harm to our reputation and diversion of attention of
our management and technical personnel, any of which could significantly harm
our business. In addition, we could face claims for product liability, tort or
breach of warranty. Defending a lawsuit, regardless of its merit, is costly and
may divert management’s attention and adversely affect the market’s perception
of us and our appliances.





Changes
in existing technologies or the emergence of new products or technologies could
reduce demand for our appliances and significantly harm our
business.





Changes
in existing technologies could cause demand for our appliances to decline. For
example, if changes in technology result in a significant reduction in the price
for hard disk drives, enterprises may not need to utilize deduplication storage
in order to cost-effectively backup and protect their data. One or more new
technologies also could be introduced that compete favorably with our appliances
or that cause our appliances to no longer be of significant benefit to our
customers. In addition, because our appliances work with enterprise backup
software applications to transfer and store data in the protection storage
environment, we are dependent on enterprises’ use of these applications for data
protection and disaster recovery purposes. If enterprises adopt products or
technologies that enable them to protect and recover their data without the need
for backup software, demand for our appliances would be reduced
significantly.




The
inability of our appliances to interoperate with backup software applications
would cause our business to suffer.





We have
designed our appliances to interoperate with the leading enterprise backup
software applications available in the market. If our appliances are not
compatible with the leading backup software applications, demand for our
appliances will decline. Some backup software providers currently offer products
that compete with ours and other providers may do so in the future. Backup
software providers may in the future make changes that would diminish the
ability of our appliances to interoperate with their applications. If this were
to occur, we may need to spend significant time and effort to ensure the
continued compatibility of our appliances, which may not be possible at all. Any
of these developments could significantly harm our business.





Data
formats may change in a way that reduces the value of our compression
technologies.





Our
compression technologies have been designed to work well for data formats
commonly seen in customer data centers today. The format of data stored on our
appliances may change in ways that reduce the benefit of our compression
technologies. Such format changes could result from changes in the applications
that create or transmit the data, changes in the systems that store the data, or
changes in policies concerning data encryption, compression, or encoding. For
example, some potential customers in the past have employed encryption or
compression technologies that they were unable or unwilling to disable and
therefore did not find the benefits of our Global Compression technologies
compelling. If the number of such potential customers were to increase
significantly in the future, our business could suffer.





14




The
U.S. government has become an important customer for us, and if it or individual
agencies within the U.S. government reduce or shift their capital spending
pattern, our financial results may be harmed.




The
U.S. government has become an important customer for
us.  Government agencies are subject to budgetary processes and
expenditure constraints, which constraints could increase due to current
economic conditions, that could lead to delays or decreased capital expenditures
in information technology spending on infrastructures. If the
U.S. government or individual agencies within the U.S. government
reduce or shift their capital spending pattern, our financial results may be
harmed.  Our sales to the U.S. government may involve longer sales
cycles than is typical of our non-government customers, increasing the
likelihood that an order may not occur in the quarter in which we had
anticipated the sale, if at all.  In addition, our sales to the
U.S. government require us to comply with U.S. laws applicable to enterprises
and products that are offered for sale to the U.S. government.  Any
failure by us to comply with and manage these obligations could result in a
reduction or delay in sales to the U.S government, or result in fines and
penalties.





If
we fail to establish and maintain proper and effective internal control over
financial reporting, our operating results and our ability to operate our
business could be harmed.





The
Sarbanes-Oxley Act of 2002 requires, among other things, that we establish and
maintain internal control over financial reporting and disclosure controls and
procedures. We performed, under the supervision and with the participation of
our management, system and process evaluations and testing of our internal
control over financial reporting, as required by Section 404 of the
Sarbanes-Oxley Act, and our management reported that our internal control over
financial reporting was effective as of December 31, 2008. However, if in the
future we are not able to comply with the requirements of Section 404 in a
timely manner, or if we or our independent registered public accounting firm
identify deficiencies in our internal control over financial reporting that are
deemed to be material weaknesses, the market price of our common stock could
decline and we could be subject to investigations or sanctions by the SEC, the
NASDAQ Stock Market, or NASDAQ, or other regulatory authorities or subject to
litigation. To the extent any material weaknesses in our internal control over
financial reporting are identified in the future, we could be required to expend
significant management time and financial resources to correct such material
weaknesses or to respond to any resulting regulatory investigations or
proceedings.




If
we are unable to protect our intellectual property rights, our competitive
position could be harmed, and we could be required to incur significant expenses
to enforce our rights.





We depend
on our ability to protect our proprietary technology. We rely on trade secret,
patent, copyright and trademark laws and confidentiality agreements with
employees and third parties, all of which offer only limited protection. Despite
our efforts, the steps we have taken to protect our proprietary rights may not
be adequate to preclude misappropriation of our proprietary information or
infringement of our intellectual property rights, and our ability to police such
misappropriation or infringement is uncertain, particularly in countries outside
of the United States. Further, we do not know whether any of our pending patent
applications will result in the issuance of patents or whether the examination
process will require us to narrow our claims. Even issued patents may be
contested, circumvented or invalidated. Moreover, the rights granted under any
issued patents may not provide us with proprietary protection or competitive
advantages, and, as with any technology, competitors may be able to develop
similar or superior technologies to our own now or in the future. In addition,
we have entered into a cross-license agreement with Quantum, a competitor of
ours, that provides Quantum and its controlled affiliates a license to our
current and future patents that relate to or are useful with respect to data
transmission or data storage and that are or may be issued or applied for (or
otherwise entitled to a priority date) on or prior to January 1, 2012. As a
result of this agreement, we will not be able to assert our existing patent
rights and many or all of our future patent rights against Quantum or its
controlled affiliates for the foreseeable future, and Quantum has certain rights
to assign this license to an acquirer of Quantum. It is also possible that we
may find it necessary or advantageous to enter into similar cross licenses in
the future with other actual or potential competitors.





Protecting
against the unauthorized use of our patents, trademarks and other proprietary
rights is expensive, difficult and, in some cases, impossible. Litigation may be
necessary in the future to enforce or defend our intellectual property rights,
to protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. Such litigation could be costly and divert
management resources, either of which could harm our business. Furthermore, many
of our current and potential competitors have the ability to dedicate
substantially greater resources to enforce their intellectual property rights
than we do. Accordingly, despite our efforts, we may not be able to prevent
third parties from infringing upon or misappropriating our intellectual
property.





Claims
by others that we infringe their proprietary technology could harm our
business.





Third
parties could claim that our appliances or technology infringe their proprietary
rights. We expect that infringement claims may increase as the number of
products and competitors in our market increases and overlaps occur. In
addition, to the extent that we gain greater visibility and market exposure as a
public company, we face a higher risk of being the subject of intellectual
property infringement claims. Any claims of infringement by a third party, even
those without merit, could cause us to incur substantial costs defending against
the claim, and could distract our management from our business. Furthermore, a
party making such a claim, if successful, could secure a judgment that requires
us to pay substantial damages. A judgment could also include an injunction or
other court order that could prevent us from offering our appliances. In
addition, we might be required to seek a license for the use of such
intellectual property, which may not be available on commercially reasonable
terms or at all. Alternatively, we may be required to develop non-infringing
technology, which could require significant effort and expense and may
ultimately not be successful. Any of these events could seriously harm our
business.





Third
parties may also assert infringement claims relating to our appliances against
our customers and channel partners. Any of these claims may require us to
initiate or defend potentially protracted and costly litigation on their behalf,
regardless of the merits of these claims, because we generally are obligated to
indemnify our channel partners and our customers, from claims of infringement of
proprietary rights of third parties. If any of these claims succeed, we may be
forced to pay damages to, or on behalf of, our customers or channel partners,
which could seriously harm our business.





Our
use of open source software could impose limitations on our ability to
commercialize our appliances.





We
incorporate open source software into our appliances. The terms of many open
source licenses have not been interpreted by United States courts, and there is
a risk that such licenses could be construed in a manner that could impose
unanticipated conditions or restrictions on our ability to commercialize our
appliances. In that event, we could be required to seek licenses from third
parties in order to continue offering our appliances, to re-engineer our
appliances, to discontinue the sale of our appliances in the event
re-engineering cannot be accomplished on a timely basis or to litigate any
disputes relating to our use of open source software, any of which could harm
our business.




15





Our
business is subject to increasingly complex environmental legislation that has
increased both our costs and the risk of noncompliance and may continue to do so
in the future.





We face
increasing complexity in the design and manufacture of our appliances as we
adjust to new and upcoming requirements relating to the materials composition of
many of our appliances. For example, the European Union, or EU, has adopted
certain directives to facilitate the recycling of electrical and electronic
equipment sold in the EU, including the Restriction on the Use of Certain
Hazardous Substances in Electrical and Electronic Equipment, or RoHS, directive.
The RoHS directive restricts the use of lead, mercury and certain other
substances in electrical and electronic products placed on the market in the EU.
A companion EU directive, the Waste Electrical and Electronic Equipment
Directive imposes responsibility for the collection, recycling and recovery for
certain electrical and electronic products on the manufacturers of such
equipment.





We have
incurred costs to comply with these regulations in the past and could incur
additional costs in the future. In addition, compliance with these regulations
could disrupt our operations and logistics. We will need to ensure that we can
design and manufacture compliant appliances and that we can be assured a supply
of compliant components from suppliers. Similar laws and regulations have been
proposed or may be enacted in other regions, including the United States,
Australia, Canada, China, Korea and Japan. These and other environmental
regulations may require us to reengineer our appliances to utilize new
components that are compatible with these regulations, which may result in
additional costs to us.




We
may not generate positive returns on our research and development
investments.





Developing
our products is expensive, and our investment in product development may involve
a long investment return cycle. For the year ended December 31, 2008, our
research and development expenses were $41.0 million, or approximately 15% of
revenue. Our future plans include significant investments in research and
development and related product opportunities. We believe that we must continue
to dedicate a significant amount of resources to our research and development
efforts to maintain our competitive position. These investments may not generate
positive returns in the near term, or at all.




We
may engage in future acquisitions that could disrupt our business, cause
dilution to our stockholders and harm our business, operating results and
financial condition.





In the
future we may acquire other businesses, products or technologies. We have not
made any acquisitions to date and, as a result, our ability as an organization
to make acquisitions is unproven. We may not be able to find suitable
acquisition candidates and we may not be able to complete acquisitions on
favorable terms, if at all. If we do complete acquisitions, we may not
ultimately strengthen our competitive position or achieve our goals, and any
acquisitions we complete could be viewed negatively by customers, financial
markets or investors. In addition, any acquisitions that we make could lead to
difficulties in integrating personnel and operations from the acquired
businesses and in retaining and motivating key personnel from these businesses.
Acquisitions may disrupt our ongoing operations, divert management from
day-to-day responsibilities, increase our expenses and harm our business. Future
acquisitions may also reduce our cash available for operations and other uses
and could result in an increase in amortization expense related to identifiable
assets acquired, potentially dilutive issuances of equity securities or the
incurrence of debt.





We
have incurred, and will continue to incur, significant costs as a result of
operating as a public company, and our management is required to devote
substantial time to compliance efforts.





As a
public company, we incur significant legal, audit, accounting and other expenses
that we did not incur as a private company. The Sarbanes-Oxley Act, as well as
rules subsequently implemented by the SEC and NASDAQ, impose additional
requirements on public companies, including enhanced corporate governance
practices. For example, the NASDAQ listing requirements require that listed
companies satisfy certain corporate governance requirements relating to
independent directors, audit committees, distribution of annual and interim
reports, stockholder meetings, stockholder approvals, solicitation of proxies,
conflicts of interest, stockholder voting rights and codes of business conduct.
Our management and other personnel are required to devote a substantial amount
of time to these requirements. Moreover, these rules and regulations have
increased our legal and financial compliance costs and have made some activities
more time-consuming and costly. These rules and regulations could also make it
more difficult for us to attract and retain qualified persons to serve on our
board of directors and board committees or as executive officers.





Our
business is subject to the risks of earthquakes, fire, floods and other natural
catastrophic events, and to interruption by man-made problems such as computer
viruses or terrorism.





Our
corporate headquarters and the operations of the contract manufacturer for our
appliances are located in the San Francisco Bay Area, a region known for seismic
activity. A significant natural disaster, such as an earthquake, fire or a
flood, could harm our business. In addition, our servers are vulnerable to
computer viruses, break-ins and similar disruptions from unauthorized tampering
with our computer systems. In addition, acts of terrorism or war could cause
disruptions in our or our customers’ business or the economy as a whole. To the
extent that such disruptions result in delays or cancellations of customer
orders, or delay the manufacture and shipment of our appliances, our business
would be harmed.




16








Risks
Related to Ownership of Our Common Stock





The
trading price of our common stock has been volatile and is likely to be volatile
in the future.





The
trading prices of our common stock as well as the securities of other technology
companies have been highly volatile, particularly in the last several months as
a result of deteriorating economic conditions. Further, our common stock has a
limited trading history. Factors affecting the trading price of our common stock
could include:





·
            variations
      in our operating results;·
            announcements
      of technological innovations, new products and services, strategic
      alliances or significant agreements by us or by our
      competitors;·
            recruitment
      or departure of key personnel;·
            changes
      in the estimates of our operating results or changes in recommendations by
      any securities analysts that elect to follow our common
    stock;·
            market
      conditions in our industry, the industries of our customers and the
      economy as a whole; and·
            adoption
      or modification of regulations, policies, procedures or programs
      applicable to our business.





In
addition, if the market for technology stocks or the stock market in general
continues to experience a loss of investor confidence, the trading price of our
common stock could continue to decline for reasons unrelated to our business,
operating results or financial condition. The trading price of our common stock
might also decline in reaction to events that affect other companies in our
industry even if these events do not directly affect us, or in reaction to
reports from industry analysts about us or our competitors or others in the
technology industry generally. Some companies that have had volatile market
prices for their securities have had securities class actions filed against
them. A suit filed against us, regardless of its merits or outcome, could cause
us to incur substantial costs and could divert management’s
attention.





Anti-takeover
provisions in our charter documents and Delaware law could discourage, delay or
prevent a change in control of our company and may affect the trading price of
our common stock.





We are a
Delaware corporation and the anti-takeover provisions of the Delaware General
Corporation Law may discourage, delay or prevent a change in control by
prohibiting us from engaging in a business combination with an interested
stockholder for a period of three years after the person becomes an interested
stockholder, even if a change in control would be beneficial to our existing
stockholders. In addition, our restated certificate of incorporation and amended
and restated bylaws may discourage, delay or prevent a change in our management
or control over us that stockholders may consider favorable. Our restated
certificate of incorporation and amended and restated bylaws:





·
            authorize
      the issuance of “blank check” preferred stock that could be issued by our
      board of directors to thwart a takeover attempt;·
            establish
      a classified board of directors, as a result of which the successors to
      the directors whose terms have expired will be elected to serve from the
      time of election and qualification until the third annual meeting
      following their election;·
            require
      that directors only be removed from office for cause;·
            provide
      that vacancies on the board of directors, including newly created
      directorships, may be filled only by a majority vote of directors then in
      office;·
            limit
      who may call special meetings of stockholders;·
            prohibit
      stockholder action by written consent, requiring all actions to be taken
      at a meeting of the stockholders; and·
            require
      supermajority stockholder voting to effect certain amendments to our
      restated certificate of incorporation and amended and restated
      bylaws.




17


Item 1B.                      Unresolved
Staff Comments




None.




Item 2.
            Properties




Our
corporate headquarters are currently located at 2421 Mission College Blvd.,
Santa Clara, California 95054. We lease approximately 200,000 square feet of
office space at this building and an adjacent office building pursuant to
leases that expire in October 31, 2017 and June 30, 2018, respectively. We
believe these facilities will accommodate our needs for the foreseeable future.
We lease a research and development facility that is 9,088 square feet in
Raleigh, North Carolina, which expires in December 2009. We also maintain sales
offices in multiple locations in the United States and
internationally.




Item 3.
            Legal
      Proceedings




We are
subject to various claims, complaints and legal actions in the normal course of
business from time to time. We do not believe we are party to any currently
pending legal proceedings, the outcome of which will have a material adverse
effect on our results of operations or financial position. There can be no
assurance that existing or future legal proceedings arising in the ordinary
course of business, or otherwise, will not have a material adverse effect on our
business, consolidated financial position, results of operations or cash
flow.




Item 4.
            Submission
      of Matters to a Vote of Security
Holders




There
were no matters submitted to a vote of security holders during the fourth
quarter of 2008.




Item 4A. Executive
Officers of the Registrant




Our
executive officers, and their ages and positions as of  March 11, 2009, are
set forth below:




Name
                    Age
                    PositionFrank
      Slootman
                    50
                    President
      and Chief Executive OfficerMichael
      P. Scarpelli
                    42
                    Senior
      Vice President and Chief Financial OfficerNick
      Bacica
                    55
                    Senior
      Vice President of OperationsDaniel
      R. McGee
                    49
                    Senior
      Vice President of EngineeringDavid
      L. Schneider
                    40
                    Senior
      Vice President of Worldwide
Sales




Frank
Slootman has served as a member of our board of directors and as our
President and Chief Executive Officer since July 2003. Prior to joining us,
Mr. Slootman served as an executive at Borland Software Corporation from
June 2000 to June 2003, most recently as Senior Vice President of Products. From
March 1993 to June 2000, Mr. Slootman held management positions for two
enterprise software divisions of Compuware Corporation. Mr. Slootman earned
his undergraduate and graduate degrees in Economics from Erasmus University
Rotterdam in the Netherlands.




Michael P.
Scarpelli joined us as our Vice President and Chief Financial Officer in
September 2006, and was promoted to Senior Vice President in January 2008. From
January 2006 to September 2006, Mr. Scarpelli served as Executive Vice
President and Chief Financial Officer for Lexar Media, Inc., a flash memory
manufacturer which was acquired by Micron Technology, Inc. in 2006. From January
2002 to January 2006, Mr. Scarpelli held senior positions at HPL
Technologies, Inc., a provider of yield management software and test chip
solutions, most recently as Senior Vice President and Chief Financial Officer.
Mr. Scarpelli began his career at PricewaterhouseCoopers LLP from May 1989
to December 2001. Mr. Scarpelli holds a B.A. in Economics from the
University of Western Ontario.




Nick
Bacica joined us as our Vice President of Operations in November 2008 and
was promoted to Senior Vice President of Operations in January 2009. From 2004
to 2008, Mr. Bacica was Vice President of Operations at Azul Systems, a global
provider of enterprise server appliances. From 2001 to 2004, Mr. Bacica served
as Senior Vice President of World-Wide Operations for Brocade Communications
Systems. From 1997 to 2001, Mr. Bacica served as Director of Global
Transformation at Cisco Systems, Inc. Mr. Bacica has also held senior level
positions at Apple Computer, Burroughs Corporation and Xerox Corporation. Mr.
Bacica attended East Texas State University.






Daniel R.
McGee joined us as our Vice President of Engineering in February 2006,
and was promoted to Senior Vice President of Engineering in January 2008. From
March 2004 to February 2006, Mr. McGee was the Vice President of
Engineering for Aventail Corporation, a provider of secure remote access
products. From August 1999 to March 2004, Mr. McGee held various senior
management positions at Pinnacle Systems, Inc., a provider of video editing
solutions, TV tuners for personal computers and digital media adapters.
Mr. McGee holds a M.S. in Engineering Management from Stanford University
and a B.S. in Electrical Engineering & Computer Science from Oregon
State University.




David L.
Schneider joined us as our Vice President of Worldwide Sales in January
2004, and was promoted to Senior Vice President of Worldwide Sales in January
2008. From January 2003 to December 2003, Mr. Schneider served as Vice
President of Alliances, Channel and OEM sales for Borland Software Corporation.
From May 2002 to January 2003, Mr. Schneider served as Vice President of
Western United States Sales for TogetherSoft Corporation (later acquired by
Borland Software Corporation). From January 1999 to May 2002, Mr. Schneider
was Western Regional Manager at Iona Technologies, Inc. Mr. Schneider holds
a B.A. in Political Science from the University of California,
Irvine.




18




Part
II




Item 5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities




Market
for Common Stock




Our
common stock traded on The NASDAQ Global Market under the symbol “DDUP” from
June 27, 2007, the date of our initial public offering, through January 1,
2009, and has traded on The NASDAQ Global Select Market since January 2, 2009.
Prior to our initial public offering, there was no public market for our common
stock. The following table sets forth for the periods indicated the high and low
sale prices of our common stock, as reported by The NASDAQ Global
Market.







High
                    
                    
                    LowYear
      Ended December 31, 2008First
      quarter
                    
                    $
                    26.49
                    
                    
                    $
                    18.93Second
      quarter
                    
                    $
                    25.16
                    
                    
                    $
                    20.00Third
      quarter
                    
                    $
                    23.93
                    
                    
                    $
                    19.30Fourth
      quarter
                    
                    $
                    22.46
                    
                    
                    $
                    14.83Year
      Ended December 31, 2007Second
      Quarter (from June 27, 2007)
                    
                    $
                    25.40
                    
                    
                    $
                    19.94Third
      Quarter
                    
                    $
                    32.73
                    
                    
                    $
                    21.47Fourth
      Quarter
                    
                    $
                    41.14
                    
                    
                    $
                    23.86









Stock
Price Performance Graph




The graph
below matches the cumulative 18-month total return of holders of our common
stock with the cumulative total returns of the NASDAQ Composite index, the
NASDAQ Computer index and a customized peer group of seven companies that
consists of: 3Par Inc., Commvault Systems Inc., EMC Corp., Isilon Systems Inc.,
NetApp, Inc., Quantum Corp. and Riverbed Technology Inc. The graph assumes that
the value of the investment in our common stock, in each index, and in the peer
group (including reinvestment of dividends) was $100 on June 27, 2007 and tracks
it through December 31, 2008.






19








6/27/07
                    
                    
                    
                    9/07
                    
                    
                    
                    12/07
                    
                    
                    
                    3/08
                    
                    
                    
                    6/08
                    
                    
                    
                    9/08
                    
                    
                    
                    12/08Data
      Domain, Inc.
                    
                    
                    100.00
                    
                    
                    
                    124.05
                    
                    
                    
                    105.57
                    
                    
                    
                    95.39
                    
                    
                    
                    93.51
                    
                    
                    
                    89.26
                    
                    
                    
                    75.35Nasdaq
      Composite
                    
                    
                    100.00
                    
                    
                    
                    104.21
                    
                    
                    
                    101.53
                    
                    
                    
                    87.25
                    
                    
                    
                    88.15
                    
                    
                    
                    78.22
                    
                    
                    
                    59.15Nasdaq
      Computer
                    
                    
                    100.00
                    
                    
                    
                    105.28
                    
                    
                    
                    109.69
                    
                    
                    
                    87.54
                    
                    
                    
                    91.70
                    
                    
                    
                    78.21
                    
                    
                    
                    58.49Peer
      Group
                    
                    
                    100.00
                    
                    
                    
                    106.71
                    
                    
                    
                    94.45
                    
                    
                    
                    72.27
                    
                    
                    
                    74.57
                    
                    
                    
                    61.22
                    
                    
                    
                    52.61




The stock
price performance included in this graph is not necessarily indicative of future
stock price performance. We believe that a number of factors may cause the
market price of our common stock to fluctuate significantly. Please see “Item
1A- Risk Factors.”




Holders
of Record




As of
March 11, 2009, there were 94 stockholders of record of our common
stock.




Dividends




We have
never declared or paid cash dividends on our common stock nor do we intend in
the foreseeable future to pay cash dividends on our common stock.




20


Issuer
Purchases of Equity Securities




We did
not repurchase any of our common stock during the fourth quarter of
2008.




Item 6.
            Selected
      Financial Data




You
should read the following selected consolidated historical financial data in
conjunction with the section titled “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” and the consolidated financial
statements, related notes and other financial information included in this
Annual Report. The selected financial data in this section is not intended to
replace the consolidated financial statements and is qualified in its entirety
by the consolidated financial statements and related notes included in this
Annual Report.




We
derived the selected consolidated financial data for the years ended
December 31, 2008, 2007 and 2006 and as of December 31, 2008 and 2007
from our audited consolidated financial statements and related notes, which are
included elsewhere in this Annual Report. We derived the selected consolidated
financial data for the years ended December 31, 2005 and 2004 and as of
December 31, 2006 and 2005 from our audited consolidated financial
statements and related notes which are not included in this Annual Report. We
derived the selected consolidated financial data as of
December 31, 2004 from our unaudited consolidated financial statements
which are not included in this Annual Report. Historical results are not
necessarily indicative of future results.




Year ended
      December 31,(inthousands,
      except per share amounts)
                              
                              2008
                              
                              
                              2007
                              
                              
                              2006
                              
                              
                              2005
                              
                              
                              2004Consolidated
      Statements of Operations Data:Total
      revenue
                              
                              $
                              274,085
                              
                              
                              $
                              123,622
                              
                              
                              $
                              46,434
                              
                              
                              $
                              8,121
                              
                              
                              $
                              779Total cost of
      revenue (1)
                              
                              
                              76,180
                              
                              
                              
                              35,901
                              
                              
                              
                              14,523
                              
                              
                              
                              5,170
                              
                              
                              
                              1,424Gross
      profit (loss)
                              
                              
                              197,905
                              
                              
                              
                              87,721
                              
                              
                              
                              31,911
                              
                              
                              
                              2,951
                              
                              
                              
                              (645
                              )Operating
      expenses:Sales and marketing
      (1)
                              
                              
                              115,817
                              
                              
                              
                              60,441
                              
                              
                              
                              20,252
                              
                              
                              
                              9,495
                              
                              
                              
                              4,177Research and
      development (1)
                              
                              
                              41,039
                              
                              
                              
                              23,463
                              
                              
                              
                              10,447
                              
                              
                              
                              6,450
                              
                              
                              
                              4,454General and
      administrative (1)
                              
                              
                              24,239
                              
                              
                              
                              11,006
                              
                              
                              
                              2,831
                              
                              
                              
                              1,039
                              
                              
                              
                              739Settlement
      expense
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              2,919
                              
                              
                              
                              —
                              
                              
                              
                              —Total
      operating expenses
                              
                              
                              181,095
                              
                              
                              
                              94,910
                              
                              
                              
                              36,449
                              
                              
                              
                              16,984
                              
                              
                              
                              9,370Operating
      income (loss)
                              
                              
                              16,810
                              
                              
                              
                              (7,189
                              )
                              
                              
                              (4,538
                              )
                              
                              
                              (14,033
                              )
                              
                              
                              (10,015
                              )Total
      other income, net
                              
                              
                              4,788
                              
                              
                              
                              4,022
                              
                              
                              
                              723
                              
                              
                              
                              283
                              
                              
                              
                              189Income
      (loss) before provision for income taxes
                              
                              
                              21,598
                              
                              
                              
                              (3,167
                              )
                              
                              
                              (3,815
                              )
                              
                              
                              (13,750
                              )
                              
                              
                              (9,826
                              )Provision
      for income taxes
                              
                              
                              5
                              
                              
                              
                              493
                              
                              
                              
                              211
                              
                              
                              
                              33
                              
                              
                              
                              2Net
      income (loss)
                              
                              $
                              21,593
                              
                              
                              $
                              (3,660
                              )
                              
                              $
                              (4,026
                              )
                              
                              $
                              (13,783
                              )
                              
                              $
                              (9,828
                              )Net
      income (loss) per common share, basic
                              
                              $
                              0.37
                              
                              
                              $
                              (0.12
                              )
                              
                              $
                              (0.56
                              )
                              
                              $
                              (2.38
                              )
                              
                              $
                              (2.10
                              )Net
      income (loss) per common share, diluted
                              
                              $
                              0.33
                              
                              
                              $
                              (0.12
                              )
                              
                              $
                              (0.56
                              )
                              
                              $
                              (2.38
                              )
                              
                              $
                              (2.10
                              )Shares
      used in computing basic net income (loss) per share
                              
                              
                              58,254
                              
                              
                              
                              31,482
                              
                              
                              
                              7,128
                              
                              
                              
                              5,801
                              
                              
                              
                              4,672Shares
      used in computing diluted net income (loss) per share
                              
                              
                              65,814
                              
                              
                              
                              31,482
                              
                              
                              
                              7,128
                              
                              
                              
                              5,801
                              
                              
                              
                              4,672


______________________________


(1) Includes the
following stock-based compensation:





Year ended December
      31,(in thousands)
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Cost
      of revenue
              
              $
              1,698
              
              
              $
              507
              
              
              $
              36
              
              
              $
              4
              
              
              $
              1Sales
      and marketing
              
              
              11,505
              
              
              
              6,313
              
              
              
              485
              
              
              
              28
              
              
              
              8Research and
      development
              
              
              5,504
              
              
              
              2,981
              
              
              
              558
              
              
              
              47
              
              
              
              15General
      and administrative
              
              
              4,677
              
              
              
              2,250
              
              
              
              212
              
              
              
              17
              
              
              
              11Total
      stock-based
      compensation
              
              $
              23,384
              
              
              $
              12,051
              
              
              $
              1,291
              
              
              $
              96
              
              
              $
              35









December
      31,(in
      thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004(unaudited)Consolidated
      Balance Sheet
    Data:Cash and cash
      equivalents and short-term
      investments
                  
                  $
                  233,892
                  
                  
                  $
                  207,136
                  
                  
                  $
                  11,857
                  
                  
                  $
                  12,505
                  
                  
                  $
                  9,358Working capital
                  
                  
                  232,996
                  
                  
                  
                  203,688
                  
                  
                  
                  12,856
                  
                  
                  
                  9,692
                  
                  
                  
                  8,233Total
      assets
                  
                  
                  386,981
                  
                  
                  
                  261,364
                  
                  
                  
                  30,913
                  
                  
                  
                  18,896
                  
                  
                  
                  11,394Other
      liabilities(2)
                  
                  
                  2,910
                  
                  
                  
                  594
                  
                  
                  
                  3,319
                  
                  
                  
                  —
                  
                  
                  
                  —Mandatorily
      redeemable convertible preferred
      stock
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  41,514
                  
                  
                  
                  41,309
                  
                  
                  
                  26,273Common stock
      and additional paid-in
      capital
                  
                  
                  295,564
                  
                  
                  
                  248,078
                  
                  
                  
                  3,049
                  
                  
                  
                  1,542
                  
                  
                  
                  1,293Total
      stockholders’
      equity
      (deficit)
                  
                  
                  276,884
                  
                  
                  
                  207,862
                  
                  
                  
                  (33,566
                  )
                  
                  
                  (31,037
                  )
                  
                  
                  (17,516
                  )
  ____________________________________________


(2) See Note 14 of
the Notes to our Consolidated Financial Statements.
    21


Item 7.
            MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS




The
following discussion and analysis of the financial condition and results of our
operations should be read in conjunction with the consolidated financial
statements and related notes included elsewhere in this Form 10-K. This
discussion contains forward-looking statements that involve risks and
uncertainties. Our actual results could differ materially from those discussed
below. Factors that could cause or contribute to such differences include, but
are not limited to, those identified below, and those discussed in the section
titled “Risk Factors” included in Item 1A of this Form 10-K.




Overview





We are a
leading provider of storage solutions for backup and archive applications based
on deduplication technology.  Our deduplication storage systems are
designed to deliver reliable, efficient, and cost-effective solutions that
enable enterprises of all sizes to manage, retain and protect their
data.







We
believe offering a simple-to-manage deduplication storage product family
supporting both high throughput for backup/restore and adaptability to other
nearline applications, such as archiving, provides the application independent,
consolidative infrastructure required for enterprise data protection storage. In
addition to our storage systems, we provide global product support as well
as software updates to customers that purchase a support and services contract,
and we offer professional services.







Our
products and services are designed to meet the demands of data protection for
enterprise backup and archive applications.  To this end, we work with
leading application providers such as Symantec Corporation and F5 Networks to
help ensure reliable, high performance joint deployments. To meet the needs of
backup applications and disaster recovery, our systems must have high throughput
to meet backup windows and sophisticated wide area network, or WAN, replication
options.  To meet the needs of file archiving, our products must support
many millions of files and offer specialized features such as deduplicated
snapshots and governance-oriented file locking.  For both requirements, we
believe the simplifying nature of our inline deduplication technology and
plug-in appliances makes our products cost effective and easy to
manage.







We
shipped the world’s first inline deduplication storage appliance in 2004. Since
then, we have brought to market many significant innovations and industry firsts
in deduplication storage and data management. We sell our appliances to
enterprises worldwide in a variety of industries, including defense, education,
entertainment, finance, government, healthcare, technology, legal, media and
retail. As of December 31, 2008, the total number of customers that
have purchased our appliances since inception was approximately 2,900 customers
worldwide.





We are
headquartered in Santa Clara, California. Our personnel are located throughout
the United States and in numerous countries worldwide. We have grown to
over 800 employees as of February 2009, with operations in over 25
countries around the world. We expect to continue to add personnel in the
United States and internationally to provide additional geographic sales and
technical support coverage.




We sell
our appliances through a network of channel partners and through our direct
sales force. In the year ended December 31, 2008, 2007 and 2006,
approximately 84%, 86% and 85%, respectively, of our revenue was generated by
sales through indirect channels. As of December 31, 2008, we had over 450
channel partners, and we expect that we will continue to sell a substantial
majority of our appliances through our channel partners. We consider the
development of indirect sales channels in domestic and international markets to
be important to future revenue growth and widespread acceptance of our products.
We intend to expand these channel partner relationships in the future to further
extend our distribution coverage.




Growth of
our product revenue will depend on our ability to attract new customers and to
make additional sales to existing customers. Our growth will also depend on our
ability to introduce and achieve market acceptance of new products with higher
capacity and performance and new products designed to serve other sectors of the
storage market beyond protection storage that we believe will benefit from
deduplication technology. Revenue from existing customers increased as a
percentage of total revenue, a trend we expect to generally continue. It is
important to note, however, that our revenue, including our revenue from
existing customers, may be impacted by the timing of large orders which tend to
have a longer sales cycle and are more difficult to forecast. The recent
downturn of the global economy could negatively impact the timing of these large
orders and spending by our customers’ information technology, or IT, departments
generally. We also expect growth in international markets to be a significant
factor contributing to our revenue growth in future periods. International
revenue accounted for approximately 23%, 28% and 32% of our total revenue in the
years ended December 31, 2008, 2007 and 2006, respectively. International
revenue was 5% lower as a percentage of total revenue for fiscal 2008 compared
with 2007 due to an increase in the number of larger transactions that we
completed in North America, and because we expanded our sales force more quickly
in North America. International revenue was 4% lower as a percentage of total
revenue for fiscal 2007 compared with 2006 due to the higher growth rate of
sales in North America as more new sales personnel were added and
as they became productive more quickly in North America than elsewhere. Despite
these year-over-year reductions in the percentage of our international revenue,
over time, we expect international revenue to increase in absolute dollars and
as a percentage of our total revenue, as we add additional sales
personnel and enhance our distribution channels internationally. 
However, our international revenue will also be susceptible to any further
deterioration in global economic conditions. Our growth in support and services
revenue will depend upon increasing the number of systems under support and
services contracts. Any such increases will depend on a growing customer base
and the renewal of existing support and services contracts. To date, no
individual customer has accounted for greater than 10% of our total revenue in
any year.




We intend
to continue to hire in our sales and research and development organizations,
with selective hiring across all other functional areas. We will also intend to
continue to invest significantly in our direct marketing campaigns, both
domestically and internationally, to drive customer lead generation, which we
feel is a key component to position us for revenue growth.




Our
ability to sustain profitability will be affected by the extent to which we
incur additional expenses to expand our sales, marketing, product development
and general and administrative capabilities. Personnel costs constitute the
largest component of our operating expenses and include salaries, benefits,
incentive compensation and stock-based compensation expense. We recognize that
we may need to reduce our hiring plans to the extent we continue to be affected
by the challenging global economy. As we expand internationally, we may incur
additional costs to conform our products to comply with local laws or local
product specifications and to ship our products to our international
customers.






We
believe our operations are more efficient and flexible because we outsource
manufacturing of our products, and because we subcontract with third parties to
provide onsite hardware repair and replacement services for our appliances,
except in those instances where channel partners provide these services directly
to our customers.




As a
consequence of the rapidly evolving nature of our business and our limited
operating history, we believe that period-to-period comparisons of revenue and
operating results, including gross margin and operating expenses as a percentage
of total revenue, are not necessarily meaningful and should not be relied upon
as indications of future performance. Although we have experienced significant
growth in our total revenue, you should not assume that our historical growth
rates are indicative of future growth.






22




Revenue. Revenue
is composed of product revenue, support and services revenue, and ratable
products and related support and services revenue. Our product revenue is
composed of sales of our appliances, which includes sales of expansion shelves
that augment the internal storage of our appliances, and shipping charges. Our
support and services revenue is derived from support and services contracts,
which typically have a duration of one to three years, professional services and
installation services. Ratable product and related support and services revenue
is derived from pre-2006 arrangements in which product and support were bundled
and no vendor specified objective evidence of fair value existed for the
undelivered support and services. For those arrangements, we recognize the
entire arrangement fee over the period of the related support and services
contract. As of December 31, 2008, we had no remaining balance in deferred
revenue related to ratable product and related support and services
revenue.






Cost of
Revenue. Cost of revenue is composed of cost of product revenue,
cost of support and services revenue and cost of ratable products and related
support and services revenue. Cost of product revenue consists primarily of the
cost charged by our contract manufacturer to manufacture our appliances, the
cost of expansion shelves charged by the original equipment manufacturer,
shipping charges, warranty obligations, the amortization of evaluation units,
overhead allocations, personnel-related costs, stock-based compensation and
provisions for excess and obsolete inventory, if any. Cost of support and
services revenue consists of salaries, related costs of customer support and
professional services personnel, stock-based compensation, overhead allocations
and any third-party costs we incur in order to provide hardware repair and
replacement services. Cost of ratable product and related support and services
revenue consists of hardware and support and services costs related to
transactions recognized ratably.




Gross
Margin. Our gross margin has been and will continue to be affected
by a variety of factors, including our appliance configuration mix, as our
higher-capacity and higher-performance configurations tend to have higher gross
margins; average selling prices of our appliances; the extent to which our
revenue is composed of support and services and professional services revenue,
which tend to have lower gross margins; new product introductions and
enhancements; the cost of the components incorporated in our appliances; the
cost of providing support and services; amortization of evaluation units; and
the mix of direct sales and sales through our channel partners, which affects
our average unit sales prices.




Operating
Expenses. Operating expenses consist of sales and marketing,
research and development, and general and administrative expenses.
Employee-related costs, which include stock-based compensation expense, are the
most significant component of each of these expense categories. We grew from 179
employees as of December 31, 2006 to 435 employees as of December 31, 2007
to 777 employees as of December 31, 2008. We expect to continue to hire new
employees in order to position our company for continued growth, though we may
need to reduce our hiring plans to the extent we continue to be affected by the
challenging global economy. In any particular period, the timing of additional
hires could materially affect our operating expenses, both in absolute dollars
and as a percentage of revenue. We anticipate that our operating expenses will
increase significantly in absolute dollar amounts.




•
            Sales and
      Marketing—Sales and marketing expenses represent the largest
      component of our operating expenses and include personnel costs,
      stock-based compensation, employee sales commissions and marketing
      programs. We intend to continue to invest significantly in sales and
      marketing by increasing the number of sales and channel support personnel
      worldwide. We anticipate that sales and marketing expenses will increase
      in absolute dollars in fiscal year 2009, but remain relatively stable as a
      percentage of our total revenue, due to our plans to continue to expand
      our sales force, both domestically and internationally, and to make
      significant investments in our direct marketing campaigns. Hiring
      additional sales personnel reduces operating margins until the new sales
      personnel generate meaningful
revenue.




•
            Research
      and Development—Research and development expenses primarily include
      personnel costs, stock-based compensation, depreciation on lab equipment,
      costs of prototype equipment, quality assurance infrastructure
      depreciation, other related costs of quality assurance and overhead
      allocations. We expense research and development costs as incurred. Though
      we incur software development costs, the costs of software development
      that we incur after a product has reached technological feasibility are
      considered immaterial, and to date, we have not capitalized any such
      costs. We anticipate that research and development expenses as a
      percentage of our total revenue will remain relatively stable in fiscal
      year 2009, but expect that the absolute dollar amount will increase as we
      continue to invest in research, new product development and enhancements
      to our existing appliances and hire additional research and development
      personnel, particularly at our Research Triangle Park, North Carolina
      facility.




•
            General and
      Administrative—General and administrative expenses consist
      primarily of compensation and related costs for personnel and facilities
      related to our executive, finance, human resource, information technology
      and legal organizations, stock-based compensation and fees for
      professional services. Professional services consist of outside legal, tax
      and audit costs. We expect the absolute amount of our general and
      administrative expenses to increase in 2009 as we expand our finance
      function and incur additional costs associated with being a public
      company, but our aggregate general administrative expenses should remain
      relatively stable as a percentage of our total
  revenue.




Other Income
(Expense), Net.Other income (expense), net consists primarily of
interest income on cash and cash equivalents and short-term investment balances
and foreign currency remeasurement gains or losses. We historically have
invested our cash in money market funds, and we have invested the funds from our
initial public offering, or IPO, that we completed in July 2007 and follow-on
offering that we completed in December 2007 in a combination of commercial
paper, corporate bonds, U.S. government agencies, money market funds and
auction-rate securities.




Provision for
Income Taxes. In the years ended December 31, 2008, 2007 and
2006, we recorded an income tax provision for both federal and California
alternative minimum taxes, or AMT,  foreign taxes and other state
income taxes.  Our provision for income taxes decreased $488,000 to
$5,000 in the year ended December 31, 2008 from $493,000 in the year ended
December 31, 2007. The income tax provision for the year ended
December 31, 2008 was due to an income tax provision of $13.2 million,
which was the result of increased profitability, non-deductible stock
compensation benefits and increased state taxes mainly due to suspension of
California net operating losses, mostly offset by an income tax benefit of $13.2
million resulting from a release of the deferred tax asset valuation
allowance.




Critical
Accounting Policies and Estimates




Our
consolidated financial statements are prepared in accordance with U.S. generally
accepted accounting principles, or GAAP. These accounting principles require us
to make certain estimates and judgments that can affect the reported amounts of
assets and liabilities as of the date of the consolidated financial statements,
as well as the reported amounts of revenue and expenses during the periods
presented. We believe that the estimates and judgments upon which we rely are
reasonable based upon information available to us at the time that these
estimates and judgments are made. To the extent there are material differences
between these estimates and actual results, our consolidated financial
statements will be affected. The accounting policies that reflect our more
significant estimates and judgments and that we believe are the most critical to
aid in fully understanding and evaluating our reported financial results include
revenue recognition, stock-based compensation, inventory valuation, warranty
reserve, allowance for doubtful accounts, short and long-term investments and
income taxes.




Revenue
Recognition




Our
software is integrated with industry standard components and is essential to the
functionality of our appliances. We provide unspecified software updates and
enhancements related to our products through support and services contracts.
Accordingly, we recognize revenue in accordance with the guidance provided under
AICPA Statement of Position, or SOP, No. 97-2,Software Revenue
Recognition, or SOP 97-2, and SOP No. 98-9,Modification of
SOP No. 97-2, Software Revenue Recognition, with Respect to Certain
Transactions, or SOP 98-9. Product revenue is recognized when all of
the following have occurred: (1) we have entered into a legally binding
arrangement with a customer; (2) delivery has occurred, which is when the
product title has transferred to the customer; (3) customer payment is
deemed fixed or determinable and free of contingencies and significant
uncertainties; and (4) collection is probable. Our fees are considered
fixed or determinable upon establishing an arrangement that contains the final
terms of sale including the description, quantity and price of each product
purchased. Our customer arrangements do not include rights of return or
acceptance provisions. We assess our ability to collect from our customers based
on a number of factors, including creditworthiness and past transaction history
of the customer. If the customer is deemed not creditworthy, all revenue from
the arrangement is deferred until payment is received and all other revenue
recognition criteria have been met. Revenues are recorded net of customer
returns which are estimated at the time of sale.




We
recognize revenue for our appliances, which include multiple elements, using the
residual method as allowed by SOP 98-9. Under this method, we allocate and defer
revenue for the undelivered elements, which are generally support and services,
including professional services and installation, based on fair value. We
recognize the difference between the total arrangement fee and the amount
deferred for the undelivered elements as product revenue. The determination of
fair value of the undelivered elements is based on the price charged when those
elements are sold separately, which is referred to as vendor specific objective
evidence of fair value, or VSOE.




We have
established VSOE of fair value of our support and services based on the renewal
prices offered to and paid by our customers. As a result, product revenue is
generally recognized upon shipment, assuming all other criteria for recognition
discussed above have been met and, in the case of all indirect channel sales,
persuasive evidence of the identity of the customer has been obtained. The fair
value of the support and services is recognized as support and services revenue
on a straight-line basis over the term of the related support period, which is
typically one to three years.




Stock-Based
Compensation





We
account for stock-based compensation using the fair value method in accordance
with the provisions of Statement of Financial Accounting Standards, or SFAS,
No. 123(R),Share-Based
Payment,or SFAS 123R. We recognize this expense on a straight-line basis
over the optionees’ requisite service period, which is assumed to be the same as
the vesting schedule of the options. We estimate the grant date fair value of
stock option awards under the provisions of SFAS 123R using the
Black-Scholes option valuation model, which requires the input of highly
subjective assumptions, including the expected life of the share-based award and
stock price volatility. The assumptions used in calculating the fair value of
stock-based compensation represent management’s best estimates, but these
estimates involve inherent uncertainties and the application of management
judgment. As a result, if other assumptions had been used, our stock-based
compensation expense could have been materially different. In addition, we are
required to estimate the expected forfeiture rate and only recognize expense for
those awards expected to vest. If our actual forfeiture rate is materially
different from our estimate, the share-based compensation expense could be
materially different.




For stock
options granted prior to our IPO, we determined that it was not practicable to
calculate the volatility of our share price because our securities were not
publicly traded and therefore there was no readily determinable market value for
our stock, we had limited information on our own past volatility, and we had a
limited operating history. Therefore, we estimated our expected volatility based
on reported market value data for a group of publicly traded companies, that we
selected from market indices which we believed were relatively comparable after
consideration of their size, maturity, profitability, growth, risk and return on
investment. We used the average expected volatility rates reported by the
comparable group for an expected term that approximated the expected term that
we estimated. Over time, once historical data and market trends become apparent,
this information could change our estimates. A small change in the estimates
used can result in a relatively large change in the estimated
valuation.




Given the
absence of an active market for our common stock prior to our IPO, our board of
directors, taking into consideration the work of an independent valuation firm,
determined the fair value of our common stock at each meeting in which grants
were approved based on several factors, including valuation criteria and
analysis, the preferential rights attributable to our then outstanding
convertible preferred stock, developments in our business, the illiquid nature
of our common stock and the likelihood of achieving a liquidity event, such as
an initial public offering or sale of the company. Our board of directors made
such determinations based on valuation criteria and analyses, the business,
financial and venture capital experience of the individual directors and input
from management.




If we had
made different assumptions and estimates, the amount of our recognized and to be
recognized stock-based compensation expense, net loss and net loss per share
amounts could have been materially different. We believe that we used reasonable
methodologies, approaches and assumptions consistent with the American Institute
of Certified Public Accountants Practice Guide,Valuation of Privately-Held-Company
Equity Securities Issued as Compensation, in determining the fair value
of our common stock prior to our IPO for financial reporting
purposes.




In
December 2008, we began issuing restricted stock units, or RSUs, to employees.
The cost of these awards is determined using the fair value of our common stock
on the date of the grant, and compensation is recognized on a straight-line
basis over the requisite service period.





We
recorded stock-based compensation expense of $23.4 million, $12.1 million and
$1.3 million for the years ended December 31, 2008, 2007 and 2006,
respectively. In future periods, stock-based compensation expense may increase
as we issue additional equity-based awards to attract and retain employees and
non-employee directors. Additionally, SFAS 123R requires that we recognize
compensation expense only for the portion of stock options that are expected to
vest. Our estimated forfeiture rate for all periods is 5%. If the actual rate of
forfeitures differs from that estimated by management, we may be required to
record adjustments to stock-based compensation expense in future
periods.




Inventory
Valuation




Inventories
consist of hardware and related component parts and are stated at the lower of
cost (on a first-in, first-out basis) or market value, or cost less accumulated
amortization in the case of evaluation units. We ship evaluation units to enable
some of our prospective customers to test our equipment prior to purchasing. We
amortize evaluation inventory on a straight-line basis over the shorter of
twelve months or until sold, commencing in the month the product goes into the
evaluation inventory pool. The amortization expense is included in the cost of
product revenue. If a unit is purchased, we record a sale in accordance with our
revenue recognition policy. We assess the valuation of our inventory on a
quarterly basis and write down the value for estimated excess and obsolete
inventory based upon estimates of future demand, including in-warranty and
out-of-warranty service requirements. Inherent in our estimates of market value
in determining inventory valuation are estimates related to economic trends,
future demand for our products and technological obsolescence of our products.
Inventory write-downs are reflected as cost of product revenue. During the year
ended December 31, 2007, we incurred an expense of $264,000 for inventory
write-downs related to our discontinuance of our 4xx products. Amortization of
evaluation units was approximately $2.5 million, $2.6 million and $1.4 million
for the years ended December 31, 2008, 2007 and 2006, respectively. We do
not allocate indirect overhead costs to finished goods inventory as these
amounts are not material. Spare parts are part of our warranty reserve accrual,
and expensed against the accrual as purchased. As of December 31, 2008 and
2007, we had approximately $5.4 million and $2.9 million, respectively, in
historical costs of spare parts inventory on hand that had been fully expensed.
The increase in expenses related to spare parts reflects the increase in revenue
and growth of our business and our installed base.






23




Warranty
Reserve




Upon
shipment of products to our customers, we provide for the estimated cost to
repair or replace products that may be returned under warranty. Our warranty
period is typically 12 months from the date of shipment to the customer for
hardware and 90 days for software. Our warranty costs consist of the estimated
labor and shipping costs for the warranty repair, as the hardware component
costs are covered by our manufacturers’ warranties, and the estimated costs for
spare parts on units sold. For existing products, the warranty reserve is based
on actual historical experience. For new products, the warranty reserve is based
on historical experience of similar products until such time as sufficient
historical data has been collected for the new product.




During
the three months ended March 31, 2007, we recorded an estimated charge of
$1.2 million associated with a field replacement program that was initiated in
April 2007 to replace a circuit board used in some of our appliances. During the
three months ended September 30, 2007, we recorded an estimated charge of
$450,000 to expand this replacement program for additional circuit boards used
in some of our appliances. During the three months ended June 30, 2008, we
recorded an additional charge of $25,000 as we revised our estimate of the costs
of the replacement program. To date, these circuit boards have experienced
failures in less than 1% of the appliances that we believe are potentially
affected. Through the replacement program, we are offering to replace the
potentially affected circuit boards with circuit boards manufactured by an
alternate supplier. As of December 31, 2008, we had incurred approximately
$1.6 million of costs associated with these field replacement programs and
$68,000 remains in accrued liabilities to cover future costs for the units
potentially affected. We believe our estimates and judgments for the replacement
program are reasonable based upon information available at this time. Our
estimated charge associated with the replacement program is based on the number
of circuit boards we expect to replace under the program, the anticipated cost
of replacement and refurbishment and other associated costs. To the extent there
are differences between our estimates and actual results, our consolidated
financial statements will be affected.




Allowance
for Doubtful Accounts




We
perform credit evaluations of our customers’ financial condition and generally
do not require collateral from our customers. These evaluations require
significant judgment and are based on a variety of factors including, but not
limited to, current economic trends, payment history and financial review of the
customer. We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability or unwillingness of our customers to make required
payments. When we become aware that a specific customer is unable or unwilling
to meet its financial obligations, we record a specific allowance to reflect the
level of credit risk in the customer’s outstanding receivable balance. In
addition, we record additional allowances based on certain percentages of aged
receivable balances. We classify bad debt expenses as general and administrative
expenses. To date, our accounts receivable write-offs have not been significant
and the allowance for doubtful accounts has not been material.  In February
2009, one of our resellers filed for Chapter 11 bankruptcy.   As
of December 31, 2008, we had a trade receivable of $1.1 million from this
reseller, for which we have not recorded an allowance.  As part of the
bankruptcy proceeding, a primary investor in this reseller has agreed
to purchase the assets and assume certain liabilities of this reseller
in its efforts to recapitalize the reseller.  Specifically,this investor
 has filed a statement with the bankruptcy court of its intention to assume
the $1.1 million liability payable to us.  This asset purchase
agreement is subject to the final approval of the bankruptcy court, and
 if the asset purchase is not completed, all or a portion of this
amount due us may be uncollectible and require a recognition of bad
debt expense.




Short-Term
and Long-Term Investments




We have a
short-term investment portfolio comprised of cash, money market funds,
commercial paper, corporate bonds and U.S. government agency securities, and a
long-term investment portfolio comprised of auction-rate securities, which we
actively manage with an objective of capital preservation. The value of these
securities is subject to market volatility for the period we hold these
investments and until their sale or maturity. We recognize realized losses when
declines in the fair value of our investments, below their cost basis, are
judged to be other-than-temporary. In determining whether a decline in fair
value is other-than-temporary, we consider various factors including market
price (when available), investment ratings, the financial condition and
near-term prospects of the investee, the length of time and the extent to which
the fair value has been less than our cost basis, auction success and failure
rates, and our intent and ability to hold the investment until maturity or for a
period of time sufficient to allow for any anticipated recovery in market value.
We make significant judgments in considering these factors. If it is judged that
a decline in fair value is other-than-temporary, the investment is valued at the
current fair value and a realized loss equal to the decline is recorded, which
could materially adversely affect our operating results of
operations.







Effective
January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements, or
SFAS 157, with respect to only our financial assets and
liabilities.  SFAS 157 defines fair value, establishes a framework for
measuring fair value under U.S. GAAP and enhances disclosures about fair value
measurements. Fair value is defined under SFAS 157 as the exchange price that
would be received for an asset or paid to transfer a liability (an exit price)
in the principal or most advantageous market for the asset or liability in an
orderly transaction between market participants on the measurement date.
Valuation techniques used to measure fair value under SFAS 157 must maximize the
use of observable inputs and minimize the use of unobservable inputs. The
standard describes a fair value hierarchy based on three levels of inputs, of
which the first two are considered observable and the last unobservable, that
may be used to measure fair value.







In the
current market environment, the assessment of fair value of securities can be
difficult and subjective. The volume of trading activity of certain securities
has declined, and the rapid changes occurring in today’s financial markets can
lead to changes in the fair value of financial instruments in relatively short
periods of time. The standard describes a fair value hierarchy based on three
levels of inputs, of which the first two are considered observable and the last
unobservable, that may be used to measure fair value. Each level of input has
different levels of subjectivity and difficulty in determining fair value, as
follows:





·
              Level
      1 - Quoted prices in active markets for identical assets or
      liabilities.·
              Level
      2 - Inputs other than Level 1 that are observable, either directly or
      indirectly, such as quoted prices for similar assets or liabilities;
      quoted prices in markets that are not active; or other inputs that are
      observable or can be corroborated by observable market data for
      substantially the full term of the assets or
  liabilities.·
              Level
      3 - Unobservable inputs that are supported by little or no market activity
      and that are significant to the fair value of the assets or
      liabilities.




Instruments
that are classified within Level 1 of the fair value hierarchy generally include
most money market securities.  Determination of fair value for Level 1
instruments does not require significant judgment or estimation. Instruments
that are classified within Level 2 of the fair value hierarchy generally include
U.S. government agency securities, commercial paper and corporate bonds. We
determine the fair values for these instruments using industry standard pricing
services, data providers and other third-party sources.






Level 3
instruments consist of auction-rate securities whose underlying assets are
generally student loans that are substantially backed by the federal
governments. In February 2008, auctions began to fail for these securities and
each auction since then has failed. In the absence of a liquid market to value
these securities, the fair value of these auction-rate securities was determined
using a discounted cash flow pricing model that incorporated financial inputs
such as projected cash flows, discount rates, expected interest rates to be paid
to investors and an estimated liquidity discount. As of December 31, 2008, we
had $31.0 million of principal valued at $26.1 million related to these
auction-rate securities, or approximately 12% of our cash equivalents,
short-term investment and long-term investment portfolio.







In
November 2008, we signed a broad-based settlement proposal from UBS in which we
have the right to sell the securities back to affiliates of UBS at par during
the period from June 30, 2010 to July 2, 2012 if liquidity does not return to
the auction-rate securities market sooner (the "Put Option").  The
affiliates of UBS will retain the right to sell our auction-rate securities on
our behalf, without prior notification, at any time prior to July 2, 2012 as
long as we receive par value from such sale. See Note 2 of our Notes to the
Consolidated Financial Statements.




The
enforceability of this right results in a Put Option that is accounted for
separately from the auction-rate securities. We elected to account for this put
option at fair value under FASB Statement No. 159, The Fair Value Option for Financial
Assets and Liabilities, or SFAS 159. We valued the put option using a
discounted cash flow approach including estimates of, based on data available as
of December 31, 2008, interest rates, timing and amount of cash flow, adjusted
for any bearer risk associated with UBS’s financial ability to repurchase the
auction-rate securities beginning June 30, 2010. Based on the discounted cash
flow model, we determined the fair value of the put option to be $4.8 million.
Any change in these assumptions and market conditions would affect the value of
this put option. In connection with the put option, we reclassified our
auction-rate securities from available-for-sale to trading securities. As a
result of the reclassification of these securities to trading, we recorded a
loss of $4.9 million in other income (expense), net. The transfer to trading
securities reflects management’s intent to exercise the put option during the
period June 30, 2010 to July 2, 2012.




The value of
the put option of $4.8 million is included in the Consolidated Balance Sheet as
of December 31, 2008 as a long-term investment. The net effect of the recording
of the put option and the realized loss on the auction-rate securities was a
loss of $162,000, which was recorded in other income (expense), net in our
Statement of Operations for the year ended December 31, 2008. We believe that
subsequent changes in the value of the put option will largely offset the
subsequent fair value movements of the auction-rate securities, subject to the
continued expected performance by UBS of its obligations under the
agreement
  24


Income
Taxes




Significant
management judgment is required in determining our provision for income taxes,
deferred tax assets and liabilities and any valuation allowance recorded against
net deferred tax assets in accordance with SFAS No. 109, Accounting for Income Taxes,
or SFAS 109. These estimates and judgments occur in the calculation of tax
credits, benefits, and deductions, and in the calculation of certain tax assets
and liabilities, which arise from differences in the timing of recognition of
revenue and expense for tax and financial statement purposes, as well as the
interest and penalties related to uncertain tax positions. Significant changes
to these estimates may result in an increase or decrease to our tax provision in
the current or subsequent period.




We must
assess the likelihood that we will be able to recover our deferred tax assets.
If recovery is not likely, we must increase our provision for taxes by recording
a valuation allowance against the deferred tax assets that we estimate will more
likely than not be realized. We believe that we will more likely than not
realize substantially all of the deferred tax assets recorded on our
Consolidated Balance Sheet as of December 31, 2008. However, should there be a
change in our ability to recover our deferred tax assets, our tax provision
would increase in the period in which we determined that the recovery was not
likely.




The
calculation of our tax liabilities involves dealing with uncertainties in the
application of complex tax regulations. In accordance with the FASB issued
Interpretation No. 48, Accounting for Uncertainty in Income
Taxes—an interpretation of SFAS No. 109, or FIN 48, and related guidance,
we recognize liabilities for uncertain tax positions based on a two-step
process. The first step is to evaluate the tax position for recognition by
determining if the weight of available evidence indicates that it is more likely
than not that the position will be sustained on audit, including resolution of
related appeals or litigation processes, if any. If we determine that a tax
position will more likely than not be sustained on audit, then the second step
requires us to estimate and measure the tax benefit as the largest amount that
is more than 50% likely to be realized upon ultimate settlement. It is
inherently difficult and subjective to estimate such amounts, as we have to
determine the probability of various possible outcomes. We reevaluate these
uncertain tax positions on a quarterly basis. This evaluation is based on
factors including, but not limited to, changes in facts or circumstances,
changes in tax law, effective settlement of audit issues, and new audit
activity. Such a change in recognition or measurement would result in the
recognition of a tax benefit or an additional charge to the tax
provision.




Results
of Operations






Revenue




The
following table sets forth each of our sources of revenue for the specified
periods and as a percentage of our total revenue for those periods.




Year ended
      December 31,(in
      thousands except for percentages)
                              
                              2008
                              
                              
                              2007
                              
                              
                              2006Total
      revenue
                              
                              $
                              274,085
                              
                              
                              $
                              123,622
                              
                              
                              $
                              46,434Total
      revenue by type:Product
                              
                              $
                              232,712
                              
                              
                              $
                              108,869
                              
                              
                              $
                              36,884Support
      and services
                              
                              
                              41,286
                              
                              
                              
                              14,423
                              
                              
                              
                              2,898Ratable
      product and related support and services
                              
                              
                              87
                              
                              
                              
                              330
                              
                              
                              
                              6,652%
      of revenue by type:Product
                              
                              
                              85
                              %
                              
                              
                              88
                              %
                              
                              
                              79
                              %Support
      and services
                              
                              
                              15
                              %
                              
                              
                              12
                              %
                              
                              
                              6
                              %Ratable
      product and related support and services
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              15
                              %Total
      revenue by geography:North
      America
                              
                              $
                              212,527
                              
                              
                              $
                              89,003
                              
                              
                              $
                              31,734Europe,
      Africa, Middle East
                              
                              
                              43,355
                              
                              
                              
                              26,026
                              
                              
                              
                              12,210Asia
      Pacific
                              
                              
                              18,203
                              
                              
                              
                              8,593
                              
                              
                              
                              2,490%
      of revenue by geography:North
      America
                              
                              
                              77
                              %
                              
                              
                              72
                              %
                              
                              
                              68
                              %Europe,
      Africa, Middle East
                              
                              
                              16
                              %
                              
                              
                              21
                              %
                              
                              
                              26
                              %Asia
      Pacific
                              
                              
                              7
                              %
                              
                              
                              7
                              %
                              
                              
                              6
                              %




Year Ended
December 31, 2008 Compared to the Year Ended December 31,
2007:For the year ended December 31, 2008, product revenue
increased $123.8 million to $232.7 million from the $108.9 million reported for
the year ended December 31, 2007.  This increase was due to an
increase in the number of units sold to new and existing customers, facilitated
by an increase of 190 in the number of sales and marketing personnel, the
introduction of new and higher capacity products such as our DD690 and an
increase in the number of our channel partners. The total number of customers
that have purchased our products since inception increased from over 1,500
customers as of December 31, 2007 to over 2,900 as of  December 31,
2008. Our new products, principally our DD690, had higher average sales prices
compared to our legacy products due to their higher capacity and higher
performance.




For the
year ended December 31, 2008, support and services revenue increased $26.9
million to $41.3 million from $14.4 million reported for the year ended December
31, 2007.  This increase was the result of increased product sales
and, to a lesser extent, the renewal of support and services contracts by
existing customers. Substantially all of our customers purchase support and
service contracts when they purchase our appliances.




For the
year ended December 31, 2008, ratable product and related support and services
revenue decreased $243,000 to $87,000 from $330,000 reported for the year ended
December 31, 2007. This decrease was the result of establishing VSOE of fair
value for all support and services agreements in fiscal 2006. At
December 31, 2008, we had no remaining balance in deferred revenue related
to ratable product and related support and services revenue.




For the
years ended December 31, 2008 and 2007, international revenue was 23% and 28%,
respectively, of total revenue. Although revenue outside North America increased
in the year ended December 31, 2008 in absolute amounts, total
international revenue as a percentage of total revenue declined in 2008 compared
with 2007 due to the higher growth rate of sales in North America as we expanded
our sales force more quickly in North America than elsewhere. As we continue to
expand into international locations and introduce our products in new markets,
we expect international revenue to increase in absolute dollars and as a
percentage of total revenue.




We expect
to continue to release new products with higher capacity, higher performance and
higher average selling prices.  In addition, as our customer base
grows, we expect the proportion of revenue generated from support and services
to increase over time, from both new contracts and renewals of existing
contracts.




25




Year Ended
December 31, 2007 Compared to the Year Ended December 31, 2006:For the year ended December 31, 2007, product revenue increased $72.0
million to $108.9 million from $36.9 million in the year ended December 31,
2006. This increase was due to an increase in the number of units sold to new
and existing customers, facilitated by an increase in the number of sales
personnel, an increase in the number of our channel partners and the
introduction of new products. The introduction of new products, principally our
DD510, DD530, DD565 and the DD580 product lines, which have higher capacity and
higher performance than our legacy products, were sold at higher average sales
prices than our legacy products.




For the
year ended December 31, 2007, support and services revenue increased $11.5
million to $14.4 million from $2.9 million in the year ended December 31,
2006. This increase was the result of increased product sales and, to a lesser
extent, the renewal of support and services contracts by existing customers.
Substantially all of our customers purchase support and service contracts when
they purchase our appliances.




For the
year ended December 31, 2007, ratable product and related support and services
decreased $6.3 million to $330,000 from $6.7 million in the year ended
December 31, 2006. This decrease was the result of establishing VSOE of
fair value for all support and services agreements in fiscal 2006. At
December 31, 2007, we had $83,000 in remaining deferred revenue related to
ratable product and related support and services revenue.




International
revenue was 28% and 32% of total revenue for the years ended December 31,
2007 and 2006, respectively. Although revenue outside North America increased in
the year ended December 31, 2007 in absolute amounts, the percentage of
total revenue it represented in such period declined compared with 2006 due to
the higher growth rate of sales in North America as new sales personnel were
added more rapidly and became productive more quickly in North America than
elsewhere.




Cost
of Revenue, Gross Profit and Gross Margin




The
following table sets forth each of our costs of revenue, gross profit and gross
margin for the specified periods.




Year ended
      December 31,(dollars
      in thousands)
                              
                              2008
                              
                              
                              2007
                              
                              
                              2006Total
      revenue
                              
                              $
                              274,085
                              
                              
                              $
                              123,622
                              
                              
                              $
                              46,434Cost
      of product
                              
                              
                              61,133
                              
                              
                              
                              30,646
                              
                              
                              
                              11,059Cost
      of support and services
                              
                              
                              15,042
                              
                              
                              
                              5,152
                              
                              
                              
                              1,873Cost
      of ratable product and related support and services
                              
                              
                              5
                              
                              
                              
                              103
                              
                              
                              
                              1,591Total
      cost of revenue
                              
                              
                              76,180
                              
                              
                              
                              35,901
                              
                              
                              
                              14,523Gross
      profit
                              
                              $
                              197,905
                              
                              
                              $
                              87,721
                              
                              
                              $
                              31,911Margin
      by type:Product
      (as a percentage of product
      revenue)
                              
                              
                              74
                              %
                              
                              
                              72
                              %
                              
                              
                              70
                              %Support
      and services (as a percentage of support and services
    revenue)
                              
                              
                              64
                              %
                              
                              
                              64
                              %
                              
                              
                              35
                              %Ratable
      product and related support and services (as a percentage of ratable
      product and related support and services revenue)
                              
                              
                              95
                              %
                              
                              
                              69
                              %
                              
                              
                              76
                              %Total
      gross margin (as a percentage of total revenue)
                              
                              
                              72
                              %
                              
                              
                              71
                              %
                              
                              
                              69
                              %







Year Ended
December 31, 2008 Compared to the Year Ended December 31,
2007: For the year ended December 31, 2008, cost of product revenue
increased $30.5 million to $61.1 million from the $30.6 million reported for the
year ended December 31, 2007. This increase was due to increased aggregate
product costs associated with an increased volume of shipments of appliances to
our customers, and, to a lesser extent, increased personnel costs. The increase
was partially offset by lower warranty costs due to $1.6 million of charges
recorded in the year ended December 31, 2007 for the field replacement program
to replace a circuit board in some of our appliances.  To date, less
than 1% of these circuit boards have experienced failures. In April 2007, we
initiated this field replacement program in which we are offering to replace
circuit boards that we believe are potentially affected with circuit boards
manufactured by an alternate supplier, and we expanded this program in September
2007 for additional circuit boards used in some of our appliances. This warranty
charge does not assume any recovery from our suppliers because any recovery is
uncertain at this time. Salaries and employee-related benefits accounted for
$1.6 million of the increase in cost of product revenue, and stock-based
compensation accounted for $0.6 million of the increase. We expect the cost of
product revenue to increase in fiscal year 2009 as we continue to hire in our
operations group and due to an increase in product
revenue.




For the
year ended December 31, 2008, cost of support and services revenue increased
$9.9 million to $15.0 million from $5.2 million in the year ended
December 31, 2007. This increase was due to increases in installation costs
and in the number of our support and services employees, which grew to 61
employees at December 31, 2008 from 24 employees at December 31, 2007.
Salaries and employee-related benefits accounted for $3.3 million of the
increase, stock-based compensation expense accounted for $0.6 million, and
increased outside service costs accounted for $3.5 million. We expect the cost
of support and services revenue to continue to increase in 2009 as our installed
base continues to grow and we add additional support personnel.




For the
year ended December 31, 2008, cost of ratable product and related support and
services declined in line with the decline in ratable product and related
support and services revenue.




For the
year ended December 31, 2008, our gross margin increased 1% to 72% from 71% in
the year ended December 31, 2007, due primarily to the increase in product
margin from 72% to 74%. The increase in product margin was due to increased
sales of higher capacity and higher performance products that have higher gross
margins, cost reductions realized with respect to our products from increased
sales volume and decreases in hardware costs.  Margins on support and
services revenue were flat year over year. The gross margin for the year ended
December 31, 2007 also included warranty costs associated with the field
replacement program of $1.6 million.




26




Year Ended
December 31, 2007 Compared to the Year Ended December 31,
2006: For the year ended December 31, 2007, cost of product revenue
increased $19.6 million to $30.7 million from $11.1 million in the year ended
December 31, 2006. This increase was due to increased hardware costs
associated with an increased number of shipments of appliances to our customers,
as noted in the discussion of product revenue above, an increase in salaries and
employee related benefits of $815,000 and an increase in stock-based
compensation of $196,000. Also included in the increase for the year ended
December 31, 2007 is a charge of $1.6 million for estimated warranty costs
associated with a field replacement program for a circuit board used in our
appliances.




For the
year ended December 31, 2007, cost of support and services revenue increased
$3.3 million to $5.2 million from $1.9 million in the year ended
December 31, 2006. This increase was due to increases in our support
personnel that increased our salary expense, recruiting and employee-related
benefits by $1.1 million. Also contributing to the increase was stock-based
compensation, which accounted for $275,000 of the increase, increased outside
service costs of $939,000 related to support of our products from increased
sales, and an increase in installation costs of $599,000.




For the
year ended December 31, 2007, cost of ratable product and related support and
services declined in line with the decline in ratable product and related
support and services revenue.




For the
year ended December 31, 2007, gross margin increased to 71% from 69% in the year
ended December 31, 2006. The increase in gross margin was due to increased
product margin from cost reductions realized with respect to our products from
increased sales volume and decreases in hardware costs, increased sales of
higher capacity and higher performance products that have higher gross margins,
and increased margins on support and services revenue resulting from increased
operational efficiency due to a larger installed base. These increases were
partially offset by a provision on inventories of $264,000 and estimated
warranty costs associated with the field replacement program of $1.6
million.







Sales
and Marketing Expenses




Year ended
      December 31,(dollars
      in thousands)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Sales
      and marketing expenses
                      
                      $
                      115,817
                      
                      
                      $
                      60,441
                      
                      
                      $
                      20,252Percent
      of total revenue
                      
                      
                      42
                      %
                      
                      
                      49
                      %
                      
                      
                      44
                      %Headcount
      at year-end
                      
                      
                      434
                      
                      
                      
                      244
                      
                      
                      
                      90




Year Ended
December 31, 2008 Compared to the Year Ended December 31, 2007:
For the year ended December 31, 2008, sales and marketing expenses increased
$55.4 million to $115.8 million from $60.4 million in the year ended
December 31, 2007. This increase was primarily due to the increase in the
number of sales and marketing employees, which grew to 434 employees at
December 31, 2008 from 244 employees at December 31, 2007. The
increase in employees resulted in higher salary expense, employee-related
benefits and fees for recruitment of new employees. In addition, commission
expenses increased due to the substantial increase in our total revenue and the
higher number of employees eligible to receive commissions, which are earned and
recognized as expense on bookings. Salaries, employee-related benefits, fees for
recruitment of new employees and commissions accounted for $34.8 million of the
increase, stock-based compensation expense accounted for $5.1 million, costs
related to the opening of new sales offices accounted for $1.0 million, and
promotional, tradeshows and marketing costs accounted for $3.6 million of the
increase. The remaining $10.9 million of the increase was primarily the result
of increased travel and other costs associated with expanded domestic and
international operations.




We anticipate
that sales and marketing expenses will increase in absolute dollars in fiscal
year 2009 due to our plans to continue to expand our sales force, both
domestically and internationally, and to make significant investments in our
direct marketing campaigns.  However, based upon our expectations of future
revenue, we expect sales and marketing expenses will remain relatively stable as
a percentage of our total revenue.




Year Ended
December 31, 2007 Compared to the Year Ended December 31, 2006:
For the year ended December 31, 2007, sales and marketing expenses increased
$40.2 million to $60.5 million from $20.3 million in the year ended
December 31, 2006. This increase was due to an increase in the number of
sales and marketing employees, which grew to 244 employees at December 31,
2007 from 90 employees at December 31, 2006, including the addition of
approximately 50 sales and marketing employees associated with our international
operations. Salaries, employee-related benefits, fees for recruitment of new
employees and commissions accounted for $26.9 million, stock-based compensation
expense accounted for $5.8 million, and promotional, tradeshows and marketing
costs accounted for $2.1 million of the fiscal 2007 increase. The remaining $5.4
million of the increase was principally the result of increased costs from
travel and costs associated with international operations.




Research
and Development Expenses




Year ended
      December 31,(dollars
      in thousands)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Research
      and development expenses
                      
                      $
                      41,039
                      
                      
                      $
                      23,463
                      
                      
                      $
                      10,447Percent
      of total revenue
                      
                      
                      15
                      %
                      
                      
                      19
                      %
                      
                      
                      22
                      %Headcount
      at year-end
                      
                      
                      182
                      
                      
                      
                      116
                      
                      
                      
                      64




Year Ended
December 31, 2008 Compared to the Year Ended December 31,
2007: For the year ended December 31, 2008, research and development
expenses increased $17.6 million to $41.0 million from $23.5 million in the year
ended December 31, 2007. The increase was the direct result of hiring
additional personnel to drive new product introductions and broaden our product
line. Salaries and employee-related benefits accounted for $8.4 million of the
increase as the result of research and development headcount increasing to 182
employees at December 31, 2008 from 116 employees at December 31,
2007. Also contributing to the increase were increased expenses related to
stock-based compensation of $2.5 million and depreciation on capitalized
equipment used in our development lab of $1.3 million.




We
anticipate that research and development expenses in absolute dollars will
increase as we continue to invest in research, new product development and
enhancements to our existing appliances and hire additional research and
development personnel, particularly at our Research Triangle Park, North
Carolina facility.  However, based upon our expectations of future revenue,
we expect research and development expenses will remain relatively stable as a
percentage of our total revenue.




27




Year Ended
December 31, 2007 Compared to the Year Ended December 31,
2006: For the year ended December 31, 2007, research and development
expenses increased $13.0 million to $23.4 million from $10.4 million in the year
ended December 31, 2006. Of the increase, salaries and employee-related
benefits and recruiting costs accounted for $7.9 million, as the result of
research and development headcount increasing to 116 employees at
December 31, 2007 from 64 employees at December 31, 2006. Increased
expenses related to cost of consultants accounted for $756,000, stock-based
compensation accounted for $2.4 million and facility-related costs for equipment
and depreciation on capitalized equipment accounted for $829,000 of the
increase.




General
and Administrative Expenses




Year ended
      December 31,(dollars
      in thousands)
                        
                        2008
                        
                        
                        2007
                        
                        
                        2006General
      and administrative expenses
                        
                        $
                        24,239
                        
                        
                        $
                        11,006
                        
                        
                        $
                        2,831Percent
      of total revenue
                        
                        
                        9
                        %
                        
                        
                        9
                        %
                        
                        
                        6
                        %Headcount
      at year-end
                        
                        
                        70
                        
                        
                        
                        39
                        
                        
                        
                        11




Year Ended
December 31, 2008 Compared to the Year Ended December 31,
2007:For the year ended December 31, 2008, general and
administrative expenses increased $13.2 million to $24.2 million from $11.0
million in the year ended December 31, 2007. The increase was primarily due
to an increase in general and administrative headcount to 70 employees at
December 31, 2008 from 39 employees at December 31, 2007. Salaries and
employee-related benefits associated with the increased headcount accounted for
$4.4 million of the increase, professional service and consultant fees accounted
for $2.8 million, higher depreciation related to our new corporate headquarters
and equipment accounted for $2.8 million and increased stock-based compensation
expense accounted for $2.4 million.




The
additional employee-related and professional service fees were the result of our
ongoing efforts to build our legal, finance, human resources, recruiting and
information technology functions, and additional professional service fees were
necessitated by our public company status. We expect the absolute amount of our
general and administrative expenses to increase in the future as we expand our
finance function to manage our expected growth.  However, based upon our
expectations of future revenue, we expect general and administrative
expenses will remain relatively stable as a percentage of our total
revenue.




Year Ended
December 31, 2007 Compared to the Year Ended December 31,
2006:For the year ended December 31, 2007, general and
administrative expenses increased $8.2 million to $11.0 million from $2.8
million in the year ended December 31, 2006. Salaries, employee-related
benefits and recruiting costs accounted for $3.4 million of the increase,
professional service and consultant fees accounted for $2.2 million of the
increase and stock-based compensation expense accounted for $2.0 million of the
increase. The increase in salaries and employee-related benefits was due to an
increase in headcount to 39 employees at December 31, 2007 from 11
employees at December 31, 2006.




Settlement
Expense




In the
fourth quarter of 2006, we received an inquiry from Quantum Corporation, or
Quantum, regarding our interest in licensing certain patents that Quantum
believed we may have previously incorporated into our products or may
incorporate in the future. As a result of our discussions with Quantum, which
commenced in 2006, we entered into a patent cross-license agreement with Quantum
in March 2007, with an effective date of January 1, 2007. Under the terms
of the cross-license, we issued Quantum 390,000 shares of our common stock in
March 2007. We engaged an independent valuation firm to assist us in our
estimate of the value of the shares of our common stock as of the date of
issuance. Based on consideration of this valuation, we estimated the value of
the common stock issued under the agreement to be approximately
$3.3 million.




The same
independent valuation firm assisted us in our estimate of the value of the
intangible asset associated with the cross-license agreement and to estimate its
useful life. Based on consideration of this valuation, we estimated the fair
value of the intangible asset to be $400,000 that had an estimated useful life
of three years. This asset is amortized to cost of product revenue, beginning
January 1, 2007. The $2.9 million balance of the settlement amount
represents payment to Quantum for a release of all claims for any past acts or
conduct, and we have recorded the amount as settlement expense in our
consolidated statement of operations for the year ended December 31,
2006.




Other
Income (Expense), Net




Year ended December 31,(dollars
      in thousands)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Interest
      income
                      
                      $
                      6,256
                      
                      
                      $
                      3,899
                      
                      
                      $
                      523Loss
      on trading securities, net
                      
                      
                      (162
                      )
                      
                      
                      —
                      
                      
                      
                      —Other
      income (expense), net
                      
                      
                      (1,306
                      )
                      
                      
                      123
                      
                      
                      
                      200Total
      other income (expense), net
                      
                      $
                      4,788
                      
                      
                      $
                      4,022
                      
                      
                      $
                      723




Year Ended
December 31, 2008 Compared to the Year Ended December 31,
2007: For the year ended December 31, 2008, total other income
(expense), net increased $0.8 million to $4.8 million from $4.0 million in the
year ended December 31, 2007. The increase in interest income was the
result of income earned from the investment of net proceeds from our IPO and
follow-on offering and cash generated from operations, offset by lower overall
interest rates. Other income (expense), which is primarily comprised of foreign
exchange gains net of foreign exchange losses, net declined $1.4 million as the
Euro, British sterling and Canadian dollar declined compared to the U.S. dollar.
Included in other income (expense), net is $162,000 of net expense from the loss
on our auction-rate securities as a result of the reclassification of these
securities from available-for-sale to trading securities, which was offset by
the gain we recorded resulting from the UBS Put Option. See Note 2 of the Notes
to our Consolidated Financial Statements.  Due to the relatively short
duration of our investment portfolio, we expect interest income to fluctuate
primarily as a result of short-term interest rates, which have been under
significant downward pressure since the fourth quarter of 2008.




Year Ended
December 31, 2007 Compared to the Year Ended December 31,
2006: For the year ended December 31, 2008, total other income
(expense), net increased $3.3 million to $4.0 million from $723,000 in the year
ended December 31, 2006, as a result of income earned from the investment
of our IPO and follow-on offering net proceeds and other funds, net of foreign
currency net gains that declined year over year. Foreign currency net gains
decreased $77,000 for the year ended December 31, 2007 from the year ended
December 31, 2006.




28




Provision
for Income Taxes




Year ended December 31, 2008
Compared to the Year Ended December 31, 2007:  For the year ended
December 31, 2008, our provision for income taxes decreased $488,000 to
$5,000 from $493,000 in the year ended December 31, 2007.  The income tax
provision for the year ended December 31, 2008 was due to an income tax
provision of $13.2 million which was the result of increased profitability,
non-deductible stock compensation benefits and increased state taxes mainly due
to suspension of California net operating losses.  These amounts were
offset by an income tax benefit of $13.2 million as a result of the release of
the deferred tax asset valuation allowance.
  As of
December 31, 2007, our deferred tax assets, the tax benefits of loss
carryforwards, tax credits, and accounting accruals due to timing difference,
were offset in full by a valuation allowance because of our history of losses
through the third quarter of 2008. As a result of our analysis of expected
future income at December 31, 2008, we determined that it was more likely
than not that our deferred tax asset valuation allowance was no longer required.
As a result, we released our previously recorded valuation allowance resulting
in a $13.2 million deferred tax benefit. Deferred tax assets do not include
the tax benefits attributable to approximately $51.7 million of excess tax
deductions related to stock options. These benefits will only be recorded when
realized on tax returns and will be credited to equity at that
time.




In
evaluating our ability to realize our deferred tax assets, we consider all
available positive and negative evidence, including our past operating results,
the existence of cumulative losses in the most recent fiscal years prior to
2008, forecasted earnings and future taxable income, the mix of earnings in the
jurisdictions in which we operate and prudent and feasible tax planning
strategies. The assumptions utilized in determining future taxable income
require significant judgment and are consistent with the plans and estimates we
are using to manage the underlying businesses. We believe that the deferred tax
assets recorded on our balance sheet will more likely than not be realized. In
the event we were to determine that we would not be able to realize all or part
of our net deferred tax assets in the future, an adjustment to the deferred tax
assets would be charged to earnings in the period in which we make such
determination.




As of December 31, 2008, we had
net operating loss carryforwards for federal and state income tax purposes of
$0.3 million and $15.1 million, respectively. As of December 31, 2008, the
portion of the federal and state operating loss carryforwards which related to
stock option benefits was approximately $45.5 million, which will be recorded to
stockholders equity when they reduce taxes payable in cash. We also had federal
and state research and development tax credit carryforwards of approximately
$1.6 million. Federal research and development tax credits begin to expire in
2022 and the California research and development credits have no expiration
date.




Effective
January 1, 2007, we adopted FIN 48. Our total amount of unrecognized tax
benefits as of December 31, 2008 and December 31, 2007 was $2.1 million and
$1.6 million, respectively.  Of this total, $1.8 million
represents the amount of unrecognized tax benefits that, if recognized, would
affect our effective tax rate. We expect that the amount of unrecognized
benefits will change during the next 12 months; however, we do not expect the
change to have a material impact on our financial position.




Upon
adoption of FIN 48, our policy to include interest and penalties related to
unrecognized tax benefits within our provision for income taxes did not change.
For the years ended December 31, 2008 and 2007, we recognized $53,000 and
$12,000, respectively, of interest and penalties related to unrecognized tax
benefits in our provision for income taxes.




The tax
years 2002 through 2008 remain open to examination by the major domestic taxing
jurisdictions to which we are subject, and for the international jurisdictions
the tax years open to examination vary depending on the local tax
laws.





Year ended
December 31, 2007 Compared to the Year Ended December 31, 2006: Our
provision for income taxes increased $282,000 to $493,000 in the year ended
December 31, 2007 from $211,000 in the year ended December 31, 2006. This
increase was due to our increased international activities resulting in
increased foreign taxes, federal and California AMT and state income
taxes.




Liquidity
and Capital Resources




Working
Capital




December
      31,(in
      thousands)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Working
      capital
                      
                      $
                      232,996
                      
                      
                      $
                      203,688
                      
                      
                      $
                      12,856Cash
      and cash equivalents
                      
                      
                      128,380
                      
                      
                      
                      102,939
                      
                      
                      
                      11,857Short-term
      investments
                      
                      
                      105,512
                      
                      
                      
                      104,197
                      
                      
                      
                      —




Working
capital consists principally of cash and cash equivalents, short-term
investments, accounts receivable, inventories, prepaid expenses and other
current assets, net of accounts payable, accrued compensation and related
benefits, other accrued liabilities, income taxes payable and current deferred
revenue. Working capital increased $29.3 million from December 31, 2007 to
December 31, 2008, due primarily to cash flows provided by operations of
$75.9 million, partially offset by the reclassification of $30.9 million of our
investments in auction-rate securities to long-term investments and purchases of
property, plant and equipment. Other changes of note are:







·
            The
      increase in cash was the result of improved collections from accounts
      receivable reflected in our decrease in days sales outstanding from an
      average of 71 days as of December 31, 2007 to an average of 64 days as of
      December 31, 2008, computed based on the respective revenue from the
      immediately preceding quarter.·
            Accounts
      receivable increased from increased revenue, partially offset by somewhat
      shorter average collection periods resulting in lower days sales
      outstanding. We anticipate that accounts receivable will comprise a
      significant portion of working capital as we continue to grow revenue
      because a substantial portion of our sales, and therefore our shipping and
      billing, occurs near the end of the quarter.·
            Inventory
      increased due to the net increase in the number of units held in the
      evaluation inventory pool and purchases of raw materials for safety
      stock.·
            Prepaid
      expenses and other current assets increased for prepaid third-party
      break-fix costs, maintenance contracts, insurance, software and
      maintenance licenses, seminars, rent and other deposits, as well as due to
      restricted cash funded as required by our lease for our corporate
      headquarters.·
            Accounts
      payable increased from increased purchases of inventory and property,
      plant and equipment to support increased headcount and research and
      development spending.·
            Accrued
      compensation increased due to higher accrued commissions from higher net
      bookings, an increase in accrued vacation from the increase in employees,
      increase in accrued payroll and payroll taxes, and an increase in accrued
      employee stock purchase plan contributions.·
            Other
      accrued liabilities increased due to higher accrued travel, sales tax and
      accruals for services provided to us prior to the end of the reporting
      period, but, not billed to us by those providers as of the end of the
      reporting period.·
            Current
      deferred revenue increased from higher product revenue and the related
      support that is recognized over the term of the support services
      contract.




29




Cash
and Cash Equivalents




Cash and
cash equivalents consist of highly liquid investments in time deposits held at
major banks, commercial paper, U.S. government agency securities, money market
mutual funds and other money market securities with original maturities of 90
days or less.




Since
2005, we have expanded our operations internationally. Our sales contracts are
mainly denominated in United States dollars for sales in Asia and Japan,
denominated in Euros for sales in Europe, British sterling for sales in the
United Kingdom and Canadian dollars for certain sales in Canada. We currently do
not hedge the operating expenses that are primarily denominated in foreign
currency in countries where we have sales or operating personnel because we
believe those situations create natural hedges. We may begin to sell our
products in local currency in other locations. As we fund our international
operations, our cash and cash equivalents are affected by changes in exchange
rates for those expenses we do not hedge. The foreign currency effect on our
cash and cash equivalents and working capital were gains (losses) of $(1.3)
million and $123,000 for the years ended December 31, 2008 and 2007,
respectively.




Short-term
and Long-term Investments




Short-term
investments consist of commercial paper, U.S. government agency securities and
corporate bonds with original maturities of 90 to 365 days.




Long-term
investments consist of auction-rate securities. As of December 31, 2008, we had
$31.0 million of principal valued at $26.1 million related to auction-rate
securities.  In November 2008, we signed a broad-based settlement
proposal from UBS in which we would have the right to sell the securities back
to UBS at the principal value during the period from June 30, 2010 to July 2,
2012 if liquidity does not return to the auction-rate securities market sooner.
See Note 2 of the Notes to our Consolidated Financial Statements.




Due to
current market conditions these investments have continued to experience failed
auctions. These failed auctions have resulted in a lack of liquidity for the
securities but do not affect the underlying collateral of the securities. We
believe that given their government guaranteed status , we will ultimately
recover at par all amounts invested in these securities. Based on our expected
operating cash flows and our other sources of cash, we do not anticipate the
potential lack of liquidity of these investments will affect our ability to
execute our current business plan. We will continue to monitor efforts by the
financial markets to find alternative means for restoring the liquidity of these
investments. These investments will remain classified as non-current assets
until we have better visibility as to when their liquidity will be restored. The
classification and valuation of these securities will continue to be reviewed
quarterly.




Cash
Flows




Year ended
      December 31,(in
      thousands)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Cash
      provided by (used in) operating activities
                      
                      $
                      75,902
                      
                      
                      $
                      22,117
                      
                      
                      $
                      (572
                      )Cash
      used in investing activities
                      
                      
                      (62,605
                      )
                      
                      
                      (118,840
                      )
                      
                      
                      (1,351
                      )Cash
      provided by financial activities
                      
                      
                      12,540
                      
                      
                      
                      187,761
                      
                      
                      
                      1,285




Cash
Flows Provided by Operating Activities




Our cash
flows provided by operating activities will continue to be affected principally
by the extent to which we spend on increasing personnel, primarily in sales and
marketing and research and development, in order to grow our business. The
timing of hiring sales personnel in particular affects cash flows as there is a
lag between the hiring of sales personnel and the generation of revenue and cash
flows from such recently hired sales personnel. Our largest source of cash flows
from operating activities is cash collections from our customers. Our primary
uses of cash from operating activities are for employee-related expenditures,
rent payments, inventory purchases to support our revenue growth and research
and development costs.




For the
year ended December 31, 2008, cash flows provided by operating activities
increased $53.8 million to $75.9 million from $22.1 million in the year ended
December 31, 2007 due to continued growth in sales and improved gross margins,
improved collections of accounts receivable and an increase in deferred revenue
resulting from increased payments on support and services contracts. Based on
our expectations of future revenue levels, we believe we will be able to
continue to generate positive cash flows from operating activities in the near
term even to the extent we continue to add personnel, increase inventory
purchases, increase research and development activities and invest in functions
associated with being a public company.




For the
year ended December 31, 2007, cash flows provided by operating activities
increased $22.7 million to $22.1 million from ($572,000) for the year ended
December 31, 2006 due to increased sales activity, improved collections of
accounts receivable as a result of increased finance staffing and
focus on our collection process, and an increase in deferred revenue
resulting from payments on support and services contracts.




Cash
Flows Used in Investing Activities




Cash
flows used in investing activities primarily relate to capital expenditures to
support our employee headcount growth and net purchases of investment
securities. For the year ended December 31, 2008, cash flows used in investing
activities decreased $56.2 million to $62.6 million from $118.8 million in the
year ended December 31, 2007. The decrease in usage of cash was primarily
due to higher proceeds from maturity of available-for-sale investments of $128.8
million, offset by larger purchases of property, plant and equipment, reflecting
our increase in headcount of 342 in the period, and investments in computer
equipment, lab equipment for research and development, leasehold and furniture
and fixtures from our new corporate headquarters.




For the
year ended December 31, 2007, cash flows used in investing activities increased
$117.5 million to $118.8 million compared to $1.4 million in the year ended
December 31, 2006. Included in the year ended December 31, 2007 is the
investment of $104.2 million of our IPO and follow-on offering net proceeds in
short-term investments, along with $14.6 million of purchases of property,
plant and equipment, reflecting our increase in headcount of 256 in the
period, and investments in computer equipment, lab equipment for research and
development, leasehold and furniture and fixtures from our new corporate
headquarters and new system infrastructure.




30




Cash
Flows Provided by Financing Activities




For the
year ended December 31, 2008, cash flows provided by financing activities
decreased $175.2 million to $12.5 million from $187.8 million in the year
ended December 31, 2007, primarily from the proceeds of our IPO and follow-on
offering that each occurred during 2007. Cash flows provided by financing
activities of $12.5 million during the year ended December 31, 2008 resulted
from the cash exercise of stock options to purchase 2,984,000 shares of our
common stock by our employees as well as the purchase of 486,000 shares of our
common stock by our employees through our employee stock purchase plan,
partially offset by our repurchase of 13,000 shares of our common stock from
former employees.




For the
year ended December 31, 2007, cash flows provided by financing activities
increased $186.5 million to $187.8 million from $1.3 million for the year
ended December 31, 2006, primarily as a result of the net proceeds from our IPO
and follow-on offering, proceeds of $555,000 from the cash exercise of stock
options to purchase 672,000 shares of our common stock by our employees and
proceeds of $267,000 from the purchase of 30,000 fully vested shares by one of
our directors, offset by $64,000 of common stock repurchases.




We
believe that our existing cash balances will be sufficient to fund our projected
operating requirements for at least 12 months. However, we may need to raise
additional capital or incur indebtedness to respond to competitive pressures or
strategic opportunities. Our future capital requirements will depend on many
factors, including our rate of revenue growth, the expansion of our sales and
marketing activities, the timing and extent of expansion into new territories,
the timing of new product introductions and enhancements to existing products,
and the continuing market acceptance of our products. Although we currently are
not a party to any agreement or letter of intent with respect to potential
investments in, or acquisitions of, complementary businesses, services or
technologies, we may enter into these types of arrangements in the future, which
could also require us to seek additional equity or debt financing. Additional
funds may not be available on terms favorable to us, or at all.




Contractual
Obligations




The
following is a summary of our contractual obligations as of December 31,
2008:




Total
                          
                          
                          Less Than
                            One
      Year
                          
                          
                          1-3
                            Years
                          
                          
                          3-5
                            Years
                          
                          
                          More Than
                            5
      YearsOperating
      leases(1)
                          
                          $
                          53,723
                          
                          
                          $
                          7,133
                          
                          
                          $
                          11,860
                          
                          
                          $
                          11,965
                          
                          
                          $
                          22,765Purchase
      obligations(2)
                          
                          
                          26,493
                          
                          
                          
                          26,493
                          
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          
                          —Total
      contractual obligations
                          
                          $
                          80,216
                          
                          
                          $
                          33,626
                          
                          
                          $
                          11,860
                          
                          
                          $
                          11,965
                          
                          
                          $
                          22,765





(1
              )
              In
      2007, we entered into an operating lease for our corporate headquarters.
      In 2008, we entered into a new lease for a building adjacent to our
      corporate headquarters and a lease for a research and development facility
      in Raleigh, North Carolina.


(2
              )
              Represents
      amounts associated with agreements that are enforceable, legally binding
      and specify terms, including: fixed or minimum quantities to be purchased;
      fixed, minimum or variable price provisions; and the approximate timing of
      payment. Obligations under contracts that we can cancel without a
      significant penalty are not included in the table above.




We
purchase all of our appliances from our contract manufacturer, Flextronics
International, or Flextronics, which became our contract manufacturer through
its acquisition of Solectron Corporation. We provide Flextronics with a rolling
six-month forecast for planning purposes and place firm purchase orders for 30
days of expected purchases, which we are contractually committed to purchase. As
of December 31, 2008, we had $16.7 million in aggregate non-cancellable
purchase commitments placed with Flextronics. In addition, as of
December 31, 2008, we had an additional $9.8 million of other
non-cancellable purchase commitments with other third-party
vendors.




On
July 10, 2007, we entered into a lease for our new corporate headquarters.
The term of the lease is from November 1, 2007 to October 31, 2017 and
the approximate aggregate rent due over the term of the lease is $23.0 million.
Under the terms of the lease, we are obligated to provide a letter of credit for
$209,000, which we have funded.




In
January 2008, we signed an agreement to lease approximately 100,000 square feet
of office space adjacent to our existing corporate facility. The new lease took
effect on October 1, 2008. Future minimum lease payments will be approximately
$25.0 million, commencing in January 2009 and continuing through June 2018. As
part of signing the lease, we are obligated to provide a letter of credit for
$1.4 million, which we have funded.




Our
agreements with our channel partners and customers generally include certain
provisions for indemnifying the channel partners and customers against
liabilities if our products infringe a third party’s intellectual property
rights. To date, we have not incurred any material costs as a result of such
indemnification provisions and have not accrued any liabilities related to such
obligations in our consolidated financial statements.




At
December 31, 2008, we had a liability for unrecognized tax benefits and an
accrual for the payment of related interest totaling $2.1 million, of which none
is expected to be paid within one year. Due to uncertainties related to these
tax matters, we are unable to make a reasonably reliable estimate when cash
settlements with the taxing authority will occur.




Off-Balance
Sheet Arrangements




At
December 31, 2008 and 2007, we did not have any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes.




Recent
Accounting Pronouncements




See Note
1 of the Notes to our Consolidated Financial Statements for recent accounting
pronouncements that could have an effect on us.




31




Item 7A.
            Quantitative
      and Qualitative Disclosures about Market
Risk




Foreign
Currency Risk




Our
European revenue is denominated in Euros. As a result, our European revenue
is subject to foreign currency risk due to fluctuations in the value of the Euro
compared to the U.S. dollar. We had Euro-denominated revenue of
approximately $36.7 million, $25.9 million and $12.2 million for the years ended
December 31, 2008, 2007 and 2006, respectively. We had $3.6 million and
$0.7 million in Canadian dollar revenue for the years ended December 31,
2008 and 2007, respectively, and none in the year ended December 31, 2006. In
addition, for the year ended December 31, 2008, we had $7.1 million of British
sterling revenue and $0.5 million of Australian dollar revenue, and none in the
years ended December 31, 2007 and December 31, 2006 for either
currency.




Our
international sales and marketing operations incur expenses that are denominated
in foreign currencies. As a result, our operating expenses and cash flows
are subject to fluctuations in the value of the U.S. dollar compared to the
British sterling, Euro, Canadian dollar and, to a lesser extent, the Australian
and Singapore dollar, and Danish, Chinese, Korean, Taiwanese, New Zealand,
Mexican, Malaysian, Israeli and Swedish currencies. We had foreign currency
denominated expenses of approximately $45.5 million, $13.6 million and $4.2
million for the years ended December 31, 2008, 2007 and 2006,
respectively.




As of
December 31, 2008, we had approximately $5.4 million in accounts receivable
denominated in Euros, $1.9 million in accounts receivable denominated in
Canadian dollars and approximately $3.4 million in accounts receivable
denominated in other foreign currencies.




Changes
in currency exchange rates could adversely affect our revenue and profitability,
and require us to reduce our prices to remain competitive in foreign markets,
which could also have a material adverse effect on our results of
operations. We have not entered into any foreign currency hedging
contracts. We are presently evaluating the desirability of entering into
foreign currency hedging contracts to offset our exposure to revenue in foreign
currencies, primarily Euro-based contracts, to reduce our exposure to
fluctuations in currency exchange rates.




We
estimate that a 10% decline in the value of the U.S. dollar as measured against
the other currencies in which our transactions are denominated would have
negatively impacted our net income in the year ended December 31, 2008 by
approximately $4.6 million. This sensitivity analysis disregards the
possibilities that rates can move in opposite directions and that losses from
one geographic area may be offset by gains from another
geographic area.




Interest
Rate Sensitivity and Market Risk




The
primary objective of our investment activities is to preserve principal while at
the same time maximizing the income we receive from our investments, without
significantly increasing risk. To achieve this objective, we maintain our
portfolio of cash equivalents and short-term and long-term investments in a
variety of high quality securities, including U.S. government agency securities,
corporate bonds, money market funds, commercial paper and auction-rate
securities. All investments, except for auction-rate securities, are classified
as available-for-sale and held for working capital purposes. We do not enter
into investments for trading or speculative purposes. We believe that we do not
have any material exposure to changes in fair value as a result of changes in
interest rates. Declines in interest rates, however, will reduce future
investment income. If overall interest rates fell by 10% in the year ended
December 31, 2008 and 2007, our interest income would have declined
approximately $630,000 and $390,000, respectively, assuming consistent
investment levels.




At
December 31, 2008, we held approximately $31.0 million in principal, valued at
$26.1 million, of auction-rate securities, classified as long-term investments.
In February 2008, the majority of these auction-rate securities failed to
auction, causing access to these funds to be restricted. An auction failure
means that the parties wishing to sell securities, could not. As a result, our
ability to liquidate these investments and fully recover the carrying value of
our investment was restricted. All of our auction-rate securities are currently
AAA-rated taxable municipal debt obligations. If the issuers are unable to
successfully close future auctions and their credit ratings deteriorate, we may
in the future be required to record an impairment charge on these
investments.




In
November 2008, we signed a broad-based settlement proposal from UBS in which we
would have the right, in the form of a put option, to sell the securities back
to UBS at par value during the period from June 30, 2010 to July 2, 2012 if
liquidity does not return to the auction-rate securities market sooner. We
valued the put option using a discounted cash flow approach including estimates
of, based on data available as of December 31, 2008, interest rates, timing and
amount of cash flow, adjusted for any bearer risk associated with UBS’s
financial ability to repurchase the auction-rate securities beginning June 30,
2010. Based on the discounted cash flow model, we determined the fair value of
the put option to be $4.8 million. In connection with the put option, we
transferred our auction-rate securities from available-for-sale to trading
securities. The transfer to trading securities reflects management’s intent to
exercise the put option during the period June 30, 2010 to July 2,
2012.




We expect
to sell our auction-rate securities under the put option. However, if the put
option is not exercised before July 2, 2012, it will expire and UBS will have no
further rights or obligations to buy our auction-rate securities. As long as we
hold our auction-rate securities, they will continue to accrue interest as
determined by the auction process or the terms specified in the auction-rate
securities if the auction process fails. We expect that the future changes in
value of the put option will largely be offset by the changes in fair value of
the auction-rate securities, assuming UBS will continue to be able to honor the
put option.




UBS’s
obligations under the put option are not secured by its assets and do not
require UBS to obtain any financing to support its performance obligations under
the put option. UBS has disclaimed any assurance that it will have sufficient
financial resources to satisfy its obligations under the put option. If UBS has
insufficient funding to buy back the auction-rate securities and the auction
process continues to fail, then we may incur further losses.




The
valuation of our investment portfolio is subject to uncertainties that are
difficult to predict. Factors that may impact its valuation include changes to
credit ratings of the securities, discount rates and ongoing strength and
quality of market credit and liquidity. If the current market conditions
deteriorate further, or the anticipated recovery in market values does not
occur, we may be required to record impairment charges in future
quarters.







32


Item 8.
Financial Statements and Supplementary Data




INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS




Reports
      of Independent Registered Public Accounting Firm
            34Consolidated
      Balance Sheets
            36Consolidated
      Statements of Operations
            37Consolidated
      Statements of Mandatorily Redeemable Convertible Preferred Stock and
      Stockholders’ Equity (Deficit)
            38Consolidated
      Statements of Cash Flows
            39Notes
      to Consolidated Financial Statements
            40




33


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




The Board
of Directors and Stockholders


Data
Domain, Inc.




We have
audited the accompanying consolidated balance sheets of Data Domain, Inc. as of
December 31, 2008 and 2007, and the related consolidated statements of
operations, mandatorily redeemable convertible preferred stock and stockholders’
equity (deficit), and cash flows for each of the three years in the period ended
December 31, 2008. Our audits also included the financial statement
schedule listed in the index at Item 15. These financial statements and
schedule are the responsibility of the Company’s management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.




In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Data Domain, Inc. at
December 31, 2008 and 2007, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended
December 31, 2008, in conformity with U.S. generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth
therein.




As
discussed in Note 1 to the consolidated financial statements, Data Domain, Inc.
changed its method of accounting for uncertain tax positions as of
January 1, 2007.




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Data Domain, Inc.’s internal control over
financial reporting as of December 31, 2008, based on criteria established in
Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated March 12,
2009 expressed an unqualified opinion thereon.




/s/ ERNST &
YOUNG LLP




San Jose,
California


March 12,
2009






34


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM










The Board
of Directors and Stockholders


Data
Domain, Inc.





We have
audited Data Domain, Inc.’s internal control over financial reporting as of
December 31, 2008, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (the COSO criteria). Data Domain, Inc.’s management is responsible
for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting
included in the accompanying Management’s Report on Internal Control Over
Financial Reporting. Our responsibility is to express an opinion on the
Company’s internal control over financial reporting based on our
audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management’s assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.





A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





In our
opinion, Data Domain, Inc. maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2008, based on the
COSO criteria.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Data Domain,
Inc. as of December 31, 2008 and 2007, and the related consolidated statements
of operations, mandatorily redeemable convertible preferred stock and
stockholders’ equity (deficit), and cash flows for each of the three years in
the period ended December 31, 2008 and our report dated March 12, 2009 expressed an unqualified
opinion thereon.





/s/ ERNST & YOUNG
LLP





San Jose,
California


March 12,
2009










35


DATA
DOMAIN, INC.




CONSOLIDATED
BALANCE SHEETS


(in
thousands, except per share data)




December 31,2008
                    
                    
                    2007Current
      Assets:Cash
      and cash equivalents
                    
                    $
                    128,380
                    
                    
                    $
                    102,939Short-term
      investments
                    
                    
                    105,512
                    
                    
                    
                    104,197Accounts
      receivable (net of allowances of $120 and $0,
respectively)
                    
                    
                    60,322
                    
                    
                    
                    35,320Inventories
                    
                    
                    4,638
                    
                    
                    
                    2,341Deferred
      tax asset
                    
                    
                    7,531
                    
                    
                    
                    —Prepaid
      expenses and other current assets
                    
                    
                    5,116
                    
                    
                    
                    1,711Total
      current assets
                    
                    
                    311,499
                    
                    
                    
                    246,508Long-term
      investments
                    
                    
                    30,866
                    
                    
                    
                    —Long-term
      deferred tax asset
                    
                    
                    5,629
                    
                    
                    
                    —Intangible
      asset
                    
                    
                    133
                    
                    
                    
                    267Property,
      plant and equipment, net
                    
                    
                    38,854
                    
                    
                    
                    14,589Total
      assets
                    
                    $
                    386,981
                    
                    
                    $
                    261,364Current
      Liabilities:Accounts
      payable
                    
                    $
                    10,970
                    
                    
                    $
                    7,251Accrued
      compensation and related benefits
                    
                    
                    16,720
                    
                    
                    
                    11,992Other
      accrued liabilities
                    
                    
                    10,441
                    
                    
                    
                    6,731Income
      taxes payable
                    
                    
                    1,051
                    
                    
                    
                    196Deferred
      revenue, current
                    
                    
                    39,321
                    
                    
                    
                    16,650Total
      current liabilities
                    
                    
                    78,503
                    
                    
                    
                    42,820Deferred
      revenue, non-current
                    
                    
                    28,399
                    
                    
                    
                    9,322Long-term
      exercised unvested stock options
                    
                    
                    285
                    
                    
                    
                    766Other
      liabilities
                    
                    
                    2,910
                    
                    
                    
                    594Commitments
      and contingenciesStockholders’
      equity:Common
      stock and additional paid in capital; $0.0001 par value—300,000 shares
      authorized as of December 31, 2008 and 2007; 60,169 and 56,714 shares
      issued and outstanding as of December 31, 2008 and 2007,
      respectively
                    
                    
                    295,564
                    
                    
                    
                    248,078Accumulated
      other comprehensive income (loss)
                    
                    
                    (10
                    )
                    
                    
                    47Accumulated
      deficit
                    
                    
                    (18,670
                    )
                    
                    
                    (40,263
                    )Total
      stockholders’ equity
                    
                    
                    276,884
                    
                    
                    
                    207,862Total
      liabilities and stockholders’ equity
                    
                    $
                    386,981
                    
                    
                    $
                    261,364




See Notes
to Consolidated Financial Statements










36


DATA
DOMAIN, INC.




CONSOLIDATED
STATEMENTS OF OPERATIONS


(in
thousands, except per share data)




Year Ended
      December 31,2008
                      
                      
                      2007
                      
                      
                      2006Revenue:Product
                      
                      $
                      232,712
                      
                      
                      $
                      108,869
                      
                      
                      $
                      36,884Support
      and services
                      
                      
                      41,286
                      
                      
                      
                      14,423
                      
                      
                      
                      2,898Ratable
      product and related support and services
                      
                      
                      87
                      
                      
                      
                      330
                      
                      
                      
                      6,652Total
      revenue
                      
                      
                      274,085
                      
                      
                      
                      123,622
                      
                      
                      
                      46,434Cost
      of revenue:Cost
      of product
                      
                      
                      61,133
                      
                      
                      
                      30,646
                      
                      
                      
                      11,059Cost
      of support and services
                      
                      
                      15,042
                      
                      
                      
                      5,152
                      
                      
                      
                      1,873Cost
      of ratable product and related support and services
                      
                      
                      5
                      
                      
                      
                      103
                      
                      
                      
                      1,591Total
      cost of revenue
                      
                      
                      76,180
                      
                      
                      
                      35,901
                      
                      
                      
                      14,523Gross
      profit
                      
                      
                      197,905
                      
                      
                      
                      87,721
                      
                      
                      
                      31,911Operating
      expenses:Sales
      and marketing
                      
                      
                      115,817
                      
                      
                      
                      60,441
                      
                      
                      
                      20,252Research
      and development
                      
                      
                      41,039
                      
                      
                      
                      23,463
                      
                      
                      
                      10,447General
      and administrative
                      
                      
                      24,239
                      
                      
                      
                      11,006
                      
                      
                      
                      2,831Settlement
      expense
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      2,919Total
      operating expenses
                      
                      
                      181,095
                      
                      
                      
                      94,910
                      
                      
                      
                      36,449Operating
      income (loss)
                      
                      
                      16,810
                      
                      
                      
                      (7,189
                      )
                      
                      
                      (4,538
                      )Other
      income (expense), net:Interest
      income
                      
                      
                      6,256
                      
                      
                      
                      3,899
                      
                      
                      
                      523Other
      income (expense), net
                      
                      
                      (1,468
                      )
                      
                      
                      123
                      
                      
                      
                      200Total
      other income (expense), net
                      
                      
                      4,788
                      
                      
                      
                      4,022
                      
                      
                      
                      723Income
      (loss) before provision for income taxes
                      
                      
                      21,598
                      
                      
                      
                      (3,167
                      )
                      
                      
                      (3,815
                      )Provision
      for income taxes
                      
                      
                      5
                      
                      
                      
                      493
                      
                      
                      
                      211Net
      income (loss)
                      
                      $
                      21,593
                      
                      
                      $
                      (3,660
                      )
                      
                      $
                      (4,026
                      )Net
      income (loss) per share, basic
                      
                      $
                      0.37
                      
                      
                      $
                      (0.12
                      )
                      
                      $
                      (0.56
                      )Net
      income (loss) per share, diluted
                      
                      $
                      0.33
                      
                      
                      $
                      (0.12
                      )
                      
                      $
                      (0.56
                      )Shares
      used in computing net income (loss) per share, basic
                      
                      
                      58,254
                      
                      
                      
                      31,482
                      
                      
                      
                      7,128Shares
      used in computing net income (loss) per share, diluted
                      
                      
                      65,814
                      
                      
                      
                      31,482
                      
                      
                      
                      7,128




See Notes
to Consolidated Financial Statements










37


DATA
DOMAIN, INC.


CONSOLIDATED STATEMENTS
OF MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
STOCKHOLDERS’ EQUITY (DEFICIT)


(in
thousands)





Mandatorily
      Redeemable Convertible Preferred Stock
                  
                  
                  Common
      Stock and Additional Paid-In CapitalShares
                  
                  
                  Amount
                  
                  
                  Shares
                  
                  
                  Amount
                  
                  
                  Accumulated
      Other Comprehensive
                      Income
                  
                  
                  Stockholder
      Note Receivable
                  
                  
                  Accumulated
      Deficit
                  
                  
                  Total
      Stockholders’
                      Equity
      (Deficit)Balances,
      December 31, 2005
                  
                  
                  34,721
                  
                  
                  $
                  41,310
                  
                  
                  
                  7,463
                  
                  
                  $
                  1,542
                  
                  
                  $
                  13
                  
                  
                  $
                  (15
                  )
                  
                  $
                  (32,577
                  )
                  
                  $
                  (31,037
                  )Issuance
      of preferred stock for cash
                  
                  
                  60
                  
                  
                  
                  180Issuance
      of common stock for services rendered
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  72
                  
                  
                  
                  7
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  7Stock
      options exercised
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,882
                  
                  
                  
                  1,109
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,109Stock
      options repurchased
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (32
                  )
                  
                  
                  (4
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4
                  )Accretion
      of preferred stock
                  
                  
                  
                  
                  
                  
                  24
                  
                  
                  
                  
                  
                  
                  
                  (25
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (25
                  )Reclassification
      of options exercised but not yet vested
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (871
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (871
                  )Stock-based
      compensation
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,291
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,291Comprehensive
      loss:Currency
      translation adjustment
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (10
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (10
                  )Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,026
                  )
                  
                  
                  (4,026
                  )Comprehensive
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,036
                  )Balances,
      December 31, 2006
                  
                  
                  34,781
                  
                  
                  
                  41,514
                  
                  
                  
                  9,385
                  
                  
                  
                  3,049
                  
                  
                  
                  3
                  
                  
                  
                  (15
                  )
                  
                  
                  (36,603
                  )
                  
                  
                  (33,566
                  )Stock
      options exercised
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  672
                  
                  
                  
                  555
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  555Stock
      options repurchased
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (88
                  )
                  
                  
                  (64
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (64
                  )Issuance
      of restricted stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  384Repayment
      of stockholder note receivable
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  15
                  
                  
                  
                  
                  
                  
                  
                  15Stock
      award to purchase common stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  30
                  
                  
                  
                  267
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  267Accretion
      of preferred stock
                  
                  
                  
                  
                  
                  
                  6
                  
                  
                  
                  
                  
                  
                  
                  (6
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (6
                  )Preferred
      stock converted to common stock
                  
                  
                  (34,781
                  )
                  
                  
                  (41,520
                  )
                  
                  
                  34,781
                  
                  
                  
                  41,520
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  41,520Issuance
      of common stock for  Quantum settlement
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  390
                  
                  
                  
                  3,319
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3,319Stock
      issued from initial public offering, net of expenses of $12.4
      million
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  8,109
                  
                  
                  
                  109,161
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  109,161Stock
      issued from follow-on offering, net of expenses of $4.6
      million
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3,051
                  
                  
                  
                  77,827
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  77,827Reclassification
      of options exercised but not yet vested
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  290
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  290Tax
      benefit for excess stock option deduction
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  109
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  109Stock-based
      compensation
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  12,051
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  12,051Comprehensive
      loss:Currency
      translation adjustment
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  22
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  22Unrealized
      gain on short-term investments
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  22
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  22Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (3,660
                  )
                  
                  
                  (3,660
                  )Comprehensive
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (3,616
                  )Balances,
      December 31, 2007
                  
                  
                  ——
                  
                  
                  
                  ——
                  
                  
                  
                  56,714
                  
                  
                  
                  248,078
                  
                  
                  
                  47
                  
                  
                  
                  ——
                  
                  
                  
                  (40,263
                  )
                  
                  
                  207,862Stock
      options exercised
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,983
                  
                  
                  
                  5,233
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  5,233Stock
      options repurchased
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (14
                  )
                  
                  
                  (7
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (7
                  )Stock
      issued from employee stock purchase plan
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  486
                  
                  
                  
                  7,314
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  7,314Reclassification
      of options exercised but not yet vested
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  481
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  481Tax
      benefit for excess stock option deduction
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  11,081
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  11,081Stock-based
      compensation
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  23,384
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  23,384Comprehensive
      income:Currency
      translation adjustment
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (397
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (397
                  )Unrealized gain on short-term  and long-term
      investments
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  340
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  340Net
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  21,593
                  
                  
                  
                  21,593Comprehensive
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  21,536Balances,
      December 31, 2008
                  
                  
                  ——
                  
                  
                  
                  ——
                  
                  
                  
                  60,169
                  
                  
                  $
                  295,564
                  
                  
                  $
                  (10
                  )
                  
                  
                  ——
                  
                  
                  $
                  (18,670
                  )
                  
                  $
                  276,884





See Notes
to Consolidated Financial Statements


38




DATA
DOMAIN, INC.
  CONSOLIDATED
STATEMENT OF CASH FLOWS
  (in
thousands)
 
 
 Fiscal
      YearsEnded December
      31,2008
                                                
                                                
                                                2007
                                                
                                                
                                                2006Cash
      flows from operating activities:Net
      income (loss)
                                                
                                                $
                                                21,593
                                                
                                                
                                                $
                                                (3,660
                                                )
                                                
                                                $
                                                (4,026
                                                )Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                                                
                                                
                                                6,498
                                                
                                                
                                                
                                                1,885
                                                
                                                
                                                
                                                982Stock-based
      compensation expense
                                                
                                                
                                                23,384
                                                
                                                
                                                
                                                12,051
                                                
                                                
                                                
                                                1,291Excess
      tax benefit from stock-based compensation
                                                
                                                
                                                11,092
                                                
                                                
                                                
                                                109
                                                
                                                
                                                
                                                —Deferred
      income taxes
                                                
                                                
                                                (12,564
                                                )
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —Provision
      (release) for accounts receivable allowances
                                                
                                                
                                                120
                                                
                                                
                                                
                                                (10
                                                )
                                                
                                                
                                                9Amortization
      of evaluation units in inventory
                                                
                                                
                                                2,536
                                                
                                                
                                                
                                                2,596
                                                
                                                
                                                
                                                1,365Gain
      on value of option to put securities
                                                
                                                
                                                (4,779
                                                )
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —Mark-to-market,
      trading loss
                                                
                                                
                                                4,913
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —Settlement
      expense
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                2,919Common
      stock issued for services
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                7Changes
      in operating assets and liabilities:(Increase)
      in accounts receivable
                                                
                                                
                                                (25,122
                                                )
                                                
                                                
                                                (19,856
                                                )
                                                
                                                
                                                (11,124
                                                )(Increase
      in inventories
                                                
                                                
                                                (4,832
                                                )
                                                
                                                
                                                (3,744
                                                )
                                                
                                                
                                                (2,009
                                                )(Increase)
      in prepaid expenses and other current assets
                                                
                                                
                                                (3,405
                                                )
                                                
                                                
                                                (1,400
                                                )
                                                
                                                
                                                (137
                                                )Increase
      in accounts payable
                                                
                                                
                                                3,719
                                                
                                                
                                                
                                                3,661
                                                
                                                
                                                
                                                2,635Increase
      in accrued compensation and related benefits
                                                
                                                
                                                4,728
                                                
                                                
                                                
                                                8,304
                                                
                                                
                                                
                                                2,309Increase
      in other accrued liabilities
                                                
                                                
                                                5,419
                                                
                                                
                                                
                                                5,554
                                                
                                                
                                                
                                                1,471Increase
      (decrease) in income taxes payable
                                                
                                                
                                                855
                                                
                                                
                                                
                                                (50
                                                )
                                                
                                                
                                                211Increase
      in deferred revenue
                                                
                                                
                                                41,747
                                                
                                                
                                                
                                                16,677
                                                
                                                
                                                
                                                3,525Net
      cash provided by (used in) operating activities
                                                
                                                
                                                75,902
                                                
                                                
                                                
                                                22,117
                                                
                                                
                                                
                                                (572
                                                )Cash
      flows from investing activities:Purchases
      of property, plant and equipment
                                                
                                                
                                                (30,629
                                                )
                                                
                                                
                                                (14,643
                                                )
                                                
                                                
                                                (1,351
                                                )Purchases
      of available-for-sale securities
                                                
                                                
                                                (145,603
                                                )
                                                
                                                
                                                (120,022
                                                )
                                                
                                                
                                                —Proceeds
      from maturity of available-for-sale securities
                                                
                                                
                                                144,627
                                                
                                                
                                                
                                                15,825
                                                
                                                
                                                
                                                —Purchases
      of long-term investments
                                                
                                                
                                                (31,000
                                                )
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —Net
      cash used in investing activities
                                                
                                                
                                                (62,605
                                                )
                                                
                                                
                                                (118,840
                                                )
                                                
                                                
                                                (1,351
                                                )Cash
      flows from financing activities:Proceeds
      from initial public offering, net of offering costs
                                                
                                                
                                                —
                                                
                                                
                                                
                                                109,161
                                                
                                                
                                                
                                                —Proceeds
      from follow-on offering, net of offering costs
                                                
                                                
                                                —
                                                
                                                
                                                
                                                77,827
                                                
                                                
                                                
                                                —Repayment
      of stockholder note receivable
                                                
                                                
                                                —
                                                
                                                
                                                
                                                15
                                                
                                                
                                                
                                                —Proceeds
      from issuance of mandatorily redeemable convertible preferred stock, net
      of issuance costs
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                180Proceeds
      from issuance of common stock, net of repurchases
                                                
                                                
                                                12,540
                                                
                                                
                                                
                                                758
                                                
                                                
                                                
                                                1,105Net
      cash provided by financing activities
                                                
                                                
                                                12,540
                                                
                                                
                                                
                                                187,761
                                                
                                                
                                                
                                                1,285Effect
      of exchange rate changes on cash and cash equivalents
                                                
                                                
                                                (396
                                                )
                                                
                                                
                                                44
                                                
                                                
                                                
                                                (10
                                                )Net
      increase (decrease) in cash and cash equivalents
                                                
                                                
                                                25,441
                                                
                                                
                                                
                                                91,082
                                                
                                                
                                                
                                                (648
                                                )Cash
      and cash equivalents at beginning of the year
                                                
                                                
                                                102,939
                                                
                                                
                                                
                                                11,857
                                                
                                                
                                                
                                                12,505Cash
      and cash equivalents at end of the year
                                                
                                                $
                                                128,380
                                                
                                                
                                                $
                                                102,939
                                                
                                                
                                                $
                                                11,857Supplemental
      disclosure of cash flow information:Cash
      paid for income taxes
                                                
                                                $
                                                723
                                                
                                                
                                                $
                                                494
                                                
                                                
                                                $
                                                10Non-cash
      operating activities:Issuance
      of common stock for Quantum settlement
                                                
                                                
                                                —
                                                
                                                
                                                
                                                3,319
                                                
                                                
                                                
                                                —Acquisition
      of cross-license
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                400Non-cash
      financing activities:Conversion
      of mandatorily redeemable convertible preferred stock to common stock and
      additional paid-in capital
                                                
                                                $
                                                —
                                                
                                                
                                                $
                                                41,514
                                                
                                                
                                                $
                                                —
 See
Notes to Consolidated Financial Statements








39




DATA DOMAIN, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


1.
ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES









Organization




Data
Domain, Inc. was incorporated in the State of Delaware in October 2001. Our
appliances provide storage solutions for backup and archive applications based
on deduplication technology. We began selling our products and services in
February 2004. Our product sales generally include a software license, hardware,
post-contract customer support and, in some cases, installation and professional
services.







Summary
of Significant Accounting Policies









Basis
of Presentation




The
consolidated financial statements include our accounts and the accounts of our
wholly owned subsidiaries. Intercompany transactions and balances have been
eliminated. The consolidated financial statements and accompanying notes have
been prepared in accordance with United States generally accepted accounting
principles, or GAAP, pursuant to the rules and regulations of the Securities and
Exchange Commission.






Use
of Estimates






The
preparation of financial statements in conformity with GAAP requires us to make
certain estimates and judgments that can affect the reported amounts of assets
and liabilities as of the date of the consolidated financial statements, as well
as the reported amounts of revenue and expenses during the periods presented.
Significant estimates and assumptions made by management include revenue
recognition, the determination of the fair value of stock awards, inventory
valuation, warranty reserve, the allowance for doubtful accounts, short and
long-term investments and the accounting for income taxes. We believe that the
estimates and judgments upon which we rely are reasonable based upon information
available to us at the time that these estimates and judgments are made. To the
extent there are material differences between these estimates and actual
results, our consolidated financial statements will be affected.






Revenue
Recognition






We derive
our revenue from sales of our products and support services through third-party
value added resellers and distributors, or channel partners, and directly to
customers. Product revenue primarily consists of revenue from sales of our
appliances and expansion shelves. Revenues are recorded net of customer returns
which are estimated at the time of sale. Shipping charges billed to customers
are included in product revenue and the related shipping costs are included in
cost of product revenue.






Our
software is integrated with our industry standard appliance hardware and is
essential to the functionality of the integrated system product. We provide
unspecified software updates and enhancements related to our products through
support and services contracts. Accordingly, we recognize revenue in accordance
with the guidance provided under the American Institute of Certified Public
Accountants, or AICPA, Statement of Position No. 97-2, Software Revenue Recognition,
or SOP 97-2, and No. 98-9, Modification of SOP No. 97-2
Software Revenue Recognition with Respect to Certain Transactions, or SOP
98-9. Product revenue is recognized when all of the following have occurred: (1)
we have entered into a legally binding arrangement with a customer; (2) delivery
has occurred, which is when the product title has transferred to the customer;
(3) customer payment is deemed fixed or determinable and free of contingencies
and significant uncertainties; and (4) collection is probable. Our fees are
considered fixed or determinable upon the establishment of an arrangement that
contains the final terms of sale including the description, quantity and price
of each product purchased. Our customer arrangements do not include rights of
return or acceptance provisions. We assess the ability to collect from our
customers based on a number of factors, including creditworthiness and past
transaction history of the customer. If the customer is deemed not creditworthy,
all revenue from the arrangement is deferred until payment is received and all
other revenue recognition criteria have been met.






Substantially
all of our products have been sold in combination with support and services,
which primarily consist of hardware and software support. Hardware support
includes repair or replacement in the event of breakage or failure, and
telephone and internet access to technical information and support personnel
during the term of the support period. Software support provides customers with
rights to unspecified software updates and to maintenance releases and patches
released during the term of the support period. Installation or professional
services, when provided, are also included in support and services revenue. We
have established vendor specific objective evidence, or VSOE, of fair value of
our support and services as measured by the renewal prices offered to and paid
by our customers. Accordingly, we use the residual method, as allowed by SOP
98-9, to determine the amount of product revenue to be recognized. Under the
residual method, the fair value of the undelivered support and services, which
is a specified dollar amount, is deferred and the remaining portion of the
arrangement is recognized as product revenue. This product revenue is generally
recognized upon shipment, except for certain customers whose terms are FOB
destination point wherein the revenue is recognized upon delivery, based on
freight terms of FOB shipping point or FCA (Incoterms 2000) shipping point,
assuming all other criteria for revenue recognition discussed above have been
met and, in the case of all indirect channel sales, persuasive evidence of the
identity of the end customer has been obtained. In all cases of direct or
indirect channel sales, we recognize revenue once an end customer is identified
and shipment has occurred, assuming all other criteria for revenue recognition
discussed above have been met. The fair value of the support and services is
recognized as support and services revenue on a straight-line basis over the
term of the related support period, which is typically one to three
years.




40






Product
sales sometimes include installation services. Installation revenue is deferred
and recognized upon the earlier of customer notice that the installation is
complete or sixty days after shipment. We have established VSOE of fair value
for our installation services based on the price separately charged to our
customers. Revenue from installation, which is included in support and services
revenue, was $3.9 million, $1.6 million and $0.4 million for the years ended
December 31, 2008, 2007 and 2006, respectively.




Deferred
Cost of Product Revenue




When our
products have been delivered, but the product revenue associated with the
arrangement has been deferred as a result of not meeting the revenue recognition
criteria in SOP 97-2, we defer the related inventory costs for the delivered
items and net the amount against the applicable deferred revenue in the balance
sheet presentation in accordance with Accounting Research Bulletin 43,Restatement and Revision of
Accounting Research Bulletins.




Research
and Development




All costs
to develop our products are expensed as incurred. In accordance with Statement
of Financial Accounting Standards, or SFAS, No. 86,Accounting for the Costs of
Computer Software to be Sold, Leased or Otherwise Marketed, software
development costs are capitalized beginning when a product’s technological
feasibility has been established and ending when a product is available for sale
to customers. Generally, our products are released for sale soon after
technological feasibility has been established. As a result, costs subsequent to
achieving technological feasibility have not been significant and all software
development costs have been expensed as incurred.




Stock-Based
Compensation




We
account for stock-based compensation using the fair value method in accordance
with the provisions of SFAS No. 123(R), Share-Based Payments, or SFAS
123R. We recognize this expense on a straight-line basis over the optionees’
requisite service period, which is assumed to be the same as the vesting
schedule of the options. We estimate the grant date fair value of stock option
awards under the provisions of SFAS 123R using the Black-Scholes option
valuation model, which requires the input of highly subjective assumptions,
including the expected life of the share-based award and stock price volatility.
The assumptions used in calculating the fair value of stock-based compensation
represent management’s best estimates, but these estimates involve inherent
uncertainties and the application of management judgment. As a result, if other
assumptions had been used, our stock-based compensation expense could have been
materially different. In addition, we are required to estimate the expected
forfeiture rate and only recognize expense for those awards expected to vest. If
our actual forfeiture rate is materially different from our estimate, the
share-based compensation expense could be materially different.




For stock
options granted prior to our initial public offering, or IPO, that we completed
in July 2007, we determined that it was not practicable to calculate the
volatility of our share price because our common stock was not publicly traded
and therefore there was no readily determinable market value for our common
stock, we had limited information on our own past volatility and we had a
limited operating history. Therefore, we estimated our expected volatility based
on reported market value data for a group of publicly traded companies, which we
selected from market indices that we believed were relatively comparable after
consideration of their size, maturity, profitability, growth, risk and return on
investment. We used the average expected volatility rates reported by the
comparable group for an expected term that approximated the expected term that
we estimated. Over time, once historical data and market trends become apparent,
this information could change our estimates. A small change in the estimates
used could result in a relatively large change in the estimated
valuation.




Given the
absence of an active market for our common stock prior to our IPO, our board of
directors, taking into consideration the work of an independent valuation firm,
determined the fair value of our common stock at each meeting at which stock
option grants were approved based on several factors, including valuation
criteria and analysis, the preferential rights attributable to our then
outstanding convertible preferred stock, developments in our business, the
illiquid nature of our common stock and the likelihood of achieving a liquidity
event, such as an initial public offering or sale of the company. Our board of
directors made such determinations based on the business, financial and venture
capital experience of the individual directors and input from
management.




If we had
made different assumptions and estimates, the amount of our recognized and to be
recognized stock-based compensation expense, net income (loss) and net income
(loss) per share amounts could have been materially different. We believe that
we have used reasonable methodologies, approaches and assumptions consistent
with the American Institute of Certified Public Accountants Practice Guide,Valuation of Privately-Held-Company
Equity Securities Issued as Compensation, in determining the fair value
of our common stock prior to our IPO for financial reporting
purposes.




On June
20, 2007, we granted 383,998 shares of restricted stock, granted at fair value,
10,000 shares of which vested immediately on June 27, 2007 and the remainder
vest over a four year period that commenced on June 27, 2007. As of December 31,
2008, 257,124 shares remained unvested.




On June
27, 2007, we implemented our 2007 Employee Stock Purchase Plan, or ESPP, which
is compensatory and results in compensation costs accounted for under SFAS
123R.




For all
of our stock option grants and issuance of ESPP shares, the risk-free interest
rate is based on the yield available on U.S. Treasury zero-coupon issues with an
equivalent remaining expected life. We have not paid dividends on our common
stock in the past and do not plan to pay any dividends in the foreseeable
future. We estimate our expected volatility based on reported market value data
for a group of publicly traded companies, which we selected from market indices
that we believed were relatively comparable after consideration of their size,
maturity, profitability, growth, risk and return on investment. We use the
average expected volatility rates reported by the comparable group for an
expected term that approximated the expected term that we estimated. The
expected life for options granted is based on an analysis of our historical
exercise and cancellation data.




We
account for stock compensation arrangements with non-employees in accordance
Emerging Issues Task Force, or EITF, No. 96-18,Accounting for Equity Instruments
That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services, using a fair value approach. For stock
options granted to non-employees, the fair value of the stock options is
estimated using a Black-Scholes valuation model. This model utilizes the
estimated fair value of common stock and requires that we use the contractual
term of the option, the expected volatility of the price of our common stock,
risk free interest rates and expected dividend yield of our common stock.
Non-employee stock options have a contractual term of four to ten years,
expected volatility of 65-70% and no dividend yield. Stock-based compensation
expense associated with grants to non-employees was $432,000, $876,000 and
$214,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.






41






Cash and Cash Equivalents and
Short-Term and Long-term
Investments





Cash and Cash Equivalents.We
consider all highly liquid investments purchased with an original maturity of 90
days or less to be cash equivalents. Cash and cash equivalents are stated at
cost, which approximates fair value.




Short-term and Long-term
Investments. Our investments are comprised of money market funds,
commercial paper, corporate bonds, auction-rate securities and U.S. government
agency securities. Investments with original maturities greater than
approximately three months and remaining maturities less than one year are
classified as short-term investments as these investments are considered
available for current operations. Investments with remaining maturities greater
than one year are classified as long-term investments. All investments, except
for auction-rate securities, are designated as available-for-sale and are
therefore reported at fair value, with unrealized gains and losses recorded in
accumulated other comprehensive income (loss). Unrealized gains or losses
amounted to $362,000 and $22,000 of unrealized gain at December 31, 2008
and December 31, 2007, respectively. During the fourth quarter of fiscal 2008,
we reclassified our auction-rate securities from available-for-sale to trading
securities, which are reported at fair value, with gains or losses resulting
from changes in fair value recognized in earnings. See Note 2, “Cash and
Investments and Fair Value Measurements” for further detailed discussion. The
cost of securities sold is based on the specific identification method. Realized
gains and losses on the sale of investments are recorded in other income
(expense), net.






Effective
January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements, or
SFAS 157. In February 2008, the FASB, issued FSP 157-2, which provides a one
year deferral of the effective date of SFAS 157 for non-financial assets and
non-financial liabilities, except those that are recognized or disclosed in the
financial statements at fair value at least annually. Therefore, we have adopted
the provisions of SFAS 157 with respect to our financial assets and liabilities
only. SFAS 157 defines fair value, establishes a framework for measuring fair
value under GAAP and enhances disclosures about fair value measurements. Fair
value is defined under SFAS 157 as the exchange price that would be received for
an asset or paid to transfer a liability (an exit price) in the principal or
most advantageous market for the asset or liability in an orderly transaction
between market participants on the measurement date. Valuation techniques used
to measure fair value under SFAS 157 must maximize the use of observable inputs
and minimize the use of unobservable inputs. See Note 2, “Cash and Investments
and Fair Value Measurements,” of our Consolidated Financial
Statements.






Other-Than-Temporary
Impairment. All of our available-for-sale investments are subject to a
periodic impairment review. We recognize an impairment charge when a decline in
the fair value of our investments below our cost basis is judged to be
other-than-temporary. We consider various factors in determining whether to
recognize an impairment charge, including the length of time and extent to which
the fair value has been less than our cost basis, the financial condition and
near-term prospects of the investee, and our intent and ability to hold the
investment for a period of time sufficient to allow for any anticipated recovery
in the market value. No other-than-temporary impairment charges were recorded on
any of our available-for-sale investments during the years ended
December 31, 2008, 2007 and 2006.




Fair
Value of Financial Instruments




The
carrying amounts of cash and cash equivalents, accounts receivable, accounts
payable and income taxes payable approximate their fair values due to the
short-term maturity of these instruments. Beginning in the first quarter of
fiscal 2008, the assessment of fair value is based on the provisions of SFAS
157. We determine the fair values for cash equivalents, short-term investments
and long-term investments using industry standard pricing services, data
providers and other third-party sources and by performing valuation analyses.
See Note 2, “Cash and Investments and Fair Value Measurements,” of our
Consolidated Financial Statements for details of the valuation
methodologies.






Concentrations
of Risk




Financial
instruments that are potentially subject to concentrations of credit risk
consist primarily of cash and cash equivalents and accounts receivable.
Investment policies have been implemented that limit investments to investment
grade securities. We conduct business outside of North America in Europe and
Asia Pacific, and are considering other regions. The risk with respect to
accounts receivable is mitigated by credit evaluations we perform on our
customers and by the diversification of our customer base. Historically, we have
not hedged any of our foreign currency risk associated with accounts receivable.
No individual customer has represented more than 10% of our total revenue in the
years ended December 31, 2008, 2007 or 2006.




We
purchase all of our appliances from our contract manufacturer, Flextronics
International, or Flextronics, which became our contract manufacturer through
its acquisition of Solectron Corporation. Our capacity expansion shelves and the
chassis for our DD 690 appliance are currently supplied exclusively by a single
vendor, Xyratex Technology Limited, or Xyratex. Our appliances depend on NVRAM
cards that currently are only available from a single vendor, Curtiss-Wright
Corporation. Any disruption in our suppliers’ ability to timely procure
necessary components in the quantities required, or at reasonable prices, could
result in a delay in the shipment of our appliances.




Foreign
Currency Translation




The
majority of our sales arrangements are denominated in United States dollars or
Euros, while a smaller portion of our sales agreements are denominated in
Canadian dollars, British sterling and Australian dollars. In addition, we incur
operating expenses in local foreign currencies in those countries where we have
sales and marketing and administrative personnel. The functional currency of our
foreign operations is the local country’s currency. Consequently, expenses of
operations outside the United States are translated into United States dollars
using average exchange rates for the period reported, while assets and
liabilities of operations outside the United States are translated into United
States dollars using end-of-period exchange rates. The effects of foreign
currency translation of the financial statements of our foreign operations are
included in stockholders’ equity (deficit) as a component of accumulated other
comprehensive income (loss) in the accompanying consolidated balance sheets. The
effects of foreign currency remeasurements for non-U.S. currency denominated
assets and liabilities related to our domestic operations are recognized in our
consolidated statement of operations, and amounted to a gain or (loss) of ($1.3)
million, $123,000 and $200,000 for the years ended December 31, 2008, 2007
and 2006, respectively.




Allowance
for Doubtful Accounts




We
perform credit evaluations of our customers’ financial condition and generally
do not require collateral from our customers. These evaluations require
significant judgment and are based on a variety of factors including, but not
limited to, current economic trends, historical payments, bad debt write-off
experience and financial review of the customer.




We
maintain an allowance for doubtful accounts for estimated losses resulting from
the inability or unwillingness of our customers to make required payments. When
we become aware that a specific customer is unable or unwilling to meet its
financial obligations, we record a specific allowance to reflect the level of
credit risk in the customer’s outstanding receivable balance. In addition, we
record additional allowances based on certain percentages of aged receivable
balances. We classify bad debt expenses as general and administrative expenses.
For the year ended December 31, 2008, we did not have any write-offs of accounts
receivable. In the year ended December 31, 2007, we had one write-off of
approximately $7,000 pertaining to one customer’s accounts receivable balance.
To date, our accounts receivable write-offs have not been significant and the
allowance for doubtful accounts has not been material.




42


Inventory
Valuation




Inventories
consist of hardware and related component parts and are stated at the lower of
cost (on a first-in, first-out basis) or market value. Finished goods constitute
a large portion of our inventory and include customer evaluation units which are
carried at cost less accumulated amortization. We amortize the cost of these
evaluation units on a straight-line basis over twelve months upon the initial
transfer of a unit into the evaluation pool. The cost of the amortization of
evaluation units is included in cost of product revenue. If an evaluation unit
is purchased, we record a sale pursuant to our revenue recognition policy. We
assess the valuation of our inventory on a quarterly basis and write down the
value for estimated excess and obsolete inventory based upon estimates of future
demand, including warranty requirements. Inherent in our estimates of market
value in determining inventory valuation are estimates related to economic
trends, future demand for our products and technological obsolescence of our
products.




Inventory
write-downs are recorded in cost of product revenue and have not been material
in any period. Spares are expensed as part of our warranty accrual to cost of
product revenue. We do not allocate indirect overhead costs to finished goods
inventory as these amounts are not material.




We
outsource the assembly of our products to a third-party manufacturing facility
under an annual contract which renews automatically but may be terminated by
either party with 90 days’ written notice. We also purchase some finished
products from a single source supplier under a three-year agreement that expires
in March 2010. At December 31, 2008, we had $16.7 million of
non-cancellable purchase commitments with a third-party supplier.




Property,
Plant and Equipment




Property,
plant and equipment are stated at cost. Depreciation is computed using the
straight-line method over an estimated useful life of three to ten years.
Leasehold improvements are amortized using the straight-line method over the
shorter of the estimated useful lives of the assets or the term of the
lease.




Impairment
of Long-Lived Assets




We review
long-lived assets for impairment whenever events or changes in circumstances
indicate that the carrying amount of these assets may not be recoverable. We
assess these assets for impairment based on estimated undiscounted future cash
flows from these assets. If the carrying value of the assets exceeds the
estimated future undiscounted cash flows, a loss is recorded for the excess of
the asset’s carrying value over the fair value. To date, we have not recognized
any impairment loss for long-lived assets.




Warranty
Reserve




Upon
shipment of products to our customers, we provide for the estimated cost to
repair or replace products that may be returned under warranty. Our warranty
period is typically 12 months from the date of shipment to the customer for
hardware and 90 days for software. For existing products, the warranty reserve
is based on actual historical experience. For new products, the warranty reserve
is based on historical experience of similar products until such time as
sufficient historical data has been collected for the new product.




During
the three months ended March 31, 2007, we recorded an estimated charge of $1.2
million associated with a field replacement program that was initiated in April
2007 to replace a circuit board used in some of our appliances. During the three
months ended September 30, 2007, we recorded an additional charge of $450,000 to
expand this replacement program for additional circuit boards used in some of
our appliances. During the three months ended June 30, 2008, we recorded an
additional charge of $25,000, as we revised our estimate of the costs of the
replacement program. To date, these circuit boards have experienced failures in
less than 1% of the appliances that we believe are potentially affected. Through
the replacement program, we are offering to exchange the circuit boards in all
of the appliances that we believe are potentially affected with circuit boards
manufactured by an alternate supplier. We believe our estimates and judgments
for the replacement program continue to be reasonable based upon information
available at this time. Our estimated charge associated with the replacement
program is based on the number of circuit boards we expect to replace under the
program, the anticipated cost of replacement and refurbishment and other
associated costs. This warranty charge does not assume any recovery from our
supplier.  As of December 31, 2008, we had incurred approximately $1.6
million of costs associated with these field replacement programs and $68,000
remains in accrued liabilities to cover future costs for the units potentially
affected. To the extent there are differences between our estimates and actual
results, our consolidated financial statements will be affected. The following
table is a summary of our warranty activity that is included in other accrued
liabilities in the Consolidated Balance Sheets:




Year
      ended December 31,(in
      thousands)
                
                2008
                
                
                2007
                
                
                2006Warranty
      reserve—beginning
                
                $
                596
                
                
                $
                21
                
                
                $
                3Warranty
      expense
                
                
                3,431
                
                
                
                1,923
                
                
                
                104Warranty
      usage
                
                
                (3,359
                )
                
                
                (1,348
                )
                
                
                (86
                )Warranty
      reserve— ending
                
                $
                668
                
                
                $
                596
                
                
                $
                21




Advertising




All
advertising costs are expensed as incurred. Advertising expenses were $1.2
million, $351,000 and $71,000 for the years ended December 31, 2008, 2007
and 2006, respectively.




Income
Taxes




We
account for income taxes in accordance with SFAS No. 109,Accounting for Income Taxes,or SFAS 109. Deferred income taxes are recorded for the expected tax
consequences of temporary differences between the tax bases of assets and
liabilities for financial reporting purposes and amounts recognized for income
tax purposes. Effective January 1, 2007, we adopted Financial Accounting
Standards Interpretation, or FIN, No. 48,Accounting for Uncertainty in
Income Taxes—an interpretation of FASB Statement No. 109, or FIN
48.


43


Comprehensive
Income (Loss)




Comprehensive
income (loss) consists of net income (loss) and changes in accumulated other
comprehensive income (loss). Comprehensive income (loss) for the years ended
December 31, 2008, 2007 and 2006 was $21.5 million, $(3.6) million and $(4.0)
million, respectively, and have been reflected
in the consolidated statements of stockholders’ equity (deficit).




Accumulated
other comprehensive income (loss) presented in the accompanying consolidated
balance sheets consists of foreign currency translation and unrealized gains and
losses on available-for-sale investments, net of taxes, for all periods
presented:


December
      31,(in
      thousands)
                
                2008
                
                
                2007Accumulated
      net unrealized gain (loss) on:Available-for-sale
      investments
                
                $
                362
                
                
                $
                22Foreign
      currency
      translation
                
                
                (372
                )
                
                
                25Total
      accumulated other comprehensive income
      (loss)
                
                $
                (10
                )
                
                $
                47




Recent Accounting
Pronouncements




In October
2008, the FASB issued FSP 157-3,
Determining
the Fair Value of a Financial Asset When the Market for That Asset Is Not
Active, or FSP 157-3. FSP 157-3 clarifies the application of SFAS 157 in
a market that is not active, and addresses application issues such as the use of
internal assumptions when
relevant observable data does not exist, the use of observable market
information when the market is not active, and the use of market quotes when
assessing the relevance of observable and unobservable data. FSP 157-3 is
effective for all periods presented in accordance with SFAS 157. The adoption of
FSP 157-3 did not have a significant impact on our consolidated financial
statements or the fair values of our financial assets and liabilities, except
for our auction-rate securities, which did not have an active market. See Note
2, “Cash and Investments and Fair Value Measurements.”


In May 2008, the FASB
issued SFAS No. 162, The
Hierarchy of Generally Accepted Accounting Principles, or SFAS 162. SFAS
162 identifies the sources of accounting principles and the framework for
selecting the principles used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with generally
accepted accounting principles (the GAAP hierarchy). SFAS 162 is effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008. The adoption of SFAS 162 is not expected to have an effect on
our consolidated results of operations or financial condition.
  In April 2008, the FASB
issued FSP FAS 142-3, Determination
of the Useful Life of Intangible Assets, or FSP FAS 142-3. FSP FAS 142-3
amends the factors that should be considered in developing renewal or extension
assumptions used in determining the useful life of a recognized intangible asset
under Statement of Financial Accounting Standards No. 142, Goodwill
and Other Intangible Assets. This new guidance applies prospectively to
intangible assets that are acquired individually or with a group of other assets
in business combinations and asset acquisitions. FSP FAS 142-3 is effective for
fiscal years beginning after December 15, 2008, and early adoption is
prohibited.  As of the date of this report, we had no such applicable
assets on our balance sheet.  The impact of FSP FAS 142-3 will depend upon
the nature, terms, and size of the acquisitions we consummate after the
effective date, if any.
  In March 2008, the FASB
issued SFAS No. 161, Disclosures
about Derivative Instruments and Hedging Activities — an
amendment of FASB Statement No. 133, or SFAS 161. SFAS 161 enhances
required disclosures regarding derivatives and hedging activities, including
enhanced disclosures regarding how: (a) an entity uses derivative instruments,
(b) derivative instruments and related hedged items are accounted for under SFAS
No. 133, and (c) derivative instruments and related hedged items affect an
entity’s financial position, financial performance and cash flows. SFAS 161 is
effective for the fiscal years beginning after November 15, 2008, and will
be adopted by us on January 1, 2009. The adoption of SFAS 161 is not expected to
have an impact our consolidated results of operations or financial condition.
  In February 2008, the FASB
issued FASB Staff Position, or FSP, 157-1, Application
of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting
Pronouncements That Address Fair Value Measurements for Purposes of Lease
Classification or Measurement under Statement 13,  or FSP 157-1, and
FSP 157-2, Effective
Date of FASB Statement No. 157, or FSP 157-2. FSP 157-1 amends SFAS 157
to remove certain leasing transactions from its scope, and was effective upon
initial adoption of SFAS157. FSP 157-2 delays the effective date of SFAS 157 for
all non-financial assets and non-financial liabilities, except for items that
are recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually), until the beginning of the first quarter of
fiscal 2009. We are currently evaluating the impact that SFAS 157 will have on
our consolidated financial statements when it is applied to non-financial assets
and non-financial liabilities that are not measured at fair value on a recurring
basis, beginning in the first quarter of 2009.
  In December 2007, the FASB
issued SFAS No. 160, Noncontrolling
Interests in Consolidated Financial Statements — an amendment of Accounting
Research Bulletin No. 51, orSFAS 160. SFAS 160 addresses the accounting and reporting standards for
ownership interests in subsidiaries held by parties other than the parent, the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest, and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS 160 also establishes disclosure requirements that clearly
identify and distinguish between the interests of the parent and the interests
of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning
after December 15, 2008, and will be adopted by the Company on January 1,
2009. The adoption of SFAS 160 is not expected to have an impact on our
consolidated results of operations or financial condition.
  In December 2007, the FASB
issued SFAS No. 141 (revised 2007), Business
Combinations, or SFAS 141R. SFAS 141R establishes principles and
requirements for how the acquirer of a business recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
and any non-controlling interest in the acquiree. The statement also provides
guidance for recognizing and measuring the goodwill acquired in the business
combination and determines what information to disclose to enable users of the
financial statement to evaluate the nature and financial effects of the business
combination. SFAS 141R is effective for financial statements issued for fiscal
years beginning after December 15, 2008. Earlier application of SFAS 141R is
prohibited. The impact of SFAS 141R will depend upon the nature, terms, and size
of the acquisitions we consummate after the effective date, if
any.


44




2. CASH
AND INVESTMENTS AND FAIR VALUE MEASUREMENTS






We
consider all highly liquid investments purchased with an original maturity of 90
days or less to be cash equivalents. Cash and cash equivalents consist primarily
of highly liquid investments in time deposits held at major banks, commercial
paper, U.S. government agency securities and other money market securities.
Investments with original maturities greater than approximately three months and
remaining maturities less than one year are classified as short-term investments
as these investments are considered available for current operations.
Investments with remaining maturities greater than one year are classified as
long-term investments. All investments, except for auction-rate securities, are
designated as available-for-sale and are therefore reported at fair value, with
unrealized gains and losses recorded in accumulated other comprehensive income
(loss). Unrealized gains or losses amounted to $362,000 and $22,000 of
unrealized gains at December 31, 2008 and December 31, 2007, respectively.
As of December 31, 2008, all of our debt securities classified as
available-for-sale had maturities of one year or less.  During the
fourth quarter of fiscal 2008, we reclassified our auction-rate securities from
available-for-sale to trading securities, which are reported at fair value, with
gains or losses resulting from changes in fair value recognized in
earnings.




The
following tables summarize our cash and investments classified as
available-for-sale as of December 31, 2008 and 2007:




(in
      thousands)
                    
                    Carry
                      Value at
                      December 31,
                      2008
                    
                    
                    Gross
                      Unrealized
                      Gains
                    
                    
                    Gross
                      Unrealized
                      Losses
                    
                    
                    Fair Market
                      Value
      at
                      December 31,
                      2008Cash
      and cash equivalents:Cash
                    
                    $
                    51,019
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    $
                    51,019Commercial
      paper
                    
                    
                    5,875
                    
                    
                    
                    3
                    
                    
                    
                    —
                    
                    
                    
                    5,878Money
      market funds
                    
                    
                    63,942
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    63,942Corporate
      bonds
                    
                    
                    1,018
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    1,018U.S.
      government agencies
                    
                    
                    6,521
                    
                    
                    
                    2
                    
                    
                    
                    —
                    
                    
                    
                    6,523Total
      cash and cash equivalents
                    
                    
                    128,375
                    
                    
                    
                    5
                    
                    
                    
                    —
                    
                    
                    
                    128,380Short-term
      investments:Commercial
      paper
                    
                    
                    12,957
                    
                    
                    
                    29
                    
                    
                    
                    —
                    
                    
                    
                    12,986Corporate
      bonds
                    
                    
                    26,472
                    
                    
                    
                    89
                    
                    
                    
                    (62
                    )
                    
                    
                    26,499U.S.
      government agencies
                    
                    
                    65,726
                    
                    
                    
                    302
                    
                    
                    
                    (1
                    )
                    
                    
                    66,027Total
      short-term investments
                    
                    
                    105,155
                    
                    
                    
                    420
                    
                    
                    
                    (63
                    )
                    
                    
                    105,512Total
      cash and cash equivalents and short-term investments
                    
                    $
                    233,530
                    
                    
                    $
                    425
                    
                    
                    $
                    (63
                    )
                    
                    $
                    233,892





(in
      thousands)
                
                Carry
                    Value at
                    December 31,
                    2007
                
                
                Gross
                    Unrealized
                    Gains
                
                
                Gross
                    Unrealized
                    Losses
                
                
                Fair Market
                    Value
      at
                    December 31,
                    2007Cash
      and cash equivalents:Cash
                
                $
                29,005
                
                
                
                —
                
                
                
                —
                
                
                $
                29,005Commercial
      paper
                
                
                7,392
                
                
                
                —
                
                
                
                (1
                )
                
                
                7,391Money
      market
      funds
                
                
                66,543
                
                
                
                —
                
                
                
                —
                
                
                
                66,543Total
      cash and cash
      equivalents
                
                
                102,940
                
                
                
                —
                
                
                
                (1
                )
                
                
                102,939Short-term
      investments:Auction-rate
      securities
                
                
                29,577
                
                
                
                —
                
                
                
                —
                
                
                
                29,577Commercial
      paper
                
                
                46,642
                
                
                
                23
                
                
                
                (4
                )
                
                
                46,661Corporate
      bonds
                
                
                17,426
                
                
                
                11
                
                
                
                (15
                )
                
                
                17,422U.S.
      government
      agencies
                
                
                10,529
                
                
                
                8
                
                
                
                —
                
                
                
                10,537Total
      short-term
      investments
                
                
                104,174
                
                
                
                42
                
                
                
                (19
                )
                
                
                104,197Total
      cash and cash equivalents and short-term investments
                
                $
                207,114
                
                
                $
                42
                
                
                $
                (20
                )
                
                $
                207,136











The
following table summarizes at December 31, 2008, those available-for-sale
securities that were in an unrealized loss position, the fair value and gross
unrealized losses aggregated by type of investment instrument and the length of
time that individual securities have been in a continuous unrealized loss
position. All unrealized losses on our available-for-sale investments have been
in a continuous unrealized loss position for less than 12 months. Investments
that were in an unrealized gain position have been excluded from the
table:




Less
      Than 12 Months(in
      thousands)
              
              Market
      Value
              
              
              Gross
      Unrealized LossesCorporate
      bonds
              
              $
              11,713
              
              
              $
              (62
              )U.S.
      government
      agencies
              
              
              4,723
              
              
              
              (1
              )Total
              
              $
              16,436
              
              
              $
              (63
              )
  45




The gross
unrealized losses on the investments in corporate bonds and U.S. government
agencies were the result of overall market aversion, lack of demand for
securities that are non-government guaranteed, and the relative widening of
credit spreads relative to the U.S. treasuries. Gross unrealized losses on all
available-for-sale securities at December 31, 2008 are considered temporary in
nature. Factors considered in determining whether a loss is temporary include
the length of time and extent to which fair value has been less than the cost
basis and our intent and ability to hold an investment for a period of time
sufficient to allow for any anticipated recovery in market value.




As of
December 31, 2008, we had auction-rate securities with a face value of $31.0
million that had a fair value of $26.1 million. In February 2008, auctions began
to fail for these securities and each auction since then has failed. An auction
failure means that the parties wishing to sell securities could not. As a
result, our ability to liquidate these auction-rate securities and fully recover
the carrying value of these investments in the near term may be limited or not
exist. All of our auction-rate securities, including those subject to the
failure, are currently AAA-rated taxable municipal debt obligations. Based on
the overall failure rate of these auctions, the frequency of the failures, and
the underlying maturities of the securities, a portion of which are up to 40
years, we have classified auction-rate securities as long-term investments on
our balance sheet.






In
November 2008, we signed a broad-based settlement proposal from UBS in which we
have the right to sell the securities back to affiliates of UBS at par during
the period from June 30, 2010 to July 2, 2012 if liquidity does not return to
the auction-rate securities market sooner.  The affiliates of UBS will
retain the right to sell our auction-rate securities on our behalf, without
prior notification, at any time prior to July 2, 2012 as long as we receive par
value from such sale. Although we expect to exercise our right, if we do not
exercise it before July 2, 2012, it will expire and UBS will have no further
rights or obligations to buy our auction-rate securities. The auction-rate
securities will continue to accrue interest as determined by the auction process
or the terms outlined in the prospectus of the auction-rate securities if the
auction process fails.




The
enforceability of this right results in a put option that is accounted for
separately from the auction-rate securities. The put option represents a firm
agreement in accordance with FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities, which defines a firm agreement with
an unrelated party, binding on both parties and usually legally enforceable,
with the following characteristics: a) the agreement specifies all significant
terms, including the quantity to be exchanged, the fixed price, and the timing
of the transaction, and b) the agreement includes a disincentive for
nonperformance that is sufficiently large to make performance probable. We
elected to account for this put option at fair value under FASB Statement No.
159, The Fair Value Option for
Financial Assets and Liabilities, or SFAS 159.






Prior to
acquiring the put option, we recorded our auction-rate securities as
available-for-sale investments, and therefore recorded resulting unrealized
gains or losses, net of tax, in accumulated other comprehensive income in
stockholders’ equity. In connection with the acquisition of the put option, we
reclassified our auction-rate securities from available-for-sale to trading
securities. As a result of the reclassification of these securities to trading,
we recognized a loss of $4.9 million in other income (expense), net. The
transfer to trading securities reflects management’s intent to exercise the put
option during the period June 30, 2010 to July 2, 2012.






The fair
value of the put option of $4.8 million is included in the Consolidated Balance
Sheet as of December 31, 2008 as a long-term investment with a corresponding
credit to other income (expense), net.  The net effect of the
recording of the fair value of the put option and the loss on the auction-rate
securities was a loss of $162,000, which was recorded in other income (expense),
net in our Statement of Operations for the year ended December 31, 2008. We
believe that subsequent changes in the value of the put option will largely
offset the subsequent fair value movements of the auction-rate securities,
subject to the continued expected performance by UBS of its obligations under
the agreement.






Fair
Value Measurements






Effective
January 1, 2008, we adopted SFAS 157. In February 2008, the FASB, issued FSP
157-2, which provides a one year deferral of the effective date of SFAS 157 for
non-financial assets and non-financial liabilities, except those that are
recognized or disclosed in the financial statements at fair value at least
annually. Therefore, we have adopted the provisions of SFAS 157 with respect to
our financial assets and liabilities only. SFAS 157 defines fair value,
establishes a framework for measuring fair value under GAAP and enhances
disclosures about fair value measurements. Fair value is defined under SFAS 157
as the exchange price that would be received for an asset or paid to transfer a
liability (an exit price) in the principal or most advantageous market for the
asset or liability in an orderly transaction between market participants on the
measurement date. Valuation techniques used to measure fair value under SFAS 157
must maximize the use of observable inputs and minimize the use of unobservable
inputs. The adoption of this statement did not have a material impact on our
consolidated results of operations and financial condition.






In
February 2007, the FASB issued SFAS 159. SFAS 159 permits companies to choose to
measure many financial instruments and certain other items at fair value that
are not currently required to be measured at fair value and establishes
presentation and disclosure requirements designed to facilitate comparisons
between companies that choose different measurement attributes for similar types
of assets and liabilities.  We elected not to adopt the fair value
option on existing eligible financial instruments as of January 1, 2008.
However, because the SFAS 159 election is based on an instrument-by-instrument
election at the time the company first recognizes an eligible item or enters
into an eligible firm commitment, we may decide to exercise the option on new
items in the future. The adoption of SFAS 159 did not have a significant
impact on our consolidated results of operations and financial
condition.






The
standard describes a fair value hierarchy based on three levels of inputs, of
which the first two are considered observable and the last unobservable, that
may be used to measure fair value, as follows:




·
              Level
      1 - Quoted prices in active markets for identical assets or
      liabilities.·
              Level
      2 - Inputs other than Level 1 that are observable, either directly or
      indirectly, such as quoted prices for similar assets or liabilities;
      quoted prices in markets that are not active; or other inputs that are
      observable or can be corroborated by observable market data for
      substantially the full term of the assets or
  liabilities.·
              Level
      3 - Unobservable inputs that are supported by little or no market activity
      and that are significant to the fair value of the assets or
      liabilities.
  46




Instruments
that are classified within Level 1 of the fair value hierarchy generally include
most money market securities.  Determination of fair value for Level 1
instruments does not require significant judgment or estimation. Instruments
that are classified within Level 2 of the fair value hierarchy generally include
U.S. agency securities, commercial paper and corporate bonds. We determine the
fair values for these instruments using industry standard pricing services, data
providers and other third-party sources.




In
accordance with SFAS 157, the following table represents our fair value
hierarchy for our financial assets (cash equivalents and short-term and
long-term investments) measured at fair value on a recurring basis as of
December 31, 2008:




(in
      thousands)
              
              Level
      1
              
              
              Level
      2
              
              
              Level
      3
              
              
              TotalMoney
      market
      funds
              
              $
              63,942
              
              
              $
              —
              
              
              $
              —
              
              
              $
              63,942Commercial
      paper
              
              
              —
              
              
              
              18,864
              
              
              
              —
              
              
              
              18,864Auction-rate
      securities
              
              
              —
              
              
              
              —
              
              
              
              26,087
              
              
              
              26,087Put
      option
              
              
              —
              
              
              
              —
              
              
              
              4,779
              
              
              
              4,779Corporate
      bonds
              
              
              —
              
              
              
              27,517
              
              
              
              —
              
              
              
              27,517U.S.
      government agencies
              
              
              —
              
              
              
              72,550
              
              
              
              —
              
              
              
              72,550Total
              
              $
              63,942
              
              
              $
              118,931
              
              
              $
              30,866
              
              
              $
              213,739









Level 3
instruments consist of auction-rate securities whose underlying assets are
generally student loans that are substantially backed by the federal governments
and the UBS put option. Currently there is not an active market for the
auction-rate securities, and therefore they do not have a readily determinable
market value. At December 31, 2008, the auction-rate securities had a face value
of $31.0 million and were valued at a fair value of $26.1 million. The fair
value of these auction-rate securities was determined using a discounted cash
flow pricing model that incorporated financial inputs such as projected cash
flows, discount rates, expected interest rates to be paid to investors and an
estimated liquidity discount. The weighted average life over which cash flows
were projected was determined to be approximately five years, given the
collateral composition of the securities and related historical and projected
prepayments. The discount rates that were applied to the pricing model were
based on market data and information for comparable or similar term student loan
asset-backed securities. The expected interest rate to be paid to investors in a
failed auction was determined by the contractual terms for each security. The
liquidity discount represents an estimate of the additional return an investor
would require to compensate for the lack of liquidity of the student loan
auction-rate securities. Because there can be no assurance of a successful
auction in the future, all of our auction-rate securities are recorded in
long-term investments.






We valued
the UBS put option using a discounted cash flow approach including estimates of,
based on data available as of December 31, 2008, interest rates, timing and
amount of cash flows, adjusted for any bearer risk associated with UBS’s
financial ability to repurchase the auction-rate securities beginning June 30,
2010. Based on the discounted cash flow model, we determined the fair value of
the put option to be $4.8 million. Any change in these assumptions and market
conditions would affect the value of this put option.






The
following table provides a reconciliation for all financial instruments measured
at fair value using significant unobservable inputs (Level 3) for the year ended
December 31, 2008:




(in
      thousands)
              
              Put
      Option
              
              
              Auction-rate
      SecuritiesBalance
      at December 31, 2007
              
              $
              —
              
              
              $
              29,577Total
      gains (losses) included in earnings
              
              
              —
              
              
              
              (4,941
              )Purchases
      of auction-rate securities
              
              
              —
              
              
              
              15,601Proceeds
      from sale of auction-rate securities
              
              
              —
              
              
              
              (14,150
              )Issuance
      of put option
              
              
              4,779
              
              
              
              —Balance
      at December 31, 2008
              
              $
              4,779
              
              
              $
              26,087












47




3. INVENTORIES




Inventories
consisted of the following:




December
      31,(in
      thousands)
                        
                        2008
                        
                        
                        2007Raw
      materials and
      accessories
                        
                        $
                        876
                        
                        
                        $
                        481Evaluation
      units,
      net
                        
                        
                        2,672
                        
                        
                        
                        1,289Finished
      goods
                        
                        
                        1,090
                        
                        
                        
                        571Total
                        
                        $
                        4,638
                        
                        
                        $
                        2,341




Amortization
related to evaluation units was $2.5 million, $2.6 million and $1.4 million for
the years ended December 31, 2008, 2007 and 2006,
respectively.




48




4. PROPERTY,
PLANT AND EQUIPMENT




Property,
plant and equipment are stated at the lower of cost or net realizable value.
Depreciation is calculated using the straight-line method over the estimated
useful lives of the respective assets, which is three to ten years. Leasehold
improvements are amortized using the straight-line method over the shorter of
the lease term or estimated useful life of the asset. Repair and maintenance
costs are expensed as incurred.




Property,
plant and equipment consisted of the following:






Estimated
                            Useful Lives
                          
                          December
      31,(in
      thousands)
                          
                          2008
                          
                          
                          2007Computer
      hardware
                          3 years
                          
                          $
                          19,686
                          
                          
                          $
                          7,390Computer
      software
                          3
      years
                          
                          
                          1,652
                          
                          
                          
                          364Office
      equipment, furniture and fixtures
                          3 to 10 years
                          
                          
                          4,400
                          
                          
                          
                          1,627ERP
      financial system
                          5
      years
                          
                          
                          4,353
                          
                          
                          
                          2,277Leasehold
      improvements
                          10
      years
                          
                          
                          18,727
                          
                          
                          
                          6,530Total
      fixed assets
                          
                          
                          
                          48,818
                          
                          
                          
                          18,188Accumulated
      depreciation and amortization
                          
                          
                          
                          (9,964
                          )
                          
                          
                          (3,599
                          )Property,
      plant and equipment, net
                          
                          
                          $
                          38,854
                          
                          
                          $
                          14,589




Depreciation
expense was $6.4 million, $1.7 million and $1.0 million for the years ended
December 31, 2008, 2007 and 2006, respectively.








49




5.
DEFERRED REVENUE




Deferred
revenue consisted of the following:




December
      31,(in
      thousands)
                      
                      2008
                      
                      
                      2007Product
                      
                      $
                      924
                      
                      
                      $
                      555Support
      and services
                      
                      
                      38,589
                      
                      
                      
                      16,152Ratable
      product and related support and services
                      
                      
                      —
                      
                      
                      
                      83Less:
      deferred cost of ratable product revenue and product
    revenue
                      
                      
                      (192
                      )
                      
                      
                      (140
                      )Deferred
      revenue, current
                      
                      $
                      39,321
                      
                      
                      $
                      16,650Support
      and services, non-current
                      
                      $
                      28,399
                      
                      
                      $
                      9,322Deferred
      revenue, non-current
                      
                      $
                      28,399
                      
                      
                      $
                      9,322




Deferred
product revenue relates to arrangements where not all revenue recognition
criteria have been met. Deferred support and services revenue represents
customer payments made in advance for annual support and services contracts.
Support and services contracts are typically billed in advance on a per annum
basis and revenue is recognized ratably over the support period. Deferred
ratable product and related support and services revenue consists of revenue on
transactions prior to fiscal 2006 where VSOE of fair value of support and
services had not been established and, as a result, the entire arrangement was
being recognized ratably over the related support period. All customers are
known to us upon sale of our appliances.







50




6.
GUARANTEES




Our
agreements with our channel partners and customers generally include
certain provisions for indemnifying the channel partners and customers against
liabilities if our products infringe a third party’s intellectual property
rights. To date, we have not incurred any material costs as a result of such
indemnification provisions and have not accrued any liabilities related to such
obligations in our consolidated financial statements.




As
permitted or required under Delaware law and to the maximum extent allowable
under that law, we have certain obligations to indemnify our officers, directors
and certain key employees for certain events or occurrences while the officer,
director or employee is or was serving at our request in such capacity. These
indemnification obligations are valid as long as the director, officer or
employee acted in good faith and in a manner the person reasonably believed to
be in or not opposed to the best interests of the corporation, and, with respect
to any criminal proceeding, had no reasonable cause to believe his or her
conduct was unlawful. The maximum potential amount of future payments we could
be required to make under these indemnification obligations is unlimited;
however, we have a director and officer insurance policy that mitigates our
exposure and generally enables us to recover a portion of any future amounts
paid.


51




7. LEASE
COMMITMENTS




We lease
our worldwide facilities and certain other equipment under non-cancelable
operating lease agreements. Included in the table below is the $47.3 million of
future lease payments for our two new corporate headquarters leases that began
in November 2007 and January 2008, respectively. The lease terms for these
headquarters are for 10 years, and we have the right to renew the leases for
additional five-year terms. Under the terms of our two leases for our new
corporate headquarters, we have provided a letter of credit for $1.6 million.
Future minimum commitments for these operating leases in place as of
December 31, 2008 were as follows:




(in
      thousands)2009
                      
                      $
                      7,1332010
                      
                      
                      5,9612011
                      
                      
                      5,8992012
                      
                      
                      5,9312013
      and beyond
                      
                      
                      28,799$
                      53,723




The terms
of certain lease agreements provide for rental payments on a graduated basis. We
recognize rent expense on a straight-line basis over the lease period and have
accrued for rent expense incurred but not paid. Rent expense under operating
leases was $3.2 million, $0.9 million and $0.5 million for the years ended
December 31, 2008, 2007 and 2006, respectively.








52




8. NET
INCOME (LOSS) PER SHARE




Basic net
income (loss) per share is computed by dividing net income (loss) by the
weighted average number of common shares outstanding during the period. Diluted
net income (loss) per share is computed by giving effect to all potential
dilutive common shares, including options, common stock subject to repurchase
and convertible preferred stock.




The
following table sets forth the computation of net income (loss) per
share:




Year
      ended December 31,(in
      thousands, except per share amounts)
                                
                                2008
                                
                                
                                2007
                                
                                
                                2006Net
      income
      (loss)
                                
                                $
                                21,593
                                
                                
                                $
                                (3,660
                                )
                                
                                $
                                (4,026
                                )Shares
      used in computing net income (loss) per share, basic
                                
                                
                                58,254
                                
                                
                                
                                31,482
                                
                                
                                
                                7,128Net
      income (loss) per share,
      basic
                                
                                $
                                0.37
                                
                                
                                $
                                (0.12
                                )
                                
                                $
                                (0.56
                                )Dilutive
      potential common shares:Weighted
      average common shares
      outstanding
                                
                                
                                58,254
                                
                                
                                
                                31,482
                                
                                
                                
                                7,128Incremental
      common shares attributable to exercise of outstanding employee stock
      options, restricted stock and restricted stock units (assuming proceeds
      would be used to purchase common stock)
                                
                                
                                7,560
                                
                                
                                
                                —
                                
                                
                                
                                —Shares
      used in computing net income (loss) per share, diluted
                                
                                
                                65,814
                                
                                
                                
                                31,482
                                
                                
                                
                                7,128Net
      income (loss) per share,
      diluted
                                
                                $
                                0.33
                                
                                
                                $
                                (0.12
                                )
                                
                                $
                                (0.56
                                )




The
following weighted average outstanding options, common stock subject to
repurchase and convertible preferred stock were excluded from the computation of
diluted net income (loss) per share for the periods presented because including
them would have had an antidilutive effect:




Year ended
      December 31,(in
      thousands)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006Options
      to purchase common stock
                      
                      
                      1,931
                      
                      
                      
                      12,911
                      
                      
                      
                      9,517Common
      stock subject to repurchase
                      
                      
                      —
                      
                      
                      
                      1,024
                      
                      
                      
                      850Convertible
      preferred stock (as converted basis)
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      34,727




53


9. 
STOCKHOLDERS’ EQUITY AND STOCK-BASED COMPENSATION




Common
Stock




At
December 31, 2008, we had shares of common stock reserved for future
issuance as follows (in thousands):




Outstanding
      stock options
                  
                  
                  13,765Reserved
      for future grants
                  
                  
                  5,051Employee
      stock purchase plan
                  
                  
                  714Total
                  
                  
                  19,530




Stock
Plans




2002 Stock
Plan.  In May 2002, our board of directors adopted the 2002
Stock Plan, or 2002 Plan. The 2002 Plan provided that grants of incentive stock
options would be made at no less than the estimated fair value of our common
stock (no less than 85% of the fair value for nonqualified stock options), as
determined by our board of directors at the date of grant. Vesting and exercise
provisions were determined by our board of directors at the time of grant.
Options typically vest with respect to 25% of the shares one year after the
options’ vesting commencement date and the remainder ratably on a monthly basis
over the following three years. Options granted under the 2002 Plan have a
maximum term of ten years. Recipients of stock options under the 2002 Plan
generally have the right to exercise their options prior to vesting. Any
unvested stock issued under the 2002 Plan is subject to repurchase by
us.  The 2002 Plan has been replaced by the 2007 Equity Incentive Plan
as discussed below.  No further option grants have been or will be made
under our 2002 Plan after our IPO.  The options outstanding under the 2002
Stock Plan will continue to be governed by their existing terms.





2007 Stock
Plan.In May
2007, our board of directors approved the 2007 Equity Incentive Plan, or 2007
Plan, which replaced our 2002 Plan when we completed our IPO in July
2007.  As of December 31, 2008, six million shares have been reserved
and 5,051,439 shares remained available for grant to eligible employees,
directors and consultants under the 2007 Plan. The number of shares reserved for
issuance under the 2007 Plan will be increased automatically on January 1 of
each year for five years through January 1, 2012 by a number equal to the lesser
of: i) 5% of the shares of common stock outstanding at that time ii) 5,000,000
shares of common stock or iii) the number of shares determined by our board of
directors.  The number of shares added in fiscal year 2008 was
2,835,689.




Options
issued under our stock option plans are generally exercisable for periods not to
exceed 10 years and are issued at the fair value of the shares of common stock
on the date of grant. Following the IPO, the fair value of our common stock has
been determined by the trading price of such stock on the NASDAQ Global Market
or NASDAQ Global Select Market, as applicable. Options typically vest with
respect to 25% of the shares one year after the options’ vesting commencement
date and the remainder ratably on a monthly basis over the following three
years. For some options granted under the 2002 Plan, employees had the right to
exercise their options prior to vesting. Any unvested stock issued under the
2002 Plan is subject to repurchase by us upon the employee’s termination of
service. Grants made pursuant to the 2007 Plan generally do not provide for the
immediate exercise of options.





In
December 2008, we began issuing restricted stock units, or RSUs, to employees.
RSUs are converted into shares of our common stock upon vesting on a one-for-one
basis. Typically, vesting of RSUs is subject to the employee’s continuing
service to us.





Employee Stock
Purchase Plan.  On June 27, 2007, we implemented our
Employee Stock Purchase Plan, or ESPP, which is compensatory and results in
compensation costs accounted for under SFAS 123R. Under the ESPP, 1.2 million
shares have been reserved and employees may purchase shares of common stock at a
price per share that is 85% of the lesser of the fair market value of our common
stock as of the beginning or the end of six-month purchase
periods.  The number of shares reserved for purchase under the ESPP
will be automatically increased on January 1 of each year for a number of shares
equal to 1% of the number of shares of our common stock outstanding at that
time, but not more than 750,000 shares. The number of shares added in fiscal
year 2008 was 567,137.







54




Stock-Based
Compensation Plan Activities




Stock
Options.  A summary of option activity under all of our plans
as of December 31, 2008 and changes during the year ended December 31, 2008 is
presented below (in thousands, except for the weighted average exercise
price):







Options
      OutstandingAvailable for
      Grant
              
              
              Shares
              
              
              Weighted
      Average Exercise PriceDecember
      31, 2007
              
              
              5,538
              
              
              
              13,431
              
              
              $
              5.53Additional
      shares authorized
              
              
              2,836
              
              
              
              —
              
              
              
              —Granted
              
              
              (4,037
              )
              
              
              4,037
              
              
              $
              21.06Exercised
              
              
              —
              
              
              
              (2,983
              )
              
              $
              1.75Forfeited
              
              
              720
              
              
              
              (707
              )
              
              $
              13.48Expired
              
              
              —
              
              
              
              (13
              )
              
              $
              14.71Repurchased
              
              
              14
              
              
              
              —
              
              
              $
              0.47December
      31, 2008
              
              
              5,071
              
              
              
              13,765
              
              
              $
              10.49




The
following table summarizes options outstanding by exercise price, options vested
and expected to be vested and options exercisable at December 31, 2008 (in
thousands, except for the weighted average exercise price and weighted average
remaining contractual term):







Options
      OutstandingRange
      of Exercise Price
                    
                    
                    Shares
                    
                    
                    Weighted
      Average Exercise Price
                    
                    
                    Weighted
      Average Remaining Contractual Term (Yrs)
                    
                    
                    Aggregate
      Intrinsic Value$
                    0.05-$0.70
                    
                    
                    
                    3,866
                    
                    
                    $
                    0.39
                    
                    
                    
                    6.20$
                    0.75-$8.52
                    
                    
                    
                    2,980
                    
                    
                    $
                    4.63
                    
                    
                    
                    7.77$
                    8.90-$18.15
                    
                    
                    
                    2,877
                    
                    
                    $
                    12.02
                    
                    
                    
                    8.51$
                    19.46-$22.48
                    
                    
                    
                    2,837
                    
                    
                    $
                    21.49
                    
                    
                    
                    7.87$
                    23.43-$35.29
                    
                    
                    
                    1,205
                    
                    
                    $
                    27.85
                    
                    
                    
                    8.71$
                    0.05-$35.29
                    
                    
                    
                    13,765
                    
                    
                    $
                    10.49
                    
                    
                    
                    7.59
                    
                    
                    $
                    132,922Vested
      and expected to vest after December 31, 2008, net of
      forfeitures
                    
                    
                    
                    12,618
                    
                    
                    $
                    10.29
                    
                    
                    
                    7.55
                    
                    
                    $
                    124,206Exercisable
      at December 31, 2008
                    
                    
                    
                    4,957
                    
                    
                    $
                    4.42
                    
                    
                    
                    6.76
                    
                    
                    $
                    74,627









During
the years ended December 31, 2008, 2007 and 2006, the total intrinsic value
of stock options exercised was approximately $57.9 million, $9.9 million and
$5.7 million, respectively. During the year ended December 31, 2008, the
total cash received from the exercise of options was approximately $5.2
million.




The
weighted-average grant-date fair value per share of stock options granted was
$11.25, $7.56 and $1.53 for the years ended December 31, 2008, 2007 and
2006, respectively. The total fair value of shares vested during the year was
$32.1 million, $55.0 million and $7.4 million for the years ended December 31,
2008, 2007 and 2006, respectively. As of December 31, 2008, the total
compensation expense related to options granted to employees but not yet
recognized was approximately $58.4 million, net of estimated forfeitures. This
expense will be amortized on a straight-line basis over a weighted average
remaining life of approximately 2.72 years.




Restricted Stock
Awards.  On June 20, 2007, we granted 383,998 shares of
restricted stock, granted at fair value based on the Black-Scholes valuation
model, 10,000 shares of which vested immediately on June 27, 2007 and the
remainder vest over a four year period that commenced on June 27, 2007. In
addition, during the years ended December 31, 2007 and 2006, we awarded
30,000 and 72,270 shares of restricted stock, respectively that granted the
recipient fully vested shares of our common stock based on the deemed market
value of our common stock on the date of grant. As of December 31, 2008, we had
$3.3 million of total unrecognized compensation expense, net of estimated
forfeitures, related to all restricted stock awards, which will be recognized
over a weighted average estimated remaining life of 2.48 years.




The
following table summarizes unvested restricted stock awards outstanding at
December 31, 2007 and December 31, 2008 and the activity during the year (in
thousands, except for the weighted average grant date fair value):







Shares
                
                
                Weighted
      Average Grant Date Fair ValueUnvested
      stock outstanding at December 31, 2007
                
                
                373,998
                
                
                $
                15.00Vested
                
                
                (116,874
                )
                
                $
                15.00Unvested
      stock outstanding at December 31, 2008
                
                
                257,124
                
                
                $
                15.00






55


Restricted Stock
Units.In December 2008, we began issuing RSUs to employees.
The cost of these awards is determined using the fair value of our common stock
on the date of the grant, and compensation is recognized on a straight-line
basis over the requisite service period. During December 2008, we awarded 18,581
RSUs that had a weighted average grant date fair value of $18.15 per share. None
of these RSUs were vested as of December 31, 2008. As of December 31, 2008,
we had $310,000 of total unrecognized compensation expense, net of estimated
forfeitures, related to RSUs, which will be recognized over a weighted average
estimated remaining life of 3.88 years.




Employee Stock
Purchase Plan.Our employee stock purchase plan is compensatory, and we
recognized $3.1 million, $2.8 million and zero of expense in the years ended
December 31, 2008, 2007 and 2006, respectively. At December 31, 2008, there
was $115,000 of total unrecognized compensation cost related to the ESPP that is
expected to be recognized in January 2009.




At
December 31, 2008 and 2007, there were 586,000 and 1,219,000 shares,
respectively, subject to repurchase under all common stock repurchase agreements
upon forfeiture or early termination of employment. The cash received from the
sale of these shares is initially recorded as a liability in long-term exercised
unvested options and is subsequently reclassified to common stock as the shares
vest. At December 31, 2008 and 2007, there was $285,000 and $766,000,
respectively, recorded in non-current liabilities related to the issuance of
these shares.




Stock-Based
Compensation




We
account for stock-based compensation using the fair value method in accordance
with the provisions of SFAS 123R. We recognize this expense on a straight-line
basis over the optionees’ requisite service period, which is assumed to be the
same as the vesting schedule of the options. We estimate the grant date fair
value of stock option awards under the provisions of SFAS 123R using the
Black-Scholes option valuation model, which requires the input of highly
subjective assumptions, including the expected life of the share-based award and
stock price volatility. The assumptions used in calculating the fair value of
stock-based compensation represent management’s best estimates, but these
estimates involve inherent uncertainties and the application of management
judgment. As a result, if other assumptions had been used, our stock-based
compensation expense could have been materially different. In addition, we are
required to estimate the expected forfeiture rate and only recognize expense for
those awards expected to vest. We estimated the expected forfeiture rate at the
time of grant to be 5%. If our actual forfeiture rate is materially different
from our estimate, the stock-based compensation expense could be materially
different. We will revise the expected forfeiture rate, if necessary, in
subsequent periods if actual forfeitures differ from those
estimated.




Valuation
Assumptions




The
following table summarizes the weighted average assumptions used in determining
the fair value of stock options granted and shares issued under our
ESPP:




Year ended
      December 31,2008
                      
                      
                      2007
                      
                      
                      2006Stock
      Option PlansRisk-free
      interest rate
                      
                      
                      2.27%-3.79
                      %
                      
                      
                      3.17%-4.97
                      %
                      
                      
                      4.36%-5.09
                      %Dividend
      yield
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —Volatility
                      
                      
                      56
                      %
                      
                      
                      70
                      %
                      
                      
                      70
                      %Expected
      life (years)
                      
                      
                      5.63
                      
                      
                      
                      4.31
                      
                      
                      
                      4.00Employee
      Stock Purchase PlanRisk-free
      interest rate
                      
                      
                      2.07
                      %
                      
                      
                      4.95
                      %
                      
                      
                      N/ADividend
      yield
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      N/AVolatility
                      
                      
                      51
                      %
                      
                      
                      70
                      %
                      
                      
                      N/AExpected
      life (months)
                      
                      
                      6
                      
                      
                      
                      7
                      
                      
                      
                      N/A






For all
of our stock option grants and issuance of ESPP shares, the risk-free interest
rate is based on the yield available on U.S. Treasury zero-coupon issues with an
equivalent remaining expected life. We have not paid dividends in the past and
do not plan to pay any dividends in the foreseeable future. We estimated our
expected volatility based on reported market value data for a group of publicly
traded companies, which we selected from market indices that we believed were
relatively comparable after consideration of their size, maturity,
profitability, growth, risk and return on investment. We used the average
expected volatility rates reported by the comparable group for an expected term
that approximated the expected term that we estimated. The expected life for
options granted is based on an analysis of our historical exercise and
cancellation data.









Stock-Based
Compensation Expense




Stock-based
compensation expense included in our Consolidated Statements of Operations for
the years ended December 31, 2008, 2007 and 2006 was as
follows:






Year
      Ended December 31,(in
      thousands)
                
                2008
                
                
                2007
                
                
                2006Cost
      of
      product
                
                $
                814
                
                
                $
                217
                
                
                $
                21Cost
      of support and
      services
                
                
                884
                
                
                
                290
                
                
                
                15Sales
      and
      marketing
                
                
                11,505
                
                
                
                6,313
                
                
                
                485Research
      and
      development
                
                
                5,504
                
                
                
                2,981
                
                
                
                558General
      and
      administrative
                
                
                4,677
                
                
                
                2,250
                
                
                
                212Total
      stock-based compensation
      expense
                
                $
                23,384
                
                
                $
                12,051
                
                
                $
                1,291





56




10.
            INCOME
      TAXES




The
components of net income (loss) before provision for income taxes consisted of
the following:




Year ended
      December 31,(in
      thousands)
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006North
      America
                      
                      $
                      33,192
                      
                      
                      $
                      (3,831
                      )
                      
                      $
                      (4,151
                      )International
                      
                      
                      (11,594
                      )
                      
                      
                      664
                      
                      
                      
                      336Income
      (loss) before provision for income taxes
                      
                      $
                      21,598
                      
                      
                      $
                      (3,167
                      )
                      
                      $
                      (3,815
                      )




Our
provision for income taxes consisted of the following:





Year
      ended December 31,(in
      thousands)
                
                2008
                
                
                2007
                
                
                2006Current:Federal
                
                $
                9,205
                
                
                $
                (32
                )
                
                $
                70State
                
                
                2,975
                
                
                
                251
                
                
                
                27International
                
                
                985
                
                
                
                274
                
                
                
                114$
                13,165
                
                
                $
                493
                
                
                $
                211Deferred:Federal
                
                
                (8,298
                )
                
                
                —
                
                
                
                —State
                
                
                (4,862
                )
                
                
                —
                
                
                
                —International
                
                
                —
                
                
                
                —
                
                
                
                —(13,160
                )
                
                
                —
                
                
                
                —$
                5
                
                
                $
                493
                
                
                $
                211


Income
taxes differ from the amounts computed by applying the federal statutory rate of
35% to net income as shown below:




Year
      ended December 31,(in
      thousands)
                
                2008
                
                
                2007
                
                
                2006Income
      tax provision at federal statutory
      rate
                
                $
                7,552
                
                
                $
                (1,077
                )
                
                $
                (1,297
                )Net
      tax effects of:State
      taxes, net of federal
      benefit
                
                
                1,848
                
                
                
                166
                
                
                
                18Foreign
      rate
      differential
                
                
                4,690
                
                
                
                77
                
                
                
                —Tax
      credits
                
                
                (3,243
                )
                
                
                (1,239
                )
                
                
                (549
                )Stock-based
      compensation
      expense
                
                
                1,591
                
                
                
                2,774
                
                
                
                322Non-deductible
      meals and entertainment
      expenses
                
                
                225
                
                
                
                117
                
                
                
                53Other
      differences,
      net
                
                
                502
                
                
                
                8
                
                
                
                —Change
      in valuation
      allowance
                
                
                (13,160
                )
                
                
                (333
                )
                
                
                1,664Provision
      for income
      taxes
                
                $
                5
                
                
                $
                493
                
                
                $
                211


57




The
components of the deferred tax assets consisted of the following:




December
      31,(in
      thousands)
                        
                        2008
                        
                        
                        2007Deferred
      tax assets:Net
      operating loss carryforwards
                        
                        $
                        1,449
                        
                        
                        $
                        5,569Tax
      credits
                        
                        
                        1,676
                        
                        
                        
                        2,987Accruals
      and allowances
                        
                        
                        7,212
                        
                        
                        
                        3,110Differences
      in timing of revenue recognition
                        
                        
                        3,865
                        
                        
                        
                        552Depreciation
      and amortization
                        
                        
                        —
                        
                        
                        
                        751Stock-based
      compensation
                        
                        
                        6,373
                        
                        
                        
                        1,241Total
      deferred tax assets
                        
                        
                        20,575
                        
                        
                        
                        14,210Deferred
      tax liabilities:Unrecognized
      gains or losses
                        
                        
                        (12
                        )
                        
                        
                        —Depreciation
      and amortization
                        
                        
                        (7,403
                        )
                        
                        
                        —Total
      deferred tax liabilities
                        
                        
                        (7,415
                        )
                        
                        
                        —Less:
      valuation allowance
                        
                        
                        —
                        
                        
                        
                        (14,210
                        )Net
      deferred tax assets
                        
                        $
                        13,160
                        
                        
                        $
                        —




As of
December 31, 2008, we had net operating loss carryforwards for federal and
state income tax purposes of $0.3 million and $15.1 million, respectively. As of
December 31, 2008, the portion of the federal and state operating loss
carryforwards which relates to stock option benefits was approximately $45.5
million, which will be recorded to equity when they reduce taxes payable in
cash. We also had federal and mainly state research and development tax credit
carryforwards of approximately $1.6 million. Federal research and development
tax credits begin to expire in 2022 and the California research and development
credits have no expiration date.





As a
result of our analysis of expected future income at December 31, 2008, we
determined that we will more likely than not realize our deferred tax assets. As
of December 31, 2007, we had recorded a deferred tax benefit of $14.2 million.
In 2008, we reversed our deferred tax asset valuation allowance which resulted
in a $13.2 million tax benefit. Deferred tax assets do not include the tax
benefits attributable to approximately $51.7 million of excess tax deductions
related to stock options. These benefits will only be recorded when realized on
tax returns and will be credited to stockholders’ equity at that
time.




In
evaluating our ability to realize our deferred tax assets, we consider all
available positive and negative evidence, including our past operating results,
the existence of cumulative losses in the most recent fiscal years prior to
2008, forecasted earnings and future taxable income, the mix of earnings in the
jurisdictions in which we operate and prudent and feasible tax planning
strategies. The assumptions utilized in determining future taxable income
require significant judgment and are consistent with the plans and estimates we
are using to manage the underlying businesses. We believe that the deferred tax
assets recorded on our balance sheet will more likely than not be realized. In
the event we were to determine that we would not be able to realize all or part
of our net deferred tax assets in the future, an adjustment to the deferred tax
assets would be charged to earnings in the period in which we make such
determination.




Effective
January 1, 2007, we adopted FIN 48. Our total amount of unrecognized tax
benefits as of December 31, 2008 and December 31, 2007 was $2.1
million and $1.6 million, respectively. Of this total, $1.8 million
represents the amount of unrecognized tax benefits that, if recognized, would
affect our effective tax rate. We expect that the amount of unrecognized
benefits will change during the next 12 months; however, we do not expect the
change to have a material impact on our financial position.




The
following table summarizes activities related to our unrecognized tax benefit
for the two years ended December 31, 2008:





Unrecognized
      Tax Benefits (in thousands)Balance
      at January 1, 2007
                
                $
                820Additions
      to tax positions of prior
      years
                
                
                —Additions
      to tax positions related to
      2007
                
                
                740Reductions
      for tax positions of prior
      years
                
                
                —Settlements
      during the current
      year
                
                
                —Balance
      at December 31, 2007
                
                $
                1,560Additions
      to tax positions of prior
      years
                
                
                —Additions
      to tax positions related to
      2008
                
                
                1,075Reductions
      for tax positions of prior
      years
                
                
                (577
                )Settlements
      during the current
      year
                
                
                —Balance
      at December 31, 2008
                
                $
                2,058




Upon
adoption of FIN 48, our policy to include interest and penalties related to
unrecognized tax benefits within our provision for income taxes did not change.
For the years ended December 31, 2008 and December 31, 2007, we recognized
$53,000 and $12,000 of interest and penalties related to unrecognized tax
benefits, respectively, in our provision for income taxes.




The tax
years 2002 through 2008 remain open to examination by the major domestic taxing
jurisdictions to which we are subject, and for the international jurisdictions
the tax years open to examination vary depending on the local tax
laws.




In
connection with our adoption of SFAS 123R, we use the “with-and-without”
approach described in EITF Topic No. D-32, Intraperiod Tax Allocation of the
tax effect of pre-tax income from continuing operations, to determine the
recognition and measurement of excess tax benefits. In addition, we have elected
to account for indirect effects of stock-based awards on other tax attributes,
such as research and alternative minimum tax credits, through our statements of
operations. Accordingly, we have elected to recognize excess tax benefits from
the exercise of stock options in additional paid in capital only if an
incremental income tax benefit would be realized after considering all other tax
attributes presently available to us.




We have not
provided for federal income taxes on all of our non-U.S. subsidiaries’
undistributed earnings as of December 31, 2008, because such earnings are
intended to be indefinitely reinvested. There is no cumulative unremitted
foreign earnings at December 31, 2008.






58







11. SEGMENT
INFORMATION







Statement
of Financial Accounting Standards No. 131,Disclosures about Segments of an
Enterprise and Related Information, establishes standards for reporting
information about operating segments. Operating segments are defined as
components of an enterprise about which separate financial information is
available that is evaluated regularly by the chief operating decision maker, or
decision making group, in deciding how to allocate resources and in assessing
performance. Our chief operating decision maker is our Chief Executive Officer.
Our Chief Executive Officer reviews financial information presented on a
consolidated basis, accompanied by information about revenue by geographic
region for purposes of allocating resources and evaluating financial
performance. We have one business activity and there are no segment managers who
are held accountable for operations, operating results and plans for levels or
components below the consolidated unit level. Accordingly, we consider ourselves
to be in a single reporting segment and operating unit structure.




Revenue
by geography is based on the billing address of the customer. The following
tables set forth revenue and long-lived assets by geographic area:




Revenue




Year ended
      December 31,(in
      thousands)
                            
                            2008
                            
                            
                            2007
                            
                            
                            2006North
      America
                            
                            $
                            212,527
                            
                            
                            $
                            89,003
                            
                            
                            $
                            31,734Europe,
      Africa and Middle East
                            
                            
                            43,355
                            
                            
                            
                            26,026
                            
                            
                            
                            12,210Asia
      Pacific
                            
                            
                            18,203
                            
                            
                            
                            8,593
                            
                            
                            
                            2,490Total
                            
                            $
                            274,085
                            
                            
                            $
                            123,622
                            
                            
                            $
                            46,434




For the
above periods presented, no one country outside the United States represented
10% or more of our total revenue.




Long-lived
Assets




December
      31,(in
      thousands)
                        
                        2008
                        
                        
                        2007Domestic
                        
                        $
                        38,444
                        
                        
                        $
                        14,456International
                        
                        
                        410
                        
                        
                        
                        133Total
                        
                        $
                        38,854
                        
                        
                        $
                        14,589







59




12. EMPLOYEE
BENEFIT PLAN




We have a
401(k) plan covering all eligible employees. We are not required to contribute
to the plan and had made no contributions through December 31,
2008.




13. LEGAL
MATTERS




From time
to time, we may be involved in various legal proceedings arising in the ordinary
course of business. There were no matters at December 31, 2008 or 2007
that, in the opinion of management, might have a material adverse effect on our
financial position, results of operations or cash flows.




14. QUANTUM
SETTLEMENT AND OTHER LIABILITIES




In the
fourth quarter of 2006, we received an inquiry from Quantum Corporation
regarding our interest in licensing certain patents that Quantum believed we may
have previously incorporated into our products or may incorporate in the future.
As a result of our discussions with Quantum, which commenced in 2006, we entered
into a patent cross-license agreement in March 2007, with an effective date of
January 1, 2007. Under the terms of the cross-license, we issued Quantum
390,000 shares of our common stock in March 2007. We engaged an independent
third-party valuation firm to assist us in valuing the shares of our common
stock as of the date of issuance. Based on consideration of this valuation, our
estimate of the value of the common stock issued under the agreement was
approximately $3.3 million.




The same
third-party valuation firm assisted us in estimating the value of the intangible
asset associated with the cross-license agreement and to estimate its useful
life. Based on consideration of this valuation, we determined the fair value of
the intangible asset to be $400,000 and have an estimated useful life of three
years. We began to amortize this asset to cost of product revenue beginning
January 1, 2007, and for the years ended December 31, 2008 and 2007, we
recorded $133,000 and $133,000 of amortization expense, respectively. The $2.9
million balance of the settlement amount represents payment to Quantum for a
release of all claims for any past acts or conduct, and we have recorded the
amount as settlement expense in our consolidated statements of operations for
the year ended December 31, 2006.







60


15.
QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)




The
following table sets forth our unaudited quarterly consolidated statement of
operations data for the years ended December 31, 2008 and 2007. In
management’s opinion, the data has been prepared on the same basis as the
audited consolidated financial statements, and reflects all necessary
adjustments, consisting only of normal recurring adjustments, necessary for a
fair presentation of this data. The results of historical periods are not
necessarily indicative of the results of operations for any future
period.




For the three
      months ended (unaudited)(in
      thousands, except for per share data)
                      
                      December 31,
                        2008
                      
                      
                      September 30,
                        2008
                      
                      
                      June
      30,
                        2008
                      
                      
                      March 31,
                        2008Total
      revenue
                      
                      $
                      85,229
                      
                      
                      $
                      75,030
                      
                      
                      $
                      61,211
                      
                      
                      $
                      52,615Gross
      profit
                      
                      
                      60,711
                      
                      
                      
                      54,064
                      
                      
                      
                      44,321
                      
                      
                      
                      38,809Operating
      income
                      
                      
                      8,518
                      
                      
                      
                      5,568
                      
                      
                      
                      1,489
                      
                      
                      
                      1,235Net
      income(1)
                      
                      $
                      13,926
                      
                      
                      $
                      3,232
                      
                      
                      $
                      1,694
                      
                      
                      $
                      2,741Net
      income per share, basic
                      
                      $
                      0.23
                      
                      
                      $
                      0.06
                      
                      
                      $
                      0.03
                      
                      
                      $
                      0.05Net
      income per share, diluted
                      
                      $
                      0.21
                      
                      
                      $
                      0.05
                      
                      
                      $
                      0.03
                      
                      
                      $
                      0.04Shares
      used in computing net income per share, basic
                      
                      
                      59,394
                      
                      
                      
                      58,738
                      
                      
                      
                      57,570
                      
                      
                      
                      56,414Shares
      used in computing net income per share, diluted
                      
                      
                      66,387
                      
                      
                      
                      65,422
                      
                      
                      
                      65,381
                      
                      
                      
                      64,704


_____________________________________


(1) Includes an
income tax benefit of $13.2 million recorded as a result of the reversal of our
deferred tax asset valuation allowance.





For the three
      months ended (unaudited)(in
      thousands, except for per share data)
                    
                    December 31,
                      2007
                    
                    
                    September 30,
                      2007
                    
                    
                    June
      30,
                      2007
                    
                    
                    March 31,
                      2007Total
      revenue
                    
                    $
                    44,880
                    
                    
                    $
                    32,025
                    
                    
                    $
                    26,508
                    
                    
                    $
                    20,209Gross
      profit
                    
                    
                    32,579
                    
                    
                    
                    22,516
                    
                    
                    
                    19,140
                    
                    
                    
                    13,486Operating
      loss
                    
                    
                    (2,221
                    )
                    
                    
                    (2,242
                    )
                    
                    
                    (1,248
                    )
                    
                    
                    (1,478
                    )Net
      loss
                    
                    $
                    (76
                    )
                    
                    $
                    (880
                    )
                    
                    $
                    (1,231
                    )
                    
                    $
                    (1,473
                    )Net
      loss per share, basic and diluted
                    
                    $
                    —
                    
                    
                    $
                    (0.02
                    )
                    
                    $
                    (0.12
                    )
                    
                    $
                    (0.18
                    )Shares
      used in computing net loss per share, basic and
    diluted
                    
                    
                    53,595
                    
                    
                    
                    51,880
                    
                    
                    
                    10,064
                    
                    
                    
                    8,038






61





Item 9.
            Changes in and Disagreements
      with Accountants on Accounting and Financial
    Disclosure




None.




Item 9A.
            Controls and
      Procedures




Evaluation
of Disclosure Controls and Procedures






An
evaluation was carried out under the supervision and with the participation of
our management, including our principal executive officer and principal
financial officer, of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934) as of the end of the period covered
by this report. Based upon that evaluation, the principal executive officer
and principal financial officer concluded that those disclosure controls and
procedures were effective to ensure that information required to be disclosed by
us in the reports that it files or submits under the Exchange Act is
(i) recorded, processed, summarized and reported, within the time periods
specified in the Commission’s rules and forms and (ii) accumulated and
communicated to our management, including our principal executive officer and
principal financial officer, as appropriate to allow timely decisions regarding
required disclosure.




Management’s
Report on Internal Control over Financial Reporting




Our
management is responsible for establishing and maintaining a comprehensive
system of internal control over financial reporting  (as defined in Rules
13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934) to provide
reasonable assurance of the proper authorization of transactions, the
safeguarding of assets and the reliability of the financial records. Our
internal control system was designed to provide reasonable assurance to our
management and board of directors regarding the preparation and fair
presentation of published financial statements. The system of internal control
over financial reporting provides for appropriate division of responsibility and
is documented by written policies and procedures that are communicated to
employees. The framework upon which management relied in evaluating the
effectiveness of our internal control over financial reporting was set forth in
Internal Controls — Integrated Framework published by the Committee of
Sponsoring Organizations of the Treadway Commission.






Based on
the results of our evaluation, our management concluded that our internal
control over financial reporting was effective as of December 31,
2008.






However,
projections of any evaluation of effectiveness to future periods are subject to
the risk that controls may become inadequate because of changes in our business
or other conditions, or that the degree of compliance with our policies or
procedures may deteriorate.






Our
independent registered public accounting firm has audited the financial
statements included in Item 8 of this report and has issued an attestation
report on our internal control over financial reporting. The report on the audit
of internal control over financial reporting is included at page
48.




Changes
in Internal Control over Financial Reporting




There
were no changes in our internal control over financial reporting (as defined in
Exchange Act Rules 13a-15(f) and 15d-15(f)) during our most recent fiscal
quarter that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.




Inherent
Limitations of Internal Controls




Our
management, including our CEO and CFO, does not expect that our disclosure
controls and procedures or our internal control over financial reporting will
prevent all errors and all fraud. A control system, no matter how well conceived
and operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Because of the inherent limitations in
all control systems, no evaluation of controls can provide absolute assurance
that all control issues and instances of fraud, if any, within the company have
been detected. These inherent limitations include the realities that judgments
in decision-making can be faulty, and that 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 control. 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, controls may
become inadequate because of changes in conditions, or the degree of compliance
with the policies or procedures may deteriorate. Because of the inherent
limitations in a cost-effective control system, misstatements due to error or
fraud may occur and not be detected.




Item 9B.
            Other
      Information




None.




PART
III




Item 10.
            Directors, Executive Officers
      and Corporate Governance







Item 11.
            Executive
      Compensation







Item 12.
            Security Ownership of Certain
      Beneficial Owners and Management and Related Stockholder
      Matters







Item 13.
            Certain Relationships and
      Related Transactions, and Director
  Independence








Item 14.
            Principal Accounting Fees and
      Services




Certain
information concerning our executive officers is included under the caption,
“Executive Officers of the Registrant,” in Part I, Item 4A of this
report. Other information required by Items 10, 11, 12, 13 and 14 will be
contained in our definitive Proxy Statement for our 2009 Annual Meeting of
Stockholders which will be filed with the Securities and Exchange Commission by
April 30, 2009, and is incorporated herein by reference.




PART
IV




Item 15.
            Exhibits and Financial
      Statement Schedules




The
following documents are filed as part of this report:




1.
            Financial
      Statement: See Index to Consolidated Financial Statements under
      Item 8.2.
            Certain
      Financial Statement Schedules have been omitted since they are either not
      required, not applicable or the information is otherwise
      included.3.
            Exhibits.




62


(a)
Exhibits




Exhibit No.
                          Description3.1
                          Restated
      Certificate of Incorporation.(1)3.2
                          Amended
      and Restated Bylaws.(1)4.1
                          Reference
      is made to Exhibits 3.1 and 3.2.(1)4.2
                          Form
      of Common Stock certificate.(1)4.3
                          Amended
      and Restated Investors’ Rights Agreement, dated March 14, 2007, by and
      among the Registrant, certain stockholders and the investors listed on the
      signature pages thereto.(1)4.4
                          Amendment
      to Amended and Restated Investors’ Rights Agreement, dated November 12,
      2007, by and among the Registrant and the investors listed on the
      signature pages thereto.(4)4.5
                          Second
      Amendment to Amended and Restated Investors’ Rights Agreement, dated
      November 15, 2007, by and among the Registrant and the investors listed on
      the signature pages thereto.(4)10.1*
                          Form
      of Indemnification Agreement between the Registrant and each of its
      directors and executive officers and certain key employees.(1)10.2*
                          Data
      Domain, Inc. 2002 Stock Plan.(1)10.3*
                          Form
      of 2002 Stock Plan Stock Purchase Agreement.(1)10.4*
                          Form
      of 2002 Stock Plan Stock Option Agreement (early exercise).(1)10.5*
                          Form
      of 2002 Stock Plan Stock Option Agreement (installment vesting).(1)10.6*
                          Form
      of 2002 Stock Plan Stock Option Agreement (non-employee directors).(1)10.7*
                          2007
      Equity Incentive Plan.(1)10.8*
                          2007
      Employee Stock Purchase Plan.(1)10.9*
                          Data
      Domain, Inc. 2009 Executive Bonus Plan. (5)10.10*
                          Offer
      Letter with Frank Slootman, dated June 17, 2003.(1)10.11*
                          Offer
      Letter
      with Michael P. Scarpelli, dated September 14, 2006.(1)10.12*
                          Offer
      Letter with Daniel R. McGee, dated January 13, 2006.(1)10.13*
                          Offer Letter with
      David L. Schneider, dated December 8, 2003.(1)10.14*
                          Offer
      Letter
      with Nick Bacica , dated September 22,
      2008.10.15*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated August 28,
      2003, with Frank Slootman.(1)10.16*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated August 10,
      2005, with Frank Slootman.(1)10.17*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated September 14,
      2006, with Michael P. Scarpelli.(1)10.18*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated March 15,
      2006, with Daniel R. McGee.(1)10.19*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated January 22,
      2004, with David L. Schneider.(1)10.20*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated January 31,
      2005, with David L. Schneider.(1)10.21*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated September 14,
      2005, with David L. Schneider.(1)10.22*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated February 12,
      2007, with David L. Schneider.(1)10.23*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated March 26, 2007,
      with Frank Slootman.(1)10.24*
                          Notice
      of Stock Option Grant and Stock Option Agreement, dated March 26, 2007,
      with Michael P. Scarpelli.(1)10.25*
                          Amended
      and Restated Consulting Agreement by and between the Registrant and Kai
      Li, dated September 1, 2003.(1)10.26*
                          Management
      Change in Control Agreement.(5)10.27
                          Letter
      Agreement by and between the Registrant and Neal Ater, dated
      March 15, 2007.(1)10.28
                          Sub-Sublease
      Agreement by and between the Registrant and Juniper Networks, Inc.
      effective as of July 1, 2006.(1)10.29†
                          Manufacturing
      Services Agreement by and between the Registrant and Solectron USA, Inc.
      (subsequently acquired by Flextronics), a Delaware corporation, dba Fine
      Pitch Technology dated April 26, 2006.(1)10.30†
                          OEM
      Purchase Agreement by and between the Registrant and Xyratex Technology
      Limited, dated March 8, 2007.(1)10.31
                          Patent
      Cross-License Agreement by and between the Registrant and Quantum
      Corporation, dated March 13, 2007.(1)10.32
                          Lease,
      dated as of January 9, 2008, between Sobrato Interests and Data Domain,
      Inc.(6)10.33*
                          Form
      of 2007 Equity Incentive Plan Stock Option Agreement.(1)10.34*
                          Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Automatic Initial
      Director Grants).(1)10.35*
                          Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Automatic Annual
      Director Grants).(1)10.36*
                          Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Officer
      Grants).(1)10.37*
                          Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Chief Executive
      Officer Grants).(1)10.38*
                          Form
      of 2007 Equity Incentive Plan Restricted Stock Unit Agreement.(5)10.39*
                          Management
      Change in Control Agreement by and between the Registrant and Frank
      Slootman, dated June 6, 2007.(1)10.40*
                          Form
      of Summary of Stock Grant and Stock Grant Agreement with Kai Li, dated
      June 20, 2007(1)10.41
                          Lease
      dated as of July 10, 2007 between Sobrato Interests and the
      Registrant.(2)10.42
                          First
      Amendment To Lease dated as of August 27, 2007 between Sobrato Interests
      and the Registrant.(3)21.1
                          List
      of subsidiaries.23.1
                          Consent
      of Independent Registered Public Accounting Firm.31.1
                          Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
                          Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1
                          Certification
      of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.32.2
                          Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.





*
            Denotes
      a management contract or compensatory plan or
  arrangement.




†
            Confidential
      treatment has been granted for portions of this document. The omitted
      portions of this document have been filed with the Securities and Exchange
      Commission.




(1)
            Filed
      as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File
      No. 333-141716), as filed with the Securities and Exchange Commission
      on March 30, 2007, as amended and incorporated herein by
      reference




(2)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on July 13, 2007 and
      incorporated herein by reference




(3)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on August 30, 2007 and
      incorporated herein by reference




(4)
            Filed
      as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File
      No. 333-147092), as filed with the Securities and Exchange Commission
      on November 1, 2007, as amended and incorporated herein by
      reference




(5)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on February 3, 2009 and
      incorporated herein by reference




(6)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on January 14, 2008 and
      incorporated herein by reference




(b) Financial Statement
Schedules




The
following schedule is filed as part of this registration statement:




Schedule
II—Valuation and Qualifying Accounts




All other
schedules have been omitted because the information required to be presented in
them is not applicable or is shown in the consolidated financial statements or
related notes.








63




SCHEDULE
II




DATA
DOMAIN, INC. VALUATION AND QUALIFYING ACCOUNTS




Allowance
for Doubtful Accounts Rollforward




Trade
      Receivable Allowances:
                    
                    Beginning
                      Balance
                    
                    
                    Additions
                      (Recoveries)
                      Charged
      to
                      Operations
                    
                    
                    Write-offs
                    
                    
                    Ending
                      Balance(in
      thousands)Year
      Ended December 31, 2006
                    
                    $
                    1
                    
                    
                    $
                    9
                    
                    
                    $
                    —
                    
                    
                    $
                    10Year
      Ended December 31, 2007
                    
                    $
                    10
                    
                    
                    $
                    (3
                    )
                    
                    $
                    7
                    
                    
                    $
                    —Year
      Ended December 31, 2008
                    
                    $
                    —
                    
                    
                    $
                    120
                    
                    
                    $
                    —
                    
                    
                    $
                    120






Valuation
Allowance Rollforward




Valuation
      Allowance:
                  
                  Beginning
                    Balance
                  
                  
                  Additions
                    (Recoveries)
                    Charged
      to
                    Operations
                  
                  
                  Valuation
      Allowance Release
                  
                  
                  Ending
                    Balance(in
      thousands)Year
      Ended December 31, 2006
                  
                  $
                  13,184
                  
                  
                  $
                  1,799
                  
                  
                  $
                  —
                  
                  
                  $
                  14,983Year
      Ended December 31, 2007
                  
                  $
                  14,983
                  
                  
                  $
                  (773
                  )
                  
                  $
                  —
                  
                  
                  $
                  14,210Year
      Ended December 31, 2008
                  
                  $
                  14,210
                  
                  
                  $
                  (1,050
                  )
                  
                  $
                  (13,160
                  )
                  
                  $
                  —




* Additions include current year
valuation allowance build due to current year increase in net deferred tax
assets, for return to provision true-ups, other adjustments, and OCI impact to
deferred taxes. Deductions include current year reduction in deferred tax assets
due to current year decrease in net deferred tax assets, for return to provision
true-ups, other adjustments, and OCI impact to deferred
taxes.








64





SIGNATURES
  Pursuant
to the requirements of the Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
  
 DATA
      DOMAIN, INC.By:
              /S/  FRANK
      SLOOTMANFrank
      Slootman,President
      and Chief Executive Officer




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed by the following persons on behalf of the registrant and in the
capacities and on the dates indicated:




Signature
                  Title
                  Date/S/ FRANK
      SLOOTMAN

                            Frank Slootman
                  President,
      Chief Executive Officer and
                    Director
      (Principal Executive Officer)
                  March
      12, 2009/S/ MICHAEL
      P. SCARPELLI
                    Michael
      P. Scarpelli
                  Senior
      Vice President and Chief Financial Officer
                    (Principal
      Financial and Accounting Officer)
                  March 12, 2009/S/ RONALD
      D. BERNAL
                    Ronald
      D. Bernal
                  Director
                  March 12, 2009/S/ ANEEL
      BHUSRI
                    Aneel
      Bhusri
                  Chairman
      of the Board of Directors
                  March
      12, 2009/S/ RONALD
      E. F. CODD
                    Ronald
      E. F. Codd
                  Director
                  March 12, 2009/S/ REED
      E. HUNDT
                    Reed
      E. Hundt
                  Director
                  March 12, 2009/S/ KAI
      LI
                    Kai
      Li
                  Director
                  March 12,
      2009/S/ JEFFREY
      A. MILLER
                    Jeffrey
      A. Miller
                  Director
                  March 12, 2009/S/ SCOTT
      D. SANDELL
                    Scott
      D. Sandell
                  Director
                  March
      12, 2009






65








Exhibit No.
                Description3.1
                Restated
      Certificate of Incorporation.(1)3.2
                Amended
      and Restated Bylaws.(1)4.1
                Reference
      is made to Exhibits 3.1 and 3.2.(1)4.2
                Form
      of Common Stock certificate.(1)4.3
                Amended
      and Restated Investors’ Rights Agreement, dated March 14, 2007, by and
      among the Registrant, certain stockholders and the investors listed on the
      signature pages thereto.(1)4.4
                Amendment
      to Amended and Restated Investors’ Rights Agreement, dated November 12,
      2007, by and among the Registrant and the investors listed on the
      signature pages thereto.(4)4.5
                Second
      Amendment to Amended and Restated Investors’ Rights Agreement, dated
      November 15, 2007, by and among the Registrant and the investors listed on
      the signature pages thereto.(4)10.1*
                Form
      of Indemnification Agreement between the Registrant and each of its
      directors and executive officers and certain key employees.(1)10.2*
                Data
      Domain, Inc. 2002 Stock Plan.(1)10.3*
                Form
      of 2002 Stock Plan Stock Purchase Agreement.(1)10.4*
                Form
      of 2002 Stock Plan Stock Option Agreement (early exercise).(1)10.5*
                Form
      of 2002 Stock Plan Stock Option Agreement (installment vesting).(1)10.6*
                Form
      of 2002 Stock Plan Stock Option Agreement (non-employee directors).(1)10.7*
                2007
      Equity Incentive Plan.(1)10.8*
                2007
      Employee Stock Purchase Plan.(1)10.9*
                Data
      Domain, Inc. 2009 Executive Bonus Plan. (5)10.10*
                Offer
      Letter with Frank Slootman, dated June 17, 2003.(1)10.11*
                Offer
      Letter with Michael P. Scarpelli, dated September 14, 2006.(1)10.12*
                Offer
      Letter with Daniel R. McGee, dated January 13, 2006.(1)10.13*
                Offer
      Letter with David L.
      Schneider,
      dated December 8, 2003.(1)10.14*
                Offer Letter with Nick
      Bacica, dated September 22, 2008.10.15*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated August 28,
      2003, with Frank Slootman.(1)10.16*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated August 10,
      2005, with Frank Slootman.(1)10.17*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated September 14,
      2006, with Michael P. Scarpelli.(1)10.18*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated March 15,
      2006, with Daniel R. McGee.(1)10.19*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated January 22,
      2004, with David L. Schneider.(1)10.20*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated January 31,
      2005, with David L. Schneider.(1)10.21*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated September 14,
      2005, with David L. Schneider.(1)10.22*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated February 12,
      2007, with David L. Schneider.(1)10.23*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated March 26, 2007,
      with Frank Slootman.(1)10.24*
                Notice
      of Stock Option Grant and Stock Option Agreement, dated March 26, 2007,
      with Michael P. Scarpelli.(1)10.25*
                Amended
      and Restated Consulting Agreement by and between the Registrant and Kai
      Li, dated September 1, 2003.(1)10.26*
                Management
      Change in Control Agreement.(5)10.27
                Letter
      Agreement by and between the Registrant and Neal Ater, dated
      March 15, 2007.(1)10.28
                Sub-Sublease
      Agreement by and between the Registrant and Juniper Networks, Inc.
      effective as of July 1, 2006.(1)10.29†
                Manufacturing
      Services Agreement by and between the Registrant and Solectron USA,
      Inc.(subsequently acquired by Flextronics), a Delaware corporation,
      dba Fine Pitch Technology dated April 26, 2006.(1)10.30†
                OEM
      Purchase Agreement by and between the Registrant and Xyratex Technology
      Limited, dated March 8, 2007.(1)10.31
                Patent
      Cross-License Agreement by and between the Registrant and Quantum
      Corporation, dated March 13, 2007.(1)10.32
                Lease,
      dated as of January 9, 2008, between Sobrato Interests and Data Domain,
      Inc.(6)10.33*
                Form
      of 2007 Equity Incentive Plan Stock Option Agreement.(1)10.34*
                Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Automatic Initial
      Director Grants).(1)10.35*
                Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Automatic Annual
      Director Grants).(1)10.36*
                Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Officer
      Grants).(1)10.37*
                Form
      of 2007 Equity Incentive Plan Stock Option Agreement (Chief Executive
      Officer Grants).(1)10.38*
                Form
      of 2007 Equity Incentive Plan Restricted Stock Unit Agreement.(5)10.39*
                Management
      Change in Control Agreement by and between the Registrant and Frank
      Slootman, dated June 6, 2007.(1)10.40*
                Form
      of Summary of Stock Grant and Stock Grant Agreement with Kai Li, dated
      June 20, 2007.(1)10.41
                Lease
      dated as of July 10, 2007 between Sobrato Interests and the
      Registrant.(2)10.42
                First
      Amendment To Lease dated as of August 27, 2007 between Sobrato Interests
      and the Registrant.(3)21.1
                List
      of subsidiaries.23.1
                Consent
      of Independent Registered Public Accounting Firm.31.1
                Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
                Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1
                Certification
      of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.32.2
                Certification
      of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.








*
            Denotes
      a management contract or compensatory plan or
  arrangement.




†
            Confidential
      treatment has been granted for portions of this document. The omitted
      portions of this document have been filed with the Securities and Exchange
      Commission.




(1)
            Filed
      as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File
      No. 333-141716), as filed with the Securities and Exchange Commission
      on March 30, 2007, as amended and incorporated herein by
      reference




(2)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on July 13, 2007 and
      incorporated herein by reference




(3)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on August 30, 2007 and
      incorporated herein by reference




(4)
            Filed
      as an Exhibit to the Registrant’s Registration Statement on Form S-1 (File
      No. 333-147092), as filed with the Securities and Exchange Commission
      on November 1, 2007, as amended and incorporated herein by
      reference




(5)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on February 3, 2009 and
      incorporated herein by reference




(6)
            Filed
      as an Exhibit to the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on January 14, 2008 and
      incorporated herein by reference




(b) Financial Statement
Schedules




The
following schedule is filed as part of this registration statement:




Schedule
II—Valuation and Qualifying Accounts




All other
schedules have been omitted because the information required to be presented in
them is not applicable or is shown in the consolidated financial statements or
related notes.









66