Our principal executive offices are located at 6100 4th Avenue South, Seattle, Washington. The lease for our principal office is for 89,900 square feet and expires in July 2026. This lease includes provisions that increase our principal office space to a total of 107,642 square feet in 2018. We also occupy 1,600 square feet of office space in Vancouver, British Columbia pursuant to a lease that expires in March 2022.
(1) For more information about how we calculate total subscription pets enrolled, total pets enrolled, monthly average revenue per pet, lifetime value of a pet, average pet acquisition cost and average monthly retention, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Key Operating Metrics.”
We provide medical insurance for cats and dogs throughout the United States, Canada and Puerto Rico. Our data-driven, vertically-integrated approach enables us to provide pet owners with what we believe is the highest value medical insurance for their pets, priced specifically for each pet’s unique characteristics. Our growing and loyal member base provides us with highly predictable and recurring revenue. We operate our business similar to other subscription-based businesses, with a focus on maximizing the lifetime value of each pet while sustaining a favorable ratio of lifetime value relative to pet acquisition cost, based on our desired return on investment.
Average pet acquisition cost. Average pet acquisition cost (PAC) is calculated as net acquisition cost divided by the total number of new subscription pets enrolled in that period. Net acquisition cost, a non-GAAP financial measure, is calculated in a reporting period as sales and marketing expense, excluding stock-based compensation expense and other business segment sales and marketing expense, offset by sign-up fee revenue. We exclude stock-based compensation expense because the amount varies from period to period based on number of awards issued and market-based valuation inputs. We offset sign-up fee revenue because it is a one-time charge to new members collected at the time of enrollment used to partially offset initial setup costs, which are included in sales and marketing expenses. We exclude other business segment sales and marketing expense because that does not relate to subscription enrollments. We monitor average pet acquisition cost to evaluate the efficiency of our sales and marketing programs in acquiring new members and measure effectiveness using the ratio of our lifetime value of a pet to average pet acquisition cost, based on our desired return on investment.
This measure, which is a non-GAAP financial measure, may not provide information that is directly comparable to that provided by other companies in our industry. In addition, this measure excludes stock-based compensation expense, which has been, and is expected to continue to be for the foreseeable future, a significant recurring component of our sales and marketing expense. The presentation and utilization of non-GAAP financial measures is not meant to be considered in isolation or as a substitute for the directly comparable financial measures prepared in accordance with GAAP.
We operate in two business segments: subscription business and other business. Our subscription business segment includes revenue and expenses related to monthly subscriptions for pet medical insurance, which we market to consumers. When we do not directly market and sell to consumers, we classify the related revenue and expenses in our other business segment.
Average monthly retention. Our performance depends on our ability to continue to retain our existing and newly enrolled pets and is impacted by our ability to provide a best-in-class value and member experience. Our ability to retain enrolled pets depends on a number of factors, including the actual and perceived value of our services and the quality of our member experience, the ease and transparency of the process for reviewing and paying veterinary invoices for our members, and the competitive environment. In addition, if the number of new pets enrolled increases at a faster rate than our historical experience, our average monthly retention rate could be adversely impacted, as our retention rate is generally lower during the first year of member enrollment.
Comparison of the years ended December 31, 2017, 2016 and 2015
Year ended December 31, 2017 compared to year ended December 31, 2016. Total revenue increased by $54.4 million to $242.7 million for the year ended December 31, 2017, or 29%. Revenue from our subscription business segment increased by $45.0 million to $218.4 million for the year ended December 31, 2017, or 26%. This increase in subscription business revenue was primarily due to a 15% increase in total subscription pets enrolled as of December 31, 2017 compared to December 31, 2016, and increased average revenue per pet of 9% for the same period. Increases in pricing were due to the increased cost of veterinary care and more accurately pricing to our cost-plus margin structure by subcategory. Revenue from our other business segment increased $9.4 million to $24.3 million for the year ended December 31, 2017, or 63%, due to an increase in enrolled pets in this segment.
Year ended December 31, 2016 compared to year ended December 31, 2015. Total revenue increased by $41.3 million to $188.2 million for the year ended December 31, 2016, or 28%. Revenue for our subscription business segment increased by $40.0 million to $173.4 million for the year ended December 31, 2016, or 30%. This increase in subscription business revenue was primarily due to a 19% increase in total subscription pets enrolled as of December 31, 2016 compared to December 31, 2015, and increased average revenue per pet of 6% for the same period. Increases in pricing were due to the increased cost of veterinary care. Revenue from our other business segment increased $1.3 million to $14.9 million for the year ended December 31, 2016, or 10%, due to an increase in enrolled pets in this segment.
Year ended December 31, 2017 compared to year ended December 31, 2016. Technology and development expenses increased $0.2 million, or 2%, to $9.8 million for the year ended December 31, 2017. This increase was primarily due to a $0.5 million increase in amortization expense related to projects placed into service in late 2016. This was offset by a $0.3 million decrease in infrastructure related costs compared to the same period in the prior year.
Year ended December 31, 2016 compared to year ended December 31, 2015. General and administrative expenses decreased $0.4 million, or 2%, to $15.2 million for the year ended December 31, 2016. This was primarily due to a decrease in personnel costs and related expenses of $0.6 million resulting from lower incentive compensation while headcount remained consistent. General and administrative expenses decreased from 11% to 8% as a percentage of revenue for the year ended December 31, 2016, as we experienced scale in our support functions.
Year ended December 31, 2017 compared to year ended December 31, 2016. Sales and marketing expense increased $3.9 million, or 25%, to $19.1 million for the year ended December 31, 2017. PAC increased 24% from December 31, 2016, to $152 for the year ended December 31, 2017, as a result of $1.8 million in additional testing of new marketing initiatives. Additionally, compensation and related expenses increased by $2.0 million due to a 21% increase in headcount in the year ended December 31, 2017.
Year ended December 31, 2017 compared to year ended December 31, 2016. Total other (income) expense, net improved by $0.9 million primarily due to a $1.0 million gain related to the sale of our equity method investment in the second quarter of 2017.
Year ended December 31, 2016 compared to year ended December 31, 2015. Total other (income) expense, net decreased $0.2 million primarily due to a $0.1 million decrease in interest expense resulting from a lower outstanding average loan balance.
The Tax Act makes additional significant changes to the Code, such as, (1) imposing a mandatory one-time tax on accumulated earnings of foreign subsidiaries and transitioning U.S. international taxation from a worldwide tax system to a territorial system with base erosion rules; (2) imposing changes on the utilization of net operating losses; (3) other general changes to the taxation of corporations, including changes to cost recovery rules, changes to the deductibility of interest expense, and elimination of the performance-based compensation exception for executive compensation; therefore, the overall impact of the Tax Act on our future results of operations is uncertain at this time. We intend to continue to reinvest all of our foreign earnings indefinitely outside of the U.S.
Year ended December 31, 2016 compared to year ended December 31, 2015. The effective tax rate remained consistent for the years ended December 31, 2016 and 2015 due to our full valuation allowance on our reported deferred tax assets.
As of December 31, 2017, we had $63.3 million of cash, cash equivalents, and short-term investments and $18.7 million available under our line of credit, which excludes $1.8 million reserved under the credit agreement for an outstanding letter of credit and other ancillary services. Most of the assets in APIC and WICL Segregated Account AX are subject to certain capital and dividend rules and regulations prescribed by jurisdictions in which they are authorized to operate. As of December 31, 2017, total assets and liabilities held outside of our insurance entities totaled $42.7 million and $20.4 million, respectively, including $19.2 million of cash and cash equivalents that are segregated from other operating funds and held in trust for the payment of veterinary invoices on behalf of our subsidiaries.
Cash provided by operating activities was $5.0 million for the year ended December 31, 2016 compared to cash used in operating activities of $10.4 million for the year ended December 31, 2015. The increase in cash provided by operating activities of $15.4 million was primarily due to the $10.1 million decrease in operating loss, driven by higher revenue and decreased operating expenses as a percentage of revenue as we increased scale in our technology and general and administrative departments. Additionally, we reduced spend as a percentage of revenue in our sales and marketing department.
Cash provided by financing activities was $5.1 million and $7.7 million for the years ended December 31, 2017 and 2016, respectively. The decrease of $2.6 million was primarily due to a decrease of $1.2 million in proceeds from exercises of stock options. We also paid an additional $0.5 million for tax withholding on restricted stock.
Our obligations under the PWB credit facility are secured by substantially all of our assets and a pledge of certain of our subsidiaries’ stock. As of December 31, 2017, we had $9.5 million in aggregate borrowings outstanding under the PWB credit facility.
(1) Consists of our revolving line of credit. Excludes interest of the greater of 4.5% or 1.25% plus the prime rate (5.75% at December 31, 2017).
Expected volatility -We estimate the expected volatility based on the historical volatility of a representative group of publicly traded companies with similar characteristics to us, and our own historical volatility;
Expected term for awards granted to employees -We have based our expected term for awards issued to employees on the simplified method, as permitted by the SEC Staff Accounting Bulletin No. 110, Share-Based Payment, as we have insufficient historical information regarding our stock options to provide a basis for an estimate;
Expected dividend yield-We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero.
Property and equipment primarily consists of internally-developed software related to the Company’s website, and internal support systems, capitalized during the application development stage of the project. Property and equipment is recorded at cost and depreciated using the straight-line method over the estimated useful life of the respective asset, estimated to be between three and five years, once the asset is placed into service.
Long-lived assets, including property and equipment, are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Should an impairment exist, the impairment loss would be measured as the amount the asset's carrying value exceeds its fair value. The Company has recognized no impairment loss on long-lived assets for the years ended December 31, 2017, 2016, and 2015.
Veterinary invoice expense includes the Company’s costs to review veterinary invoices, administer the payments, and provide member services, and other operating expenses directly or indirectly related to this process. The Company also accrues for veterinary invoices that have been incurred but not yet received. This also includes amounts paid by unaffiliated general agents, and an estimate of amounts incurred and not yet paid for the other business segment.
Other cost of revenue for the subscription business segment includes direct and indirect member service expenses, Territory Partner renewal fees, credit card transaction fees and premium tax expenses. Other cost of revenue for the other business segment includes the commissions the Company pays to unaffiliated general agents, costs to administer the programs in the other business segment and premium taxes on the sales in this segment.
Stock-based compensation expense for stock options, restricted stock awards, and restricted stock units is recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective award. The Company recognizes forfeitures when they occur.
The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than a 50% likelihood of being realized. Penalties and interest are classified as a component of income taxes.
Effective January 1, 2015, the Company formed a segregated account in Bermuda as part of Wyndham Insurance Company
Company (Omega) to include its newly formed segregated account. The Company maintains all risk with the business written
allows for dividends only to the extent that the entity remains solvent and the value of its assets remain greater than the
aggregate of its liabilities and its issued share capital and share premium accounts.
For the Company’s Canadian business, all plans are written by Omega General Insurance Company (Omega) and the risk is
terms of the related customer contracts. Revenue recognized from the agreement in 2017, 2016 and 2015 was $47.1 million,
$36.5 million and $30.9 million, respectively and deferred revenue relating to this arrangement at December 31, 2017, 2016 and 2015 was $1.8 million, $1.3 million and $0.9 million, respectively. Reinsurance revenue was 19%, 19% and 21% of total revenue in 2017, 2016 and 2015, respectively. Cash designated for the purpose of paying claims related to this reinsurance agreement was $2.8 million, $2.1 million and $2.0 million at December 31, 2017, 2016 and 2015 respectively. In addition, as required by the Office of the Superintendent of Financial institutions regulations related to the Company’s reinsurance agreement with Omega, the Company is required to fund a Canadian Trust account with the greater of CAD $2.0 million or 115% of unearned Canadian premium plus 15% of outstanding Canadian claims, including all incurred but not reported claims. As of December 31, 2017, the account balance was $2.2 million and the Company was in compliance with all requirements.
In March 2016, the FASB issued an ASU amending the accounting for employee share-based payments, including income tax recognition and classification. The Company adopted this ASU as of January 1, 2017. As a result, the Company has elected to use actual forfeitures in the estimate of stock-based compensation expense. Additionally, the guidance related to the accounting for excess tax benefits and deficiencies resulted in an initial adjustment as of January 1, 2017 to the Company's net operating loss deferred tax asset to eliminate the Company's existing windfall pool amounting to $4.3 million, which was offset by an adjustment to the Company's valuation allowance. Finally, tax withholding of shares will be allowed up to the employee's maximum individual tax rate in the relevant jurisdiction without resulting in liability classification of the award, subject to the Company's internal policies for making this election.
In February 2016, the FASB issued an ASU amending the lease presentation guidance. The ASU requires organizations that lease assets to recognize the rights and obligations created by those leases on the consolidated balance sheets. This ASU is effective for fiscal years beginning after December 15, 2018 including interim periods within that reporting period, with early adoption permitted. The Company has determined this guidance will require recognition of a lease liability and corresponding asset on the consolidated balance sheets equal to the present value of minimum lease payments. The carrying amount of the asset is derived from the amount of the lease liability at the end of each reporting period. The Company plans to adopt this guidance as of January 1, 2019, and is in the process of evaluating the impact on its consolidated financial statements.
The Company acquired an insurance company in 2007, which originally included licenses in 23 states. These licenses were valued at $4.8 million. The Company is currently licensed in all 50 states, the District of Columbia and Puerto Rico. Most licenses are renewed annually upon payment of various fees assessed by the issuing state. Renewal costs are expensed as incurred. This is considered an indefinite-lived intangible asset given the planned renewal of the certificates of authority and applicable licenses for the foreseeable future. No impairments have been recorded on this asset as of December 31, 2017.
The amortized cost, gross unrealized holding gains and losses, and fair value of available-for-sale and short-term investments by major security type and class of security were as follows as of December 31, 2017 and 2016 (in thousands):
The following table summarizes, by major security type, the Company's assets that are measured at fair value on a recurring basis, and placement within the fair value hierarchy (in thousands):
As of December 31, 2017, the Company's other long-term assets balance included a $2.5 million note receivable, recorded at its estimated collectible amount. The Company estimates that the carrying value of the note receivable approximates the fair value. The estimated fair value represents a Level 3 measurement within the fair value hierarchy, and is based on market interest rates and the assessed creditworthiness of the third party.
The following summarizes the Company's contractual commitments as of December 31, 2017 (in thousands):
(1) Consists of a revolving line of credit. Excludes interest of the greater of 4.5% or 1.25% plus the prime rate (5.75% as of December 31, 2017).
(2) Consists of contractual obligations from non-cancellable office space under operating lease.
(3) Consists of contractual obligations from property and equipment purchased under capital lease.
During the third quarter of 2015, the Company entered into a lease agreement for a building located in Seattle, Washington. The initial 10-year term of the lease commenced in the third quarter of 2016. Minimum rent payments under operating leases are recognized on a straight-line basis over the term of the lease. Rental expense for operating leases was $1.8 million, $1.2 million and $1.0 million for the years ended December 31, 2017, 2016 and 2015, respectively.
The Company's reserve for the subscription business segment increased $2.6 million from $8.5 million at December 31, 2016 to $11.1 million at December 31, 2017. This change was comprised of $155.6 million in expense recorded during the period less $152.6 million in payments of veterinary invoices. This $155.6 million in veterinary invoice expense incurred includes a reduction of $0.1 million to the reserves relating to prior years, which is the result of ongoing analysis of recent payment trends. The Company's adjustments to increase prior year reserves were $0.8 million and less than $0.1 million as a result of analysis of payment trends in the years ended December 31, 2016 and 2015, respectively.
Summarized below are the changes in total liability for the Company's other business segment (in thousands):
The Company’s reserve for the other business segment increased $0.7 million from $1.0 million at December 31, 2016 to $1.7 million at December 31, 2017. This change was comprised of $14.6 million in expense recorded during the period less $13.9 million in payments of veterinary invoices. This $14.6 million in veterinary invoice expense incurred includes a reduction of $0.2 million to the reserves relating to prior years, which is the result of ongoing analysis of recent payment trends. The Company's adjustments to decrease prior year reserves were $0.1 million as a result of analysis of payment trends in each of the years ended December 31, 2016 and 2015.
Borrowings on the revolving line of credit were limited to the lesser of $30.0 million and the total amount of cash and securities held by the Company's insurance subsidiaries (American Pet Insurance Company and Wyndham Insurance Company (SAC) Limited Segregated Account AX) as of December 31, 2017 and 2016. As of December 31, 2017, available borrowing capacity on the line of credit was $18.7 million, with an outstanding balance of $1.8 million for ancillary services and letters of credit, and borrowings under the facility of $9.5 million, recorded net of financing fees of $0.2 million.
Stock-based compensation expense includes stock options, restricted stock awards, and restricted stock units granted to employees and non-employees and has been reported in the Company’s consolidated statements of operations depending on the function performed by the employee or non-employee. Stock-based compensation expense recognized in each category of the consolidated statement of operations for the years ended December 31, 2017, 2016 and 2015 was as follows (in thousands):
The grant date fair value of stock option awards are estimated on the date of grant using the Black-Scholes option-pricing model. Valuation assumptions for the years ended December 31, 2017, 2016 and 2015 are presented in the following table:
As of December 31, 2017, the Company had 100,000,000 shares of common stock authorized and 30,121,496 shares of common stock outstanding. Holders of common stock are entitled to one vote on each matter properly submitted to the stockholders of the Company except those related to matters concerning possible outstanding preferred stock. At December 31, 2017, the Company had 10,000,000 shares of undesignated shares of preferred stock authorized for future issuance and did not have any outstanding shares of preferred stock. The holders of common stock are also entitled to receive dividends as and when declared by the board of directors of the Company, whenever funds are legally available. These rights are subordinate to the dividend rights of holders of all classes of stock outstanding at the time. The Company is unable to pay dividends to stockholders as of December 31, 2017 due to restrictions in its credit agreements.
At December 31, 2017 and 2016, warrants to purchase 810,000 shares of the Company's common stock at $10.00 per share remained outstanding. The warrants expire in 2018 and 2019.
Substantially all of the Company’s long-lived assets were located in the United States as of December 31, 2017 and 2016.
Loss before income taxes was as follows for the years ended December 31, 2017, 2016 and 2015 (in thousands):
On December 22, 2017, Staff Accounting Bulletin No. 118 ("SAB 118") was issued to address the application of US GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. In accordance with SAB 118, the Company has determined that the $0.6 million income tax benefit recorded in connection with the remeasurement of its deferred tax liabilities was a provisional amount and a reasonable estimate as of December 31, 2017. Any necessary subsequent adjustments will be recorded in 2018.
(1) The Company recorded a tax benefit as of December 31, 2017, as a result of the Tax Act. See "Note 15" for additional information regarding this tax benefit.
(2) The Company sold an equity method investment during the second quarter of 2017. See "Note 1" for additional information regarding the sale.