Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, should be read in conjunction with our consolidated financial statements and notes thereto that appear elsewhere in this annual report on Form 10-K. See “Risk Factors” elsewhere in this annual report on Form 10-K for a discussion of certain risks associated with our business. The following discussion contains forward-looking statements. The forward-looking statements do not include the potential impact of any mergers, acquisitions, divestitures or other events that may be announced after the date hereof.

Overview

We provide solutions for securing, delivering and optimizing content and business applications over the Internet. The key factors that influence our financial success are our ability to build on recurring revenue commitments for our security and performance offerings, increase media traffic on our network, effectively managing the prices we charge for our solutions, develop new products and carefully manage our capital spending and other expenses.

Revenue

For most of our solutions, our customers commit to contracts having terms of a year or longer, which allows us to have a consistent and predictable base level of revenue. In addition to a base level of revenue, we are also dependent on media customers where usage of our solutions is more variable. As a result, our revenue is impacted by the amount of media and software download traffic we serve on our network, the rate of adoption of gaming, social media and video platform offerings, the timing and variability of customer-specific one-time events and the impact of seasonal variations on our business. The ability to expand our product portfolio and to effectively manage the prices we charge for our solutions are also key factors impacting our revenue growth.

We have observed the following trends related to our revenue in recent years:

•	Increased sales of our security solutions have made a significant contribution to revenue growth. We plan to continue to invest in this area with a focus on further enhancing our product portfolio and extending our go-to-market capabilities.

•	We have experienced increases in the amount of traffic delivered for customers that use our solutions for video, gaming and software downloads, contributing to an increase in our revenue in 2019 as compared to 2018.

•

We have increased committed recurring revenue from our solutions by increasing sales of incremental solutions to our existing customers and adding new customers; however, we have also experienced slower revenue growth in recent quarters particularly in our web performance solutions. We expect the trend of slower revenue growth to continue in 2020 as our commerce customers continue to experience financial pressure and we face more contract renewals with large media and other customers in 2020 as compared to 2019.

•	The prices paid by some of our customers have declined, particularly in the context of contract renewals and large media consolidations, reflecting the impact of competition and volume discounts. Our revenue would have been higher absent these price declines.

•	In recent years, revenue from our international operations has been growing at a faster pace than from our U.S. operations, particularly in terms of new customer acquisition and cross-selling of incremental solutions. Because we publicly report in U.S. dollars, if the dollar continues to strengthen, our reported revenue results will be negatively impacted.

•

We have experienced variations in certain types of revenue from quarter to quarter. In particular, we typically experience higher revenue in the fourth quarter of each year for some of our solutions as a result of holiday season activity. In addition, we experience quarterly variations in revenue attributable to, among other things, the nature and timing of software and gaming releases by our customers; whether there are large live sporting or other events that increase the amount of media traffic on our network; and the frequency and timing of purchases of custom solutions.

Expenses

Our level of profitability is also impacted by our expenses, including direct costs to support our revenue such as bandwidth and co-location costs. We have observed the following trends related to our profitability in recent years:

•

Our profitability improved in 2019 as compared to 2018 due to higher revenue as well as the effects of cost savings and efficiency initiatives we have undertaken. We expect to continue to undertake efforts intended to improve the efficiency of operations. If we are able to continue our efficiency efforts such that our rate of revenue growth exceeds our expense growth rate, we anticipate overall profitability improvement in 2020 as compared to 2019.

•

Network bandwidth costs represent a significant portion of our cost of revenue. Historically, we have been able to mitigate increases in these costs by reducing our network bandwidth costs per unit and investing in internal-use software development to improve the performance and efficiency of our network. Our total bandwidth costs may increase in the future as a result of expected higher traffic levels and serving more traffic from higher cost regions. We will need to continue to effectively manage our bandwidth costs to maintain current levels of profitability.

•

Co-location costs are also a significant portion of our cost of revenue. By improving our internal-use software and managing our hardware deployments to enable us to use servers more efficiently, we have been able to manage the growth of co-location costs. We expect to continue to scale our network in the future and will need to continue to effectively manage our co-location costs to maintain current levels of profitability.

•

Payroll and related costs stabilized in 2019 as compared to prior years. We expect to continue to manage our headcount and payroll costs in the future to focus investments on certain areas of the business while maintaining efficient operations in others. We expect to continue to hire employees in support of our strategic initiatives, but do not expect overall headcount to increase significantly in 2020.

•

Depreciation and amortization expense related to our network equipment decreased during 2019 as compared to 2018. We implemented software and hardware initiatives to manage our global network more efficiently; as a result, the expected average useful life of our network assets, primarily servers, increased from four years to five years, effective January 1, 2019. We expect to continue to invest in our network in 2020, which will increase our capital expenditures and resulting depreciation expense.

We report our revenue in two divisions: the Web Division and the Media and Carrier Division. Revenue by division is a customer-focused reporting view that reflects revenue from customers that are managed by the division. As the purchasing patterns and required account expertise of customers change over time, we may reassign a customer from one division to another. In 2019, we reassigned some of our customers from the Media and Carrier Division to the Web Division and revised historical results in order to reflect the most recent categorization and to provide a comparable view for all periods presented.

Results of Operations

The following sets forth, as a percentage of revenue, consolidated statements of income data for the years indicated:

	2019			2018			2017
Revenue	100.0	%		100.0	%		100.0	%
Costs and operating expenses:
Cost of revenue (exclusive of amortization of acquired intangible assets shown below)	34.1			35.1			35.2
Research and development	9.0			9.1			8.9
Sales and marketing	18.1			19.1			19.3
General and administrative	17.8			21.1			20.5
Amortization of acquired intangible assets	1.3			1.2			1.2
Restructuring charge	0.6			1.0			2.2
Total costs and operating expenses	80.9			86.6			87.3
Income from operations	19.1			13.4			12.7
Interest income	1.2			1.0			0.7
Interest expense	(1.7	)		(1.6	)		(0.8	)
Other (expense) income, net	—			(0.1	)		—
Income before provision for income taxes	18.6			12.7			12.6
Provision for income taxes	(1.8	)		(1.6	)		(3.7	)
Loss from equity method investment	—			—			—
Net income	16.8	%		11.1	%		8.9	%

Revenue

Revenue during the periods presented is as follows (in thousands):

	For the Years Ended December 31,														For the Years Ended December 31,
	2019				2018				% Change			% Change at Constant Currency			2018				2017				% Change			% Change at Constant Currency
Web Division	$	1,566,401			$	1,448,644			8.1	%		9.4	%		$	1,448,644			$	1,307,641			10.8	%		10.3	%
Media and Carrier Division	1,327,216				1,265,830				4.8			6.1			1,265,830				1,181,394				7.2			6.7
Total revenue	$	2,893,617			$	2,714,474			6.6	%		7.8	%		$	2,714,474			$	2,489,035			9.1	%		8.6	%

The increase in our revenue in 2019 as compared to 2018 was primarily the result of higher media traffic volumes, including from our large Internet platform customers, and continued strong growth in sales of our Cloud Security Solutions. Cloud Security Solutions revenue for the year ended December 31, 2019 was $848.7 million, compared to $658.7 million for the year ended December 31, 2018, which represents a 28.8% increase. The increase in our revenue in 2018 as compared to 2017 was primarily the result of higher media traffic volumes, increased sales of our new product offerings and continued strong growth in our Cloud Security Solutions. Cloud Security Solutions revenue for the year ended December 31, 2018 was $658.7 million, compared to $487.6 million for the year ended December 31, 2017, which represents a 35.1% increase.

The increase in Web Division revenue for 2019 as compared to 2018 was primarily the result of increased sales of both new and existing Cloud Security Solutions to this customer base. The increase in Web Division revenue in 2018 as compared to 2017 was due to increased purchases of new solutions and upgrades to existing services by this customer base. Increased sales of our Cloud Security Solutions to Web Division customers, in particular our Kona Site Defender, Prolexic and managed security solutions, as well as our new Bot Manager offering were a principal contributor to our overall revenue growth in 2018.

The increase in Media and Carrier Division revenue for 2019 as compared to 2018, as well as 2018 as compared to 2017, was primarily the result of increased customer traffic volumes from video delivery and gaming customers and sales of Cloud Security Solutions to this customer base.

Revenue derived in the U.S. and internationally during the periods presented is as follows (in thousands):

	For the Years Ended December 31,														For the Years Ended December 31,
	2019				2018				% Change			% Change at Constant Currency			2018				2017				% Change			% Change at Constant Currency
U.S.	$	1,694,211			$	1,683,272			0.6	%		0.6	%		$	1,683,272			$	1,637,198			2.8	%		2.8	%
International	1,199,406				1,031,202				16.3			19.6			1,031,202				851,837				21.1			19.7
Total revenue	$	2,893,617			$	2,714,474			6.6	%		7.8	%		$	2,714,474			$	2,489,035			9.1	%		8.6	%

The U.S. growth rate for 2019 was negatively impacted by a reduction in prices paid by some of our customers, partially offset by an increase in revenue from our large Internet platform customers, as these customers are based in the U.S. For the year ended December 31, 2019, approximately 41% of our revenue was derived from our operations located outside of the U.S., compared to 38% for the year ended December 31, 2018, and 34% for the year ended December 31, 2017. No single country outside of the U.S. accounted for 10% or more of revenue during any of these periods.

Internationally, during 2019 and 2018, we continued to see strong revenue growth from our operations in the Asia-Pacific region. Changes in foreign currency exchange rates negatively impacted our revenue by $33.9 million in 2019 as compared to 2018, and positively impacted our revenue by $11.2 million in 2018 as compared to 2017.

Cost of Revenue

Cost of revenue consisted of the following for the periods presented (in thousands):

	For the Years Ended December 31,											For the Years Ended December 31,
	2019				2018				% Change			2018				2017				% Change
Bandwidth fees	$	165,335			$	154,853			6.8	%		$	154,853			$	168,092			(7.9	)%
Co-location fees	127,024				128,082				(0.8	)		128,082				130,181				(1.6	)
Network build-out and supporting services	101,135				88,543				14.2			88,543				75,209				17.7
Payroll and related costs	248,146				238,920				3.9			238,920				216,760				10.2
Stock-based compensation, including amortization of prior capitalized amounts	51,607				45,765				12.8			45,765				36,677				24.8
Depreciation of network equipment	125,589				150,458				(16.5	)		150,458				143,825				4.6
Amortization of internal-use software	168,788				146,864				14.9			146,864				105,093				39.7
Total cost of revenue	$	987,624			$	953,485			3.6	%		$	953,485			$	875,837			8.9	%
As a percentage of revenue	34.1		%		35.1		%					35.1		%		35.2		%

The increase in total cost of revenue for 2019 as compared to 2018 was primarily due to increases in:

•	amortization of internal-use software as we continued to release internally-developed software onto our network related to new product launches and significant enhancements to our existing services;

•	network build-out and supporting service costs due to investments in network expansion;

•	bandwidth fees to support the increase in traffic served on our network; and

•	payroll and related costs due to increased hiring to support revenue growth.

These increases were partially offset by lower depreciation expense of network equipment of $31.5 million for the year ended December 31, 2019, due to software and hardware initiatives we implemented to manage our global network more efficiently, resulting in an increase in the expected average useful life of our network assets, primarily servers, from four to five years effective January 1, 2019.

The increase in total cost of revenue for 2018 as compared to 2017 was primarily due to increases in amortization of internal-use software as we continued to release internally-developed software onto our network related to new product launches and significant enhancements to our existing services throughout 2017 and 2018; payroll and related costs, as well as stock-based compensation, due to increased hiring in our services team in 2017 to support revenue growth; and amounts paid for network build-out and supporting services related to installation fees and investments in our network. These increases were partially offset by decreases in our bandwidth and co-location fees as we have been able to more effectively manage our network and reduce our costs.

During 2020, we plan to continue to focus our efforts on expanding our operating margins, including continuing to manage our bandwidth and co-location costs. We do anticipate amortization of internal-use software development costs to increase in 2020 as we plan to continue making investments in our network with the expectation that our customer base will continue to expand and that we will continue to deliver more traffic to existing customers.

Research and Development Expenses

Research and development expenses consisted of the following for the periods presented (in thousands):

	For the Years Ended December 31,											For the Years Ended December 31,
	2019				2018				% Change			2018				2017				% Change
Payroll and related costs	$	382,084			$	365,713			4.5	%		$	365,713			$	322,604			13.4	%
Stock-based compensation	49,685				44,034				12.8			44,034				38,863				13.3
Capitalized salaries and related costs	(183,282		)		(174,373		)		5.1			(174,373		)		(148,998		)		17.0
Other expenses	12,878				10,791				19.3			10,791				9,965				8.3
Total research and development	$	261,365			$	246,165			6.2	%		$	246,165			$	222,434			10.7	%
As a percentage of revenue	9.0		%		9.1		%					9.1		%		8.9		%

The increases in research and development expenses for 2019 as compared to 2018, as well as 2018 as compared to 2017, were due to increases in payroll and related costs, including stock-based compensation, as a result of headcount growth to support investments in new product development and network scaling, and as a result of employees joining us through acquisitions. These increases were partially offset by increases in capitalized salaries and related costs due to continued investment in internal-use software deployed on our network.

Research and development costs are expensed as incurred, other than certain internal-use software development costs eligible for capitalization. Capitalized development costs consist of payroll and related costs for personnel and external consulting expenses involved in the development of internal-use software used to deliver our services and operate our network. For the years ended December 31, 2019, 2018 and 2017, we capitalized $33.7 million, $31.9 million and $26.8 million, respectively, of stock-based compensation. These capitalized internal-use software development costs are amortized to cost of revenue over their estimated useful lives, which is generally two years, but can be up to seven years based on the software developed and its expected useful life.

We expect research and development costs to increase in 2020 as we maintain our focus on innovation; however, we do not expect these costs to increase as a percentage of revenue.

Sales and Marketing Expenses

Sales and marketing expenses consisted of the following for the periods presented (in thousands):

	For the Years Ended December 31,											For the Years Ended December 31,
	2019				2018				% Change			2018				2017				% Change
Payroll and related costs	$	382,570			$	388,320			(1.5	)%		$	388,320			$	342,719			13.3	%
Stock-based compensation	62,149				64,372				(3.5	)		64,372				60,247				6.8
Marketing programs and related costs	52,787				41,796				26.3			41,796				48,551				(13.9	)
Other expenses	26,377				22,865				15.4			22,865				30,005				(23.8	)
Total sales and marketing	$	523,883			$	517,353			1.3	%		$	517,353			$	481,522			7.4	%
As a percentage of revenue	18.1		%		19.1		%					19.1		%		19.3		%

The increase in sales and marketing expenses for 2019 as compared to 2018 was primarily due to increased spending for marketing programs and other expenses primarily for a customer conference that took place during 2019 that did not take place in 2018, partially offset by a decrease in payroll and related costs and stock-based compensation due to reduced headcount in the marketing organization. The increase in sales and marketing expenses for 2018 as compared to 2017 was primarily due to growth in payroll and related costs from headcount increases in 2017 to support our divisions' go-to-market strategies in pursuit of growth opportunities.

During 2020 we do not expect significant increases in sales and marketing expenses as we plan to continue to carefully manage costs in an our efforts to refine and optimize our go-to-market efforts and improve operating margins.

General and Administrative Expenses

General and administrative expenses consisted of the following for the periods presented (in thousands):

	For the Years Ended December 31,											For the Years Ended December 31,
	2019				2018				% Change			2018				2017				% Change
Payroll and related costs	$	194,232			$	188,635			3.0	%		$	188,635			$	194,199			(2.9	)%
Stock-based compensation	52,826				53,514				(1.3	)		53,514				44,884				19.2
Depreciation and amortization	78,587				80,014				(1.8	)		80,014				76,128				5.1
Facilities-related costs	90,674				86,107				5.3			86,107				80,452				7.0
Provision for doubtful accounts	1,924				2,672				(28.0	)		2,672				3,209				(16.7	)
Acquisition-related costs	1,920				2,868				(33.1	)		2,868				23,373				(87.7	)
License of patent	(8,855		)		(17,146		)		(48.4	)		(17,146		)		(16,421		)		4.4
Legal and stockholder matter costs	10,000				23,091				(56.7	)		23,091				—				100.0
Endowment of Akamai Foundation	—				50,000				(100.0	)		50,000				—				100.0
Professional fees and other expenses	94,785				104,312				(9.1	)		104,312				103,341				0.9
Total general and administrative	$	516,093			$	574,067			(10.1	)%		$	574,067			$	509,165			12.7	%
As a percentage of revenue	17.8		%		21.1		%					21.1		%		20.5		%

The decrease in general and administrative expenses for 2019 as compared to 2018 was primarily due to:

•	a one-time endowment contribution to the Akamai Foundation in 2018;

•	a reduction in legal and stockholder matter costs related to matters in 2018 that did not recur in 2019; and

•	and a decrease in other expenses due to a decrease in non-income tax reserves.

These decreases were partially offset by cessation of payments to us under the terms of a litigation settlement agreement with Limelight Networks, Inc., or Limelight.

Our general and administrative expenses increased in 2018 as compared to 2017 primarily due to the one-time endowment contribution to the Akamai Foundation, legal and stockholder matter costs related to a settlement charge from our litigation with Limelight, amounts paid to professional service providers for advisory services provided in connection with a non-routine stockholder matter and higher stock-based compensation expense, primarily due to performance-based awards that experienced higher achievement in 2018 as compared to 2017.

General and administrative expenses for 2019 and 2018 are broken out by category as follows (in thousands):

		For the Years Ended December 31,											For the Years Ended December 31,
		2019				2018				% Change			2018				2017				% Change
Global functions		$198,077				$	197,377			0.4	%		$	197,377			$	201,539			(2.1	)%
As a percentage of revenue		6.8		%		7.3		%					7.3		%		8.1		%
Infrastructure		307,500				308,915				(0.5	)		308,915				297,465				3.8
As a percentage of revenue		10.6		%		11.4		%					11.4		%		12.0		%
Other		10,516				67,775				(84.5	)		67,775				10,161				567.0
Total general and administrative expenses		$	516,093			$	574,067			(10.1	)%		$	574,067			$	509,165			12.7	%
As a percentage of revenue		17.8		%		21.1		%					21.1		%		20.5		%

Global functions expense includes payroll, stock-based compensation and other employee-related costs for administrative functions, including finance, purchasing, order entry, human resources, legal, information technology and executive personnel, as well as third-party professional service fees. Infrastructure expense includes payroll, stock-based compensation and other employee-related costs for our network infrastructure functions, as well as facility rent expense, depreciation and amortization of facility and IT-related assets, software and software-related costs, business insurance and taxes. Our network infrastructure function is responsible for network planning, sourcing, architecture evaluation and platform security. Other expense includes acquisition-related costs, provision for doubtful accounts, legal settlements, non-routine stockholder matter costs, the endowment of the Akamai Foundation, transformation costs and the licensing of a patent.

During 2020, we plan to continue to focus our efforts on expanding our operating margins and, in particular, assessing opportunities to reduce third-party spending and increase automation of manual tasks.

Amortization of Acquired Intangible Assets

	For the Years Ended December 31,											For the Years Ended December 31,
(in thousands)	2019				2018				% Change			2018				2017				% Change
Amortization of acquired intangible assets	$	38,581			$	33,311			15.8	%		$	33,311			$	30,904			7.8	%
As a percentage of revenue	1.3		%		1.2		%					1.2		%		1.2		%

The increase in amortization of acquired intangible assets in 2019 as compared to 2018, as well as 2018 as compared to 2017, was the result of amortization of assets related to our recent acquisitions.

Based on acquired intangible assets as of December 31, 2019, future amortization is expected to be approximately $41.0 million, $36.2 million, $31.0 million, $23.9 million and $16.6 million for the years ending December 31, 2020, 2021, 2022, 2023 and 2024, respectively.

Restructuring Charge

	For the Years Ended December 31,											For the Years Ended December 31,
(in thousands)	2019				2018				% Change			2018				2017				% Change
Restructuring charge	$	17,153			$	27,594			(37.8	)%		$	27,594			$	54,884			(49.7	)%
As a percentage of revenue	0.6		%		1.0		%					1.0		%		2.2		%

The restructuring charge in 2019 was primarily the result of management actions to focus on investments with the potential to accelerate revenue growth. The restructuring charge relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action.

The restructuring charge in 2018 was primarily the result of management actions intended to re-balance investments to focus on long-term growth and scale. The restructuring charge relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action.

The restructuring charge in 2017 was primarily the result of management actions intended to shift focus to more critical areas of the business and away from products that have not seen expected commercial success. The restructuring was also intended to facilitate cost efficiencies and savings. The restructuring charge relates to certain headcount and facility reductions and certain capitalized internal-use software charges for software not yet placed into service that will not be completed and implemented due to this action.

In addition to the actions described above, we have also recognized restructuring charges for redundant employees, facilities and contracts associated with completed acquisitions.

We expect to incur additional restructuring charges of $4.0 million to $7.0 million in 2020 as a result of the action committed to in the fourth quarter of 2019.

Non-Operating Income (Expense)

	For the Years Ended December 31,											For the Years Ended December 31,
(in thousands)	2019				2018				% Change			2018				2017				% Change
Interest income	$	34,355			$	26,940			27.5	%		$	26,940			$	17,855			50.9	%
As a percentage of revenue	1.2		%		1.0		%					1.0		%		0.7		%
Interest expense	$	(49,364	)		$	(43,202	)		14.3	%		$	(43,202	)		$	(18,839	)		129.3	%
As a percentage of revenue	(1.7		)%		(1.6		)%					(1.6		)%		(0.8		)%
Other (expense) income, net	$	(1,428	)		$	(3,148	)		(54.6	)%		$	(3,148	)		$	887			(454.9	)%
As a percentage of revenue	—		%		(0.1		)%					(0.1		)%		—		%

For the periods presented, interest income primarily consists of interest earned on invested cash balances and marketable securities. The increase to interest income in 2019 as compared to 2018 was primarily the result of increased cash, cash equivalents and marketable securities balances as a result of our August 2019 issuance of $1,150.0 million in par value of convertible senior notes due 2027. The increase to interest income in 2018 as compared to 2017 was primarily the result of increased cash, cash equivalents and marketable securities balances as a result of our May 2018 issuance of $1,150.0 million in par value of convertible senior notes due 2025.

Interest expense is related to our debt transactions, which are described in Note 11 to the consolidated financial statements included elsewhere in this annual report on Form 10-K. The increase to interest expense for 2019 as compared to 2018 was primarily due to the August 2019 issuance of $1,150.0 million in par value of convertible senior notes due 2027, which bear regular interest of 0.375%, but have an effective interest rate of 3.1% due to the conversion feature. The increase to interest expense for 2018 as compared to 2017 was primarily due to the May 2018 issuance of $1,150.0 million in par value of convertible senior notes due 2025, which bear regular interest of 0.125%, but have an effective interest rate of 4.26% due to the conversion feature.

Other (expense) income, net for the years ended December 31, 2019, 2018 and 2017 primarily represents net foreign exchange gains and losses mainly due to foreign currency exchange rate fluctuations on intercompany and other non-functional currency transactions. Other (expense) income, net may fluctuate in the future based on changes in foreign currency exchange rates or other events. Other (expense) income, net also includes gains and losses from certain equity investments.

Provision for Income Taxes

	For the Years Ended December 31,											For the Years Ended December 31,
(in thousands)	2019				2018				% Change			2018				2017				% Change
Provision for income taxes	$	53,350			$	44,716			19.3	%		$	44,716			$	91,426			(51.1	)%
As a percentage of revenue	1.8		%		1.6		%					1.6		%		3.7		%
Effective income tax rate	10.0		%		13.0		%					13.0		%		29.1		%

The increase in the provision for income taxes for 2019 as compared to 2018 was mainly due to an increase in profit before taxes and an increase in the valuation allowance recorded against deferred tax assets related to state credits. These amounts were partially offset by the composition of income from foreign jurisdictions that is taxed at lower rates and the release of certain tax reserves related to the expiration of local statutes of limitations.

The decrease in the provision for income taxes for 2018 as compared to 2017 was mainly due to the reduction in the U.S. federal statutory tax rate from 35.0% to 21.0% as part of the U.S. Tax Cuts and Jobs Act, or TCJA, that was enacted in December 2017, an increase in the excess tax benefit related to stock-based compensation and the net impact of the TCJA recorded in 2017. These amounts were partially offset by an intercompany sale of intellectual property and an increase in non-deductible executive compensation.

For the year ended December 31, 2019, our effective income tax rate was lower than the federal statutory tax rate due to the release of certain tax reserves related to the expiration of local statutes of limitations, foreign income taxed at lower rates, the excess tax benefit related to stock-based compensation and the benefit of the U.S. federal, state and foreign research and development credits. These amounts were partially offset by the valuation allowance recorded against deferred tax assets related to state tax credits, non-deductible executive compensation, an intercompany sale of intellectual property and state income taxes.

For the year ended December 31, 2018, our effective income tax rate was lower than the federal statutory tax rate due to foreign income taxed at lower rates, the excess tax benefit related to stock-based compensation, a decrease in the provisional amount of the one-time transition tax that was recorded in 2017, the release of certain tax reserves related to the expiration of local statutes of limitations and the benefit of U.S. federal, state and foreign research and development credits. These amounts were partially offset by an intercompany sale of intellectual property and state income taxes.

For the year ended December 31, 2017, our effective income tax rate was lower than the federal statutory tax rate due to foreign income taxed at lower rates, the re-measurement of deferred taxes at lower tax rates expected to be in place upon realization due to the TCJA, which was enacted in December 2017, the impact of the release of the acquisition-related reserve due to the expiration of the local statute of limitations and the benefit of U.S. federal, state and foreign research and development credits. These amounts were partially offset by a provisional charge for the one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings taken as part of the TCJA, the effects of stock-based compensation in accordance with authoritative guidance for share-based payments and state income taxes.

Our effective income tax rate may fluctuate between fiscal years and from quarter to quarter due to items arising from discrete events, such as tax benefits from the disposition of employee equity awards, tax law changes and settlements of tax audits and assessments. Our effective income tax rate is also impacted by, and may fluctuate in any given period because of, the composition of income in foreign jurisdictions where tax rates differ depending on the local statutory rates.

Refer to Note 19 to the consolidated financial statements included elsewhere in this annual report on Form 10-K for additional information regarding unrecognized tax benefits that, if recognized, would impact the effective income tax rate in the next 12 months and the potential impact that current litigation related to an adverse audit finding could have on our results of operations.

Loss from Equity Method Investment

	For the Years Ended December 31,											For the Years Ended December 31,
(in thousands)	2019				2018				% Change			2018				2017				% Change
Loss from equity method investment	$	1,096			$	—			100.0	%		$	—			$	—			—	%
As a percentage of revenue	—		%		—		%					—		%		—		%

During 2019, we started recognizing our share of earnings from our previously announced investment with Mitsubishi UFJ Financial Group, or MUFG. Our investment with MUFG established a joint venture, GO-NET, to offer a new blockchain-based online payment network. We recorded a loss of $1.1 million dollars which reflects our share of the losses incurred by GO-NET. We expect to record additional losses in 2020 and beyond as GO-NET continues executing on the early stages of its business plan.

Non-GAAP Financial Measures

In addition to providing financial measurements based on generally accepted accounting principles in the United States of America, or GAAP, we provide additional financial metrics that are not prepared in accordance with GAAP, or non-GAAP financial measures. Management uses non-GAAP financial measures, in addition to GAAP financial measures, to understand and compare operating results across accounting periods, for financial and operational decision making, for planning and forecasting purposes, to measure executive compensation and to evaluate our financial performance. These non-GAAP financial measures are non-GAAP income from operations, non-GAAP operating margin, non-GAAP net income, non-GAAP net income per share, Adjusted EBITDA, Adjusted EBITDA margin, capital expenditures and impact of foreign currency exchange rates, as discussed below.

Management believes that these non-GAAP financial measures reflect our ongoing business in a manner that allows for meaningful comparisons and analysis of trends in the business, as they facilitate comparing financial results across accounting periods and to those of peer companies. Management also believes that these non-GAAP financial measures enable investors to evaluate our operating results and future prospects in the same manner as management. These non-GAAP financial measures may exclude expenses and gains that may be unusual in nature, infrequent or not reflective of our ongoing operating results.

The non-GAAP financial measures do not replace the presentation of our GAAP financial measures and should only be used as a supplement to, not as a substitute for, our financial results presented in accordance with GAAP.

The non-GAAP adjustments, and our basis for excluding them from non-GAAP financial measures, are outlined below:

•

Amortization of acquired intangible assets – We have incurred amortization of intangible assets, included in our GAAP financial statements, related to various acquisitions we have made. The amount of an acquisition's purchase price allocated to intangible assets and term of its related amortization can vary significantly and are unique to each acquisition; therefore, we exclude amortization of acquired intangible assets from our non-GAAP financial measures to provide investors with a consistent basis for comparing pre- and post-acquisition operating results.

•

Stock-based compensation and amortization of capitalized stock-based compensation – Although stock-based compensation is an important aspect of the compensation paid to our employees, the grant date fair value varies based on the stock price at the time of grant, varying valuation methodologies, subjective assumptions and the variety of award types. This makes the comparison of our current financial results to previous and future periods difficult to interpret; therefore, we believe it is useful to exclude stock-based compensation and amortization of capitalized stock-based compensation from our non-GAAP financial measures in order to highlight the performance of our core business and to be consistent with the way many investors evaluate our performance and compare our operating results to peer companies.

•

Acquisition-related costs – Acquisition-related costs include transaction fees, advisory fees, due diligence costs and other direct costs associated with strategic activities. In addition, subsequent adjustments to our initial estimated amounts of contingent consideration and indemnification associated with specific acquisitions are included within acquisition-related costs. These amounts are impacted by the timing and size of the acquisitions. We exclude acquisition-related costs from our non-GAAP financial measures to provide a useful comparison of our operating results to prior periods and to our peer companies because such amounts vary significantly based on the magnitude of our acquisition transactions and do not reflect our core operations.

•

Restructuring charges – We have incurred restructuring charges that are included in our GAAP financial statements, primarily related to workforce reductions and estimated costs of exiting facility lease commitments. We exclude these items from our non-GAAP financial measures when evaluating our continuing business performance as such items vary significantly based on the magnitude of the restructuring action and do not reflect expected future operating expenses. In addition, these charges do not necessarily provide meaningful insight into the fundamentals of current or past operations of our business.

•

Amortization of debt discount and issuance costs and amortization of capitalized interest expense – In August 2019, we issued $1,150 million of convertible senior notes due 2027 with a coupon interest rate of 0.375%. In May 2018, we issued $1,150 million of convertible senior notes due 2025 with a coupon interest rate of 0.125%. In February 2014, we issued $690 million of convertible senior notes due 2019 with a coupon interest rate of 0%. The imputed interest rates of these convertible senior notes were 3.10%, 4.26% and 3.20%, respectively. This is a result of the debt discounts recorded for the conversion features that are required to be separately accounted for as equity under GAAP, thereby reducing the carrying values of the convertible debt instruments. The debt discounts are amortized as interest expense together with the issuance costs of the debt. The interest expense excluded from our non-GAAP results is comprised of these non-cash components and is excluded from management's assessment of our operating performance because management believes the non-cash expense is not representative of ongoing operating performance.

•	Gains and losses on investments – We have recorded gains and losses from the disposition, changes to fair value and impairment of certain investments. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events giving rise to them are not representative of our core business operations and ongoing operating performance.

•	Legal and stockholder matter costs – We have incurred losses related to the settlement of legal matters and costs from professional service providers related to a non-routine stockholder matter. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events giving rise to them are not representative of our core business operations.

•	Endowment of Akamai Foundation – During the second quarter of 2018, we incurred a charge to endow the Akamai Foundation. We believe excluding this amount from non-GAAP financial measures is useful to investors as this one-time event is not representative of our core business operations.

•

Transformation costs – We have incurred professional services fees associated with internal transformation programs designed to improve operating margins and that are part of a planned program intended to significantly change the manner in which business is conducted. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events and activities giving rise to them occur infrequently and are not representative of our core business operations and ongoing operating performance.

•	Income and losses from equity method investment – We record income or losses on our share of earnings and losses of our equity method investment. We exclude such income and losses because we lack control over the operations of the investment and the related income and losses are not representative of our core business operations.

•

Income tax effect of non-GAAP adjustments and certain discrete tax items – The non-GAAP adjustments described above are reported on a pre-tax basis. The income tax effect of non-GAAP adjustments is the difference between GAAP and non-GAAP income tax expense. Non-GAAP income tax expense is computed on non-GAAP pre-tax income (GAAP pre-tax income adjusted for non-GAAP adjustments) and excludes certain discrete tax items (such as recording or releasing of valuation allowances), if any. We believe that applying the non-GAAP adjustments and their related income tax effect allows us to highlight income attributable to our core operations.

The following table reconciles GAAP income from operations to non-GAAP income from operations and non-GAAP operating margin for the years ended December 31, 2019, 2018 and 2017 (in thousands):

	2019				2018				2017
Income from operations	$	548,918			$	362,499			314,289
Amortization of acquired intangible assets	38,581				33,311				30,904
Stock-based compensation	187,140				183,813				164,308
Amortization of capitalized stock-based compensation and capitalized interest expense	34,438				28,603				19,953
Restructuring charge	17,153				27,594				54,884
Acquisition-related costs	1,920				2,868				23,374
Legal and stockholder matter costs	10,000				23,091				—
Endowment of Akamai Foundation	—				50,000				—
Transformation costs	5,527				7,730				—
Non-GAAP income from operations	$	843,677			$	719,509			$	607,712
GAAP operating margin	19		%		13		%		13		%
Non-GAAP operating margin	29		%		27		%		24		%

The following table reconciles GAAP net income to non-GAAP net income for the years ended December 31, 2019, 2018 and 2017 (in thousands):

	2019				2018				2017
Net income	$	478,035			$	298,373			$	222,766
Amortization of acquired intangible assets	38,581				33,311				30,904
Stock-based compensation	187,140				183,813				164,308
Amortization of capitalized stock-based compensation and capitalized interest expense	34,438				28,603				19,953
Restructuring charge	17,153				27,594				54,884
Acquisition-related costs	1,920				2,868				23,374
Legal and stockholder matter costs	10,000				23,091				—
Endowment of Akamai Foundation	—				50,000				—
Transformation costs	5,527				7,730				—
Amortization of debt discount and issuance costs	45,857				41,958				18,839
Loss (gain) on investments	60				1,481				(450		)
Loss from equity method investment	1,096				—				—
Income tax effect of above non-GAAP adjustments and certain discrete tax items	(80,488		)		(86,391		)		(82,817		)
Non-GAAP net income	$	739,319			$	612,431			$	451,761

The following table reconciles GAAP net income per diluted share to non-GAAP net income per diluted share for the years ended December 31, 2019, 2018 and 2017 (shares in thousands):

	2019				2018				2017
GAAP net income per diluted share	$	2.90			$	1.76			$	1.29
Amortization of acquired intangible assets	0.23				0.20				0.18
Stock-based compensation	1.14				1.09				0.95
Amortization of capitalized stock-based compensation and capitalized interest expense	0.21				0.17				0.12
Restructuring charge	0.10				0.16				0.32
Acquisition-related costs	0.01				0.02				0.14
Legal and stockholder matter costs	0.06				0.14				—
Endowment of Akamai Foundation	—				0.30				—
Transformation costs	0.03				0.05				—
Amortization of debt discount and issuance costs	0.28				0.25				0.11
Loss (gain) on investments	—				0.01				—
Loss from equity method investment	0.01				—				—
Income tax effect of above non-GAAP adjustments and certain discrete tax items	(0.49		)		(0.51		)		(0.48		)
Non-GAAP net income per diluted share (1)	$	4.49			$	3.62			$	2.62
Shares used in per share calculations	164,573				169,188				172,711

(1) May not foot due to rounding

Non-GAAP net income per diluted share is calculated as non-GAAP net income divided by diluted weighted average common shares outstanding. GAAP diluted weighted average common shares outstanding are adjusted in non-GAAP per share calculations for the shares that would be delivered to us pursuant to the note hedge transactions entered into in connection with the issuance of our convertible senior notes. Under GAAP, shares delivered under hedge transactions are not considered offsetting shares in the fully-diluted share calculation until they are delivered. However, we would receive a benefit from the note hedge transactions and would not allow the dilution to occur, so management believes that adjusting for this benefit provides a meaningful view of net income per share. Unless and until our weighted average stock price is greater than $95.10, the initial conversion price of the convertible senior notes due 2025, or $116.18, the initial conversion price of the convertible senior notes due 2027, there will be no difference between our GAAP and non-GAAP diluted weighted average common shares outstanding.

We consider Adjusted EBITDA to be another important indicator of the operational strength and performance of our business and a good measure of our historical operating trends. Adjusted EBITDA eliminates items that we do not consider to be part of our core operations. We define Adjusted EBITDA as GAAP net income excluding the following items: interest income; income taxes; depreciation and amortization of tangible and intangible assets; stock-based compensation; amortization of capitalized stock-based compensation; acquisition-related costs; restructuring charges; gains and losses on legal settlements; costs from professional service providers related to a non-routine stockholder matter; costs incurred related to the endowment of the Akamai Foundation; transformation costs; foreign exchange gains and losses; interest expense; amortization of capitalized interest expense; certain gains and losses on investments; gains and losses from equity method investments; and other non-recurring or unusual items that may arise from time to time. Adjusted EBITDA margin represents Adjusted EBITDA stated as a percentage of revenue.

The following table reconciles GAAP net income to Adjusted EBITDA and Adjusted EBITDA margin for the years ended December 31, 2019, 2018 and 2017 (in thousands):

	2019				2018				2017
Net income	$	478,035			$	298,373			$	222,766
Amortization of acquired intangible assets	38,581				33,311				30,904
Stock-based compensation	187,140				183,813				164,308
Amortization of capitalized stock-based compensation and capitalized interest expense	34,438				28,603				19,953
Restructuring charge	17,153				27,594				54,884
Acquisition-related costs	1,920				2,868				23,374
Legal and stockholder matter costs	10,000				23,091				—
Interest income	(34,355		)		(26,940		)		(17,855		)
Endowment of Akamai Foundation	—				50,000				—
Transformation costs	5,527				7,730				—
Amortization of debt discount and issuance costs	49,364				43,202				18,839
Provision for income taxes	53,350				44,716				91,426
Depreciation and amortization	367,655				372,606				321,456
Loss (gain) on investments	60				1,481				(450		)
Loss from equity method investment	1,096				—				—
Other expense (income), net	1,368				1,667				(437		)
Adjusted EBITDA	$	1,211,332			$	1,092,115			$	929,168
Adjusted EBITDA margin	42		%		40		%		37		%

Impact of Foreign Currency Exchange Rates

Revenue and earnings from our international operations have historically been an important contributor to our financial results. Consequently, our financial results have been impacted, and management expects they will continue to be impacted, by fluctuations in foreign currency exchange rates. For example, when the local currencies of our foreign subsidiaries weaken, generally our consolidated results stated in U.S. dollars are negatively impacted.

Because exchange rates are a meaningful factor in understanding period-to-period comparisons, management believes the presentation of the impact of foreign currency exchange rates on revenue and earnings enhances the understanding of our financial results and evaluation of performance in comparison to prior periods. The dollar impact of changes in foreign currency exchange rates presented is calculated by translating current period results using monthly average foreign currency exchange rates from the comparative period and comparing them to the reported amount. The percentage change at constant currency presented is calculated by comparing the prior period amounts as reported and the current period amounts translated using the same monthly average foreign currency exchange rates from the comparative period.

Liquidity and Capital Resources

To date, we have financed our operations primarily through public and private sales of debt and equity securities and cash generated by operations. As of December 31, 2019, our cash, cash equivalents and marketable securities, which primarily consisted of corporate bonds and U.S. government agency obligations, totaled $2.4 billion. Factoring in our outstanding convertible senior notes of $2.3 billion, our net cash at December 31, 2019 was $72.4 million. We place our cash investments in instruments that meet high-quality credit standards, as specified in our investment policy. Our investment policy also limits the amount of our credit exposure to any one issue or issuer and seeks to manage these assets to achieve our goals of preserving principal and maintaining adequate liquidity at all times.

Changes in cash, cash equivalents and marketable securities are dependent upon changes in, among other things, working capital items such as accounts receivable, deferred revenue, accounts payable and various accrued expenses, as well as changes in our capital and financial structure due to common stock repurchases, debt repurchases and issuances, purchases and sales of marketable securities and similar events. We believe our strong balance sheet and cash position are important competitive

differentiators that provide the financial flexibility necessary to make investments at opportune times. We expect to continue to evaluate strategic investments to strengthen our business.

As of December 31, 2019, we had cash and cash equivalents of $255.4 million held in accounts outside the U.S. The TCJA establishes a territorial tax system in the U.S., which provides companies with the potential ability to repatriate earnings with minimal U.S. federal income tax impact beginning in 2018. As a result, our liquidity is not materially impacted by the amount of cash and cash equivalents held in accounts outside the U.S.

Cash Provided by Operating Activities

	For the Years Ended December 31,
(in thousands)	2019				2018				2017
Net income	$	478,035			$	298,373			$	222,766
Non-cash reconciling items included in net income	683,132				679,648				590,249
Changes in operating assets and liabilities	(102,863		)		30,306				(12,032		)
Net cash flows provided by operating activities	$	1,058,304			$	1,008,327			$	800,983

The increase in cash provided by operating activities for 2019 as compared to 2018 was primarily due to increased profitability in 2019, partially offset by the timing of cash collections from customers, an increase of $28.8 million in cash paid for income taxes and timing of collections and payments of other working capital items.

The increase in cash provided by operating activities for 2018 as compared to 2017 was primarily due to increased profitability in 2018, lower cash paid for income taxes due to a lower U.S. federal statutory tax rate due to the application of the TCJA during 2018 and the timing of collections and payments of other working capital items. The increase in cash provided by operating activities for 2018 as compared to 2017 was partially offset by a one-time contribution to the Akamai Foundation of $50.0 million, as well as higher annual bonus payouts in the first quarter of 2018 as compared to 2017 due to increased headcount from hiring in 2017.

Cash Used in Investing Activities

	For the Years Ended December 31,
(in thousands)	2019				2018				2017
Cash paid for acquired businesses, net of cash acquired	$	(165,329	)		$	(79	)		$	(369,073	)
Purchases of property and equipment and capitalization of internal-use software development costs	(562,077		)		(405,741		)		(414,778		)
Net marketable securities activity	(904,919		)		(98,647		)		326,272
Other investing activities	(35,609		)		(2,066		)		(1,586		)
Net cash used in investing activities	$	(1,667,934	)		$	(506,533	)		$	(459,165	)

The increase in cash used in investing activities in 2019 as compared to 2018 was primarily driven by an increase in purchases of marketable securities with the proceeds from our August 2019 issuance of convertible senior notes, cash paid for acquired companies in 2019, increased capital expenditures and cash invested in an equity method investment.

The increase in cash used in investing activities in 2018 as compared to 2017 was driven by marketable securities activities. In 2017, we did not reinvest all proceeds from sales and maturities of our marketable securities which created a cash inflow in that year. The increase in cash used in investing activities in 2018 as compared to 2017 was partially offset by the cash paid in 2017 for the acquisitions of Nominum, Inc. and Soasta, Inc.

Cash (Used in) Provided by Financing Activities

	For the Years Ended December 31,
(in thousands)	2019				2018				2017
Activity related to convertible senior notes	$	318,554			$	990,390			$	—
Activity related to stock-based compensation	(18,154		)		(1,697		)		(2,715		)
Repurchases of common stock	(334,519		)		(750,000		)		(361,194		)
Other financing activities	(1,558		)		(5,085		)		(1,096		)
Net cash (used in) provided by financing activities	$	(35,677	)		$	233,608			$	(365,005	)

The change in net cash used in or provided by financing activities in 2019 as compared to 2018 was due to our repayment of $690 million of aggregate principal of convertible notes in 2019, partially offset by a decrease in shares repurchased under our repurchase programs.

The change in net cash used in or provided by financing activities during 2018 as compared to 2017 was the result of our issuance of convertible senior notes issued in May 2018 and related note hedge and warrant transactions. The increase was partially offset by an increase in shares repurchased under our repurchase programs.

In February 2016, the Board of Directors authorized a $1.0 billion share repurchase program that was effective from February 2016 through December 2018. In March 2018, the Board of Directors increased the share repurchase authorization by $416.7 million, such that the amount that was authorized and available for repurchase in 2018 was $750.0 million. Subsequently, effective November 2018, the Board of Directors authorized an additional $1.1 billion repurchase program through December 2021. Our goal for the share repurchase programs is to offset the dilution created by our employee equity compensation programs and provide the flexibility to return capital to shareholders as business and market conditions warrant.

During 2019, 2018 and 2017, we repurchased 4.0 million, 10.2 million and 6.9 million shares of our common stock, respectively, at an average price per share of $82.90, $73.54 and $52.59, respectively. These repurchases have contributed to a decrease to shares outstanding over the past three years.

Convertible Senior Notes

In August 2019, we issued $1,150.0 million in par value of convertible senior notes due 2027 and entered into related convertible note hedge and warrant transactions. We intend to use the net proceeds of the offering for share repurchases, working capital and general corporate purposes, including potential acquisitions and other strategic transactions.

In May 2018, we issued $1,150.0 million in par value of convertible senior notes due 2025 and entered into related convertible note hedge and warrant transactions. We used a portion of the net proceeds to repay at maturity all of our $690.0 million outstanding aggregate principle amount of convertible senior notes due in 2019. In addition, we have used and expect to continue to use the remaining net proceeds of the offering for share repurchases, working capital and general corporate purposes, including potential acquisitions and other strategic transactions.

In February 2014, we issued $690.0 million in par value of convertible senior notes due 2019 and entered into related convertible note hedge and warrant transactions. The notes were classified as a current liability on our consolidated balance sheet as of December 31, 2018. We repaid the full $690.0 million in principal amount of the notes in cash in February 2019, as the notes matured and no conversions occurred.

The terms of the notes and the hedge and warrant transactions are discussed more fully in Note 11 to the consolidated financial statements included elsewhere in this annual report on Form 10-K.

Revolving Credit Facility

In May 2018, we entered into a $500.0 million, five-year revolving credit agreement, or the Credit Agreement. Borrowings under the facility may be used to finance working capital needs and for general corporate purposes. The facility provides for an initial $500.0 million in revolving loans. Under specified circumstances, the facility can be increased to up to $1.0 billion in aggregate principal amount.

Borrowings under the Credit Agreement bear interest, at our option, at a base rate plus a spread of 0.00% to 0.25% or an adjusted LIBOR rate plus a spread of 0.875% to 1.25%, in each case with such spread being determined based on our consolidated leverage ratio specified in the Credit Agreement. Regardless of what amounts, if any, are outstanding under the Credit Agreement, we are also obligated to pay an ongoing commitment fee on undrawn amounts at a rate of 0.075% to 0.15%, with such rate being based on our consolidated leverage ratio specified in the Credit Agreement.

The Credit Agreement contains customary representations and warranties, affirmative and negative covenants and events of default. Principal covenants include a maximum consolidated leverage ratio and a minimum consolidated interest coverage ratio. There were no outstanding borrowings under the Credit Agreement as of December 31, 2019.

Liquidity Outlook

Based on our present business plan, we expect our current cash, cash equivalents and marketable securities balances and our forecasted cash flows from operations to be sufficient to meet our foreseeable cash needs for at least the next 12 months. Our foreseeable cash needs, in addition to our recurring operating costs, include our expected capital expenditures, investments in information technology and facility expansion, opportunistic business acquisitions, anticipated share repurchases, lease and purchase commitments and settlements of other long-term liabilities.

Contractual Obligations, Contingent Liabilities and Commercial Commitments

The following table presents our contractual obligations and commercial commitments, as of December 31, 2019, for the next five years and thereafter (in thousands):

	Payments Due by Period
	Total				Less than 12 Months				12 to 36 Months				36 to 60 Months				More than 60 Months
Operating lease obligations: (1)
Real estate arrangements	$	907,441			$	77,961			$	154,960			$	141,971			$	532,549
Co-location arrangements	116,346				63,514				27,153				10,984				14,695
Bandwidth agreements	113,243				83,124				28,598				1,431				90
Open vendor purchase orders	225,813				190,042				31,525				3,882				364
Convertible senior notes	2,300,000				—				—				—				2,300,000
Total contractual obligations	$	3,662,843			$	414,641			$	242,236			$	158,268			$	2,847,698

(1) Excludes $13.7 million of obligations for operating leases that have not yet commenced. See Note 12 to our consolidated financial statements included elsewhere in this annual report on Form 10-K for additional information.

In accordance with the authoritative guidance for accounting for uncertainty in income taxes, as of December 31, 2019, we had unrecognized tax benefits of $32.6 million, including $7.8 million of accrued interest and penalties. We believe that it is reasonably possible that $2.8 million of our unrecognized tax benefits will be recognized by the end of 2020. The settlement period for the remaining amount of the unrecognized tax benefits is unknown.

Letters of Credit

As of December 31, 2019, we had outstanding $7.4 million in irrevocable letters of credit issued by us in favor of third party beneficiaries, primarily related to facility leases. These irrevocable letters of credit, which are not included in the table of contractual obligations above, are unsecured and are expected to remain in effect, in some cases, until 2026.

Off-Balance Sheet Arrangements

We have entered into indemnification agreements with third parties, including vendors, customers, landlords, our officers and directors, shareholders of acquired companies, joint venture partners and third parties to which we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by a third party due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. These indemnification obligations are considered off-balance sheet arrangements in accordance with the authoritative guidance for guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others. See Note 13 to our consolidated financial statements included elsewhere in this annual report on Form 10-K for further discussion of these indemnification agreements. The fair value of guarantees issued or modified during 2019 and 2018 was determined to be immaterial.

Legal Matters

We are party to litigation that we consider routine and incidental to our business. We do not currently expect the results of any of these litigation matters to have a material effect on our business, results of operations, financial condition or cash flows.

Significant Accounting Policies and Estimates

See Note 2 to the consolidated financial statements included elsewhere in this annual report on Form 10-K for information regarding recent and newly adopted accounting pronouncements.

Application of Critical Accounting Policies and Estimates

Overview

Our MD&A is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, accounts receivable and related reserves, valuation and impairment of marketable securities, capitalized internal-use software development costs, goodwill and acquired intangible assets, income tax reserves, impairment and useful lives of long-lived assets and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances at the time such estimates are made. Actual results may differ from these estimates. For a complete description of our significant accounting policies, see Note 2 to our consolidated financial statements included elsewhere in this annual report on Form 10-K.

Definitions

We define our critical accounting policies as those policies that require us to make subjective estimates and judgments about matters that are uncertain and are likely to have a material impact on our consolidated financial statements. Our estimates are based upon assumptions and judgments about matters that are highly uncertain at the time an accounting estimate is made and applied and require us to assess a range of potential outcomes.

Review of Critical Accounting Policies and Estimates

Revenue Recognition

Our contracts with customers sometimes include promises to transfer multiple services to a customer. Determining whether services are distinct performance obligations often requires the exercise of judgment by management. Advanced features that enhance a main product or service and are highly interrelated are generally not considered distinct; rather, they are combined with the service they relate to into one performance obligation. Different determinations related to combining services into performance obligations could result in differences in the timing and amount of revenue recognized in a period.

Determination of the standalone selling price, or SSP, also requires the exercise of judgment by management. SSP is based on observable inputs such as the price we charge for the service when sold separately, or the discounted list price per management’s approved price list. In cases where services are not sold separately or price list rates are not available, a cost-plus-margin approach or adjusted market approach is used to determine SSP. Changes to SSP could result in differences in the allocation of transaction price among performance obligations, which could result in differences in the timing and amount of revenue recognized in a period.

From time to time, we enter into contracts to sell services or license technology to unrelated enterprises at or about the same time that we enter into contracts to purchase products or services from the same enterprises. Consideration payable to a customer is reviewed as part of the transaction price. If the payment to the customer does not represent payment for a distinct service, revenue is recognized only up to the net amount of consideration after customer payment obligations are considered. Different determinations on whether a payment represents a distinct service could result in differences in the amount of revenue recognized.

We may also resell the licenses or services of third parties. If we are acting as an agent in an arrangement with a customer to provide third party services, the transaction price reflects only the net amount to which we will be entitled, after accounting for payments made to the third party responsible for satisfying the performance obligation. Different determinations on whether we are acting as an agent or a principal could change the amount of revenue recognized.

Accounts Receivable and Related Reserves

Trade accounts receivable are recorded at the invoiced amounts and do not bear interest. In addition to trade accounts receivable, our accounts receivable balance includes unbilled accounts that represent revenue recorded for customers that is typically billed within one month. We record reserves against our accounts receivable balance. These reserves primarily consist of allowances for doubtful accounts. Increases and decreases in the allowance for doubtful accounts are included as a component of general and administrative expense in the consolidated statements of income.

Estimates are used in determining our reserves and are based upon our review of outstanding balances on a customer-specific, account-by-account basis. The allowance for doubtful accounts is based upon a review of customer receivables from prior sales with collection issues where we no longer believe that the customer has the ability to pay for prior services provided. We perform ongoing credit evaluations of our customers. If such an evaluation indicates that payment is no longer reasonably assured for services provided, any future services provided to that customer will result in creation of a cash basis reserve until we receive consistent payments.

Valuation and Impairment of Marketable Securities

We measure the fair value of our financial assets and liabilities at the end of each reporting period. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. We have certain financial assets and liabilities recorded at fair value (principally cash equivalents and short- and long-term marketable securities) that have been classified as Level 1, 2 or 3 within the fair value hierarchy. Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that we can access at the reporting date. Fair values determined by Level 2 inputs utilize data points other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Fair values determined by Level 3 inputs are based on unobservable data points for the asset or liability.

Marketable securities are considered to be impaired when a decline in fair value below cost basis is determined to be other-than-temporary. We periodically evaluate whether a decline in fair value below cost basis is other-than-temporary by considering available evidence regarding these investments including, among other factors, the duration of the period that, and extent to which, the fair value is less than cost basis; the financial health of, and business outlook for, the issuer, including industry and sector performance and operational and financing cash flow factors; overall market conditions and trends; and our intent and ability to retain our investment in the security for a period of time sufficient to allow for an anticipated recovery in market value. Once a decline in fair value is determined to be other-than-temporary, a write-down is recorded and a new cost basis in the security is established. Assessing the above factors involves inherent uncertainty. Write-downs, if recorded, could be materially different from the actual market performance of marketable securities in our portfolio if, among other things, relevant information related to our investments and marketable securities was not publicly available or other factors not considered by us would have been relevant to the determination of impairment.

Impairment and Useful Lives of Long-Lived Assets

We review our long-lived assets, such as property and equipment and acquired intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events that would trigger an impairment review include a change in the use of the asset or forecasted negative cash flows related to the asset. When such events occur, we compare the carrying amount of the asset to the undiscounted expected future cash flows related to the asset. If this comparison indicates that impairment is present, the amount of the impairment is calculated as the difference between the carrying amount and the fair value of the asset. If a readily determinable market price does not exist, fair value is

estimated using discounted expected cash flows attributable to the asset. The estimates required to apply this accounting policy include forecasted usage of the long-lived assets, the useful lives of these assets and expected future cash flows. Changes in these estimates could materially impact results from operations.

Goodwill and Acquired Intangible Assets

We test goodwill for impairment on an annual basis, as of December 31, or more frequently if events or changes in circumstances indicate that the asset might be impaired. We have concluded that we have one reporting unit and that our chief operating decision maker is our chief executive officer and the executive management team. We have assigned the entire balance of goodwill to our one reporting unit. The fair value of the reporting unit was based on our market capitalization as of each of December 31, 2019 and 2018, and it was substantially in excess of the carrying value of the reporting unit at each date.

Acquired intangible assets consist of completed technologies, customer relationships, trademarks and trade names, non-compete agreements and acquired license rights. We engaged third party valuation specialists to assist us with the initial measurement of the fair value of acquired intangible assets. Acquired intangible assets, other than goodwill, are amortized over their estimated useful lives based upon the estimated economic value derived from the related intangible assets.

Income Taxes

Our provision for income taxes is comprised of a current and a deferred portion. The current income tax provision is calculated as the estimated taxes payable or refundable on tax returns for the current year. The deferred income tax provision is calculated for the estimated future tax effects attributable to temporary differences and carryforwards by using expected tax rates in effect in the years during which the differences are expected to reverse or the carryforwards are expected to be realized.

We currently have net deferred tax assets, comprised of net operating loss, or NOL, carryforwards, tax credit carryforwards and deductible temporary differences. Our management periodically weighs the positive and negative evidence to determine if it is more-likely-than-not that some or all of the deferred tax assets will be realized. In determining our net deferred tax assets and valuation allowances, annualized effective tax rates and cash paid for income taxes, management is required to make judgments and estimates about domestic and foreign profitability, the timing and extent of the utilization of NOL carryforwards, applicable tax rates, transfer pricing methodologies and tax planning strategies. Judgments and estimates related to our projections and assumptions are inherently uncertain; therefore, actual results could differ materially from our projections.

We have recorded certain tax reserves to address potential exposures involving our income tax positions. These potential tax liabilities result from the varying application of statutes, rules, regulations and interpretations by different taxing jurisdictions. Our estimate of the value of our tax reserves contains assumptions based on past experiences and judgments about the interpretation of statutes, rules and regulations by taxing jurisdictions. It is possible that the costs of the ultimate tax liability or benefit from these matters may be more or less than the amount that we estimated.

Uncertainty in income taxes is recognized in our consolidated financial statements using a two-step process to determine the amount of tax benefit to be recognized. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon external examination. If the tax position is deemed more-likely-than-not to be sustained based on technical merit, the tax position is then assessed to determine the amount of benefit to recognize in the financial statements. The amount of the benefit that may be recognized is the largest amount that we believe has a greater than 50% likelihood of being realized upon ultimate settlement.

Accounting for Stock-Based Compensation

We issue stock-based compensation awards including stock options, restricted stock units and deferred stock units. We measure the fair value of these awards at the grant date and recognize such fair value as expense over the vesting period. We have selected the Black-Scholes option pricing model to determine the fair value of stock option awards and the Monte Carlo simulation model to determine the fair value of market-based restricted stock unit awards. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected life of the stock awards and the volatility of the underlying common stock. Our assumptions may differ from those used in prior periods. Changes to the assumptions may have a significant impact on the fair value of stock-based awards, which could have a material impact on our financial statements. Judgment is also required in estimating the number of stock-based awards that are expected to be forfeited. Should our actual forfeiture rates differ significantly from our estimates, our stock-based compensation expense and results of operations could be materially impacted. In addition, for awards that vest and become exercisable only upon achievement of specified performance conditions, we make judgments and estimates each quarter about the probability that such performance

conditions will be met or achieved. Changes to the estimates we make from time to time may have a significant impact on our stock-based compensation expense and could materially impact our result of operations.

Capitalized Internal-Use Software Costs

We capitalize salaries and related costs, including stock-based compensation, of employees and consultants who devote time to the development of internal-use software development projects, as well as interest expense related to our senior convertible notes. Capitalization begins during the application development stage, once the preliminary project stage has been completed. If a project constitutes an enhancement to previously-developed software, we assess whether the enhancement creates additional functionality to the software, thus qualifying the work incurred for capitalization. Once the project is available for general release, capitalization ceases and we estimate the useful life of the asset and begin amortization. We periodically assess whether triggering events are present to review internal-use software for impairment. Changes in our estimates related to internal-use software would increase or decrease operating expenses or amortization recorded during the period.