Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")

Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is designed to provide a reader of our consolidated financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A should be read in conjunction with the other sections of this Annual Report on Form 10-K, including Part I, Item 1A: “Risk Factors”; Part II, Item 6: “Selected Financial Data”; and Part II, Item 8: “Financial Statements and Supplementary Data.” The various sections of this MD&A contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing. The tables in the MD&A sections below are derived from exact numbers and may have immaterial rounding differences.

This section discusses our results of operations for the year ended December 31, 2019 as compared to the year ended December 31, 2018. For a discussion and analysis of the year ended December 31, 2018, compared to the same period in 2017 please refer to Management's Discussion and Analysis of Financial Condition and Results of Operations included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on February 27, 2019.

Overview

Axon is a global network of devices, apps, training and people that helps public safety personnel become smarter and safer. Our technologies give law enforcement the confidence, focus and time they need to protect their communities. Our products impact every aspect of an officer's day-to-day experience. Our core mission is to protect life. We fulfill that mission through developing hardware and software products that advance our long term vision of a) obsoleting the bullet, b) reducing social conflict, and c) enabling a fair and effective justice system.

Our revenues for the year ended December 31, 2019 were $530.9 million, an increase of $110.8 million, or 26.4%, from the prior year. We had a loss from operations of $6.4 million compared to income from operations of $24.8 million in the prior year. Gross margins were compressed related to the rollout of our latest generation TASER device and increased data storage expenses, partially offset by higher margins for Software & Sensors devices. Increased cost of sales, selling, general and administrative expenses, and research and development expenses to support continued and future growth also contributed to the decline in operating results. Additionally, expenses for the year ended December 31, 2019 reflected $51.6 million in incremental stock-based compensation expense related to the CEO Performance Award and XSPP. The decline in operating results was partially offset by a $4.3 million increase in interest income. For the year ended December 31, 2019, we recorded net income of $0.9 million compared to $29.2 million for the prior year.

2020 Outlook

For the year ending December 31, 2020, we expect revenue of $615 million to $625 million. We anticipate that revenue for the three months ending March 31, 2020 will reflect approximately 13% growth as compared to the three months ended March 31, 2019. We anticipate that the timing of 2020 revenue will reflect a similar distribution as in 2019. We expect a normalized income tax rate of between 20% and 25%; this rate can fluctuate depending on geography of income and the effects of discrete items, including changes in our stock price.

In late 2019, a novel strain of coronavirus was first detected in Wuhan, China. Following the outbreak of this virus, the Chinese government has quarantined certain affected regions and certain travel restrictions have been imposed. Our operations team is closely monitoring the potential impact to our supply chain. At this time we have successfully managed through the current impacts. Our operations team has some flexibility to adapt to the changing situation; however, if the situation further deteriorates or the outbreak results in further travel restriction on both supply and demand, these impacts could affect our full year guidance.

Results of Operations

The following table presents data from our consolidated statements of operations as well as the percentage relationship to total net sales of items included in our statements of operations (dollars in thousands):

	Year Ended December 31,
	2019							2018
Net sales from products	$	399,474			75.3	%		$	327,635			78.0	%
Net sales from services	131,386				24.7	%		92,433				22.0	%
Net sales	530,860				100.0	%		420,068				100.0	%
Cost of product sales	190,683				35.9	%		139,337				33.2	%
Cost of service sales	32,891				6.2	%		22,148				5.3	%
Cost of sales	223,574				42.1	%		161,485				38.5	%
Gross margin	307,286				57.9	%		258,583				61.5	%
Operating expenses:
Sales, general and administrative	212,959				40.1	%		156,886				37.3	%
Research and development	100,721				19.0	%		76,856				18.3	%
Total operating expenses	313,680				59.1	%		233,742				55.6	%
Income (loss) from operations	(6,394		)		(1.2	)%		24,841				5.9	%
Interest and other income, net	8,464				1.6	%		3,263				0.8	%
Income before provision for income taxes	2,070				0.4	%		28,104				6.7	%
Provision (benefit) for income taxes	1,188				0.2	%		(1,101		)		(0.3	)%
Net income	$	882			0.2	%		$	29,205			7.0	%

Net sales to the U.S. and other countries are summarized as follows (dollars in thousands):

	Year Ended December 31,
	2019							2018
United States	$	446,100			84.0	%		$	335,310			79.8	%
Other Countries	84,760				16.0	%		84,758				20.2	%
Total	$	530,860			100.0	%		$	420,068			100.0	%

International revenue in 2019 remained consistent with 2018. Lower sales in Canada and the Asia Pacific region were offset by increased sales in Europe and Africa.

Our operations are comprised of two reportable segments: the manufacture and sale of CEDs, batteries, accessories and extended warranties and other products and services (collectively, the “TASER” segment); and the development, manufacture, and sale of software and sensors, which includes the sale of devices, wearables, applications, cloud and mobile products, and services (collectively, the "Software and Sensors" segment). In both segments, we report sales of products and services. Service revenue in both segments includes sales related to Axon Evidence. In the Software and Sensors segment, service revenue also includes other recurring cloud-hosted software revenue and related professional services. Collectively, this revenue is sometimes referred to as "Axon Cloud revenue." Revenue from our “products” in the Software and Sensors segment are generally from sales of sensors, including on-officer body cameras, Axon Fleet cameras, other hardware sensors, warranties on sensors, and other products, and is sometimes referred to as "Sensors and Other revenue." Within the Software and Sensors segment, we include only revenues and costs attributable to that segment which costs include: costs of sales for both products and services, direct labor, and product management and R&D for products included, or to be included, within the Software and Sensors segment. All other costs are included in the TASER segment.

For the Years Ended December 31, 2019 and 2018

Net Sales

Net sales by product line were as follows for the years ended December 31, 2019 and 2018 (dollars in thousands):

	Year Ended December 31,														Dollar Change				Percent Change
	2019							2018
TASER segment:
TASER 7	$	56,652			10.7	%		$	7,358			1.8	%		$	49,294			669.9	%
TASER X26P	52,524				9.9	%		70,638				16.8	%		(18,114		)		(25.6	)%
TASER X2	55,920				10.5	%		78,837				18.8	%		(22,917		)		(29.1	)%
TASER Pulse and Bolt	4,089				0.8	%		5,182				1.2	%		(1,093		)		(21.1	)%
Cartridges	85,987				16.2	%		68,258				16.3	%		17,729				26.0	%
Axon Evidence and cloud services	704				0.1	%		—				—	%		704				*
Extended warranties	18,074				3.4	%		15,753				3.8	%		2,321				14.7	%
Other	7,711				1.5	%		7,089				1.7	%		622				8.8	%
TASER segment	281,661				53.1	%		253,115				60.4	%		28,546				11.3	%
Software and Sensors segment:
Axon Body	44,039				8.3	%		21,883				5.2	%		22,156				101.2	%
Axon Flex	5,928				1.1	%		6,509				1.5	%		(581		)		(8.9	)%
Axon Fleet	16,182				3.0	%		12,527				3.0	%		3,655				29.2	%
Axon Dock	20,449				3.9	%		10,706				2.5	%		9,743				91.0	%
Axon Evidence and cloud services	130,265				24.5	%		90,291				21.5	%		39,974				44.3	%
TASER Cam	3,104				0.6	%		3,871				0.9	%		(767		)		(19.8	)%
Extended warranties	19,188				3.6	%		11,860				2.8	%		7,328				61.8	%
Other	10,044				1.9	%		9,306				2.2	%		738				7.9	%
Software and Sensors segment	249,199				46.9	%		166,953				39.6	%		82,246				49.3	%
Total net sales	$	530,860			100.0	%		$	420,068			100.0	%		$	110,792			26.4	%

Net unit sales were as follows:

	Year Ended December 31,
	2019			2018			Unit Change			Percent Change
TASER 7	49,221			5,759			43,462			754.7	%
TASER X26P	48,798			71,823			(23,025	)		(32.1	)%
TASER X2	40,973			65,855			(24,882	)		(37.8	)%
TASER Pulse and Bolt	11,785			18,398			(6,613	)		(35.9	)%
Cartridges	2,751,603			2,342,897			408,706			17.4	%
Axon Body	151,499			85,965			65,534			76.2	%
Axon Flex	15,586			15,541			45			0.3	%
Axon Fleet	10,467			9,445			1,022			10.8	%
Axon Dock	22,275			17,762			4,513			25.4	%
TASER Cam	5,533			8,310			(2,777	)		(33.4	)%

Net sales for the TASER segment increased $28.5 million, or 11.3%, primarily as a result of a $17.7 million increase in cartridge revenue and a net increase of $7.2 million in TASER device sales. Cartridge revenues increased due to both increased unit sales and an increase in average selling price. The decreased unit sales of X2 and X26P were partially offset by higher average selling prices. As expected, we continue to see a shift to purchases of our latest generation device, TASER 7, from legacy X2 and X26P devices. We expect recurring payment plan subscriptions to increase as we drive sales of TASER 7, which includes a software subscription with Axon Evidence.

Net sales for the Software and Sensors segment increased $82.2 million, or 49.3%. Revenue from Axon Evidence and cloud services increased $40.0 million as we continued to add users and associated devices to our network during the year ended December 31, 2019. The increase in the aggregate number of users and devices also resulted in increased extended warranty revenues of $7.3 million. Revenue from Axon Body cameras increased $22.2 million and included $19.3 million in sales of Axon Body 3, which was introduced during the third quarter of 2019. Axon Dock revenue also increased $9.7 million with increased units largely driven by the introduction of Axon Body 3, as well as an increase in the average selling price.

For the past few years, we have considered bookings for our Software and Sensors segment as an early indicator of activity for Axon camera products and Axon Evidence services. We have shifted our focus to total company future contracted revenue, which we believe is a more relevant and comprehensive forward-looking performance indicator, as it encompasses all company contracts, including TASER. As of December 31, 2019, we had approximately $1.23 billion of total company future contracted revenue, which included both recognized contract liabilities as well as amounts that will be invoiced and recognized in future periods. We expect to recognize between 20% - 25% of this balance over the next twelve months, and expect the remainder to be recognized over the following five to seven years, subject to risks related to delayed deployments, budget appropriation or other contract cancellation clauses.

Backlog - As of December 31, 2019 compared to December 31, 2018

Our backlog for products and services includes all orders that have been received and are believed to be firm.

In the TASER segment, we define backlog as equal to deferred revenue. Deferred revenue represents amounts invoiced to customers for goods and services to be delivered in subsequent periods. We process orders within the TASER segment quickly, and our best estimate of firm orders outstanding as of period end represents those that have been paid for but remain undelivered. The TASER segment backlog balance was $55.2 million as of December 31, 2019. We expect to realize $22.6 million of this deferred revenue balance as revenue during the next 12 months. This represents cash received and accounts receivable from customers on or prior to December 31, 2019 for products and services expected to be delivered in the next 12 months.

In the Software and Sensors segment, we define backlog as cumulative bookings, net of cancellations, less product and service revenue recognized to date. Bookings are generally realized as revenue over multiple years. The Software and Sensors backlog balance was $1.0 billion as of December 31, 2019. This backlog balance includes $150.6 million of deferred revenue, and $875.6 million that has been recorded as bookings but not yet invoiced, all as of December 31, 2019. We expect to realize approximately $270.0 million of the December 31, 2019 backlog balance as revenue during the next 12 months.

	TASER				Software and Sensors				Total
	(in thousands)
Balance, beginning of period	$	54,597			$	758,125			$	812,722
Add: additions to backlog, net of cancellations	282,253				517,266				799,519
Less: revenue recognized during period	(	281,661	)		(	249,199	)		(	530,860	)
Balance end of period	$	55,189			$	1,026,192			$	1,081,381

Our backlog of $1.1 billion as of December 31, 2019 has increased significantly from $812.7 million as of December 31, 2018. The increase in TASER segment backlog is not expected to have a material impact on revenue or operating margins. Our significant increase in backlog, primarily in the Software and Sensors segment is indicative of expected revenue growth in this segment. Revenue growth in the Software and Sensors segment is expected to result in improved operating margins over time as additional revenue will cover a larger portion of our selling, general and administrative expenses and research and development costs. We also anticipate gross margins to improve gradually in future years.

Cost of Product and Service Sales

Cost of Product and Service Sales (dollars in thousands):

	Year Ended December 31,														Dollar Change				Percent Change
	2019							2018
TASER segment:
Cost of product sales	$	107,188			38.1	%		$	80,354			31.7	%		$	26,834			33.4	%
Software and Sensors segment:
Cost of product sales	83,495				33.5	%		58,983				35.3	%		24,512				41.6	%
Cost of service sales	32,891				13.2	%		22,148				13.3	%		10,743				48.5	%
Total cost of sales	116,386				46.7	%		81,131				48.6	%		35,255				43.5	%
Total cost of product and service sales	$	223,574			42.1	%		$	161,485			38.4	%		$	62,089			38.4	%

Within the TASER segment, cost of product sales increased $26.8 million, or 33.4%, to $107.2 million in 2019, compared to $80.4 million in 2018. Cost as a percentage of sales increased to 38.1% from 31.7%. The increase in cost of product sales was primarily attributable to the mix of products, with higher cost per unit for TASER 7 handles and cartridges as well as higher depreciation on new production equipment for the TASER 7. Additionally, cost of product sales included approximately $3.0 million in expense for TASER 7 ramp-up and optimization costs related to scrap, obsolete inventory, and higher labor costs.

Within the Software and Sensors segment, cost of product and service sales was $116.4 million, an increase of $35.3 million, or 43.5%, from 2018. As a percentage of net sales, cost of product and service sales decreased to 46.7% in 2019 from 48.6% in 2018. Cost of product sales increased $24.5 million primarily driven by the impact of increased units as well as increased freight and customs expenses, but decreased as a percentage of total segment net sales, reflecting non-recurrence of customer fulfillment costs associated with our acquisition of VIEVU in May 2018 and higher pricing on Axon Body 2 cameras and docks. Cost of service sales increased $10.7 million driven primarily by

a $5.0 million increase in third party cloud data storage and compute costs, and by a $3.9 million increase in professional services expense due to both significant Fleet installations during 2019 and an overall increase following the acquisition of VIEVU in May 2018. In June 2019, we entered into a purchase agreement for cloud data storage with a three year term beginning July 1, 2019. We expect that this agreement, in combination with moving certain data into archive storage, will slow the growth of our future storage and compute costs, despite anticipated increases in the amount of data stored.

Gross Margin

Gross Margin (dollars in thousands):

	Year Ended December 31,
									Dollar Change				Percent Change
	2019				2018
TASER segment	$	174,473			$	172,761			$	1,712			1.0	%
Software and Sensors segment	132,813				85,822				46,991				54.8	%
Total gross margin	$	307,286			$	258,583			$	48,703			18.8	%
Gross margin as % of net sales	57.9		%		61.5		%

Gross margin increased $48.7 million to $307.3 million for the year ended December 31, 2019 compared to $258.6 million for 2018. As a percentage of net sales, gross margin decreased to 57.9% for 2019 from 61.5% for 2018.

As a percentage of net sales, gross margin for the TASER segment decreased to 61.9% for the year ended December 31, 2019 from 68.3% for the year ended December 31, 2018. TASER 7 devices have a lower average selling price per unit than legacy products due to the bundle of products and services included, and a higher cost per unit than legacy products. Additionally, gross margin was impacted by trade in credits provided to certain customers purchasing TASER 7 devices.

Within the Software and Sensors segment, gross margin as a percentage of total segment net sales was 53.3% and 51.4% for the years ended 2019 and 2018, respectively. Within the Software and Sensors segment, product gross margin was 29.8% for the year ended December 31, 2019 and 20.8% for the same period in 2018, while the service margins were 74.8% and 76.0% during those same periods, respectively.

Sales, General and Administrative Expenses

Sales, General and Administrative ("SG&A") Expenses (dollars in thousands):

	Year Ended December 31,								Dollar Change				Percent Change
	2019				2018
Salaries, benefits and bonus	$	67,582			$	63,185			$	4,397			7.0	%
Stock-based compensation	59,341				12,710				46,631				366.9	%
Professional, consulting and lobbying	21,590				24,469				(2,879		)		(11.8	)%
Sales and marketing	28,961				19,427				9,534				49.1	%
Travel and meals	11,407				9,908				1,499				15.1	%
Depreciation and amortization	5,739				6,051				(312		)		(5.2	)%
Other	18,339				21,136				(2,797		)		(13.2	)%
Total sales, general and administrative expenses	$	212,959			$	156,886			$	56,073			35.7	%
SG&A expenses as a percentage of net sales	40.1		%		37.3		%

SG&A increased $56.1 million, or 35.7%. Stock-based compensation expense increased $46.6 million in comparison to the prior year comparable period, which was primarily attributable to an increase of $30.8 million in expense related to the CEO Performance Award and expense of $11.5 million related to our XSPP. During the year ended December 31, 2019, attainment of the third through ninth tranches of the CEO Performance Award and XSPP became probable. Accordingly, we recorded expense of $26.5 million for the CEO Performance Award and $7.3 million for the XSPP reflecting the cumulative expense for the third through ninth tranches from the grant dates through December 31, 2019. Refer to Note 12 of the notes to our consolidated financial statements within this Annual Report on Form 10-K for additional discussion of the CEO Performance Award and XSPP. Stock-based compensation expense also increased over the prior year comparable period due to an increase in headcount.

Salaries, benefits and bonus expense increased $4.4 million, primarily due to an increase in headcount. The increase was partially offset by a decline in expense for contract labor. Salaries, benefits and bonus expense decreased as a percentage of sales from 15.0% for 2018 to 12.7% for 2019.

Sales and marketing expenses increased $9.5 million, driven by a $8.7 million increase in commissions tied to higher revenues. The increase in commissions was also driven by higher commission rates for higher value bundled deals, which have continued to increase.

The increases were partially offset by a decrease of $2.9 million in professional, consulting and lobbying expenses. Legal expenses increased by approximately $1.0 million, offset by a $3.8 million decrease in professional fees, which were higher during 2018 related to our acquisition of Vievu, the adoption of Topic 606, and the implementation of the CEO Performance Award and XSPP.

During 2019, we abandoned certain capitalized software related to implementation work on an enterprise resource planning system conversion, resulting in an impairment charge of $1.3 million, and certain planning and site development activities related to our planned new headquarters, resulting in an impairment charge of $0.7 million. During 2018, we recorded an impairment charge of $2.0 million related to the abandonment of certain developed technology acquired in a business combination.

As discussed in Note 9 of the notes to our consolidated financial statements within this Annual Report on Form 10-K, on January 3, 2020, we sued the FTC in the District of Arizona, and the FTC filed an enforcement action regarding our May 2018 acquisition of Vievu LLC. This litigation is expected to result in an increase in legal expenses during the year ending December 31, 2020. While the amount and timing of such expenses is unknown and will vary depending on the progression of litigation, we currently anticipate expenses in the range of $10.0 million to $15.0 million for the year, with a higher proportion of the expense expected during the first half of 2020.

Research and Development Expenses

Research and Development ("R&D") Expenses (dollars in thousands):

	Year Ended December 31,								Dollar Change				Percent Change
	2019				2018
Salaries, benefits and bonus	$	63,763			$	49,792			$	13,971			28.1	%
Stock-based compensation	17,588				8,658				8,930				103.1	%
Professional and consulting	4,525				4,183				342				8.2	%
Travel and meals	2,247				2,192				55				2.5	%
Other	12,598				12,031				567				4.7	%
Total research and development expenses	$	100,721			$	76,856			$	23,865			31.1	%
R&D expenses as a percentage of net sales	19.0		%		18.3		%

The increase in R&D expense was fully attributable to our Software and Sensors segment. Within the TASER segment, R&D expenses decreased $2.5 million or 14.9% due to lower headcount and a decrease in hardware spending,

which was higher during the prior year comparable period leading up to the TASER 7 launch. R&D expense for the Software and Sensors segment increased $26.4 million or 44.1%, but decreased to 34.6% of sales as compared to 35.8% in the prior year. Of the increase, $16.1 million related to salaries, benefits, and bonus attributable to increased headcount.

Stock-based compensation expense increased $8.9 million. Contributing to the increase was expense of $5.2 million related to our XSPP. During 2019, attainment of the third through ninth tranches of the XSPP became probable. Accordingly, we recorded expense of $3.4 million for the XSPP reflecting the cumulative expense for the third through ninth tranches from the grant dates through December 31, 2019. Stock-based compensation expense also increased over the prior year comparable period due to an increase in headcount.

Hardware spending increased approximately $2.6 million leading up to the Axon Body 3 launch. This increase was largely offset by decreases in depreciation and other expenses.

We expect R&D expense to continue to increase in absolute dollars as we focus on growing the Software and Sensors segment as we add headcount and additional resources to develop new products and services to further advance our scalable cloud-connected device platform. We believe that these investments will result in an increase in our subscription revenue base, which over time will result in revenue increasing faster than the increase in SG&A expenses and R&D costs, as we reach economies of scale.

Interest and Other Income, Net

Interest and other income, net was $8.5 million and $3.3 million for the years ended December 31, 2019 and 2018, respectively.

For the year ended December 31, 2019, we earned interest income of $8.7 million and had losses from foreign currency transaction adjustments of $0.3 million, other income, net of $0.1 million, and interest expense of less than $0.1 million. For the year ended December 31, 2018, we earned interest income of $4.4 million and had losses from foreign currency transaction adjustments of $1.1 million, interest expense of $0.1 million, and other expense of $0.1 million.

Provision for Income Taxes

The provision for income taxes was $1.2 million for the year ended December 31, 2019. The effective income tax rate for 2019 was 57.4%. The benefits related to excess stock-based compensation of $5.0 million and research and development credits of $4.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $7.6 million, an increase in uncertain tax benefits of $1.2 million and other permanently non-deductible expenses of $1.1 million and state tax expense of $0.5 million. Additionally, we recorded a $0.4 million increase to our valuation allowance as of December 31, 2019 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.

The income tax benefit was $1.1 million for the year ended December 31, 2018. The effective income tax rate for 2018 was (3.9%). The benefits related to excess stock-based compensation of $8.9 million and research and development credits of $6.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $1.2 million, an increase in uncertain tax benefits of $1.8 million and return to provision adjustments of $1.8 million. Additionally, we recorded a $2.0 million increase to our valuation allowance as of December 31, 2018 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.

Net Income

Our net income decreased by $28.3 million to $0.9 million for the year ended December 31, 2019 compared to $29.2 million in 2018. Net income per basic and diluted share was $0.01 for 2019, compared to net income per basic and diluted share of $0.52 and $0.50, respectively, for 2018.

Three Months Ended December 31, 2019 Compared to September 30, 2019

Net sales by product line were as follows (dollars in thousands):

	Three Months Ended December 31, 2019							Three Months Ended September 30, 2019							Dollar Change				Percent Change
TASER segment:
TASER 7	$	17,186			10.0	%		$	20,214			15.4	%		$	(3,028	)		(15.0	)%
TASER X26P	14,692				8.5	%		11,578				8.8	%		3,114				26.9	%
TASER X2	15,507				9.0	%		13,241				10.1	%		2,266				17.1	%
TASER Pulse and Bolt	1,169				0.7	%		1,132				0.9	%		37				3.3	%
Cartridges	28,633				16.7	%		18,901				14.4	%		9,732				51.5	%
Axon Evidence and cloud services	341				0.2	%		218				0.2	%		123				56.4	%
Extended warranties	4,733				2.8	%		4,543				3.5	%		190				4.2	%
Other	1,694				1.0	%		1,916				1.5	%		(222		)		(11.6	)%
TASER segment	83,955				48.9	%		71,743				54.8	%		12,212				17.0	%
Software and Sensors segment:
Axon Body	25,219				14.7	%		6,763				5.2	%		18,456				272.9	%
Axon Flex	1,411				0.8	%		1,670				1.3	%		(259		)		(15.5	)%
Axon Fleet	5,205				3.0	%		4,341				3.3	%		864				19.9	%
Axon Dock	11,048				6.4	%		3,358				2.6	%		7,690				229.0	%
Axon Evidence and cloud services	36,804				21.4	%		34,022				26.0	%		2,782				8.2	%
TASER Cam	623				0.4	%		534				0.4	%		89				16.7	%
Extended warranties	5,124				3.0	%		4,714				3.6	%		410				8.7	%
Other	2,462				1.4	%		3,692				2.8	%		(1,230		)		(33.3	)%
Software and Sensors segment	87,896				51.1	%		59,094				45.2	%		28,802				48.7	%
Total net sales	$	171,851			100.0	%		$	130,837			100.0	%		$	41,014			31.3	%

Net unit sales were as follows:

	Three Months Ended
	December 31, 2019			September 30, 2019			Unit Change			Percent Change
TASER 7	14,577			17,674			(3,097	)		(17.5	)%
TASER X26P	13,554			10,766			2,788			25.9	%
TASER X2	11,534			9,819			1,715			17.5	%
TASER Pulse and Bolt	2,978			3,923			(945	)		(24.1	)%
Cartridges	962,519			566,347			396,172			70.0	%
Axon Body	83,268			22,037			61,231			277.9	%
Axon Flex	3,078			5,409			(2,331	)		(43.1	)%
Axon Fleet	3,324			2,967			357			12.0	%
Axon Dock	10,149			3,724			6,425			172.5	%
TASER Cam	1,177			899			278			30.9	%

Net sales for the TASER segment increased $12.2 million, or 17.0%, on a sequential basis primarily due to an overall increase in revenue from cartridges. An inventory shortfall earlier in the year resulted in a backlog primarily for TASER 7 and X2 cartridges; this backlog was cleared during the quarter ended December 31, 2019. The increase in cartridge units were partially offset by a decrease in the average selling price. Net sales also included a net increase of $2.4 million in TASER device sales. TASER 7 sales declined compared to the three months ending September 30, 2019; as a result of a battery component supplier not being able to timely fulfill our production needs, approximately $3 million of forecasted TASER 7 sales shifted from the three months ended June 30, 2019 to the three months ending September 30, 2019. Units of our legacy TASER devices increased, while the average selling prices remained consistent with the prior quarter.

Net sales for the Software and Sensors segment increased $28.8 million, or 48.7%, on a sequential basis. Revenue from Axon Body cameras increased $18.5 million and included $18.7 million in sales of Axon Body 3, which was introduced during the third quarter of 2019. Partially offsetting this increase was a decrease in units and average selling price of Axon Body 2 units. Axon Dock revenue also increased $7.7 million with increased units largely driven by the introduction of Axon Body 3, as well as an increase in the average selling price. The increase in the aggregate number of users on our network, including on-premise users in secondary international markets, resulted in increased Axon Evidence and cloud services revenues of $2.8 million.

International sales were $24.5 million in for the three months ended December 31, 2019 as compared to $20.0 million for the three months ended September 30, 2019, an increase of $4.5 million, driven by increased sales in the Asia Pacific region which were partially offset by lower sales in Africa.

Non-GAAP Financial Measures

To supplement our financial results presented in accordance with accounting principles generally accepted in the U.S. ("GAAP"), we present the non-GAAP financial measures of EBITDA and Adjusted EBITDA (CEO Performance Award). Our management uses these non-GAAP financial measures in evaluating our performance in comparison to prior periods. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance, and when planning and forecasting our future periods. A reconciliation of GAAP to the non-GAAP financial measures is presented below.

•	EBITDA (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation and amortization.

•	Adjusted EBITDA (CEO Performance Award) (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation, amortization and non-cash stock-based compensation expense.

Although these non-GAAP financial measures are not consistent with GAAP, management believes investors will benefit by referring to these non-GAAP financial measures when assessing our operating results, as well as when forecasting and analyzing future periods. However, management recognizes that:

•	these non-GAAP financial measures are limited in their usefulness and should be considered only as a supplement to our GAAP financial measures;

•	these non-GAAP financial measures should not be considered in isolation from, or as a substitute for, our GAAP financial measures;

•	these non-GAAP financial measures should not be considered to be superior to our GAAP financial measures; and

•	these non-GAAP financial measures were not prepared in accordance with GAAP and investors should not assume that the non-GAAP financial measures presented in this Annual Report on Form 10-K were prepared under a comprehensive set of rules or principles.

EBITDA and Adjusted EBITDA (CEO Performance Award) reconcile to net income as follows (dollars in thousands):

		For the Years Ended December 31,
		2019				2018
Net income		$	882			$	29,205
Depreciation and amortization		11,361				10,615
Interest expense		46				86
Investment interest income		(7,040		)		(3,002		)
Provision for (benefit from) income taxes		1,188				(1,101		)
EBITDA		$	6,437			$	35,803
Adjustments:
Stock-based compensation expense		78,495				21,879
Adjusted EBITDA (CEO Performance Award)		$	84,932			$	57,682

Liquidity and Capital Resources

Summary

As of December 31, 2019, we had $172.3 million of cash and cash equivalents, a decrease of $177.2 million from December 31, 2018. Cash and cash equivalents and investments totaled $396.3 million, an increase of $46.8 million from December 31, 2018.

Cash Flows

The following table summarizes our cash flows from operating, investing and financing activities (in thousands):

	Year Ended December 31,
	2019				2018
Operating activities	$	65,673			$	63,875
Investing activities	(240,737		)		(9,860		)
Financing activities	(3,937		)		219,348
Effect of exchange rate changes on cash and cash equivalents	329				(774		)
Net increase (decrease) in cash and cash equivalents and restricted cash	$	(178,672	)		$	272,589

Operating activities

Net cash provided by operating activities in 2019 of $65.7 million consisted of $0.9 million in net income, the net add-back of non-cash income statement items totaling $89.4 million and a $24.6 million net change in operating assets and liabilities. Included in the non-cash items were $11.4 million in depreciation and amortization expense, $2.5 million related to the impairment of certain property and equipment, $78.5 million in stock-based compensation expense, and a $8.0 million increase in deferred income tax assets. The most significant increase to the portion of cash provided by operating activities related to the changes in operating assets and liabilities was a $24.0 million increase in deferred revenue. Of the deferred revenue increase, $10.5 million resulted from increased hardware deferred revenue from TASER subscription sales, and $13.1 million related to prepayments for Software and Sensors services. Additionally, operating cash flows were positively impacted by an increase of $5.0 million in accounts payable and accrued liabilities,

which was primarily a result of the timing of invoice payments. Operating cash flows were negatively impacted by increased inventory of $4.9 million, increased accounts and notes receivable and contract assets of $38.8 million and increased prepaid expenses and other assets of $9.8 million. The increase in accounts and notes receivable and contract assets was attributable to increased sales in 2019, primarily sales made under subscription plans. The increase in prepaid expenses and other assets of $9.8 million during 2019 was primarily attributable to a $15.0 million prepayment related to a purchase agreement for cloud data storage that commenced in July 2019, net of usage of $7.0 million, and a smaller increase in deferred commissions.

Investing activities

We used $240.7 million for investing activities in 2019. Purchases of investments, net of calls and maturities, were $224.4 million. We also invested $16.3 million in the purchase of property and equipment and intangibles.

Financing activities

Net cash used in financing activities was $3.9 million for the year ended December 31, 2019. During 2019, we paid income and payroll taxes of approximately $4.1 million on behalf of employees who net-settled stock awards during the period. These cash outflows were partially offset by $0.1 million of proceeds from the exercise of stock options.

Liquidity and Capital Resources

Our most significant source of liquidity continues to be funds generated by operating activities and available cash and cash equivalents. In addition, our $50.0 million revolving credit facility is available for additional working capital needs or investment opportunities. Under the terms of the line of credit, available borrowings are reduced by outstanding letters of credit. Advances under the line of credit bear interest at LIBOR plus 1.0 to 1.5% per year determined in accordance with a pricing grid based on our funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio.

As of December 31, 2019, we had letters of credit outstanding of $2.7 million, leaving the net amount available for borrowing of $47.3 million. The facility matures on December 31, 2021 and has an accordion feature which allows for an increase in the total line of credit up to $100.0 million, subject to certain conditions, including the availability of additional bank commitments. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our revolving credit facility. At December 31, 2019 and 2018, there were no borrowings under the line.

Our agreement with the bank requires us to comply with a maximum funded debt to EBITDA ratio, as defined, of no greater than 2.50 to 1.00 based upon a trailing four fiscal quarter period. At December 31, 2019, the Company’s funded debt to EBITDA ratio was 0.0004 to 1.00.

TASER 60 installment purchase arrangements typically involve amounts invoiced in five equal installments at the beginning of each year of the five-year term. This is in contrast to a traditional CED sale in which the entire amount being charged for the hardware is invoiced upon shipment. This impacts liquidity in a commensurate fashion, with the cash for the TASER 60 arrangement received in five annual installments rather than up front. It is our strategic intent to shift an increasing amount of our business to a subscription model, to better match the municipal budgeting process of our customers as well as to allow for multiple product offerings to be bundled into existing subscriptions. We carefully considered the cash flow impacts of this strategic shift and regularly revisit our cash flow forecast with the goal of maintaining a comfortable level of liquidity as we introduce commercial offerings in which we incur upfront cash costs to produce and fulfill hardware sales ahead of the cash inflows from our customers. We anticipate, and have prepared for, the majority of our arrangements in both reportable segments to be offered in similar subscription-type offerings over the coming years. With the launch of the TASER 7, which is primarily being sold in subscription offerings, this strategic shift continues to accelerate.

Based on our strong balance sheet and the fact that we had less than $0.1 million in total long-term debt and financing lease obligations at December 31, 2019, we believe financing will be available, both through our existing

credit line and possible additional financing. However, there is no assurance that such funding will be available on terms acceptable to us, or at all.

We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions and other liquidity requirements through at least the next 12 months. We and our Board of Directors may consider repurchases of our common stock. Further repurchases of our common stock would take place on the open market, would be financed with available cash and are subject to authorization as well as market and business conditions.

Contractual Obligations

The following table outlines our future contractual financial obligations by period in which payment is expected, as of December 31, 2019 (dollars in thousands):

		Total				Less than 1 Year				1 - 3 Years				3 - 5 Years				More than 5 Years
Operating lease obligations		$	12,042			$	4,539			$	6,330			$	1,173			$	—
Financing leases including interest		36				36				—				—				—
Purchase obligations		193,322				154,845				24,118				4,413				9,946
Total contractual obligations		$	205,400			$	159,420			$	30,448			$	5,586			$	9,946

Purchase obligations in the table above represent $137.9 million of open purchase orders and $55.4 million of other purchase obligations. The open purchase orders represent both cancelable and non-cancelable purchase orders with key vendors, which are included in this table due to our strategic relationships with these vendors.

We are subject to U.S. federal income tax as well as income taxes imposed by state and foreign jurisdictions. As of December 31, 2019, we had $6.9 million of gross unrecognized tax benefits related to uncertain tax positions. The settlement period for our long-term income tax liabilities cannot be determined; however, the liabilities are expected to increase by approximately $1.2 million within the next 12 months.

Off-Balance Sheet Arrangements

The discussion of off-balance sheet arrangements in Note 9 to the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K is incorporated by reference herein.

Critical Accounting Estimates

We have identified the following accounting estimates as critical to our business operations and the understanding of our results of operations. The preparation of this Annual Report on Form 10-K requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. While we do not believe that a change in these estimates is reasonably likely, there can be no assurance that our actual results will not differ from these estimates. The effect of these estimates on our business operations is discussed below.

Product Warranties

We warranty our CEDs, Axon cameras and certain related accessories from manufacturing defects on a limited basis for a period of one year after purchase and, thereafter, will replace any defective unit for a fee. Estimated costs for the standard warranty are charged to cost of products sold when revenue is recorded for the related product. Future warranty costs are estimated based on historical data related to warranty claims on a quarterly basis and this rate is applied to current product sales. Historically, reserve amounts have been increased if management becomes aware of a component failure or other issue that could result in larger than anticipated warranty claims from customers. The

warranty reserve is reviewed quarterly to verify that it sufficiently reflects the remaining warranty obligations based on the anticipated expenditures over the balance of the warranty obligation period, and adjustments are made when actual warranty claim experience differs from estimates. As of December 31, 2019 and 2018, our warranty reserve was approximately $1.5 million and $0.9 million, respectively. Warranty expense for the years ended December 31, 2019, 2018 and 2017 was $1.6 million, $0.7 million and $0.1 million, respectively. The increase in warranty expense for the year ended December 31, 2019 was primarily driven by the initial reserves on the new product launch of our Axon Body 3 camera as well as our continued support of TASER 7. As of December 31, 2019, our reserve included initial reserves related to Axon Body 3 cameras and docks. Warranty expense for the year ended December 31, 2018 was impacted by higher than initially expected warranty claims for the Axon Flex 2 on-officer body camera. Warranty expense for the year ended December 31, 2017, was impacted by lower than expected warranty claims for the Axon Body 2 on-officer body camera.

Revenue related to separately-priced extended warranties is initially recorded as deferred revenue at its allocated amount and subsequently recognized as net sales on a straight-line basis over the warranty service period. Costs related to extended warranties are charged to cost of product and service sales when incurred.

Inventory

Inventories are stated at the lower of cost and net realizable value. Cost is determined using the weighted average cost of raw materials, which approximates the first-in, first-out (“FIFO”) method and includes allocations of manufacturing labor and overhead. Provisions are made to reduce potentially excess, obsolete or slow-moving inventories, as well as trial and evaluation inventories to their net realizable value. These provisions are based on management’s best estimate after considering historical demand, projected future demand, inventory purchase commitments, industry and market trends and conditions among other factors. We evaluate inventory costs for abnormal costs due to excess production capacity and treats such costs as period costs.

During the year ended December 31, 2019, we recorded provisions to reduce inventories to their lower of cost and net realizable value of approximately $1.3 million compared to $3.8 million during the year ended December 31, 2018. The provision in 2019 was driven by analyses of projected sales data for existing products resulting in adjustments to state inventories at their lower of cost and net realizable value. The provision for 2018 was primarily attributable to the impact of phasing out previous generations of VIEVU cameras in an effort to convert existing customers to Axon body camera deployments.

Revenue Recognition, Deferred Revenue and Accounts and Notes Receivable

We derive revenue from two primary sources: (1) the sale of physical products, including CEDs, Axon cameras, Axon Signal enabled devices, corresponding hardware extended warranties, and related accessories such as Axon docks, cartridges and batteries, among others, and (2) subscriptions to our Axon Evidence digital evidence management SaaS (including data storage fees and other ancillary services), which includes varying levels of support. To a lesser extent, we also recognize training, professional services and revenue related to other software and SaaS services. We apply the five-step model outlined in Topic 606.

Many of our products and services are sold on a standalone basis. We also bundle our hardware products and services together and sell them to our customers in single transactions, where the customer can make payments over a multi-year period. For the years ended December 31, 2019, 2018 and 2017, the composition of revenue recognized from contracts containing multiple performance obligations and those not containing multiple performance obligations was as follows (dollars in thousands):

	For the Year Ended December 31, 2019
	TASER							Software and Sensors							Total
Contracts with Multiple Performance Obligations	$	130,761			46.4	%		$	245,416			98.5	%		$	376,177			70.9	%
Contracts without Multiple Performance Obligations	150,900				53.6			3,783				1.5			154,683				29.1
Total	$	281,661			100.0	%		$	249,199			100.0	%		$	530,860			100.0	%

	For the Year Ended December 31, 2018
	TASER							Software and Sensors							Total
Contracts with Multiple Performance Obligations	$	72,355			28.6	%		$	159,318			95.4	%		$	231,673			55.2	%
Contracts without Multiple Performance Obligations	180,760				71.4			7,635				4.6			188,395				44.8
Total	$	253,115			100.0	%		$	166,953			100.0	%		$	420,068			100.0	%

	For the Year Ended December 31, 2017 (1)
	TASER							Software and Sensors							Total
Contracts with Multiple Performance Obligations	$	53,865			23.0	%		$	102,529			93.8	%		$	156,394			45.5	%
Contracts without Multiple Performance Obligations	180,647				77.0			6,757				6.2			187,404				54.5
Total	$	234,512			100.0	%		$	109,286			100.0	%		$	343,798			100.0	%

(1) Amounts for the years ended December 31, 2017 have not been adjusted under the modified retrospective method of adoption of Topic 606, and are presented consistent with the prior period amounts reported under ASC 605.

Additionally, we offer customers the ability to purchase CED cartridges and certain services on an unlimited basis over the contractual term. Due to the unlimited nature of these arrangements whereby we are obligated to deliver unlimited products at the customer’s request, we account for these arrangements as stand-ready obligations, and recognize revenue ratably over the contract period. Cost of product sales is recognized as the products are shipped to the customer.

Revenues are recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, each of which is generally distinct and accounted for as a separate performance obligation. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental taxing authorities.

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account in Topic 606. For contracts with multiple performance obligations, we allocate the contract transaction price to each performance obligation using our estimate of the standalone selling price ("SSP") of each distinct good or service in the contract.

Performance obligations to deliver products, including CEDs, cameras and related accessories such as cartridges, batteries and docks, are generally satisfied at the point in time we ship the product, as this is when the customer obtains control of the asset under our standard terms and conditions. In certain contracts with non-standard terms and conditions, these performance obligations may not be satisfied until formal customer acceptance occurs. Performance obligations to fulfill service-type extended warranties and provide our SaaS offerings, including Axon Evidence and other cloud services, are generally satisfied over time as the customer receives and consumes the benefits of these services over the stated service period.

We have elected to recognize shipping costs as an expense in cost of product sales when the control of hardware products or accessories have transferred to the customer.

Sales tax collected on sales is netted against government remittances and thus, recorded on a net basis.

Deferred revenue consists of payments received in advance related to products and services for which the criteria for revenue recognition have not yet been met. Deferred revenue that will be recognized during the subsequent twelve month period from the balance sheet date is recorded as current deferred revenue and the remaining portion is recorded as long-term. Generally, customers are billed in annual installments.

Sales are typically made on credit, and we generally do not require collateral. Management performs ongoing credit evaluations of its customers’ financial condition, and maintains an allowance for doubtful accounts. Uncollectible accounts are charged to expense when deemed uncollectible, and accounts and notes receivable are presented net of an allowance for doubtful accounts. This allowance represents management’s best estimate and application of judgment considering a number of factors, including third-party credit reports, actual payment history, cash discounts, customer-specific financial information and broader market and economic trends and conditions.

Valuation of Goodwill, Intangibles and Long-lived Assets

We do not amortize goodwill and intangible assets with indefinite useful lives. Such assets are required to be tested for impairment at least annually, or sooner whenever events or changes in circumstances indicate that the assets may be impaired. We perform our annual impairment assessment in the fourth quarter of each year. Finite-lived intangible assets and other long-lived assets are amortized over their estimated useful lives. Management evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets and intangible assets may warrant revision or that the remaining balance of these assets, including intangible assets with indefinite lives, may not be recoverable.

Circumstances that might indicate long-lived assets might not be recoverable could include, but are not limited to, a change in the product mix, a change in the way products and services are created, produced or delivered, or a significant change in the way our products are branded and marketed. When performing a review for recoverability, management estimates the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The amount of the impairment loss, if impairment exists, is calculated based on the excess of the carrying amounts of the assets over their estimated fair value computed using discounted cash flows. During the year ended December 31, 2019, we abandoned certain capitalized software related to implementation work on an enterprise resource planning system conversion, resulting in an impairment charge of $1.3 million, and certain planning and site development activities related to our planned new headquarters, resulting in an impairment charge of $0.7 million, both of which were included in sales, general and administrative expense in the accompanying consolidated statements of operations. During the year ended December 31, 2018, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of $2.0 million. During the year ended December 31, 2017, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of $1.0 million.

Income Taxes

We recognize federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable or refundable in the current fiscal year by tax jurisdiction. We also recognize federal, state and foreign deferred tax assets or liabilities, as appropriate, for our estimate of future tax effects attributable to temporary differences and carry forwards.

We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. We must also assess whether uncertain tax positions as filed could result in the recognition of a liability for possible interest and penalties if any. We have completed research and development tax credit studies for each year a tax credit was claimed for federal, Arizona, and California income tax purposes. We determined that it was more likely than not that the full benefit of the research and development tax credit would not be sustained on examination and accordingly, have established a liability for unrecognized tax benefits of $6.1 million as of December 31, 2019. In addition, we established a $0.1 million liability related to uncertain tax positions for certain federal income tax liabilities, for a total unrecognized tax benefit of $6.2 million. We expect the amount of the unrecognized tax benefit to increase by approximately $1.2 million within the next 12 months. Should the unrecognized tax benefit of $6.2 million be recognized, our effective tax rate would be favorably impacted. Our estimates are based on information available to us at the time we prepare the income tax provision. Our income tax returns are subject to audit by federal, state, and local governments, generally years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws. Our U.S. federal income tax return for fiscal year 2016 is currently under audit by the IRS.

Our calculation of current and deferred tax assets and liabilities is based on certain estimates and judgments and involves dealing with uncertainties in the application of complex tax laws. Our estimates of current and deferred tax assets and liabilities may change based, in part, on added certainty or finality to an anticipated outcome, changes in accounting or tax laws in the U.S. and internationally, or changes in other facts or circumstances. In addition, we recognize liabilities for potential tax contingencies based on our estimate of whether, and the extent to which, additional taxes may be due. If we determine that payment of these amounts is unnecessary, or if the recorded tax liability is greater than our current assessment, we may be required to recognize an income tax benefit, or additional income tax expense, respectively, in our consolidated financial statements.

In preparing our consolidated financial statements, we assess the likelihood that our deferred tax assets will be realized from future taxable income. In evaluating our ability to recover our deferred income tax assets, we consider all available positive and negative evidence, including operating results, ongoing tax planning and forecasts of future taxable income on a jurisdiction by jurisdiction basis. A valuation allowance is established if we determine that it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to audit by tax authorities in the ordinary course of business. As of December 31, 2019, we would need to generate approximately $88.5 million of pre-tax income in the U.S. in order to realize the net deferred tax assets for which a benefit has been recorded. This estimate considers the reversal of approximately $25.3 million in gross deferred tax liabilities, $6.2 million tax-effected. We have state net operating losses ("NOLs") of $1.2 million, which produce deferred tax assets of $0.1 million, which expire at various dates between 2029 and 2036. We anticipate sufficient future pre-tax book income to realize a large portion of our deferred tax assets. However, based on expected income for years in which Arizona R&D tax credits are set to expire, and cumulative losses in certain foreign jurisdictions, a reserve of $7.2 million has been recorded as a valuation allowance against deferred tax assets as of December 31, 2019.

Stock-Based Compensation

We have historically granted stock-based compensation to key employees and non-employee directors as a means of attracting and retaining highly qualified personnel. Stock-based compensation awards primarily consist of service-based RSUs, performance-based RSUs, and performance-based stock options. Our stock-based compensation awards are classified as equity and measured at the fair market value of the underlying stock at the grant date. For service-based awards, we recognize RSU expense using the straight-line attribution method over the requisite service period. Vesting of performance-based RSUs and options is contingent upon the achievement of certain performance criteria related to our operating performance, as well as successful and timely development and market acceptance of future product introductions. For performance-based RSUs containing only performance conditions, compensation cost is recognized using the graded attribution model over the explicit or implicit service period. For awards containing multiple

service, performance or market conditions, where all conditions must be satisfied prior to vesting, compensation expense is recognized over the requisite service period, which is defined as the longest explicit, implicit or derived service period, based on management’s estimate of the probability and timing of the performance criteria being satisfied, adjusted at each balance sheet date. For both service-based and performance-based RSUs, we account for forfeitures as they occur as a reduction to stock-based compensation expense and additional paid-in-capital.

For performance-based options, stock-based compensation expense is recognized over the expected performance achievement period of individual performance goals when the achievement of each individual performance goal becomes probable. For performance-based awards with a vesting schedule based entirely on the attainment of both performance and market conditions, stock-based compensation expense is recognized over the longer of the expected achievement period of the performance and market conditions, beginning at the point in time that the relevant performance condition is considered probable of achievement. The fair value of such awards is estimated on the grant date using Monte Carlo simulations. Refer to Note 12 of the notes to our consolidated financial statements within this Annual Report on Form 10-K.

We have granted a total of approximately 14.5 million performance-based awards (options and restricted stock units) of which approximately 12.4 million are outstanding as of December 31, 2019, the vesting of which is contingent upon the achievement of certain performance criteria including the successful development and market acceptance of future product introductions as well as our future sales targets and operating performance and market capitalization. Compensation expense for performance awards will be recognized based on management’s best estimate of the probability of the performance criteria being satisfied using the most currently available projections of future product adoption and operating performance, adjusted at each balance sheet date. Changes in the subjective and probability-based assumptions can materially affect the estimates of the fair value of the awards and timing of recognition of stock-based compensation and consequently, the related amount recognized in our statements of operations and comprehensive income.

Contingencies and Accrued Litigation Expense

We are subject to the possibility of various loss contingencies arising in the ordinary course of business, including product-related and other litigation. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required. Refer to Note 9 of our consolidated financial statements within this Annual Report on Form 10-K.