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” 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, 2020 as compared to the year ended December 31, 2019. For a discussion and analysis of the year ended December 31, 2019, compared to the same period in 2018 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, 2019, filed with the SEC on February 27, 2020.

Overview

Axon is a global network of devices, apps and people that helps public safety personnel become smarter and safer. With a mission of protecting life, our technologies give law enforcement the confidence, focus and time they need to protect their communities. Our products impact every aspect of a public safety officer’s day-to-day experience with the goal of helping everyone get home safe.

Our revenues for the year ended December 31, 2020 were $681.0 million, an increase of $150.1 million, or 28.2%, from the prior year. We had a loss from operations of $14.2 million compared to $6.4 million in the prior year. The higher loss from operations was primarily the result of increased stock compensation expense for our CEO Performance Award and XSPP awards and an increase in legal expenses. Remaining cost increases were primarily attributable to the increase in unit sales and an increase in headcount. These cost increases were largely offset by higher revenue and improved gross margin. For the year ended December 31, 2020, we recorded net loss of $1.7 million compared to net income of $0.9 million for the prior year.

2021 Outlook

For the year ending December 31, 2021, we expect revenue of $740 million to $780 million. We anticipate that revenue for the three months ending March 31, 2021 will reflect approximately 12% growth as compared to the three months ended March 31, 2020. We anticipate capital expenditures of approximately $65 million to $70 million in 2021, including approximately $25 million in support of capacity expansion and automation of TASER device and cartridge manufacturing, approximately $20 million for development of our planned new manufacturing and office facility in Scottsdale, Arizona, and the remainder on investments to support our continued growth.

COVID-19

In late 2019, COVID-19 was first detected in Wuhan, China. In March 2020 the World Health Organization declared COVID-19 a global pandemic. This contagious disease outbreak, which has continued to spread throughout the United States and world, has adversely affected workforces, economies, and financial markets globally, leading to an economic downturn. As an essential provider of products and services for law enforcement and other first responders, we remain focused on protecting the health and wellbeing of our employees while assuring the continuity of our business operations.

In response to the pandemic, Axon has taken a number of actions:

Customer support:

	●	Free access to Axon Citizen cloud software to all public law enforcement agencies in 2020 to enable social distancing;

	●	A partnership with the National Police Foundation to provide personal protective equipment (“PPE”) for first responders;

	●	An online support center for our customers, www.axon.com/covid-19-support-center; and

	●	Our annual Axon Accelerate user conference was held virtually in late August 2020.

​

Employee safety and manufacturing:

	●	Curbed all non-essential travel at the beginning of March;

	●	We continue to allow for a remote work model for the majority of our office staff, with medical screening for any employees who do work in our offices; and

	●	Mitigating contamination risk in our facilities through staggered shifts, the use of PPE, increased distancing, cleaning standards that exceed CDC guidance, and paying or subsidizing certain high-risk employees while they stay at home.

​

Supply chain:

	●	We previously took steps to diversify our supply chain and global manufacturing footprint, which have positioned us well to manage through the pandemic. Thus far, we have been able to produce and ship our critical core products with little to no interruption.

	●	We have proactively built up a safety stock of raw and finished goods inventory aligned to our strategic model to help meet strong product demand while also preparing us to stagger factory work schedules. We continue to adjust strategic inventory levels based on areas of risk to mitigate potential supply disruptions.

	●	In light of our broad geographic supplier base both domestic and international, we are continuously monitoring our supply chain to manage through potential impacts, finding alternate sources as well as shipping / logistic options as available or working with foreign regulators to ensure that our suppliers can provide parts.

​

Shareholder engagement:

	●	We have pivoted our shareholder engagement to a virtual format.

	o	Our annual meeting was held virtually on May 29, 2020, and we anticipate holding our 2021 annual meeting virtually;

	o	We completed a follow-on equity offering in June 2020 for which all related marketing was conducted virtually; and

	o	We will continue to participate in several upcoming investor conferences utilizing video conferencing. All investor materials and events are available at investor.axon.com.

​

We are in a strong liquidity position, with substantial cash and investments on hand, which are discussed in more detail under Liquidity and Capital Resources. We believe that our existing liquidity and other sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions or strategic investments and other liquidity requirements through at least the next 12 months. Our expenses for the year ended December 31, 2020 increased by approximately $4.1 million for costs related to the pandemic. We expect ongoing increased costs related to the mitigation of contamination risk at our facilities. We expect these incremental costs will continue to be partially offset by savings on travel and events and other cost-savings measures.

​

We have elected to participate in the social security deferral program offered under the Coronavirus Aid, Relief, and Economic Security Act, whereby we deferred payment of the employer portion of all social security taxes that would otherwise have been payable from March 27, 2020 through December 31, 2020. Payment of the deferred amount is due 50% on December 31, 2021 and 50% on December 31, 2022.

​

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,
​	​	2020					​	2019
Net sales from products		$	500,250		73.5	%	​	$	399,474		75.3	%
Net sales from services	​		180,753		26.5	​	​		131,386		24.7	​
Net sales	​		681,003		100.0	​	​		530,860		100.0	​
Cost of product sales	​		224,131		32.9	​	​		190,683		35.9	​
Cost of service sales	​		40,541		6.0	​	​		32,891		6.2	​
Cost of sales	​		264,672		38.9	​	​		223,574		42.1	​
Gross margin	​		416,331		61.1	​	​		307,286		57.9	​
Operating expenses:	​	​	​	​	​	​	​	​	​	​	​	​
Sales, general and administrative	​		307,286		45.1	​	​		212,959		40.1	​
Research and development	​		123,195		18.1	​	​		100,721		19.0	​
Total operating expenses	​		430,481		63.2	​	​		313,680		59.1	​
Income (loss) from operations	​		(14,150)		(2.1)	​	​		(6,394)		(1.2)	​
Interest and other income, net	​		7,859		1.1	​	​		8,464		1.6	​
Income (loss) before provision for income taxes	​		(6,291)		(1.0)	​	​		2,070		0.4	​
Provision for (benefit from) income taxes	​		(4,567)		(0.7)	​	​		1,188		0.2	​
Net income (loss)		$	(1,724)		(0.3)	%	​	$	882		0.2	%

​

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

​

​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	Year Ended December 31,
​	​	2020				​	​	2019
United States		$	535,079		79	%	​	$	446,100		84	%
Other Countries	​		145,924		21	​	​		84,760		16	​
Total	​	$	681,003		100	%	​	$	530,860		100	%

​

International revenue in 2020 increased substantially compared to 2019, driven by strength in all of our international regions and most notably within EMEA.

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 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 TASER segment, service revenue also includes digital subscription training content. 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, 2020 and 2019

Net Sales

Net sales by product line were as follows for the years ended December 31, 2020 and 2019 (dollars in thousands):

​

​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	Year Ended December 31,										Dollar			Percent
​	​	2020				​	2019				​	Change		​	Change
TASER segment:		​					​					​				​
TASER 7	​	$	107,506		15.8	%	$	56,652		10.7	%	$	50,854		89.8	%
TASER X26P	​		41,724		6.1	​		52,524		9.9	​		(10,800)		(20.6)	​
TASER X2	​		60,107		8.8	​		55,920		10.5	​		4,187		7.5	​
TASER Pulse	​		9,407		1.4	​		4,089		0.8	​		5,318		130.1	​
Cartridges	​		115,193		16.9	​		85,987		16.2	​		29,206		34.0	​
Axon Evidence and cloud services	​		2,935		0.4	​		704		0.1	​		2,231		316.9	​
Extended warranties	​		20,754		3.0	​		18,074		3.4	​		2,680		14.8	​
Other	​		8,926		1.3	​		7,711		1.5	​		1,215		15.8	​
TASER segment	​		366,552		53.7	​		281,661		53.1	​		84,891		30.1	​
Software and Sensors segment:	​		​		​	​		​		​	​					​
Axon Body	​		57,150		8.4	​		44,039		8.3	​		13,111		29.8	​
Axon Flex	​		4,082		0.6	​		5,928		1.1	​		(1,846)		(31.1)	​
Axon Fleet	​		20,108		3.0	​		16,182		3.0	​		3,926		24.3	​
Axon Dock	​		19,723		2.9	​		20,449		3.9	​		(726)		(3.6)	​
Axon Evidence and cloud services	​		176,797		26.0	​		130,265		24.5	​		46,532		35.7	​
Extended warranties	​		24,408		3.6	​		19,188		3.6	​		5,220		27.2	​
Other	​		12,183		1.8	​		13,148		2.5	​		(965)		(7.3)	​
Software and Sensors segment	​		314,451		46.3	​		249,199		46.9	​		65,252		26.2	​
Total net sales	​	$	681,003		100.0	%	$	530,860		100.0	%	$	150,143		28.3	%

​

Net unit sales were as follows:

​

​	​	​	​	​	​	​	​	​	​
​	​	Year Ended December 31,			​	Unit	​	Percent
​		2020		2019		Change		Change
TASER 7		77,451		49,221		28,230		57.4	%
TASER X26P		37,391		48,798		(11,407)		(23.4)	%
TASER X2		43,407		40,973		2,434		5.9	%
TASER Pulse		33,158		11,785		21,373		181.4	%
Cartridges		3,714,291		2,751,603		962,688		35.0	%
Axon Body		182,538		151,499		31,039		20.5	%
Axon Flex		8,962		15,586		(6,624)		(42.5)	%
Axon Fleet		11,304		10,467		837		8.0	%
Axon Dock		25,422		22,275		3,147		14.1	%

​

Net sales for the TASER segment increased $84.9 million, or 30.1%, primarily as a result of a net increase of $49.6 million in TASER device sales and a $29.2 million increase in cartridge revenue. Cartridge revenue increased due to increased unit sales, partially offset by a slight decrease in average selling price. We continue to see a shift to purchases of our latest generation device, TASER 7, from legacy devices, especially X26P devices. Sales of our TASER 7 device also drove the increase in revenue from Axon Evidence and cloud services. Revenue was also impacted by higher average selling prices for TASER 7, X2, and X26P. Revenue from consumer TASER Pulse devices increased due to a substantial increase in volume, partially offset by lower average selling prices.

Net sales for the Software and Sensors segment increased $65.3 million, or 26.2%. Revenue from Axon Evidence and cloud services increased $46.5 million as we continued to add users and associated devices to our network during

the year ended December 31, 2020. The increase in the aggregate number of users and devices also resulted in increased extended warranty revenues of $5.2 million. Revenue from Axon Body cameras increased $13.1 million following the introduction of our Axon Body 3 camera during the third quarter of 2019.

Backlog - As of December 31, 2020 compared to December 31, 2019

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 invoiced but remain undelivered. The TASER segment backlog balance was $61.8 million as of December 31, 2020. We expect to realize $28.9 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, 2020 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 $1.4 billion as of December 31, 2020. This backlog balance includes $213.4 million of deferred revenue, and $1.2 billion that has been recorded as bookings but not yet invoiced, all as of December 31, 2020. We expect to realize approximately $370.0 million of the December 31, 2020 backlog balance as revenue during the next 12 months.

​

​	​	​	​	​	​	​	​	​	​
​		TASER			Software and Sensors			Total
​	​	(in thousands)
Balance, beginning of period	​	$	55,189	​	$	1,026,192	​	$	1,081,381
Add: additions to backlog, net of cancellations	​	​	373,119	​	​	716,145	​	​	1,089,264
Less: revenue recognized during period	​	​	(366,552)	​	​	(314,451)	​	​	(681,003)
Balance end of period	​	$	61,756		$	1,427,886		$	1,489,642

​

Our backlog of $1.5 billion as of December 31, 2020 has increased significantly from $1.1 billion as of December 31, 2019. 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.

Cost of Product and Service Sales

Cost of product and services sales in dollars and as a percent of related segment sales (dollars in thousands):

​

​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	Year Ended December 31,									​	Dollar		​	Percent
​	​	2020				​	2019				​	Change		​	Change
TASER segment:		​	​		​		​	​		​		​	​		​
Cost of product sales	​	$	136,925	​	37.4	%	$	107,188	​	38.1	%	$	29,737	​	27.7	%
Software and Sensors segment:	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​
Cost of product sales	​	​	87,206		27.7	%		83,495		33.5	%		3,711		4.4	%
Cost of service sales	​	​	40,541		12.9	%		32,891		13.2	%		7,650		23.3	%
Total cost of sales	​	​	127,747		40.6	%		116,386		46.7	%		11,361		9.8	%
Total cost of product and service sales	​	$	264,672		38.9	%	$	223,574		42.1	%	$	41,098		18.4	%

​

Within the TASER segment, cost of product and service sales was $136.9 million, an increase of $29.7 million, or 27.7%, from 2019. Cost as a percentage of sales decreased to 37.4% from 38.1%. The increase in cost of sales was primarily a result of increased sales, with improvement to the cost as a percentage of sales primarily a result of

increased leverage on manufacturing overhead expenses and higher expense in the prior year 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 $127.7 million, an increase of $11.4 million, or 9.8%, from 2019. As a percentage of net sales, cost of product and service sales decreased to 40.6% in 2020 from 46.7% in 2019. Cost of product sales increased $3.7 million primarily driven by the impact of increased units, but decreased as a percentage of total segment net sales, reflecting higher average selling prices on Axon cameras and docks, overall product mix, and relatively stable unit costs. Cost of service sales increased $7.7 million driven primarily by a $3.9 million increase in third party cloud data cost, and an increase in professional services expense due to increased deployments in 2020.

Gross Margin

Gross Margin (dollars in thousands):

​

​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	Year Ended December 31,					​	Dollar		​	Percent	​
​		2020			2019			Change			Change	​
TASER segment	​	$	229,627	​	$	174,473	​	$	55,154	​	31.6	%
Software and Sensors segment	​	​	186,704	​	​	132,813	​	​	53,891	​	40.6	%
Total gross margin	​	$	416,331	​	$	307,286	​	$	109,045		35.5	%
Gross margin as % of net sales	​	​	61.1	%		57.9	%	​	​	​	​	​

​

Gross margin increased $109.0 million to $416.3 million for the year ended December 31, 2020 compared to $307.3 million for 2019. As a percentage of net sales, gross margin increased to 61.1% for 2020 from 57.9% for 2019.

As a percentage of net sales, gross margin for the TASER segment increased to 62.6% for the year ended December 31, 2020 from 61.9% for the year ended December 31, 2019.

Within the Software and Sensors segment, gross margin as a percentage of total segment net sales was 59.4% and 53.3% for the years ended 2020 and 2019, respectively. Within the Software and Sensors segment, product gross margin was 36.6% for the year ended December 31, 2020 and 29.8% for the same period in 2019, while the service margins were 77.1% and 74.8% 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		​	Percent
​		2020			2019			Change			Change
Salaries, benefits and bonus	​	$	83,287	​	$	67,582	​	$	15,705	​	23.2	%
Stock-based compensation	​	​	103,860	​	​	59,341	​	​	44,519	​	75.0	​
Professional, consulting and lobbying	​	​	45,541	​	​	21,590	​	​	23,951	​	110.9	​
Sales and marketing	​	​	32,464	​	​	28,961	​	​	3,503	​	12.1	​
Office and building	​	​	9,076	​	​	6,650	​	​	2,426	​	36.5	​
Travel and meals	​	​	5,630	​	​	11,407	​	​	(5,777)	​	(50.6)	​
Depreciation and amortization	​	​	6,079	​	​	5,739	​	​	340	​	5.9	​
Other	​	​	21,349	​	​	11,689	​	​	9,660	​	82.6	​
Total sales, general and administrative expenses	​	$	307,286	​	$	212,959	​	$	94,327		44.3	%
SG&A expenses as a percentage of net sales	​	​	45.1	%	​	40.1	%	​	​	​	​	​

​

SG&A expenses increased $94.3 million, or 44.3%. Stock-based compensation expense increased $44.5 million in comparison to the prior year comparable period, which was primarily attributable to an increase of $41.5

million in expense related to the CEO Performance Award and XSPP. As of December 31, 2020, eleven operational goals for the CEO Performance Award and XSPP are considered probable of attainment or have been attained; during the prior year comparable period, nine operational goals were considered probable. Refer to Note 13 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.

Professional, consulting and lobbying expenses increased $24.0 million, driven primarily by an increase of $19.1 million in expenses related to the FTC litigation. As discussed in Note 10 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. Also contributing to the increase were higher expenses related to our enterprise resource planning system conversion.

Salaries, benefits and bonus expense increased $15.7 million, primarily due to an increase in headcount. Salaries, benefits and bonus expense decreased as a percentage of sales from 12.7% for 2019 to 12.2% for 2020.

Sales and marketing expenses increased $3.5 million, driven by a $4.8 million increase in commissions tied to higher revenues. The increase was partially offset by savings driven by the cancellation of in-person events, including our annual Axon Accelerate user conference.

Other SG&A expenses increased by $9.7 million, primarily driven by the following:

	●	Supplies expense increased $3.0 million, including a $2.4 million increase in computer licenses and maintenance supporting increased headcount, and a $0.7 million increase for PPE and other COVID-19 related expenses.

	●	Charitable contributions increased $1.8 million, primarily reflecting our donations of PPE under our Got You Covered campaign.

	●	Insurance expense increased $1.4 million primarily as a result of increases in the cost of comparable policies.

	●	Recruiting expense increased $0.9 million as a result of increased hiring needs in 2020.

​

Partially offsetting the noted increases was a $5.8 million decrease in travel expenses following the suspension of all non-essential travel in mid-March 2020 in response to the COVID-19 pandemic.

Research and Development Expenses

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

​

​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	Year Ended December 31,					​	Dollar		​	Percent
​		2020			2019			Change			Change
Salaries, benefits and bonus	​	$	71,488	​	$	63,763	​	$	7,725	​	12.1	%
Stock-based compensation	​	​	26,248	​	​	17,588	​	​	8,660	​	49.2	​
Professional and consulting	​	​	10,503	​	​	4,525	​	​	5,978	​	132.1	​
Travel and meals	​	​	594	​	​	2,247	​	​	(1,653)	​	(73.6)	​
Other	​	​	14,362	​	​	12,598	​	​	1,764	​	14.0	​
Total research and development expenses	​	$	123,195	​	$	100,721	​	$	22,474		22.3	%
R&D expenses as a percentage of net sales	​	​	18.1	%	​	19.0	%	​	​	​	​	​

​

The increase in R&D expense was primarily attributable to our Software and Sensors segment. Within the TASER segment, R&D expenses increased $0.9 million or 6.3%, reflecting increased consulting expense and supplies in the current year related to the development of next generation products. The increase was partially offset by lower compensation and benefits resulting from decreased headcount.

R&D expense for the Software and Sensors segment increased $21.6 million or 25.0% but remained relatively consistent at 34.3% of sales as compared to 34.6% in the prior year. Of the increase, $9.1 million related to salaries, benefits, and bonus attributable to increased headcount.

Stock-based compensation expense increased $8.7 million. Contributing to the increase was expense of $3.8 million related to our XSPP. As of December 31, 2020, eleven operational goals for the XSPP are considered probable of attainment or have been attained; during the prior year comparable period, nine operational goals were considered probable. Stock-based compensation expense also increased over the prior year comparable period due to an increase in headcount.

Professional and consulting expenses increased $6.0 million related to development of next generation products.

The increases were partially offset by a decrease of $1.7 million in travel and meals expense following the suspension of all non-essential travel in mid-March 2020 due to the COVID-19 pandemic

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 as we reach economies of scale.

Interest and Other Income, Net

Interest and other income, net was $7.9 million and $8.5 million for the years ended December 31, 2020 and 2019, respectively.

For the year ended December 31, 2020, we earned interest income of $5.1 million, other income, net of $0.6 million, had losses from foreign currency transaction adjustments of $0.2 million, and interest expense of $0.1 million. Additionally, we recorded a net gain of $2.1 million related to an observable price change for our investment in Flock Group, Inc. and related warrants. The decrease in interest income was a result of decreased interest rates during the current period, partially offset by higher balances of cash, cash equivalents, and investments.

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.

Provision for Income Taxes

The provision for income taxes was a benefit of $4.6 million for the year ended December 31, 2020. The effective income tax rate for 2020 was 72.6%. The benefits related to excess stock-based compensation of $9.0 million, research and development credits of $10.2 million, and a deduction for foreign derived intangible income (“FDII”) of $0.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $15.5 million, an increase in uncertain tax benefits of $1.0 million, other permanently non-deductible expenses of $0.8 million and state tax expense of $0.9 million. Additionally, we recorded a $0.2 million increase to our valuation allowance as of December 31, 2020 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.

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.

Net Income

We recorded net loss of $1.7 million for the year ended December 31, 2020 compared to net income of $0.9 million in 2019. Net loss per basic and diluted share was $0.03 for 2020, compared to net income per basic and diluted share of $0.01 for 2019.

Three Months Ended December 31, 2020 Compared to September 30, 2020

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

​

​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​
​		Three Months Ended					Three Months Ended					Dollar			Percent
​	​	December 31, 2020				​	September 30, 2020				​	Change		​	Change
TASER segment:	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​
TASER 7	​	$	58,890		26.0	%	$	21,702		13.0	%	$	37,188		171.4	%
TASER X26P	​		11,386		5.0	​		9,766		5.9	​		1,620		16.6	​
TASER X2	​		14,706		6.5	​		14,494		8.7	​		212		1.5	​
TASER Pulse	​		3,033		1.4	​		2,981		1.8	​		52		1.7	​
Cartridges	​	​	38,461	​	17.0	​	​	26,335	​	15.8	​	​	12,126	​	46.0	​
Axon Evidence and cloud services	​		1,159		0.5	​		692		0.4	​		467		67.5	​
Extended warranties	​		5,414		2.4	​		5,265		3.2	​		149		2.8	​
Other	​		2,712		1.2	​		3,171		1.9	​		(459)		(14.5)	​
TASER segment	​		135,761		60.0	​		84,406		50.7	​		51,355		60.8	​
Software and Sensors segment:	​					​					​					​
Axon Body	​		16,505		7.3	​		15,978		9.6	​		527		3.3	​
Axon Flex	​		630		0.3	​		1,589		1.0	​		(959)		(60.4)	​
Axon Fleet	​		7,020		3.1	​		4,215		2.5	​		2,805		66.5	​
Axon Dock	​		5,009		2.2	​		5,708		3.4	​		(699)		(12.2)	​
Axon Evidence and cloud services	​		50,302		22.2	​		45,450		27.3	​		4,852		10.7	​
Extended warranties	​		6,701		3.0	​		6,514		3.9	​		187		2.9	​
Other	​		4,212		1.9	​		2,582		1.6	​		1,630		63.1	​
Software and Sensors segment	​		90,379		40.0	​		82,036		49.3	​		8,343		10.2	​
Total net sales	​	$	226,140		100.0	%	$	166,442		100.0	%	$	59,698		35.9	%

​

Net unit sales were as follows:

​

​	​	​	​	​	​	​	​	​	​
​		Three Months Ended				​		​
​	​	​	​	​	​	Unit	​	Percent
​	​	December 31, 2020	​	September 30, 2020	​	Change	​	Change
TASER 7		41,099		15,908		25,191		158.4	%
TASER X26P		10,611		8,119		2,492		30.7	%
TASER X2		9,751		10,078		(327)		(3.2)	%
TASER Pulse		11,657		12,811		(1,154)		(9.0)	%
Cartridges		1,272,679		852,980		419,699		49.2	%
Axon Body		44,735		62,873		(18,138)		(28.8)	%
Axon Flex		749		3,175		(2,426)		(76.4)	%
Axon Fleet		3,905		2,396		1,509		63.0	%
Axon Dock		6,326		9,165		(2,839)		(31.0)	%

​

Net sales for the TASER segment increased $51.4 million, or 60.8%, on a sequential basis primarily due to a $37.2 million increase in revenue from TASER 7 devices and a $12.1 million increase in cartridge revenue. The

increase in TASER 7 revenues was a result of both increased unit sales and a higher average selling price, driven by greater adoption of TASER 7, especially internationally.

Net sales for the Software and Sensors segment increased $8.3 million, or 10.2%, on a sequential basis primarily due to a $4.9 million increase in Axon Evidence and cloud services revenue and a $2.8 million increase in Axon Fleet revenue. The increase in Axon Evidence and cloud services revenue was a result of the increase in the aggregate number of users on our network. Axon Fleet revenue was driven primarily by increased unit sales, as well as an increase in the average selling price.

International sales were $59.5 million in for the three months ended December 31, 2020 as compared to $23.1 million for the three months ended September 30, 2020, an increase of $36.4 million, primarily driven by increased sales in Europe.

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,
​		December 31,			December 31,
​	​	2020		​	2019
Net income (loss)	​	$	(1,724)	​	$	882
Depreciation and amortization	​		12,475	​		11,361
Interest expense	​		55	​		46
Investment interest income	​		(4,086)	​		(7,040)
Provision for (benefit from) income taxes	​		(4,567)	​		1,188
EBITDA	​	$	2,153	​	$	6,437
​	​	​	​	​	​	​
Adjustments:	​			​
Stock-based compensation expense	​		133,572	​		78,495
Adjusted EBITDA (CEO Performance Award)	​	$	135,725	​	$	84,932

​

Liquidity and Capital Resources

Summary

As of December 31, 2020, we had $155.4 million of cash and cash equivalents, a decrease of $16.8 million from December 31, 2019. Cash and cash equivalents and investments totaled $652.6 million, an increase of $256.4 million from December 31, 2019.

Cash Flows

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

​

​	​	​	​	​	​	​
​	​	Year Ended December 31,
​		2020			2019
Operating activities	​	$	38,481	​	$	65,673
Investing activities	​	​	(356,526)	​	​	(240,737)
Financing activities	​	​	299,265	​	​	(3,937)
Effect of exchange rate changes on cash and cash equivalents	​		1,976	​		329
Net decrease in cash and cash equivalents and restricted cash	​	$	(16,804)	​	$	(178,672)

​

Operating activities

Net cash provided by operating activities in 2020 of $38.5 million consisted of $1.7 million in net loss, the net add-back of non-cash income statement items totaling $141.0 million and a $100.8 million net change in operating assets and liabilities. Included in the non-cash items were $12.5 million in depreciation and amortization expense, $133.6 million in stock-based compensation expense, and a $16.5 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 $107.8 million increase in accounts and notes receivable and contract assets. The increase in accounts and notes receivable and contract assets was attributable to increased sales in 2020, primarily sales made under subscription plans. Operating cash flows were also negatively impacted by increased inventory of $52.2 million, as we proactively built up a safety stock of inventory to help meet strong product demand while also preparing us to stagger factory work schedules, and increased prepaid expenses and other assets of $14.9 million resulting primarily from an increase in deferred commissions expense. Operating cash flows were positively impacted by an increase in deferred revenue of $65.1 million. The increase in deferred revenue was primarily attributable to increased prepayments for Software and Sensors hardware and services, and a smaller increase in hardware deferred revenue from TASER subscription sales.

Investing activities

We used $356.5 million for investing activities in 2020. Purchases of investments, net of calls and maturities, were $276.7 million. We also invested $72.6 million in the purchase of property and equipment and intangibles, including $54.1 million for land on which we intend to construct our new manufacturing and office facility, and $7.1 million for equity investments in unconsolidated affiliates.

Financing activities

Net cash used provided by financing activities was $299.3 million for the year ended December 31, 2020. During 2020, we completed an equity offering that generated net proceeds of $306.8 million. Certain RSUs that vested in the year ended December 31, 2020 were net-share settled, such that we withheld shares to cover the employees’ tax obligation for the applicable income and other employment taxes, and remitted the cash, which totaled $7.8 million, to the appropriate taxing authorities.

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, 2020, we had letters of credit outstanding of $6.1 million, leaving the net amount available for borrowing of $43.9 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, 2020 and 2019, 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, 2020, the Company’s funded debt to EBITDA ratio was 0.0000 to 1.00.

On January 29, 2021, we entered into an amendment to the credit agreement which extends the maturity date to December 31, 2023 and increases the amount of the unsecured revolving line of credit which is available for letters of credit from $10 million to $20 million.

TASER subscription and 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 subscription or installment purchase 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.

Based on our strong balance sheet and the fact that we had no long-term debt or financing lease obligations at December 31, 2020, 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 or strategic investments 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, 2020 (dollars in thousands):

​

​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	​	​	​	Less than		​	​	​	​	​	​	​	More than
​		Total			1 Year			1 - 3 Years			3 - 5 Years			5 Years
Operating lease obligations	​	$	26,409	​	$	6,277	​	$	12,069	​	$	7,860	​	$	203
Purchase obligations	​	​	209,258	​	​	192,826	​	​	4,169	​	​	5,003	​	​	7,260
Total contractual obligations		$	235,667		$	199,103		$	16,238		$	12,863		$	7,463

​

Purchase obligations in the table above represent $169.3 million of open purchase orders and $40.0 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, 2020, we had $7.7 million of gross unrecognized tax benefits related to uncertain tax positions. The settlement period for these long-term income tax liabilities cannot be determined; however, the liabilities are expected to increase by approximately $0.1 million within the next 12 months.

Off-Balance Sheet Arrangements

The discussion of off-balance sheet arrangements in Note 10 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, 2020 and 2019, our warranty reserve was approximately $0.8 million and $1.5 million, respectively. Warranty expense for the years ended December 31, 2020, 2019 and 2018 was $0.0 million, $1.6 million and $0.7 million, respectively. Warranty expense for the year ended December 31, 2020, was impacted by lower than expected warranty claims for the Axon Body 3 on-officer body camera. Warranty expense for the year ended December 31, 2019 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, 2018, 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 treat such costs as period costs.

During the year ended December 31, 2020, we recorded provisions to reduce inventories to their lower of cost and net realizable value of approximately $3.8 million compared to $1.3 million during the year ended December 31, 2019. The largest driver of the increase in the provision in 2020 compared to 2019 was a $2.2 million reduction in the carrying amount of our trial and evaluation inventory to zero which is our estimate of its net realizable value. The provision in 2020 and 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.

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 Accounting Standards Codification ("ASC") Topic 606, Revenue from Contracts with Customers ("Topic 606").

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.

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.

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.

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, 2020, 2019 and 2018, 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, 2020														​
​	​	TASER					Software and Sensors					Total
Contracts with Multiple Performance Obligations		$	186,427		50.9	%	$	311,187		99.0	%	$	497,614		73.1	%
Contracts without Multiple Performance Obligations	​	​	180,125	​	49.1	​	​	3,264	​	1.0	​	​	183,389	​	26.9
Total	​	$	366,552	​	100.0	%	$	314,451	​	100.0	%	$	681,003	​	100.0	%

​

​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​	​
​	​	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	%

​

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.

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.

Valuation of Goodwill, Intangible and Long-lived Assets

We do not amortize goodwill and intangible assets with indefinite useful lives; rather, 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, 2020, we abandoned certain planning and site development activities related to our planned new headquarters, resulting in an impairment charge of $0.7 million. Additionally, we recognized impairment charges totaling $0.5 million related to improvements and remodeling of certain of our offices. Both charges were included in sales, general and administrative expense in the accompanying consolidated statements of operations. 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 and comprehensive income (loss). 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.

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 $7.7 million as of December 31, 2020. We expect the amount of the unrecognized tax benefit to increase by approximately $0.1 million within the next 12 months. Should the unrecognized tax benefit of $7.7 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. During 2020, we completed an audit of our 2016 U.S. federal income tax return by the Internal Revenue Service and began an audit of our 2016 and 2017 California income tax returns for which we are currently in the closing phase with the Franchise Tax Board. Additionally, we have been notified that an audit will commence for Axon Public Safety Southeast Asia LLC, our entity in Vietnam. The tax period has not yet been defined.

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.

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 certain identified intangibles with an indefinite life, a reserve of $7.3 million has been recorded as a valuation allowance against deferred tax assets as of December 31, 2020.

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 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 13 of the notes to our consolidated financial statements within this Annual Report on Form 10-K.

We have granted a total of approximately 15.0 million performance-based awards (options and restricted stock units) of which approximately 12.0 million are outstanding as of December 31, 2020, 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 10 of our consolidated financial statements within this Annual Report on Form 10-K.

Reserve for Expected Credit Losses

We are exposed to the risk of credit losses primarily through sales of products and services. Our expected credit loss allowance for accounts receivable, notes receivable, and contract assets represents management’s best estimate and application of judgment considering a number of factors, including historical collection experience, published or estimated credit default rates for entities that represent our customer base, current and future economic and market conditions and a review of the current status of customers' trade accounts receivables. Additionally, specific reserve amounts are established to record the appropriate provision for customers that have a higher probability of default. Our monitoring activities include account reconciliation, dispute resolution, payment confirmation, consideration of customers' financial condition and macroeconomic conditions. Balances are written off when determined to be uncollectible.

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We review receivables for U.S. and international customers separately to better reflect different published credit default rates and economic and market conditions.

A majority of our customers are governmental agencies. Due to municipal government funding rules, certain of our contracts are subject to appropriation, termination for convenience, or similar cancellation clauses, which could allow our customers to cancel or not exercise options to renew contracts in the future. Economic slowdowns that negatively affect municipal tax collections and put pressure on law enforcement may increase this risk and negatively impact the realizability of our accounts and notes receivable and contract assets. We considered the current and expected future economic and market conditions surrounding the COVID-19 pandemic and increased our reserve for expected credit losses by approximately $0.9 million during the year ended December 31, 2020.

Based on the balances of our financial instruments as of December 31, 2020, a hypothetical 25 percent increase in expected credit loss rates across all pools would result in a $0.7 million increase in the allowance for expected credit losses.

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