UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q

 

 

 

 

Commission file no. 1-33350

 

 

SOURCEFIRE, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

 

Registrant’s telephone number including area code:       410-290-1616

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one)

 

 

Large Accelerated filer o          Accelerated filer o          Non-accelerated filer þ

 

 

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

 

 

As of August 2, 2007 there were 24,020,593 shares of the registrant’s common stock outstanding.

 

 

 

Sourcefire, Inc.
Index
Form 10-Q

 

 

SOURCEFIRE, INC.

 

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share and per share data)

 

 

See accompanying notes to consolidated financial statements.

SOURCEFIRE, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except share and per share data)

 

 

See accompanying notes to consolidated financial statements.

 

SOURCEFIRE, INC.

 

CONSOLIDATED STATEMENT OF CHANGES IN CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)

(Amounts in thousands, except share data)

(unaudited)

 

 

See accompanying notes to consolidated financial statements.

 

SOURCEFIRE, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

 

 

See accompanying notes to consolidated financial statements.

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)

 

 

In March 2007, the Company completed an initial public offering (“IPO”) of common stock in which it sold and issued 6,185,500 shares of common stock, including 865,500 shares sold pursuant to the underwriters’ full exercise of their over-allotment option, at an issue price of $15.00 per share. The Company raised a total of $92.8 million in gross proceeds from the IPO, or approximately $83.8 million in net proceeds after deducting underwriting discounts and commissions of $6.5 million and other offering costs of $2.5 million. Upon the closing of the IPO, all shares of convertible preferred stock outstanding automatically converted into an aggregate of 14,302,056 shares of common stock.

 

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial reporting and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to those rules or regulations. The interim financial statements are unaudited, but reflect all adjustments (consisting of normal recurring accruals) which are, in the opinion of management, considered necessary for a fair presentation. These financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto for the year ended December 31, 2006 included in the Company’s registration statement on Form S-1 dated March 8, 2007. The results of operations for the interim periods are not necessarily indicative of results to be expected in future periods.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

 

Accounts Receivable and Allowance for Doubtful Accounts

 

The Company reports accounts receivable at net realizable value. The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company calculates the allowance based on a specific analysis of past due balances and also considers historical trends of write-offs. Actual collection experience has not differed significantly from the Company’s estimates, due primarily to the Company’s credit and collections practices and the financial strength of its customers.

 

The Company offers standard payment terms that typically range from 30 to 60 days from the invoice date. Invoices are typically generated when the Company delivers the product and/or service to the customer. Standard terms do not require a down payment from the customer or any other collateral and payments terms are not tied to specific milestones or acceptance clauses. Additionally, the Company does not generally accept product returns or offer refunds.

 

Inventories

 

Inventories consist of hardware and related component parts and are stated at the lower of cost (on a first-in, first-out basis) or market. A significant portion of the Company’s inventory includes products used for customer testing and evaluation. This inventory is predominantly located at the customer’s premises. Inventory that is obsolete or in excess of the Company’s forecasted demand is written down to its estimated net realizable value

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

based on historical usage, expected demand, and evaluation unit age. Inherent in the Company’s estimates of market value in determining inventory valuation are estimates related to economic trends, as well as technological obsolescence of the Company’s products.

 

Revenue Recognition

 

The Company derives revenue from arrangements that include products with embedded software, software licenses and royalties, technical support, and professional services. Revenue from products in the accompanying consolidated statements of operations consists primarily of sales of software-based appliances, but also includes fees and royalties for the license of the Company’s technology in a software-only format and subscriptions to receive rules released by the Company’s Vulnerability Research Team (“VRT”) that are used to update the appliances for current exploits and vulnerabilities. Revenues derived from the non-product components of products currently represent less than 10% of total “products” revenue in the accompanying consolidated statements of operations. Technical support, which typically has a term of 12 to 48 months, includes telephone and web-based support, software updates, and rights to software upgrades on a when-and-if-available basis. Professional services include training and consulting.

 

For each arrangement, the Company defers revenue recognition until: (a) persuasive evidence of an arrangement exists; (b) delivery of the product has occurred and there are no remaining obligations or substantive customer acceptance provisions; (c) the fee is fixed or determinable; and (d) collection of the fee is probable.

 

The Company allocates the total arrangement fee among each deliverable based on the fair value of each of the deliverables, determined based on vendor-specific objective evidence. If vendor-specific objective evidence of fair value does not exist for each of the deliverables, all revenue from the arrangement is further deferred until the earlier of the point at which sufficient vendor-specific objective evidence of fair value can be determined or all elements of the arrangement have been delivered. However, if the only undelivered elements are technical support and/or professional services, elements for which the Company currently has vendor specific objective evidence of fair value, the Company recognizes revenue for the delivered elements based on the residual method as prescribed by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions. The Company has established vendor specific objective evidence of fair value for its technical support based upon actual renewals of technical support for each type of technical support that is offered and for each customer class. Technical support and technical support renewals are currently priced based on a percentage of the list price of the respective product or software and historically have not varied from a narrow range of values in the substantial majority of the Company’s arrangements. Revenue related to technical support is deferred and recognized ratably over the contractual period of the technical support arrangement, which ranges from 12 to 48 months in most arrangements.

 

The vendor specific objective evidence of fair value of the Company’s other services is based on the price for these same services when they are sold separately. Revenue for services that are sold either on a stand-alone basis or included in multiple element arrangements is deferred and recognized as the services are performed.

 

All amounts billed or received in excess of the revenue recognized are included in deferred revenue. In addition, the Company defers all direct costs associated with revenue that has been deferred. These amounts are included in either prepaid expenses and other current assets or inventory in the accompanying balance sheets, depending on the nature of the costs and the reason for the deferral.

 

For sales through resellers and distributors, the Company recognizes revenue upon the shipment of the product only if those resellers and distributors provide the Company, at the time of placing their order, with the identity of the end user customer to whom the product has been sold. The Company does not currently offer any rights to return products sold to resellers and distributors. To the extent that a reseller or distributor requests an inventory or stock of products, the Company defers revenue on that product until it receives notification that it has been sold through to an identified end user.

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

For each of the three and six months ended June 30, 2007 and 2006, the Company had no significant customers that accounted for greater than 10% of the revenue recognized.

 

Warranty

 

The Company warrants that its software will perform in accordance with its documentation for a period of 90 days from the date of shipment. Similarly, the Company warrants that the hardware will perform in accordance with its documentation for a period of one year from date of shipment. The Company further agrees to repair or replace software or products that do not conform to those warranties. The one year warranty on hardware coincides with the hardware warranty that the Company obtains from the manufacturer. The Company estimates the costs that may be incurred under its warranties and records a liability at the time product revenue is recognized. Factors that affect the Company’s warranty liability include the number of installed units, historical and anticipated rates of warranty claims and the estimated cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amounts as necessary. While warranty costs have historically been within the Company’s expectations, it is possible that warranty rates will change in the future based on new product introductions and other factors.

 

Income Taxes

 

The Company accounts for income taxes in accordance with FASB Statement No. 109, Accounting for Income Taxes. Deferred income taxes are recorded for the expected tax consequences of temporary differences between the tax basis of assets and liabilities for financial reporting purposes and amounts recognized for income tax purposes. The Company records a valuation allowance to reduce the Company’s deferred tax assets to the amount of future tax benefit that is more likely than not to be realized. At June 30, 2007 and December 31, 2006, the Company recorded a valuation allowance equal to the full recorded amount of the Company’s net deferred tax assets since it was not more likely than not that such benefits would be realized. The Company recorded a provision for income taxes of $58,000 and $70,000 for the three and six month periods ended June 30, 2007, respectively related to foreign income taxes.

 

Stock-Based Compensation

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 123(R), Share-Based Payment (“SFAS No. 123(R)”). SFAS No. 123(R) focuses primarily on transactions in which an entity obtains employee services in exchange for share-based payments. Under SFAS No. 123(R), an entity generally is required to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award, with such cost recognized over the applicable requisite service period. In addition, SFAS No. 123(R) requires an entity to provide certain disclosures in order to assist in understanding the nature of share-based payment transactions and the effects of those transactions on the financial statements.

 

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R) using the prospective transition method, which requires the Company to apply its provisions only to awards granted, modified, repurchased or cancelled after the effective date. Under this transition method, stock-based compensation expense recognized beginning January 1, 2006 is based on the grant date fair value of stock awards granted or modified after January 1, 2006. As the Company had used the minimum value method for valuing its stock options under the disclosure requirements of Statement of Financial Accounting Standard (“SFAS”) No. 123, Accounting for Stock Based Compensation (“SFAS No. 123”), all options granted prior to January 1, 2006 continue to be accounted for under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”). Additionally, the pro forma disclosures that were required under the original provisions of SFAS No. 123 are no longer provided for outstanding awards accounted for under the intrinsic-value method of APB No. 25 beginning in periods after the adoption of SFAS No. 123(R).

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Based on the estimated grant date fair value of employee stock options subsequently granted or modified, the Company recognized aggregate compensation expense of $433,000 and $103,000 for the three months ended June 30, 2007 and 2006, respectively, and $854,000 and $130,000 for the six months ended June 30, 2007 and 2006, respectively. The Company uses the Black-Scholes option pricing model to estimate the fair value of granted stock options. The use of option valuation models requires the input of highly subjective assumptions, including the expected term and the expected stock price volatility. However, the Company currently does not have sufficient information available on which to base a reasonable and supportable estimate of the expected volatility of its share prices. Accordingly, the Company uses an alternative method (defined as “calculated value”) that incorporates each of the inputs required by SFAS No. 123(R), with the exception of the expected volatility of its stock. Rather than use the expected volatility of the Company’s own stock, the Company has identified similar public entities for which sufficient historical share price information is available and has considered the volatility of those entities’ share prices in estimating expected volatility. Additionally, the Company has estimated the expected term of granted options to be the weighted-average mid-point between the vesting date and the end of the contractual term of an award, in accordance with SEC Staff Accounting Bulletin No. 107.

 

The weighted-average estimated fair value of stock options granted during the three months ended June 30, 2007 and 2006 was $8.90 and $3.82 per share, respectively, and for the six months ended June 30, 2007 and 2006 was $9.28 and $4.46 per share, respectively, calculated using the following weighted average assumptions:

 

 

The grant date aggregate fair value of options, net of estimated forfeitures, not yet recognized as expense as of June 30, 2007 was $4.9 million, which will be recognized using the straight-line method over a weighted-average period of approximately four years.

 

The fair value of the unvested restricted stock awards is measured using the closing price of the Company’s stock on the date of grant, or the estimated fair value of the common stock if granted prior to the Company’s initial public offering. The total compensation expense related to restricted stock awards was $234,000 and $5,000 for the three months ended June 30, 2007 and 2006, respectively, and $337,000 and $10,000 for the six months ended June 30, 2007 and 2006, respectively.

 

As of June 30, 2007, there was $685,000 of unrecognized equity-based compensation expense related to unvested restricted stock awards. The cost is expected to be recognized over a weighted-average remaining period of 1.6 years.

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Compensation cost under SFAS 123(R) for the three and six months ended June, 2007 and 2006 is included in the accompanying consolidated statement of operations as follows (in thousands except per share data):

 

 

The Company accounts for stock option grants to non-employees who are not directors in accordance with SFAS No. 123(R) and Emerging Issues Tax Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, which require that the estimated fair value of these instruments measured at the earlier of the performance commitment date or the date at which performance is complete be recognized as an expense ratably over the period in which the related services are rendered. The Company determines the fair value of these instruments using the Black-Scholes option pricing model.

 

Net Loss Attributable to Common Stockholders Per Share

 

Basic net loss attributable to common stockholders per share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted net loss attributable to common stockholders per share includes the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.

 

The following summarizes the potential outstanding common stock of the Company as of the end of each period:

 

 

If the outstanding options, warrants, unvested restricted stock, and preferred stock were exercised or converted into common stock, the result would be anti-dilutive. Accordingly, basic and diluted net loss attributable to

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

common stockholders per share are identical for all periods presented in the accompanying consolidated statements of operations.

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist primarily of cash and cash equivalents, held-to-maturity investments, accounts receivable, accounts payable and long-term debt. The fair value of these financial instruments approximates their carrying amounts reported in the consolidated balance sheets.

 

Recent Accounting Pronouncements

 

In June 2006, FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109, Accounting for Income Taxes (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. As of January 1, 2007, the Company adopted FIN 48. The adoption of FIN 48 did not have an impact on the Company’s financial position and results of operations.

 

In September 2006, FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”). This statement defines fair value and provides guidance for measuring fair value and the necessary disclosures. SFAS No. 157 does not require any new fair value measurements but rather applies to all other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 will be effective for the fiscal year ending December 31, 2008. The Company does not currently expect any material impact from adoption of this new accounting pronouncement on the consolidated financial statements.

 

 

Property and equipment consists of the following (dollars in thousands):

 

 

 

During the quarter ended March 31, 2007, all borrowings under the Company’s credit agreements were repaid and such agreements were terminated.

 

 

During 2002, the Company adopted the Sourcefire, Inc. 2002 Stock Incentive Plan. The plan provides for the granting of equity-based awards, including stock options, restricted or unrestricted stock awards, and stock appreciation rights to employees, officers, directors, and other individuals as determined by the Board of Directors. The Company has reserved 5,100,841 shares of common stock under the 2002 plan.

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In March 2007, in connection with the Company’s IPO, the Board of Directors approved the 2007 Stock Incentive Plan. The plan provides for the granting of equity-based awards, including stock options, restricted or unrestricted stock awards, and stock appreciation rights to employees, officers, directors, and other individuals as determined by the Board of Directors. The Company has reserved 3,142,452 shares of common stock under the 2007 plan.

 

The plan administrator determines the vesting period for awards under each plan, which generally ranges from three to four years, and options granted have a maximum term of 10 years. The exercise price of the awards is equal to or greater than the fair value of the common stock as estimated by the Board of Directors on the date of grant. Following the Company’s IPO, the fair value of the common stock is determined by the closing trading price of such stock on the NASDAQ Global Market on the date of grant.

 

The following table summarizes the aggregate activity of the plans (dollars in thousands, except per share data):

 

 

The total intrinsic value of options exercised during the six months ended June 30, 2007 was $488,000.

 

The following table summarizes information about stock options outstanding at June 30, 2007:

 

 

Unvested restricted stock awards as of June 30, 2007 and changes during the six months then ended are as follows:

 

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The restricted stock awards are subject to various restrictions including time-based vesting provisions, performance-based vesting provisions and provisions for acceleration of vesting upon change in control and in certain other circumstances. The compensation expense associated with these awards is evaluated on a quarterly basis based upon the criteria stated above. The compensation expense is recognized ratably over the estimated vesting period. The vesting restrictions for outstanding restricted stock lapse over a period of 6 to 36 months.

 

 

The Company manages its operations on a consolidated basis for purposes of assessing performance and making operating decisions. Accordingly, the Company does not have reportable segments of its business.

 

Revenues by geographic area are as follows (dollars in thousands):

 

 

 

On June 7, 2007, the Company and certain other parties reached a definitive agreement with NetClarity, Inc. (formerly known as PredatorWatch) to settle a lawsuit filed by NetClarity on February 22, 2006 against the Company and such other parties, alleging that Martin F. Roesch, the Company’s founder and Chief Technology Officer, together with one of the Company’s stockholders, had misappropriated NetClarity’s trade secrets. On June 13, 2007, the Superior Court of Suffolk County, Massachusetts entered a Stipulation of Dismissal with prejudice with respect to the NetClarity lawsuit. The agreement to settle did not have a material impact on the unaudited consolidated financial statements for the three and six month periods ended June 30, 2007.

 

On May 8, 2007, a putative class action lawsuit was filed in the United States District Court for the District of Maryland, against the Company and certain of the Company’s officers and directors, captioned Howard Katz v. Sourcefire, Inc., et al., Case No. 1:07-cv-01210-WMN. Since then, two other putative class action lawsuits were filed in the United States District Court of Maryland against the Company and certain of the Company’s officers and directors and other parties making similar allegations, captioned Mark Reaves v. Sourcefire, Inc. et al, Case No. 1:07-cv-01351-JFM and Joan Raveill v. Sourcefire, Inc. et al, Case No. 1:07-cv-01425-WMN. In addition, a fourth putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company and certain of the Company’s officers and directors and other parties making similar allegations, captioned Barry Pincus v. Sourcefire, Inc., et al., Case No. 1:07-cv-04720-RJH. Pursuant to a stipulation of the parties, in an order entered on or about June 29, 2007 by the United States District Court of the Southern District of New York, the court ordered that the Pincus case should be transferred to the United States District Court for the District of Maryland.

 

These actions claim to be filed on behalf of all persons or entities who purchased the Company’s common stock pursuant to the registration statement and prospectus issued in connection with the Company’s initial public offering. These lawsuits allege violations of Section 11, Section 12 and Section 15 of the Securities Act of 1933, as amended, in connection with allegedly material misleading statements and/or omissions contained in the registration statement and prospectus.. The plaintiffs seek, among other things, a determination of class action status, compensatory and rescission damages, a rescission of the initial public offering, as well as fees and costs on behalf of a putative class.

 

SOURCEFIRE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The Company has reached stipulations with all plaintiffs’ counsel to extend the time to answer, move or otherwise respond to the complaints until after the appointment of a lead plaintiff and approval of lead plaintiff’s counsel pursuant to 15 U.S.C. § 78u-4(a)(3)(B) and the filing of a consolidated amended complaint. On July 13, 2007, Sandra Amrhein filed a motion to consolidate the four cases, to appoint her lead plaintiff and to approve her choice of lead and liaison counsel. The Court has not entered orders consolidating these cases, appointing lead plaintiff or approving lead plaintiff’s counsel. The plaintiffs have not filed a consolidated amended complaint. The Court has not made a determination of whether a putative class can be certified. At this time, plaintiffs have not specified the amount of damages they are seeking in these actions. The Company intends to vigorously defend these actions.

 

 

The Company has entered into a purchase commitment with a hardware manufacturing vendor with whom it has a current arrangement. Under the terms of this commitment, the Company has agreed to purchase a fixed quantity of inventory over an 18-month period. The value of the purchase commitment is approximately $800,000 of which $25,000 has been purchased to date.

 

Additionally, the Company purchases components for its products from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that allow them to procure inventory based upon information provided by the Company. In certain instances, these agreements allow the Company the option to cancel, reschedule, and adjust the Company’s requirements based on its business needs prior to firm orders being placed. Consequently, a portion of the Company’s reported purchase commitments arising from these agreements are firm, non-cancelable, and unconditional commitments. As of June 30, 2007, the Company had total purchase commitments for inventory of approximately $2.2 million, exclusive of the commitment described above.

 

Certain statements contained in this Quarterly Report on From 10-Q may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words or phrases “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” or similar expressions, or the negative of such words or phrases, are intended to identify “forward-looking statements.” We have based these forward-looking statements on our current expectations and projections about future events. Because such statements include risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in “Risk Factors,” and our other filings with the Securities and Exchange Commission. Statements made herein are as of the date of the filing of this Form 10-Q with the Securities and Exchange Commission and should not be relied upon as of any subsequent date. Unless otherwise required by applicable law, we do not undertake, and we specifically disclaim, any obligation to update any forward-looking statements to reflect occurrences, developments, unanticipated events or circumstances after the date of such statement.

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission filings, including our final prospectus dated March 8, 2007, which we filed in connection with our IPO. Our actual results could differ materially from those discussed in or implied by the forward-looking statements.

 

Overview

 

Sourcefire is a leading provider of intelligence driven, open source network security solutions that enable our customers to protect their computer networks in an effective, efficient and highly automated manner. We apply a comprehensive Discover, Determine and Defend, or 3D, approach to network security through which we: 1) discover potential threats and vulnerabilities, 2) determine the potential impact of those observations to the network and 3) defend the network through aggressive enforcement of security policies. We sell our security solutions to a diverse customer base that includes over 27 of the Fortune 100 companies and over half of the 30 largest U.S. government agencies. We also manage one of the security industry’s leading open source initiatives, Snort.

 

Our Sourcefire 3D^tm approach to network security integrates four key technologies, (1) Intrusion Prevention Systems (IPS), (2) Network Behavior Analysis (NBA), (3) Network Access Control (NAC), and (4) Vulnerability Assessment (VA) with network and user intelligence under a single management console. We refer to this comprehensive approach as Enterprise Threat Management (ETM).

 

Sourcefire IPS^tm (Intrusion Prevention Sensors).  The Intrusion Prevention Sensors utilize open source Snort^® and our proprietary technology to monitor network traffic. These sensors compare observed traffic to a set of “Rules”, or a set of network traffic characteristics, which can be indicative of malicious activity. Once the Intrusion Sensors match a Rule to the observed traffic, they block malicious traffic and/or send an alert to the Defense Center for further analysis, prioritization and possible action.

 

Network Behavior Analysis (NBA).  At the heart of the Sourcefire 3D security solution is Real-time Network Awareness, or RNA, our network intelligence product that provides persistent visibility into the composition, behavior, topology (the relationship of network components) and risk profile of the network. This information provides a platform for the Defense Center’s automated decision-making and network policy compliance enforcement. The ability to continuously discover characteristics and vulnerabilities of any computing device communicating on a network such as a computer, printer or server, or endpoint intelligence, enables our Intrusion Prevention products to more precisely identify and block threatening traffic and to more efficiently classify threatening and/or suspicious behavior than products lacking network intelligence.

Sourcefire Defense Center.  The Sourcefire Defense Center is the central management console that aggregates, correlates and prioritizes security and compliance event data from IPS, RNA, and open source Snort for forensic analysis, trends analysis and management reporting. Our customers can leverage our Network Access Control (NAC) technology in order to establish and enforce permissible network usage parameters, as well as our Vulnerability Assessment (VA) technology in order to conduct targeted, active scanning of suspicious vulnerabilities and/or network end points. A single Sourcefire Defense Center can control multiple 3D Sensors to provide our customers a comprehensive view of event activity on their networks. The Defense Center has an open architecture that is designed to leverage existing IT infrastructure such as firewalls, routers, trouble ticketing, and patch management systems for virtually any task, including alerting, blocking and initiating corrective measures.

 

Sourcefire RUA^tm (Real-time User Awareness).  Sourcefire RUA is a new technology feature that will enable our customers to correlate user identity information with network intelligence to reveal the source of policy breaches, attacks, or network vulnerabilities. Adding this intelligence to the information already collected and analyzed by the Sourcefire Defense Center will enhance our customers’ ability to effectively and efficiently protect their networks.

 

Initial Public Offering

 

In March 2007, we completed the initial public offering or IPO of our common stock in which we sold and issued 6,185,500 shares of our common stock, including 865,500 shares sold by us pursuant to the underwriters’ full exercise of their over-allotment option, at an issue price of $15.00 per share. We raised a total of $92.8 million in gross proceeds from the IPO, or approximately $83.8 million in net proceeds after deducting underwriting discounts and commissions of $6.5 million and other offering costs of $2.5 million. Upon the closing of the IPO, all shares of convertible preferred stock outstanding automatically converted into an aggregate of 14,302,056 shares of common stock.

 

Key Financial Metrics and Trends

 

Pricing and Discounts

 

We maintain a standard price list for all our products. Additionally, we have a corporate policy that governs the level of discounts our sales organization may offer on our products based on factors such as transaction size, volume of products, federal or state programs, reseller or distributor involvement and the level of technical support commitment. Our total product revenue and the resulting cost of revenue and gross profit percentage are directly affected by our ability to manage our product pricing policy. Although we have not experienced pressure to reduce our prices, competition is increasing and, in the future, we may be forced to reduce our prices to remain competitive.

 

Revenue

 

We currently derive revenue from product sales and services. Product revenue is principally derived from the sale of our network security solutions. Our network security solutions include a perpetual software license bundled with a third-party hardware platform. Services revenue is principally derived from technical support and professional services. We typically sell technical support to complement our network security solutions. Technical support entitles a customer to product updates, new Rules releases and both telephone and web assistance for using our products. Our professional services revenue includes optional installation, configuration and tuning (“network security deployment services”). These network security deployment services typically occur on-site after delivery has occurred.

 

Product sales are typically recognized as revenue at shipment of the product to the customer, whether sold directly or through resellers. For sales made through distributors and original equipment manufacturers, or OEMs, we do not recognize revenue until we receive the monthly sales report which indicates the sell-through volume to end user customers. Revenue from services is recognized when the services are performed. For technical support services, revenue is recognized ratably over the term of the support arrangement, which is usually a 12-month agreement providing for payment in advance and automatic renewals.

We sell our network security solutions globally. However, over 80% of our revenue for 2006 and 76% of our revenue for the six months ended June 30, 2007 was generated by sales to U.S.-based customers. We expect that our revenue from customers based outside of the United States will increase in amount and as a percentage of total revenue as we execute our strategy to strengthen our international presence. We also expect that our revenue from sales through OEMs and distributors will increase in amount and as a percentage of total revenue as we execute our strategy to expand such relationships. We manage our operations on a consolidated basis for purposes of assessing performance and making operating decisions. Accordingly, our business does not have reportable segments.

 

Revenue from product sales has historically been highly seasonal, with more than one-third of our total product revenue in recent fiscal years generated in the fourth quarter. The timing of our year-end shipments could materially affect our fourth quarter product revenue in any fiscal year and sequential quarterly comparisons. Revenue from our government customers has occasionally been influenced by the September 30th fiscal year-end of the U.S. federal government, which has historically resulted in our revenue from government customers being highest in the third quarter. Although we do not expect these general seasonal patterns to change substantially in the future, our revenue within a particular quarter is often affected significantly by the unpredictable procurement patterns of our customers. Our prospective customers usually spend a long time evaluating and making purchase decisions for network security solutions. Historically, many of our customers have not finalized their purchasing decisions until the final weeks or days of a quarter. We expect these purchasing patterns to continue in the future. Therefore, a delay in even one large order beyond the end of the quarter could materially reduce our anticipated revenue for a quarter. Because many of our expenses must be incurred before we expect to generate revenue, delayed orders could negatively impact our results of operations for the period and cause us to fail to meet the financial performance expectations of securities industry research analysts or investors.

 

Cost of Revenue

 

Cost of product revenue includes the cost of the hardware platform bundled into our network security solution, royalties for third-party software included in our network security solution, materials and labor that are incorporated in the quality assurance of our products, logistics, warranty, shipping and handling costs and, in the limited instance where we lease our network security solutions to our customers, depreciation and amortization. For the three months ended June, 2007 and 2006, cost of product revenue was 26% and 28% of total product revenue for each period, respectively. For the six months ended June, 2007 and 2006, cost of product revenue was 27% of total product revenue for each period, respectively. Hardware costs, which are our most significant cost item, generally have not fluctuated materially as a percentage of revenue in recent years because competition among hardware platform suppliers has remained strong and, therefore, per unit hardware cost has remained consistent. Because of the competition among hardware suppliers and our outsourcing of the manufacture of our products to three separate domestic contract manufacturers, we currently have no reason to expect that our cost of product revenue as a percentage of total product revenue will change significantly in the foreseeable future due to hardware pricing increases. However, hardware or other costs of manufacturing may increase in the future. We incur labor and associated overhead expenses, such as occupancy costs and fringe benefits costs, as part of managing the outsourced manufacturing process. These costs are included as a component of our cost of product revenue, but they have not been material.

 

Cost of service revenue includes the direct labor costs of professionals and outside consultants engaged to furnish those services, as well as their travel and associated direct material costs. Additionally, we include in cost of service revenue an allocation of overhead expenses such as occupancy costs, fringe benefits and supplies as well as the cost of time and materials to service or repair the hardware component of our products covered under a renewed support arrangement beyond the manufacturer’s warranty. For the three months ended June 30, 2007 and 2006, cost of service revenue was 14% and 19%, respectively, of total service revenue. For the six months ended June 30, 2007 and 2006, cost of service revenue was 15% and 20%, respectively, of total service revenue. We anticipate incurring an increasing amount of costs in the future for additional personnel to support and service our growing customer base.

Gross Profit

 

Our gross profit is affected by a variety of factors, including competition, the mix and average selling prices of our products, our pricing policy, technical support and professional services, new product introductions, the cost of hardware platforms, the cost of labor to generate such revenue and the mix of distribution channels through which our products are sold. Although we have not had to reduce the prices of our products or vary our pricing policy in recent years, our gross profit would be adversely affected by price declines if we are unable to reduce costs on existing products and fail to introduce new products with higher margins. Currently, product sales typically have a lower gross profit as a percentage of revenue than our services due to the cost of the hardware platform. Our gross profit for any particular quarter could be adversely affected if we do not complete a sufficient level of sales of higher-margin products by the end of the quarter. As discussed above, many of our customers do not finalize purchasing decisions until the final weeks or days of a quarter, so a delay in even one large order of a higher-margin product could reduce our total gross profit percentage for that quarter. For the three months ended June 30, 2007 and 2006, gross profit was 79% and 75%, respectively, of total revenue. For the six months ended June 30, 2007 and 2006, gross profit was 79% and 76%, respectively, of total revenue. Based on current market conditions, we do not expect these percentages to change significantly in the foreseeable future, although unexpected pricing pressures or an increase in hardware or other costs would cause our gross profit percentage to decline.

 

Operating Expenses

 

Research and Development.  Research and development expenses consist primarily of payroll, benefits and related occupancy and other overhead for our engineers, costs for professional services to test our products, and costs associated with data used by us in our product development.

 

We have significantly expanded our research and development capabilities and expect to continue to expand these capabilities in the future. All of our research and development is performed in the United States. We are committed to increasing the level of innovative design and development of new products as we strive to enhance our ability to serve our existing commercial and federal government markets as well as new markets for security solutions. To meet the changing requirements of our customers, we will need to fund investments in several development projects in parallel. Accordingly, we anticipate that our research and development expenses will continue to increase in absolute dollars for the foreseeable future, but should decline moderately as a percentage of total revenue as we expect to grow our revenues more rapidly than our research and development expenditures. For the three months ended June 30, 2007 and 2006, research and development expense was $2.7 million and $2.2 million, or 24% and 23% of total revenue, respectively. For the six months ended June 30, 2007 and 2006, research and development expense was $5.2 million and $4.3 million, or 24% of total revenue for both periods.

 

Sales and Marketing.  Sales and marketing expenses consist primarily of salaries, incentive compensation, benefits and related costs for sales and marketing personnel; trade show, advertising, marketing and other brand-building costs; marketing consultants and other professional services; training, seminars and conferences; travel and related costs; and occupancy and other overhead costs.

 

As we focus on increasing our market penetration, expanding internationally and continuing to build brand awareness, we anticipate that selling and marketing expenses will continue to increase in absolute dollars, but decrease as a percentage of our revenue, in the future.

 

For the three months ended June 30, 2007 and 2006, sales and marketing expense was $5.9 million and $4.8 million, or 52% and 50% of total revenue, respectively. For the six months ended June 30, 2007 and 2006, sales and marketing expense was $11.8 million and $9.6 million, or 54% and 53% of total revenue, respectively.

 

General and Administrative.  General and administrative expenses consist primarily of salaries, incentive compensation, benefits and related occupancy costs for executive, finance, information system and administrative personnel; legal, accounting and tax preparation and advisory fees; travel and related costs; information systems and infrastructure costs; and corporate insurance.

 

General and administrative expenses have increased during the period of time leading up to our IPO, and as we operate as a public company, we expect to incur additional expenses for costs associated with compliance with

Section 404 of the Sarbanes-Oxley Act of 2002, directors’ and officers’ liability insurance, and our investor relations function.

 

For the three months ended June 30, 2007 and 2006, general and administrative expense was $2.4 million and $1.2 million, or 21% and 13% of total revenue, respectively. For the six months ended June 30, 2007 and 2006, general and administrative expense was $4.7 million and $2.5 million, or 22% and 14% of total revenue, respectively.

 

Stock-Based Compensation.  Effective January 1, 2006, we adopted the fair value recognition provisions of the Financial Accounting Standards Board’s SFAS No. 123(R), “Share-Based Payment,” using the prospective transition method, which requires us to apply its provisions only to awards granted, modified, repurchased or cancelled after the effective date. Under this transition method, stock-based compensation expense recognized beginning January 1, 2006 is based on the grant date fair value of stock awards granted or modified after January 1, 2006.

 

As a result of adopting SFAS No. 123(R) on January 1, 2006, based on the estimated grant date fair value of employee stock options subsequently granted or modified, we recognized aggregate stock-based compensation expense of $667,000 and $108,000 for the three months ended June 30, 2007 and 2006, respectively and $1,190,000 and $139,000 for the six months ended June 30, 2007 and 2006, respectively. We use the Black-Scholes option pricing model to estimate the calculated value of granted stock options. The use of option valuation models requires the input of highly subjective assumptions, including the expected term and the expected stock price volatility.

 

The grant date fair value of options not yet recognized as expense as of June 30, 2007 aggregated approximately $4.9 million, net of estimated forfeitures, which will be recognized over a weighted-average period of approximately four years. We expect to record aggregate amortization of stock-based compensation related to granted stock options of approximately $0.9 million for the remainder of fiscal year 2007 and $1.7 million, $1.4 million, $0.8 million and $0.1 million during fiscal years 2008, 2009, 2010 and 2011, respectively, from these outstanding awards, subject to continued vesting.

 

Critical Accounting Policies and Estimates

 

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates.

 

We believe that, of our significant accounting policies, which are described in Note 2 to our unaudited consolidated financial statements contained in this report, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe that the following accounting policies are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.

 

Revenue Recognition.  We recognize substantially all of our revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” or SOP 97-2, as amended by SOP 98-4 and SOP 98-9. For each arrangement, we defer revenue recognition until all of the following criteria have been met:

 

 

We allocate the total value of the arrangement among each deliverable based on its fair value as determined by vendor-specific objective evidence, such as standard product discount levels, daily service rates and consistent support level renewal pricing. If vendor-specific objective evidence of fair value does not exist for each of the deliverables, all revenue from the arrangement is further deferred until the earlier of the point at which sufficient

vendor-specific objective evidence of fair value can be determined or all elements of the arrangement have been delivered. However, if the only undelivered elements are technical support and/or professional services, elements for which we currently have established vendor specific objective evidence of fair value, we recognize revenue for the delivered elements using the residual method. Changes in judgments and estimates about these assumptions could materially impact the timing of revenue recognition.

 

Accounting for Stock-Based Compensation.  In December 2004, the Statement of Financial Accounting Standard (“SFAS”) No. 123(R), Share-Based Payment (“SFAS No. 123(R)”) was issued. SFAS No. 123(R) focuses primarily on transactions in which an entity obtains employee services in exchange for share-based payments. Under SFAS No. 123(R), we generally are required to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award, with such cost recognized over the applicable requisite service period. In addition, SFAS No. 123(R) requires us to provide certain disclosures in order to assist in understanding the nature of share-based payment transactions and the effects of those transactions on the financial statements.

 

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R) using the prospective transition method, which requires us to apply its provisions only to awards granted, modified, repurchased or cancelled after the effective date. Under this transition method, stock-based compensation expense recognized beginning January 1, 2006 is based on the grant date fair value of stock awards granted or modified after January 1, 2006. As we had used the minimum value method for valuing our stock options under the disclosure requirements of Statement of Financial Accounting Standard (“SFAS”) No. 123, Accounting for Stock Based Compensation (“SFAS No. 123”), all options granted prior to January 1, 2006 continue to be accounted for under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”). Additionally, the pro forma disclosures that were required under the original provisions of SFAS No. 123 are no longer provided for outstanding awards accounted for under the intrinsic-value method of APB No. 25 beginning in periods after the adoption of SFAS No. 123(R).

 

Prior to March 8, 2007, we did not have any class of capital stock that was covered by an effective registration statement, and thus we had no public market from which we could determine fair value of any share based payments. Accordingly, for share-based payments made prior to March 8, 2007, we conducted contemporaneous valuations relying on the guidance prescribed by the American Institute of Certified Public Accountants in its practice aid, “Valuation of Privately-Held-Company Equity Securities Issued as Compensation,” or the Practice Aid, in order to determine the grant date fair value of such share-based payments. In each instance where we made such a valuation determination, and as more fully described below, we generally first determined a fair value of the enterprise using one or both of the market approach or the income approach, as described in the Practice Aid. Once we determined an estimated fair value of the enterprise, we then allocated that enterprise value to each of our classes of stock based upon a consideration of those classes’ relative economic and control rights, using a methodology consistent with the Practice Aid, as discussed in further detail below.

 

We did not obtain contemporaneous valuations by an unrelated valuation specialist that we could rely on during the periods outlined below. Instead, we relied on the experience of our management team and our board of directors, which includes several venture capitalists who have considerable experience in the valuation of emerging companies and one member with extensive experience as a chief financial officer of a publicly traded company who joined our board in August 2006.

 

In January 2007, we granted options to purchase a total of 67,730 shares of our common stock to our employees at an exercise price of $12.26 per share. In accordance with SFAS 123(R), we measured share-based compensation expense with respect to these grants using the Black-Scholes option pricing model using a fair value of our common stock of $12.26 per share. In concluding that $12.26 was the fair value of our common stock, we calculated an enterprise value of $250.0 million using a market approach, which we corroborated using both an income approach that considered discounted cash flows and valuation discussions that we conducted with our underwriters with respect to other recent technology initial public offerings, and our perceptions of the then-current market conditions.

 

In allocating the $250.0 million enterprise value, we followed the probability-weighted expected return method. Thus, we assigned a 100% likelihood that the IPO scenario would occur and a 0% likelihood that the M&A

scenario would occur. Under the IPO scenario, we calculated the fair value of approximately $12.26 per share assuming conversion of all securities into shares of common stock. Thus, in January 2007, our board of directors considered the foregoing analysis and concluded that $12.26 was the best estimate of the fair value of our common stock for purposes of granting options at that time.

 

On March 9, 2007, we granted certain executives options to purchase an aggregate of 57,243 shares of common stock at an exercise price of $15.49. Additionally, on March 9, 2007, we granted certain of our executives and our board members an aggregate of 60,126 shares of restricted stock. Our board of directors determined that $15.49 was the best estimate of the fair value of our common stock for the purposes of granting options at that time because that was the per share price of our common stock as reported on NASDAQ Global Market as of close of business on March 9, 2007, and that approach was consistent with the terms and conditions of our 2007 Stock Incentive Plan.

 

During the three months ended June 30, 2007, we granted additional options to employees to purchase an aggregate of 190,300 shares of common stock. In accordance with the terms of our 2007 Stock Incentive Plan, the exercise prices for these grants are equal to the per share price of our common stock as reported on NASDAQ Global Market as of the close of business on the respective grant dates.

 

As noted above, we use the Black-Scholes option pricing model to estimate the calculated value of granted stock options. The use of option valuation models requires the input of highly subjective assumptions, including the expected term and the expected stock price volatility. Additionally, the recognition of expense requires the estimation of the number of options that will ultimately vest and the number of options that will ultimately be forfeited. Accordingly, the use of different estimates and assumptions can have a significant impact on the amount of stock-based compensation that is measured and recognized.

 

Accounting for Income Taxes.  We account for income taxes in accordance with FASB Statement No. 109, Accounting for Income Taxes. Deferred income taxes are recorded for the expected tax consequences of temporary differences between the tax basis of assets and liabilities for financial reporting purposes and amounts recognized for income tax purposes. We record a valuation allowance to reduce our deferred tax assets to the amount of future tax benefit that is more likely than not to be realized. At June 30, 2007 and December 31, 2006, we recorded a valuation allowance equal to our net deferred tax assets since it was not more likely than not that such benefits would be realized. We recorded a provision for income taxes of $58,000 for the three month period ended June 30, 2007 and $70,000 for the six month period ended June 30, 2007 related to foreign income taxes. For the year ending December 31, 2007, we anticipate an overall effective income tax rate of 29.8%, consisting of state and foreign income taxes, and alternative minimum tax. The change in the overall effective income tax rate from the prior quarter was due to changes in forecasted net income for the year and tax projections for the Company’s various tax jurisdictions.

 

Warranty.  We warrant that our software will perform in accordance with its documentation for a period of ninety days from the date of shipment. Similarly, we warrant that the hardware will perform in accordance with its documentation for a period of one year from date of shipment. We further agree to repair or replace software or products that do not conform to those warranties. The one year warranty on hardware coincides with the hardware warranty that we obtain from the manufacturer. We estimate the costs that may be incurred under our warranties, currently at less than 1.5% of product revenue, and record a liability at the time product revenue is recognized. Factors that affect our warranty liability include the number of installed units, historical and anticipated rates of warranty claims and the estimated cost per claim. We periodically assess the adequacy of our recorded warranty liability and adjust the amounts as necessary. While warranty costs have historically been within management’s expectations, it is possible that warranty rates will change in the future based on new product introductions and other factors.

 

Bad Debt Reserve.  We have historically used a rate of 1.0%-2.0% of outstanding accounts receivable to estimate our reserve for bad debts based on analysis of past due balances and historical experiences of write-offs. As we expand our business, we expect our accounts receivable balance to grow. If our future experience of actual write-offs for bad debts exceeds 1.0%-2.0% of our accounts receivable balance, we will have to increase our reserve accordingly.

Inventory Valuation.  We outsource our manufacturing and our products are generally drop-shipped directly to our customers by the manufacturers. Therefore, we usually carry relatively little inventory. The inventory on our balance sheet also includes products that we use for demonstration purposes at customer locations. We value our inventory at the lower of the actual cost of our inventory or its current estimated market value. We write down inventory for obsolescence or lack of marketability based upon condition of the inventory and our view about future demand and market conditions. Because of the seasonality of our product sales, obsolescence of technology and product life cycles, we generally write down inventory to net realizable value based on forecasted product demand. Actual demand and market conditions may be lower than those that we project and this difference could have a material adverse effect on our gross profit if inventory write-downs beyond those initially recorded become necessary.

 

Results of Operations

 

The following table sets forth our results of operations for the periods shown:

 

The following table sets forth our results of operations as a percentage of total revenue for the periods shown:

 

 

Comparison of Three Months Ended June 30, 2007 and 2006

 

Revenue.  Total revenue increased 18% to $11.3 million in the three months ended June 30, 2007 from $9.5 million in the three months ended June 30, 2006. Product revenue increased to $6.1 million in the three months ended June 30, 2007 from $6.0 million in the three months ended June 30, 2006. We did not ship any new products during the three months ended June 30, 2007, nor did we change the prices of our products significantly during the three months ended June 30, 2007. The increase in product revenue was driven primarily due to higher demand for our defense center products which increased $116,000, software license sales which increased $174,000 and royalty sales which increased $219,000; these increases were offset by a decrease in sales of our sensor products. Our services revenue increased 49% to $5.2 million in the three months ended June 30, 2007 from $3.5 million in the three months ended June 30, 2006. The increase in service revenue was attributable primarily to the fact that our support services are being provided to a larger installed customer base comprised of new customers as well as current customers who have renewed their maintenance subscriptions.

 

Cost of Revenue.  Total cost of revenue decreased 3% to $2.3 million in the three months ended June 30, 2007, compared to $2.4 million in the three months ended June 30, 2006. Product cost of revenue was $1.6 million for the three months ended June 30, 2007 and $1.7 million for the three months ended June 30, 2006. The decrease in product cost of revenue was driven primarily due to a volume purchase rebate provided from one of our suppliers in the amount of $131,000. During the three months ended June 30, 2007, we did not experience a material increase in our cost per unit of hardware platforms, which is the largest component of our product cost of revenue. Our services cost of revenue increased 10% to $749,000 in the three months ended June 30, 2007, compared to $681,000

in the three months ended June 30, 2006. This increase was attributable to our hiring of additional personnel to both service our larger installed customer base and to provide training and professional services to our customers.

 

Gross Profit.  Gross profit increased $1.8 million, or 25%, to $8.9 million in the three months ended June 30, 2007, from $7.1 million in the three months ended June 30, 2006. Gross profit as a percentage of total revenue increased to 79% in the three months ended June 30, 2007, from 75% in the three months ended June 30, 2006. The increases of $1.8 million in gross profit and 4% in gross profit margin were due primarily to an increase in our service revenue, which grew at a higher rate than our expenses and a volume purchase rebate of $131,000 provided from one of our suppliers.

 

Research and Development.  Research and development expenses increased 24% to $2.7 million, or 24% of total revenue, in the three months ended June 30, 2007 from $2.2 million, or 23% of total revenue, in the three months ended June 30, 2006. The increase in the amount of research and development expenses was primarily due to an increase in payroll and benefits of $360,000, an increase in facility overhead of $96,000 and an increase in stock-based compensation expense of $70,000 all of which resulted from adding personnel in our research and development department to support the release of updates and enhancements to our 3D products.

 

Sales and Marketing.  Sales and marketing expenses increased 23% to $5.9 million, or 52% of total revenue, in the three months ended June 30, 2007 from $4.8 million, or 50% of total revenue, in the three months ended June 30, 2006. The increase in the amount of sales and marketing expenses was primarily due to an increase of $595,000 in salary and benefit expenses for additional sales and marketing personnel, as well as an increase of $194,000 for stock-based compensation expense and an increase in $144,000 for advertising, promotion and trade show expenses in support of our network security solutions.

 

General and Administrative.  General and administrative expenses increased 98% to $2.4 million, or 21% of total revenue in the three months ended June 30, 2007 from $1.2 million, or 13% of total revenue in the three months ended June 30, 2006. This increase in general and administrative expense was primarily due to increases of (i) payroll and benefits of $320,000 for personnel hired in our accounting, information technology, human resources and legal departments, (ii) $286,000 for stock-based compensation expense, (iii) $128,000 in consultant fees related to audit, tax and regulatory compliance, and (iv) $152,000 in insurance premiums primarily due to an increase in our D&O insurance coverage.

 

Depreciation and Amortization.  Depreciation and amortization expenses increased 22% to $388,000 in the three months ended June 30, 2007 from $317,000 in the three months ended June 30, 2006. These expenses increased principally due to amortization of leasehold improvements to our UK office, additional lab and testing equipment purchased for the engineering department and personal computers purchased for personnel hired since June 30, 2006.

 

Other income (expense).  Other income (expense) increased $1.2 million to $1.4 million during the three months ended June 30, 2007 from $156,000 in the three months ended June 30, 2006. The increase was primarily due to an increase in interest and investment income as a result of higher cash balances resulting from our March 2007 IPO.

 

Provision for income taxes.  The provision for income taxes was $58,000 for the three months ended June 30, 2007 as compared to no provision for the three months ended June 30, 2006. We record a valuation allowance to reduce our deferred tax assets to the amount of future tax benefit that is more likely than not to be realized. At June 30, 2007 and 2006, our net deferred tax assets were fully reserved. The provision for income taxes of $58,000 for the three months ended June 30, 2007 relates to foreign income taxes.

 

Comparison of Six Months Ended June 30, 2007 and 2006

 

Revenue.  Total revenue increased 20% to $21.7 million in the six months ended June 30, 2007 from $18.1 million in the six months ended June 30, 2006. Product revenue increased 2% to $11.7 million in the six months ended June 30, 2007 from $11.5 million in the six months ended June 30, 2006. We did not ship any new products during the six months ended June 30, 2007, nor did we change the prices of our products significantly during the six months ended June 30, 2007. The increase in product revenue was driven primarily due to higher demand for our defense center products which increased $540,000 and royalty sales which increased $252,000;

these increases were offset by a decrease in sales of our sensor products. Our services revenue increased 52% to $10.0 million in the six months ended June 30, 2007 from $6.6 million in the six months ended June 30, 2006. The increase in service revenue was attributable primarily to the fact that our support services are being provided to a larger installed customer base comprised of new customers as well as current customers who have renewed their maintenance subscriptions.

 

Cost of Revenue.  Total cost of revenue increased 5% to $4.6 million in the six months ended June 30, 2007, compared to $4.4 million in the six months ended June 30, 2006. Product cost of revenue increased 1% to $3.1 million in the six months ended June 30, 2007, compared to $3.1 million in the six months ended June 30, 2006. The increase in product cost of revenue was driven primarily due to higher volume demand for our defense center products for which we must procure and provide the hardware platform to our customers; offset by a volume purchase rebate provided from one of our suppliers in the amount of $131,000 and less sensor hardware purchased. During the six months ended June 30, 2007, we did not experience a material increase in our cost per unit of hardware platforms, which is the largest component of our product cost of revenue. Our services cost of revenue increased 14% to $1.5 million in the six months ended June 30, 2007, compared to $1.3 million in the six months ended June 30, 2006. This increase was attributable to our hiring of additional personnel to both service our larger installed customer base and to provide training and professional services to our customers.

 

Gross Profit.  Gross profit increased $3.4 million, or 25%, to $17.1 million in the six months ended June 30, 2007, from $13.7 million in the six months ended June 30, 2006. Gross profit as a percentage of total revenue increased to 79% in the six months ended June 30, 2007, from 76% in the six months ended June 30, 2006. The increases of $3.4 million in gross profit and 3% in gross profit margin were due primarily to an increase in our service revenue, which grew at a higher rate than our expenses and a volume purchase rebate of $131,000 provided from one of our suppliers.

 

Research and Development.  Research and development expenses increased 22% to $5.2 million, or 24% of total revenue, in the six months ended June 30, 2007 from $4.3 million, or 24% of total revenue, in the six months ended June 30, 2006. The increase in the amount of research and development expenses was primarily due to an increase in payroll and benefits of $745,000, an increase in facility overhead of $254,000 and an increase in stock-based compensation expense of $146,000 all of which resulted from adding personnel in our research and development department to support the release of updates and enhancements to our 3D products. These increases were offset by a reduction in consulting expenses of $226,000.

 

Sales and Marketing.  Sales and marketing expenses increased 23% to $11.8 million, or 54% of total revenue, in the six months ended June 30, 2007 from $9.6 million, or 53% of total revenue, in the six months ended June 30, 2006. The increase in the amount of sales and marketing expenses was primarily due to an increase of $1.3 million in salary and benefit expenses for additional sales and marketing personnel, as well as an increase of $390,000 for stock-based compensation expense and an increase in $343,000 for advertising, promotion and trade show expenses in support of our network security solutions.

 

General and Administrative.  General and administrative expenses increased 91% to $4.7 million, or 22% of total revenue in the six months ended June 30, 2007 from $2.5 million, or 14% of total revenue in the six months ended June 30, 2006. This increase in general and administrative expense was primarily due to (i) an increase in payroll and benefits of $519,000 for personnel hired in our accounting, information technology, human resources and legal departments, (ii) an increase of $499,000 for stock-based compensation expense, (iii) an increase of $307,000 in consultant fees related to audit, tax and regulatory compliance, and (iv) an increase of $198,000 in insurance premiums primarily due to an increase in our D&O insurance coverage.

 

Depreciation and Amortization.  Depreciation and amortization expenses increased 24% to $750,000 in the six months ended June 30, 2007 from $606,000 in the six months ended June 30, 2006. These expenses increased principally due to amortization of leasehold improvements to our UK office, additional lab and testing equipment purchased for the engineering department and personal computers purchased for personnel hired since June 30, 2006.

 

Other income (expense).  Other income (expense) increased $1.7 million to $1.9 million during the six months ended June 30, 2007 from $146,000 in the six months ended June 30, 2006. The increase was primarily due

to an increase in interest and investment income as a result of higher cash and investment balances resulting from our March 2007 IPO.

 

Provision for income taxes.  The provision for income taxes was $70,000 for the six months ended June 30, 2007. We did not record a provision for the six months ended June 30, 2006. We record a valuation allowance to reduce our deferred tax assets to the amount of future tax benefit that is more likely than not to be realized. At June 30, 2007 and 2006, our net deferred tax assets were fully reserved. The provision for income taxes of $70,000 for the six months ended June 30, 2007 relates to foreign income taxes.

 

Seasonality

 

Our product revenue has tended to be seasonal. In our third quarter, we have historically benefited from the Federal government’s fiscal year end purchasing activity. This increase has been partially offset by European sales, which have tended to decline significantly in the summer months due to the practice of many Europeans taking extended vacation time and delaying capital purchase activities until their return in the fall. We have historically generated a significant portion of product revenue in the fourth quarter due to the combination of increased activity in Europe coupled with North American enterprise customers who often wait until the fourth quarter to extract favorable pricing terms from their vendors, including Sourcefire. The timing of these shipments could materially affect our year-end product revenue. Currently, we do not see any indication that these seasonal patterns will change significantly in the foreseeable future.

 

Quarterly Timing of Revenue

 

On a quarterly basis, we have usually generated the majority of our product revenue in the final month of each quarter. We believe this occurs for two reasons. First, many customers wait until the end of the quarter to extract favorable pricing terms from their vendors, including Sourcefire. Second, our sales personnel, who have a strong incentive to meet quarterly sales targets, have tended to increase their sales activity as the end of a quarter nears, while their participation in sales management review and planning activities are typically scheduled at the beginning of a quarter.

 

Liquidity and Capital Resources

 

At June 30, 2007 our principal sources of liquidity were cash and cash equivalents of $50.3 million, held-to-maturity investments of $59.3 million and accounts receivable of $10.8 million. At June 30, 2007, we had working capital of approximately $105.8 million.

 

Prior to our IPO in March 2007, we funded our operations primarily through private sales of our convertible preferred stock and collections from our customers and, to a lesser extent, borrowings under a credit facility. In March 2007, we completed our IPO which provided us with aggregate net proceeds of $83.8 million.

 

We manufacture and distribute our products through contract manufacturers and OEMs. We believe that this approach gives us the advantages of relatively low capital investment and significant flexibility in scheduling production and managing inventory levels. By leasing our office facilities, we also minimize the cash needed for expansion. Our capital spending is generally limited to leasehold improvements, computers, office furniture and product-specific test equipment. The majority of our products are delivered to our customers directly from our contract manufacturers. Accordingly, our contract manufacturers are responsible for purchasing and stocking the components required for the production of our products and they invoice us when the finished goods are shipped.

 

Our product sales are, and are expected to continue to be, highly seasonal. This seasonality typically results in a significant amount of cash provided by our operating activities during the first half of the year with lower to negative cash flow during the second half of the year. We believe that our current cash reserves are sufficient for any short-term cash needs resulting from the seasonality of our business.

 

Operating Activities

 

The decrease of $461,000 in net cash provided by operating activities during the six months ended June 30, 2007, as compared to the same period in 2006, was primarily due to an increase of cash used to purchase inventory

of long lead time items, an increase of our net loss, a payment of $855,000 under an agreement to license and distribute database software used in our products and an increase in pre-payments by us for service contracts and marketing events. These uses of cash were offset partially by cash provided by an increase in deferred revenue and an increase in cash collections as a result of the increased volume of customer invoices in the fourth quarter of 2006.

 

Investing Activities

 

The increase of $48.8 million in net cash used in investing activities during the six months ended June 30, 2007, as compared to the same period in 2006, was primarily due to an increase in purchases of short- and long-term held-to-maturity investments, an increase in leasehold improvements for our new office space in the U.K. and computer and network equipment for additional personnel.

 

Financing Activities

 

The increase of $61.0 million in net cash provided by financing activities during the six months ended June 30, 2007, as compared to the same period in 2006, was primarily due to the $83.8 million net cash proceeds of our IPO, offset by the retirement of indebtedness in 2007 in the amount of $1.4 million and proceeds received from a private equity financing of $23.0 million in May and June of 2006.

 

Credit Facility.  During the quarter ended March 31, 2007 all borrowings under the Company’s credit agreements were repaid and such agreements were terminated.

 

Working Capital and Capital Expenditure Needs

 

We believe that the anticipated net proceeds from our future operations, together with our cash balance at June 30, 2007 will be sufficient to fund our projected operating requirements for at least the next 12 months. Except as disclosed in the Contractual Obligations table below, we currently have no material cash commitments, except for normal recurring trade payables and expense accruals. In addition, we do not currently anticipate significant investment in property, plant and equipment, and we believe that our outsourced approach to manufacturing provides us with significant flexibility in both managing inventory levels and financing our inventory. In the event that our revenue plan does not meet our expectations, we may be required to eliminate or curtail expenditures to mitigate the impact on our working capital. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our marketing and sales activities, the timing and extent of spending to support product development efforts, the timing of introductions of new products and enhancements to existing products, the acquisition of new capabilities or technologies, and the continuing market acceptance of our products and services. Moreover, to the extent that existing cash, cash equivalents, held-to-maturity investments and cash from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing.

 

Although we are currently not a party to any binding commitments with respect to potential investments in, or acquisitions of, businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all.

 

Contractual Obligations

 

Our principal commitments consist of obligations under our equipment facility, leases for office space and minimum contractual obligations for services. The following table describes our commitments to settle contractual obligations in cash as of June 30, 2007 (in thousands):

 

 

 

Recent Accounting Pronouncements

 

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. As of January 1, 2007, we adopted FIN 48. The adoption of FIN 48 did not have an impact on our financial position and results of operations.

 

In September 2006, FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”). This statement defines fair value and provides guidance for measuring fair value and the necessary disclosures. SFAS No. 157 does not require any new fair value measurements, but rather applies to all other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 will be effective for our fiscal year ending December 31, 2008. We do not currently expect any material impact from adoption of this new accounting pronouncement on our financial statements.

 

Foreign Currency Risk

 

Nearly all of our revenue is derived from transactions denominated in U.S. dollars, even though we maintain sales and business operations in foreign countries. As such, we have exposure to adverse changes in exchange rates associated with operating expenses of, and cash held in, our foreign operations, but we believe this exposure to be immaterial at this time. As we grow our international operations, our exposure to foreign currency risk could become more significant.

 

Interest Rate Sensitivity

 

We had unrestricted cash, cash equivalents and held-to-maturity investments totaling $109.7 million at June 30, 2007. The unrestricted cash and cash equivalents are held for working capital purposes while investments, made in accordance with our low-risk investment policy, take advantage of higher interest income yields. In accordance with our investment policy, we do not enter into investments for trading or speculative purposes. Some of the securities in which we invest, however, may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and long-term investments in a variety of securities, including commercial paper, money market funds, debt securities and certificates of deposit. Due to the nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.

 

Evaluation of Sourcefire’s Disclosure Controls and Internal Controls.  Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) pursuant to Rule 13a-15(c) under the Exchange Act as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable SEC rules and forms and is accumulated and communicated to our management, including Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Limitations.  A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with our policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. We continuously evaluate our internal controls and make changes to improve them.

 

Changes in Internal Controls Over Financial Reporting.  There was no change in our internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

NetClarity

 

On June 7, 2007, we reached a definitive agreement with NetClarity, Inc. (formerly known as PredatorWatch) to settle a lawsuit filed by NetClarity against us on February 22, 2006. This lawsuit was filed in Superior Court of Suffolk County, Massachusetts and had alleged that we and Martin F. Roesch, our founder and Chief Technology Officer, together with one of our stockholders, had misappropriated NetClarity’s trade secrets, among other things.

 

On June 13, 2007, the Superior Court of Suffolk County, Massachusetts entered a Stipulation of Dismissal with prejudice with respect to the NetClarity lawsuit. The agreement to settle this matter did not have a material impact on the unaudited consolidated financial statements.

 

Securities Class Action Lawsuits

 

On May 8, 2007, a putative class action lawsuit was filed in the United States District Court for the District of Maryland, against us and certain of our officers and directors, captioned Howard Katz v. Sourcefire, Inc., et al., Case No. 1:07-cv-01210-WMN. Since then, two other putative class action lawsuits were filed in the United States District Court of Maryland against us and certain of our officers and directors and other parties making similar allegations, captioned Mark Reaves v. Sourcefire, Inc. et al, Case No. 1:07-cv-01351-JFM and Joan Raveill v.

Sourcefire, Inc. et al, Case No. 1:07-cv-01425-WMN. In addition, a fourth putative class action lawsuit was filed in the United States District Court for the Southern District of New York against us and certain of our officers and directors and other parties making similar allegations, captioned Barry Pincus v. Sourcefire, Inc., et al., Case No. 1:07-cv-04720-RJH. Pursuant to a stipulation of the parties, in an order entered on or about June 29, 2007, United States District Court of the Southern District of New York ordered that the Pincus case should be transferred to the United States District Court for the District of Maryland.

 

These actions claim to be filed on behalf of all persons or entities who purchased our common stock pursuant to an allegedly false and misleading registration statement and prospectus issued in connection with our initial public offering. These lawsuits allege violations of Section 11, Section 12 and Section 15 of the Securities Act of 1933, as amended, in connection with allegedly material misleading statements and/or omissions contained in our registration statement and prospectus issued in connection with our initial public offering. The plaintiffs seek, among other things, a determination of class action status, compensatory and rescission damages, a rescission of the initial public offering, as well as fees and costs on behalf of a putative class.

 

We have reached stipulations with all plaintiffs’ counsel to extend the time to answer, move or otherwise respond to the complaints until after the appointment of a lead plaintiff and approval of lead plaintiff’s counsel pursuant to 15 U.S.C. § 78u-4(a)(3)(B) and the filing of a consolidated amended complaint. On July 13, 2007, Sandra Amrhein filed a motion to consolidate the four cases, to appoint her lead plaintiff and to approve her choice of lead and liaison counsel. The Court has not entered orders consolidating these cases, appointing lead plaintiff or approving lead plaintiff’s counsel. The plaintiffs have not filed a consolidated amended complaint. The Court has not made a determination of whether a putative class can be certified. At this time, plaintiffs have not specified the amount of damages they are seeking in these actions. We intend to vigorously defend these actions.