Zendesk Announces Second Quarter 2020 Results

Highlights

• Second quarter revenue increased 27% year over year to $246.7 million
• Second quarter GAAP operating loss of $31.5 million and non-GAAP operating income of $19.1 million
• Archana Agrawal, Chief Marketing Officer of Airtable, joins board of directors

SAN FRANCISCO--(BUSINESS WIRE)--Zendesk, Inc. (NYSE: ZEN) today reported financial results for the second quarter ended June 30, 2020, and released a Shareholder Letter on its investor relations website at https://investor.zendesk.com.

Results for the Second Quarter 2020

Revenue was $246.7 million for the quarter ended June 30, 2020, an increase of 27% over the prior year period. GAAP net loss for the quarter ended June 30, 2020 was $64.7 million, and GAAP net loss per share (basic and diluted) was $0.56. Non-GAAP net income was $16.4 million, non-GAAP net income per share (basic and diluted) was $0.14. Non-GAAP net income excludes approximately $46.5 million in share-based compensation and related expenses (including $2.3 million of employer tax related to employee stock transactions and $0.5 million of amortization of share-based compensation capitalized in internal-use software), a $26.0 million loss on early extinguishment of debt, $7.5 million of amortization of debt discount and issuance costs, $2.3 million of amortization of purchased intangibles, $1.8 million of acquisition-related expenses, and non-GAAP income tax effects and adjustments of $3.1 million. GAAP net loss per share for the quarter ended June 30, 2020 was based on 114.6 million weighted average shares outstanding (basic and diluted), and non-GAAP net income per share for the quarter ended June 30, 2020 was based on 114.6 million weighted average shares outstanding (basic) and 120.4 million weighted average shares outstanding (diluted).

Appointment of Archana Agrawal to Board of Directors

Zendesk appointed Archana Agrawal to its board of directors, effective July 27, 2020. Archana is a seasoned technology executive with nearly two decades of experience in the software industry. She has served as the Chief Marketing Officer of Airtable, a low-code app development platform, since March 2020 and as a member of the board of directors of MongoDB, Inc., since August 2019. Previously, Archana served as the Head of Enterprise and Cloud Marketing at Atlassian, an enterprise software company, from May 2016 to March 2020. Archana joined Atlassian in 2013 as Head of Data Science and Growth Marketing. Prior to that, Archana was at Ladders, Inc. from 2007 until 2013, where she led corporate-wide analytics. She began her career at the IBM Almaden Research Center. She holds an M.B.A. from Harvard Business School and received her M.S. in computer science from the University of Illinois at Urbana-Champaign.

“Archana has a unique background in applying data science to enterprise marketing and customer acquisition,” said Mikkel Svane, Zendesk chief executive officer. “Her experience across fast-growing software companies will serve us well as we continue to expand our reach in the enterprise.”

“Zendesk has led the way in changing how organizations buy enterprise software and in making customer experience a critical differentiator for businesses,” Agrawal said. “I’m thrilled to be joining the board at a time when Zendesk has become so critical to companies of every size as they rapidly adapt to new customer and business realities.”

Outlook

We believe our financial performance will continue to be impacted by uncertain and highly disrupted global economic conditions. Many customers continue to face end-market demand challenges and we are seeing higher levels of contraction compared to historical trends. We continue to partner with customers who are undergoing business challenges to help them with modified invoicing and subscription terms. These conditions and actions have impacted and will continue to impact our near-term net expansion rate and overall financial performance, and have played a role in impacting our free cash flow generation. We are being disciplined and prudent in how we manage our business.

Longer term, with improved macroeconomic conditions, we continue to believe the fundamentals of our business model will drive meaningful revenue growth. In particular, we believe that our customer experience solutions will continue to lead in innovation and be more compelling relative to traditional larger enterprise competitors. We will continue to innovate and improve our product offering and how we operate and engage with consumers. These initiatives give us confidence in our plan to deliver high revenue growth and operating leverage.

As of July 30, 2020, Zendesk provided guidance for the quarter ending September 30, 2020.

For the quarter ending September 30, 2020, Zendesk expects to report:

• Revenue in the range of $250 - 255 million
• GAAP operating income (loss) in the range of $(42) - (38) million, which includes share-based compensation and related expenses of approximately $48 million, amortization of purchased intangibles of approximately $2 million, and acquisition-related expenses of approximately $2 million
• Non-GAAP operating income (loss) in the range of $10 - 14 million, which excludes share-based compensation and related expenses of approximately $48 million, amortization of purchased intangibles of approximately $2 million, and acquisition-related expenses of approximately $2 million
• Approximately 116 million weighted average shares outstanding (basic)
• Approximately 122 million weighted average shares outstanding (diluted)

There are many factors that can affect our actual results which are discussed below and in the risk factors in our filings with the Securities and Exchange Commission. Some of the key risk factors include global macroeconomic conditions, the impact of the COVID-19 pandemic on our business, business conditions of customers in challenged industries, the effect on demand for our products from customers, and the ability of our customers to manage the current severe economic downturn.

We have not reconciled free cash flow guidance to net cash from operating activities for the full year 2020 because we do not provide guidance on the reconciling items between net cash from operating activities and free cash flow, as a result of the uncertainty regarding, and the potential variability of, these items. The actual amount of such reconciling items will have a significant impact on our free cash flow and, accordingly, a reconciliation of net cash from operating activities to free cash flow for the full year 2020 is not available without unreasonable effort.

Additionally, Zendesk’s estimates of share-based compensation and related expenses, amortization of purchased intangibles, acquisition-related expenses, weighted average shares outstanding, and free cash flow in future periods assume, among other things, the occurrence of no additional acquisitions, investments, or restructurings and no further revisions to share-based compensation and related expenses.

COVID-19 Update

Over the last several months, we have continued to focus on supporting our employees, customers, and community as we navigate the COVID-19 pandemic. Our business continuity plans continue to ensure that we take care of health and safety of our employees while continuing to drive innovation in customer experience solutions for our customers. Additional information regarding these efforts and the expected impact on our business can be found in our Shareholder Letter for the quarter ended June 30, 2020, as well as our quarterly report on Form 10-Q for the quarter ended June 30, 2020 to be filed with the Securities and Exchange Commission.

Shareholder Letter and Conference Call Information

The detailed Shareholder Letter is available at https://investor.zendesk.com and Zendesk will host a live video webcast at 2:00 p.m. Pacific Time (5:00 p.m. Eastern Time) on Thursday, July 30, 2020 to discuss the results. The live video webcast can be accessed through Zendesk’s investor relations website at https://investor.zendesk.com. A replay of the webcast will be available for 12 months.

About Zendesk

Zendesk is a service-first CRM company that builds support, sales, and customer engagement software designed to foster better customer relationships. From large enterprises to startups, we believe that powerful, innovative customer experiences should be within reach for every company, no matter the size, industry or ambition. Zendesk serves more than 160,000 customers across a multitude of industries in over 30 languages. Zendesk is headquartered in San Francisco, and operates offices worldwide. Learn more at www.zendesk.com.

Forward-Looking Statements

This press release contains forward-looking statements, including, among other things, statements regarding Zendesk’s future financial performance, its continued investment to grow its business, and progress toward its long-term financial objectives. Words such as “may,” “should,” “will,” “believe,” “expect,” “anticipate,” “target,” “project,” and similar phrases that denote future expectation or intent regarding Zendesk’s financial results, operations, and other matters are intended to identify forward-looking statements. You should not rely upon forward-looking statements as predictions of future events.

The outcome of the events described in these forward-looking statements is subject to known and unknown risks, uncertainties, and other factors that may cause Zendesk’s actual results, performance, or achievements to differ materially, including (i) the effect of uncertainties related to the COVID-19 pandemic on U.S. and global markets, Zendesk’s business, operations, revenue results, cash flow, operating expenses, hiring, demand for its solutions, sales cycles, customer retention, and its customers’ businesses; (ii) other adverse changes in general economic or market conditions; (iii) Zendesk’s ability to adapt its products to changing market dynamics and customer preferences or achieve increased market acceptance of its products; (iv) Zendesk’s ability to effectively expand its sales capabilities; (v) Zendesk’s substantial reliance on its customers renewing their subscriptions and purchasing additional subscriptions; (vi) Zendesk’s expectation that the future growth rate of its revenues will decline, and that, as its costs increase, Zendesk may not be able to generate sufficient revenues to achieve or sustain profitability; (vii) the intensely competitive market in which Zendesk operates and the difficulty that Zendesk may have in competing effectively; (viii) Zendesk’s ability to effectively market and sell its products to larger enterprises; (ix) Zendesk’s ability to introduce and market new products and to support its products on a shared services platform; (x) Zendesk’s ability to maintain and develop its strategic relationships with third parties; (xi) Zendesk’s ability to prevent, mitigate, and respond effectively to both historical and future data breaches and to securely maintain customer data; (xii) Zendesk’s ability to effectively manage its growth and organizational change, including its international expansion strategy; (xiii) Zendesk’s ability to integrate acquired businesses and technologies successfully or achieve the expected benefits of such acquisitions; (xiv) Zendesk's ability to comply with privacy and data security regulations; (xv) potential service interruptions or performance problems associated with Zendesk’s technology and infrastructure; (xvi) the development of the market for software as a service business software applications; (xvii) real or perceived errors, failures, or bugs in its products; and (xviii) Zendesk’s ability to accurately forecast expenditures on third-party managed hosting services.

The forward-looking statements contained in this press release are also subject to additional risks, uncertainties, and factors, including those more fully described in Zendesk’s filings with the Securities and Exchange Commission, including its Quarterly Report on Form 10-Q for the quarter ended March 31, 2020. Further information on potential risks that could affect actual results will be included in the subsequent periodic and current reports and other filings that Zendesk makes with the Securities and Exchange Commission from time to time, including its Quarterly Report on Form 10-Q for the quarter ended June 30, 2020.

Forward-looking statements represent Zendesk’s management’s beliefs and assumptions only as of the date such statements are made. Zendesk undertakes no obligation to update any forward-looking statements made in this press release to reflect events or circumstances after the date of this press release or to reflect new information or the occurrence of unanticipated events, except as required by law.

Condensed Consolidated Statements of Operations (In thousands, except per share data; unaudited)
	Three Months Ended June 30,				Six Months Ended June 30,
	2020		2019		2020		2019
Revenue	$	246,664	$	194,583	$	484,140	$	376,068
Cost of revenue	61,515		57,670		121,217		113,324
Gross profit	185,149		136,913		362,923		262,744
Operating expenses:
Research and development	59,003		50,510		119,424		97,301
Sales and marketing	121,397		94,746		245,707		186,447
General and administrative	36,247		43,019		70,573		74,271
Total operating expenses	216,647		188,275		435,704		358,019
Operating loss	(31,498)		(51,362)		(72,781)		(95,275)
Other expense, net:
Interest expense	(8,086)		(6,614)		(14,973)		(13,158)
Loss on early extinguishment of debt	(25,950)		—		(25,950)		—
Interest and other income, net	2,166		4,026		9,068		10,196
Total other expense, net	(31,870)		(2,588)		(31,855)		(2,962)
Loss before provision for income taxes	(63,368)		(53,950)		(104,636)		(98,237)
Provision for income taxes	1,288		591		2,804		1,024
Net loss	$	(64,656)	$	(54,541)	$	(107,440)	$	(99,261)
Net loss per share, basic and diluted	$	(0.56)	$	(0.50)	$	(0.94)	$	(0.91)
Weighted-average shares used to compute net loss per share, basic and diluted	114,600		109,986		114,069		109,312

Condensed Consolidated Balance Sheets (In thousands, except par value; unaudited)
	June 30, 2020		December 31, 2019
Assets
Current assets:
Cash and cash equivalents	$	700,457	$	196,591
Marketable securities	296,829		286,958
Accounts receivable, net of allowance for doubtful accounts of $7,914 and $2,846 as of June 30, 2020 and December 31, 2019, respectively	143,017		127,808
Deferred costs	40,939		35,619
Prepaid expenses and other current assets	50,210		45,847
Total current assets	1,231,452		692,823
Marketable securities, noncurrent	303,861		361,948
Property and equipment, net	102,601		102,090
Deferred costs, noncurrent	38,192		35,230
Lease right-of-use assets	93,523		89,983
Goodwill and intangible assets, net	201,804		206,883
Other assets	24,585		25,632
Total assets	$	1,996,018	$	1,514,589
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	13,793	$	38,376
Accrued liabilities	35,904		36,347
Accrued compensation and related benefits	64,270		61,512
Deferred revenue	314,179		320,642
Lease liabilities	23,309		21,804
Total current liabilities	451,455		478,681
Convertible senior notes, net	1,043,365		483,464
Deferred revenue, noncurrent	1,934		3,320
Lease liabilities, noncurrent	83,495		83,478
Other liabilities	5,460		7,662
Total liabilities	1,585,709		1,056,605
Stockholders’ equity:
Preferred stock, par value $0.01 per share	—		—
Common stock, par value $0.01 per share	1,151		1,130
Additional paid-in capital	1,212,469		1,155,044
Accumulated other comprehensive income	2,834		591
Accumulated deficit	(806,145)		(698,781)
Total stockholders’ equity	410,309		457,984
Total liabilities and stockholders’ equity	$	1,996,018	$	1,514,589

Condensed Consolidated Statements of Cash Flows (In thousands; unaudited)
	Three Months Ended June 30,
	2020		2019
Cash flows from operating activities
Net loss	$	(64,656)	$	(54,541)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization	10,749		8,969
Share-based compensation	43,712		43,751
Amortization of deferred costs	10,765		7,622
Amortization of debt discount and issuance costs	7,487		6,277
Loss on early extinguishment of debt	25,950		—
Repayment of convertible senior notes attributable to debt discount	(38,637)		—
Other	3,090		452
Changes in operating assets and liabilities:
Accounts receivable	(46,666)		(15,901)
Prepaid expenses and other current assets	(4,959)		(5,380)
Deferred costs	(14,867)		(14,123)
Lease right-of-use assets	5,272		4,734
Other assets and liabilities	(308)		(1,242)
Accounts payable	(12,692)		5,678
Accrued liabilities	1,638		(2,057)
Accrued compensation and related benefits	13,329		8,887
Deferred revenue	13,616		27,294
Lease liabilities	(3,534)		(2,562)
Net cash provided by (used in) operating activities	(50,711)		17,858
Cash flows from investing activities
Purchases of property and equipment	(5,622)		(4,896)
Internal-use software development costs	(3,225)		(1,753)
Purchases of marketable securities	(111,906)		(125,681)
Proceeds from maturities of marketable securities	117,752		53,031
Proceeds from sales of marketable securities	39,814		151,550
Business combinations, net of cash acquired	—		(70,794)
Net cash provided by investing activities	36,813		1,457
Cash flows from financing activities
Proceeds from issuance of convertible senior notes, net of issuance costs paid of $20,400	1,129,600		—
Purchase of capped calls related to 2025 convertible senior notes	(129,950)		—
Payments for 2023 convertible senior notes partial repurchase	(578,973)		—
Proceeds from capped calls related to 2023 convertible senior notes	83,040		—
Proceeds from exercises of employee stock options	5,101		4,773
Proceeds from employee stock purchase plan	8,802		6,895
Taxes paid related to net share settlement of share-based awards	(2,241)		(2,663)
Net cash provided by financing activities	515,379		9,005
Effect of exchange rate changes on cash, cash equivalents and restricted cash	15		33
Net increase in cash, cash equivalents and restricted cash	501,496		28,353
Cash, cash equivalents and restricted cash at beginning of period	202,620		145,028
Cash, cash equivalents and restricted cash at end of period	$	704,116	$	173,381

Non-GAAP Results (In thousands, except per share data) The following table shows Zendesk’s GAAP results reconciled to non-GAAP results included in this release.
	Three Months Ended June 30,						Six Months Ended June 30,
	2020			2019			2020			2019
Reconciliation of gross profit and gross margin
GAAP gross profit	$	185,149		$	136,913		$	362,923		$	262,744
Plus: Share-based compensation	5,187			5,246			10,246			10,183
Plus: Employer tax related to employee stock transactions	292			391			717			840
Plus: Amortization of purchased intangibles	1,617			1,943			3,724			3,561
Plus: Amortization of share-based compensation capitalized in internal-use software	464			413			914			833
Plus: Acquisition-related expenses	66			160			$	207		$	274
Non-GAAP gross profit	$	192,775		$	145,066		$	378,731		$	278,435
GAAP gross margin	75		%	70		%	75		%	70		%
Non-GAAP adjustments	3		%	5		%	3		%	4		%
Non-GAAP gross margin	78		%	75		%	78		%	74		%
Reconciliation of operating expenses
GAAP research and development	$	59,003		$	50,510		$	119,424		$	97,301
Less: Share-based compensation	(12,529)			(11,911)			(25,155)			(23,548)
Less: Employer tax related to employee stock transactions	(700)			(931)			(1,587)			(2,223)
Less: Acquisition-related expenses	(1,167)			(864)			(2,178)			(1,431)
Non-GAAP research and development	$	44,607		$	36,804		$	90,504		$	70,099
GAAP research and development as percentage of revenue	24		%	26		%	25		%	26		%
Non-GAAP research and development as percentage of revenue	18		%	19		%	19		%	19		%
GAAP sales and marketing	$	121,397		$	94,746		$	245,707		$	186,447
Less: Share-based compensation	(17,573)			(13,575)			(34,132)			(25,973)
Less: Employer tax related to employee stock transactions	(890)			(763)			(2,064)			(1,791)
Less: Amortization of purchased intangibles	(671)			(658)			(1,370)			(1,235)
Less: Acquisition-related expenses	(470)			(379)			(1,091)			(771)
Non-GAAP sales and marketing	$	101,793		$	79,371		$	207,050		$	156,677
GAAP sales and marketing as percentage of revenue	49		%	49		%	51		%	50		%
Non-GAAP sales and marketing as percentage of revenue	41		%	41		%	43		%	42		%
GAAP general and administrative	$	36,247		$	43,019		$	70,573		$	74,271
Less: Share-based compensation	(8,423)			(13,019)			(16,261)			(20,704)
Less: Employer tax related to employee stock transactions	(462)			(567)			(1,225)			(1,318)
Less: Acquisition-related expenses	(134)			(4,358)			(238)			(4,989)
Non-GAAP general and administrative	$	27,228		$	25,075		$	52,849		$	47,260
GAAP general and administrative as percentage of revenue	15		%	22		%	15		%	20		%
Non-GAAP general and administrative as percentage of revenue	11		%	13		%	11		%	13		%
Reconciliation of operating income (loss) and operating margin
GAAP operating loss	$	(31,498)		$	(51,362)		$	(72,781)		$	(95,275)
Plus: Share-based compensation	43,712			43,751			85,794			80,408
Plus: Employer tax related to employee stock transactions	2,344			2,652			5,593			6,172
Plus: Amortization of purchased intangibles	2,288			2,601			5,094			4,796
Plus: Acquisition-related expenses	1,837			5,761			3,714			7,465
Plus: Amortization of share-based compensation capitalized in internal-use software	464			413			914			833
Non-GAAP operating income	$	19,147		$	3,816		$	28,328		$	4,399
GAAP operating margin	(13)		%	(26)		%	(15)		%	(25)		%
Non-GAAP adjustments	21		%	28		%	21		%	26		%
Non-GAAP operating margin	8		%	2		%	6		%	1		%
	Three Months Ended June 30,						Six Months Ended June 30,
	2020			2019			2020			2019
Reconciliation of net income (loss)
GAAP net loss	$	(64,656)		$	(54,541)		$	(107,440)		$	(99,261)
Plus: Share-based compensation	43,712			43,751			85,794			80,408
Plus: Employer tax related to employee stock transactions	2,344			2,652			5,593			6,172
Plus: Amortization of purchased intangibles	2,288			2,601			5,094			4,796
Plus: Acquisition-related expenses	1,837			5,761			3,714			7,465
Plus: Amortization of share-based compensation capitalized in internal-use software	464			413			914			833
Plus: Amortization of debt discount and issuance costs	7,487			6,277			14,036			12,465
Plus: Loss on early extinguishment of debt	25,950			—			25,950			—
Less: Income tax effects and adjustments	(3,063)			(985)			(4,854)			(1,896)
Non-GAAP net income	$	16,363		$	5,929		$	28,801		$	10,982
Reconciliation of net income (loss) per share, basic
GAAP net loss per share, basic	$	(0.56)		$	(0.50)		$	(0.94)		$	(0.91)
Non-GAAP adjustments to net loss	0.70			0.55			1.19			1.01
Non-GAAP net income per share, basic	$	0.14		$	0.05		$	0.25		$	0.10
Reconciliation of net income (loss) per share, diluted
GAAP net loss per share, diluted	$	(0.56)		$	(0.50)		$	(0.94)		$	(0.91)
Non-GAAP adjustments to net loss	0.70			0.55			1.18			1.00
Non-GAAP net income per share, diluted	$	0.14		$	0.05		$	0.24		$	0.09
Weighted-average shares used in GAAP per share calculation, basic and diluted	114,600			109,986			114,069			109,312
Weighted-average shares used in non-GAAP per share calculation
Basic	114,600			109,986			114,069			109,312
Diluted	120,397			119,678			120,309			118,339
Computation of free cash flow
Net cash provided by (used in) operating activities	$	(50,711)		$	17,858		$	(53,320)		$	36,827
Plus: repayment of convertible senior notes attributable to debt discount	38,637			—			38,637			—
Less: purchases of property and equipment	(5,622)			(4,896)			(15,560)			(14,154)
Less: internal-use software development costs	(3,225)			(1,753)			(6,283)			(2,966)
Free cash flow	$	(20,921)		$	11,209		$	(36,526)		$	19,707
Net cash provided by (used in) operating activities margin	(21)		%	9		%	(11)		%	10		%
Non-GAAP adjustments	13		%	(3)		%	3		%	(5)		%
Free cash flow margin	(8)		%	6		%	(8)		%	5		%

About Non-GAAP Financial Measures

To provide investors and others with additional information regarding Zendesk’s results, the following non-GAAP financial measures were disclosed: non-GAAP gross profit and gross margin, non-GAAP operating expenses, non-GAAP operating income (loss) and operating margin, non-GAAP net income (loss), non-GAAP net income (loss) per share, basic and diluted, free cash flow, and free cash flow margin.

Specifically, Zendesk excludes the following from its historical and prospective non-GAAP financial measures, as applicable:

Share-Based Compensation and Amortization of Share-Based Compensation Capitalized in Internal-use Software: Zendesk utilizes share-based compensation to attract and retain employees. It is principally aimed at aligning their interests with those of its stockholders and at long-term retention, rather than to address operational performance for any particular period. As a result, share-based compensation expenses vary for reasons that are generally unrelated to financial and operational performance in any particular period.

Employer Tax Related to Employee Stock Transactions: Zendesk views the amount of employer taxes related to its employee stock transactions as an expense that is dependent on its stock price, employee exercise and other award disposition activity, and other factors that are beyond Zendesk’s control. As a result, employer taxes related to its employee stock transactions vary for reasons that are generally unrelated to financial and operational performance in any particular period.

Amortization of Purchased Intangibles: Zendesk views amortization of purchased intangible assets, including the amortization of the cost associated with an acquired entity’s developed technology, as items arising from pre-acquisition activities determined at the time of an acquisition. While these intangible assets are evaluated for impairment regularly, amortization of the cost of purchased intangibles is an expense that is not typically affected by operations during any particular period.

Acquisition-Related Expenses: Zendesk views acquisition-related expenses, such as transaction costs, integration costs, restructuring costs, and acquisition-related retention payments, including amortization of acquisition-related retention payments capitalized in internal-use software, as events that are not necessarily reflective of operational performance during a period. In particular, Zendesk believes the consideration of measures that exclude such expenses can assist in the comparison of operational performance in different periods which may or may not include such expenses.

Loss on Early Extinguishment of Debt: In March 2018, Zendesk issued $575 million aggregate principal amount of 0.25% convertible senior notes due in 2023 (the “2023 Notes”). In June 2020, Zendesk issued $1,150 million aggregate principal amount of 0.625% convertible senior notes due in 2025 (the “2025 Notes”). In connection with the offering of the 2025 Notes, Zendesk used $618 million of the net proceeds from the offering of the 2025 Notes to repurchase $426 million aggregate principal amount of the 2023 Notes in cash through individual privately negotiated transactions (the “2023 Notes Partial Repurchase”). Of the $618 million consideration, $393 million and $225 million were allocated to the debt and equity components, respectively. As of the repurchase date, the carrying value of the 2023 Notes subject to the 2023 Notes Partial Repurchase, net of unamortized debt discount and issuance costs, was $367 million. The 2023 Notes Partial Repurchase resulted in a $26 million loss on early debt extinguishment. As of June 30, 2020, $149 million of principal remains outstanding on the 2023 Notes. The loss on early extinguishment of debt is a non-cash item, and we believe the exclusion of this expense will provide for a more useful comparison of our operational performance in different periods.

Amortization of Debt Discount and Issuance Costs: The imputed interest rates of the 2023 Notes and the 2025 Notes were approximately 5.26% and 5.00%, respectively. This is a result of the debt discounts recorded for the conversion features of the Notes that are required to be separately accounted for as equity, and debt issuance costs, which reduce the carrying value of the convertible debt instruments. The debt discounts are amortized as interest expense together with the issuance costs of the debt. The expense for the amortization of debt discount and debt issuance costs is a non-cash item, and we believe the exclusion of this interest expense will provide for a more useful comparison of our operational performance in different periods.

Income Tax Effects: Zendesk utilizes a fixed long-term projected tax rate in its computation of non-GAAP income tax effects to provide better consistency across interim reporting periods. In projecting this long-term non-GAAP tax rate, Zendesk utilizes a financial projection that excludes the direct impact of other non-GAAP adjustments. The projected rate considers other factors such as Zendesk’s current operating structure, existing tax positions in various jurisdictions, and key legislation in major jurisdictions where Zendesk operates. For the year ending December 31, 2020, Zendesk has determined the projected non-GAAP tax rate to be 21%. Zendesk will periodically re-evaluate this tax rate, as necessary, for significant events, based on relevant tax law changes, material changes in the forecasted geographic earnings mix, and any significant acquisitions.

Zendesk provides disclosures regarding its free cash flow, which is defined as net cash from operating activities, plus repayment of convertible senior notes attributable to debt discount, less purchases of property and equipment and internal-use software development costs. Free cash flow margin is calculated as free cash flow as a percentage of total revenue. Zendesk uses free cash flow, free cash flow margin, and other measures, to evaluate the ability of its operations to generate cash that is available for purposes other than capital expenditures and capitalized software development costs. Zendesk believes that information regarding free cash flow and free cash flow margin provides investors with an important perspective on the cash available to fund ongoing operations.

Zendesk has not reconciled free cash flow guidance to net cash from operating activities for the year ending December 31, 2020 because Zendesk does not provide guidance on the reconciling items between net cash from operating activities and free cash flow, as a result of the uncertainty regarding, and the potential variability of, these items. The actual amount of such reconciling items will have a significant impact on Zendesk’s free cash flow and, accordingly, a reconciliation of net cash from operating activities to free cash flow for the year ending December 31, 2020 is not available without unreasonable effort.

Zendesk does not provide a reconciliation of its non-GAAP operating margin guidance to GAAP operating margin beyond the fiscal quarter ending September 30, 2020 because Zendesk does not provide guidance on the reconciling items between GAAP operating margin and non-GAAP operating margin for such periods, as a result of the uncertainty regarding, and the potential variability of, these items. The actual amount of such reconciling items will have a significant impact on Zendesk’s non-GAAP operating margin and, accordingly, a reconciliation of GAAP operating margin to non-GAAP operating margin guidance for such periods is not available without unreasonable effort.

Zendesk’s disclosures regarding its expectations for its non-GAAP gross margin include adjustments to its expectations for its GAAP gross margin that exclude share-based compensation and related expenses in Zendesk’s cost of revenue, amortization of purchased intangibles primarily related to developed technology, and acquisition-related expenses. The share-based compensation and related expenses excluded due to such adjustments are primarily comprised of the share-based compensation and related expenses for employees associated with Zendesk’s infrastructure and customer experience organization.

Zendesk does not provide a reconciliation of its non-GAAP gross margin guidance to GAAP gross margin for future periods because Zendesk does not provide guidance on the reconciling items between GAAP gross margin and non-GAAP gross margin, as a result of the uncertainty regarding, and the potential variability of, these items. The actual amount of such reconciling items will have a significant impact on Zendesk’s non-GAAP gross margin and, accordingly, a reconciliation of GAAP gross margin to non-GAAP gross margin guidance for the period is not available without unreasonable effort.

Zendesk uses non-GAAP financial information to evaluate its ongoing operations and for internal planning and forecasting purposes. Zendesk’s management does not itself, nor does it suggest that investors should, consider such non-GAAP financial measures in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. Zendesk presents such non-GAAP financial measures in reporting its financial results to provide investors with an additional tool to evaluate Zendesk’s operating results. Zendesk believes these non-GAAP financial measures are useful because they allow for greater transparency with respect to key metrics used by management in its financial and operational decision-making. This allows investors and others to better understand and evaluate Zendesk’s operating results and future prospects in the same manner as management.

Zendesk’s management believes it is useful for itself and investors to review, as applicable, both GAAP information that may include items such as share-based compensation and related expenses, amortization of debt discount and issuance costs, amortization of purchased intangibles, and acquisition-related expenses, and the non-GAAP measures that exclude such information in order to assess the performance of Zendesk’s business and for planning and forecasting in subsequent periods. When Zendesk uses such a non-GAAP financial measure with respect to historical periods, it provides a reconciliation of the non-GAAP financial measure to the most closely comparable GAAP financial measure. When Zendesk uses such a non-GAAP financial measure in a forward-looking manner for future periods, and a reconciliation is not determinable without unreasonable effort, Zendesk provides the reconciling information that is determinable without unreasonable effort and identifies the information that would need to be added or subtracted from the non-GAAP measure to arrive at the most directly comparable GAAP measure. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measure as detailed above.

About Operating Metrics

Zendesk reviews a number of operating metrics to evaluate its business, measure performance, identify trends, formulate business plans, and make strategic decisions. These include the number of paid customer accounts on Zendesk Support, Zendesk Chat, and its other products, dollar-based net expansion rate, annual recurring revenue represented by its churned customers, and the percentage of its annual recurring revenue from Support originating from customers with 100 or more agents on Support.

Zendesk defines the number of paid customer accounts at the end of any particular period as the sum of (i) the number of accounts on Support, exclusive of its legacy Starter plan, free trials, or other free services, (ii) the number of accounts using Chat, exclusive of free trials or other free services, and (iii) the number of accounts on all of its other products, exclusive of free trials and other free services, each as of the end of the period and as identified by a unique account identifier. In the quarter ended June 30, 2018, Zendesk began to offer an omnichannel subscription which provides access to multiple products through a single paid customer account, Zendesk Suite, and in the quarter ended June 30, 2019, Zendesk began to offer a subscription which provides access to Sell and Support through a single paid customer account, Zendesk Duet. In the quarter ended March 31, 2020, Zendesk began to offer two new omnichannel subscriptions, the Zendesk Support Suite and the Zendesk Sell Suite, which provide access to multiple support solutions and sales solutions, respectively, through a single paid customer account. The number of Support Suite paid customer accounts are included in the number of paid customer accounts on Suite, which are included in the number of paid customer accounts on products other than Support and Chat and are not included in the number of paid customer accounts on Support or Chat. The number of Sell Suite paid customer accounts are included in the number of paid customer accounts on products other than Support and Chat and are not included in the number of paid customer accounts on Support or Chat. Each Duet paid customer account is included once in the number of paid customer accounts on Support and once in the number of paid customer accounts on products other than Support and Chat.

Existing customers may also expand their utilization of Zendesk’s products by adding new accounts and a single consolidated organization or customer may have multiple accounts across each of Zendesk’s products to service separate subsidiaries, divisions, or work processes. Other than usage of Zendesk’s products through its omnichannel subscription offering, each of these accounts is also treated as a separate paid customer account.

Zendesk’s dollar-based net expansion rate provides a measurement of its ability to increase revenue across its existing customer base through expansion of authorized agents associated with a paid customer account, upgrades in subscription plans, and the purchase of additional products as offset by churn, contraction in authorized agents associated with a paid customer account, and downgrades in subscription plans. Zendesk’s dollar-based net expansion rate is based upon annual recurring revenue for a set of paid customer accounts on its products. Zendesk determines the annual recurring revenue value of a contract by multiplying the monthly recurring revenue for such contract by twelve.

Monthly recurring revenue for a paid customer account is a legal and contractual determination made by assessing the contractual terms of each paid customer account, as of the date of determination, as to the revenue Zendesk expects to generate in the next monthly period for that paid customer account, assuming no changes to the subscription and without taking into account any platform usage above the subscription base, if any, that may be applicable to such subscription. Beginning with the quarter ended June 30, 2019, we excluded the impact of revenue that we expect to generate from fixed-term contracts that are each associated with an existing account, are solely for additional temporary agents, and are not contemplated to last for the duration of the primary contract for the existing account from our determination of monthly recurring revenue. Monthly recurring revenue is not determined by reference to historical revenue, deferred revenue, or any other GAAP financial measure over any period. It is forward-looking and contractually derived as of the date of determination.

Zendesk calculates its dollar-based net expansion rate by dividing the retained revenue net of contraction and churn by Zendesk’s base revenue. Zendesk defines its base revenue as the aggregate annual recurring revenue across its products for customers with paid customer accounts as of the date one year prior to the date of calculation. Zendesk defines the retained revenue net of contraction and churn as the aggregate annual recurring revenue across its products for the same customer base included in the measure of base revenue at the end of the annual period being measured. The dollar-based net expansion rate is also adjusted to eliminate the effect of certain activities that Zendesk identifies involving the consolidation of customer accounts or the split of a single paid customer account into multiple paid customer accounts. In addition, the dollar-based net expansion rate is adjusted to include paid customer accounts in the customer base used to determine retained revenue net of contraction and churn that share common corporate information with customers in the customer base that are used to determine the base revenue. Giving effect to this consolidation results in Zendesk’s dollar-based net expansion rate being calculated across approximately 108,300 customers, as compared to the approximately 164,200 total paid customer accounts as of June 30, 2020.

To the extent that Zendesk can determine that the underlying customers do not share common corporate information, Zendesk does not aggregate paid customer accounts associated with reseller and other similar channel arrangements for the purposes of determining its dollar-based net expansion rate. While not material, Zendesk believes the failure to account for these activities would otherwise skew the dollar-based net expansion metrics associated with customers that maintain multiple paid customer accounts across its products and paid customer accounts associated with reseller and other similar channel arrangements.

Zendesk does not currently incorporate operating metrics associated with its legacy analytics product, its legacy Outbound product, its legacy Starter plan, Sell, Sunshine Conversations, its legacy Smooch product, free trials, or other free services into its measurement of dollar-based net expansion rate.

For a more detailed description of how Zendesk calculates its dollar-based net expansion rate, please refer to Zendesk’s periodic reports filed with the Securities and Exchange Commission.

Zendesk’s percentage of annual recurring revenue from Support that is generated by customers with 100 or more agents on Support is determined by dividing the annual recurring revenue from Support for paid customer accounts with 100 or more agents on Support as of the measurement date by the annual recurring revenue from Support for all paid customer accounts on Support as of the measurement date. Zendesk determines the customers with 100 or more agents on Support as of the measurement date based on the number of activated agents on Support at the measurement date and includes adjustments to aggregate paid customer accounts that share common corporate information. For the purpose of determining this metric, Zendesk builds an estimation of the proportion of annual recurring revenue from Suite attributable to Support and includes such portion in the annual recurring revenue from Support.

Zendesk does not currently incorporate operating metrics associated with products other than Support into its measurement of the percentage of annual recurring revenue from Support that is generated by customers with 100 or more agents on Support.

Zendesk’s annual revenue run rate is based on its revenue for the most recent applicable quarter. Zendesk annualizes such results to estimate its annual revenue run rate by multiplying the revenue for its most recent applicable quarter by four. Zendesk’s annual revenue run rate is not a comprehensive statement of its financial results for such period and should not be viewed as a substitute for full annual or interim financial statements prepared in accordance with GAAP. In addition, Zendesk’s revenue for the most recent applicable quarter or annual revenue run rate are not necessarily indicative of the results to be achieved in any future period.

Source: Zendesk, Inc.