APPFOLIO INC (APPF)

ITEM 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition, results of operations and liquidity should be read together with our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report.

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The following discussion and analysis of our financial condition and results of operations includes 2024 and 2023 items and year-over-year comparisons between 2024 and 2023. For discussion of 2022 items and year-over-year comparisons between 2023 and 2022, refer to Part II. Item 7. “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2023.

Overview

We are a technology leader powering the future of the real estate industry. We provide a cloud-based platform on which our customers operate their businesses. We help our customers navigate an increasingly interconnected and growing network of stakeholders in their business ecosystems, including property managers, property investors, potential residents, residents, and vendors. We also provide key functionality related to critical transactions across the real estate lifecycle, including screening potential residents, sending and receiving payments, and providing insurance-related risk mitigation services. Our services enable our customers to connect communities, increase operational efficiency, deliver exceptional customer experiences, and improve financial and operational performance.

Key Business Metric

We monitor the key business metric set forth below to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions.

Property management units under management. We believe that our ability to increase the number of property management units under management is an indicator of our market penetration, growth, and potential future business opportunities. We define property management units under management as active or committed units under management at the period end date. We had 8.7 million and 8.2 million property management units under management, as of December 31, 2024 and 2023, respectively.

Seasonality

We have historically experienced seasonality in our Value Added Services revenue due to seasonally higher leasing activities in the second quarter. Specifically, higher tenant applications in the second quarter typically result in increased use by our property management customers of our tenant screening services and, in the third quarter once resident move-ins have occurred, higher demand for our risk mitigation services. Because of the seasonality in our Value Added Services, we typically experience a sequential increase in revenue in the first, second, and third quarters and a sequential decline in revenue in the fourth quarter. Moreover, if macroeconomic factors in a given fiscal year impact tenant behavior, our product portfolio mix, or the adoption rate of our other less seasonally impacted Value Added Services, the effect that seasonal factors have on our revenue may be exacerbated. Although these seasonal factors are common in the real estate industry, historical patterns should not be considered a reliable indicator of our future sales activity or performance.

Key Components of Results of Operations

Revenue

Our core solutions and certain of our Value Added Services are offered on a subscription basis. The subscription fees for our core solutions vary by property type and are designed to scale with the size of our customers’ businesses. We recognize revenue for subscription-based services on a straight-line basis over the contract term beginning on the date that our service is made available. We generally invoice monthly or, to a lesser extent, annually in advance of a subscription period.

We also offer certain Value Added Services, which are not covered by our subscription fees, on a per-use basis. Usage-based fees are charged either as a percentage of the transaction amount (e.g., for certain of our electronic payment services) or on a flat fee per transaction basis generally with no minimum usage commitments (e.g., for our tenant screening and risk mitigation services). We recognize revenue for usage-based services in the period the service is rendered. Our payments services fees are recorded gross of any interchange and payment processing related fees. We generally invoice our usage-based services on a monthly basis or collect the fee at the time of service. A significant majority of our Value Added Services revenue comes from the use of our electronic payment services, tenant screening services, and risk mitigation services.

In addition, we charge our customers for assistance onboarding onto our core solutions and for certain other non-recurring services. We generally invoice for these other services in advance of the services being completed and recognize revenue in the period the service is rendered. We also generate revenue from the legacy customers of businesses we acquire that provide standalone services outside of our platform. Revenue derived from these services is recorded in Other revenue. As of December 31, 2024 and 2023, we had 20,784 and 19,737 property management customers, respectively.

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Costs and Operating Expenses

Cost of Revenue (Exclusive of Depreciation and Amortization). Many of our Value Added Services are facilitated by third-party service providers. Cost of revenue paid to these third-party service providers includes, without limitation, the cost of electronic interchange and payment processing-related services to support our payments services, the cost of credit reporting services for our tenant screening services, and various costs associated with our risk mitigation service providers. These third-party costs vary both in amount and as a percent of revenue for each Value Added Service offering. Cost of revenue also includes personnel-related costs for our employees focused on customer service and the support of our operations (including salaries, cash bonuses, benefits, and stock-based compensation), platform infrastructure costs (such as data center operations and hosting-related costs), and allocated shared and other costs. Cost of revenue excludes depreciation of property and equipment, amortization of capitalized software development costs and amortization of intangible assets.

Sales and Marketing. Sales and marketing expense consists of personnel-related costs for our employees focused on sales and marketing (including salaries, sales commissions, cash bonuses, benefits, and stock-based compensation), costs associated with sales and marketing activities, and allocated shared and other costs. Marketing activities include advertising, online lead generation, lead nurturing, customer and industry events, and the creation of industry-related content and collateral. We focus our sales and marketing efforts on generating awareness of our software solutions, creating sales leads, establishing and promoting our brands, and cultivating an educated community of successful and vocal customers.

Research and Product Development. Research and product development expense consists of personnel-related costs for our employees focused on research and product development (including salaries, cash bonuses, benefits, and stock-based compensation), fees for third-party development resources, and allocated shared and other costs. Our research and product development efforts are focused on expanding functionality and the ease of use of our existing software solutions by adding new core functionality, Value Added Services and other improvements, as well as developing new products and services. We capitalize our software development costs that meet the criteria for capitalization. Amortization of capitalized software development costs is included in depreciation and amortization expense.

General and Administrative. General and administrative expense consists of personnel-related costs for employees in our executive, finance, information technology, human resources, legal, compliance, and administrative organizations (including salaries, cash bonuses, benefits, and stock-based compensation). In addition, general and administrative expense includes fees for third-party professional services (including audit, legal, compliance, and tax services), regulatory fees, other corporate expenses, impairment of long-lived assets, gains on lease modifications, and allocated shared and other costs.

Depreciation and Amortization. Depreciation and amortization expense includes depreciation of property and equipment, amortization of capitalized software development costs, and amortization of intangible assets. We depreciate or amortize property and equipment, software development costs, and intangible assets over their expected useful lives on a straight-line basis, which approximates the pattern in which the economic benefits of the assets are consumed.

Interest Income, Net. Interest income, net includes interest earned on investment securities, amortization and accretion of the premium and discounts paid from the purchase of investment securities, and interest earned on cash deposited in our bank accounts.

(Benefit from) provision for income taxes. (Benefit from) provision for income taxes consists of federal and state income taxes in the United States.

Results of Operations

Revenue

The increase in revenue for the year ended December 31, 2024, compared to the prior year, was primarily attributable to an increase in the usage of our electronic payment, tenant screening, and risk mitigation services. During the year ended December 31, 2024, we experienced growth of 6% in the number of property management units under management compared to the prior year, which drove growth in both the number users and usage of our subscription and usage-based services.

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Our electronic payment services experienced increased usage during the comparative periods as residents, property managers, and owners transacted more business online. In addition, we stopped waiving eCheck (ACH) transaction fees beginning in the third quarter of 2023. Our tenant screening and risk mitigation services usage also increased during the comparative periods, driven by higher adoption and growth in units under management, respectively.

We expect total revenue for the year ending December 31, 2025 to increase compared to the year ended December 31, 2024 as we continue to add new customers and property management units under management, along with increased adoption and usage of our Value Added Services.

Cost of Revenue (Exclusive of Depreciation and Amortization)

Cost of revenue (exclusive of depreciation and amortization) for the year ended December 31, 2024, increased primarily due to increases in expenditures to third-party service providers related to the delivery of our Value Added Services of $40.7 million compared to the prior year. This increase was directly associated with the increased adoption and utilization of our Value Added Services. Allocated shared and other costs increased by $3.5 million for the year ended December 31, 2024, compared to the prior year, primarily related to investment in platform infrastructure in support of our overall growth.

We expect cost of revenue (exclusive of depreciation and amortization) for the year ending December 31, 2025, to stay relatively flat as a percentage of revenue compared to the year ended December 31, 2024.

Sales and Marketing

Sales and marketing expense for the year ended December 31, 2024 increased compared to the prior year, primarily due to a $2.4 million increase in advertising and promotion expense and a $3.4 million increase related to our FUTURE conference. These increases were partially offset by a $1.5 million reduction in personnel-related costs, including cash bonuses and stock-based compensation. The reduction in personnel-related costs included $3.8 million of severance and related personnel expenses from a workforce reduction in the third quarter of 2023. For additional information, see Note 17, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

For the year ended December 31, 2024, stock-based compensation increased due to additional grants to current and new employees with higher grant date fair value.

We expect sales and marketing expense for the year ending December 31, 2025 to slightly increase as a percentage of revenue compared to the year ended December 31, 2024 as we increase awareness and presence through targeted go-to-market investment.

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Research and Product Development

Research and product development expense for the year ended December 31, 2024 increased compared to the prior year. The increase was mainly due to a $4.8 million rise in personnel-related costs, including cash bonuses and stock-based compensation. These costs, net of capitalized software development costs, were driven by headcount growth and higher salaries as we continued to invest in innovation. Additionally, there was a $4.2 million increase in allocated shared and other costs, largely due to higher technology expense. The increase in personnel costs was partially offset by $3.4 million in severance and related expenses from a workforce reduction in the third quarter of 2023. For additional information, see Note 17, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

For the year ended December 31, 2024, stock-based compensation increased due to additional grants to current and new employees with higher grant date fair value.

We expect research and product development expenses for the year ending December 31, 2025 to decrease as a percentage of revenue compared to the year ended December 31, 2024, as we continue to leverage headcount efficiencies.

General and Administrative

General and administrative expense for the year ended December 31, 2024 decreased compared to the prior year, primarily due to a $15.4 million decrease in personnel-related costs, including cash bonuses and stock-based compensation, which was partially offset by a $7.8 million increase in allocated shared and other costs. The decrease in personnel-related costs was primarily due to the $14.9 million separation costs incurred in the first quarter of 2023 in connection with our former Chief Executive Officer's separation and the $2.5 million severance related expenses from a workforce reduction in the third quarter of 2023. For additional information, see Note 9, Accrued Employee Expenses, and Note 17, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report. The increase in allocated shared and other costs was primarily due to a $4.3 million lease modifications gain recognized in 2023 and a $3.5 million increase in technology and professional services expenses to support our growth in 2024.

We expect general and administrative expenses for the year ending December 31, 2025 to decrease as a percentage of revenue compared to the year ended December 31, 2024, as we continue to leverage headcount efficiencies.

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Depreciation and Amortization

Depreciation and amortization expense for the year ended December 31, 2024 decreased, compared to the prior year, primarily due to decreased amortization expense associated with capitalized software development and intangible balances.

We expect depreciation and amortization expenses for the year ending December 31, 2025 to increase as a percentage of revenue compared to the year ended December 31, 2024 due to amortization of the intangible assets recognized from the acquisition of Move EZ, Inc. in the fourth quarter of 2024. For additional information, see Note 7, Business Combination, and Note 8, Goodwill and Intangible Assets, Net, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

Interest Income, Net

Interest income for the year ended December 31, 2024 increased, compared to the prior year, primarily due to higher interest rates and purchases of available-for-sale investment securities.

(Benefit from) provision for income taxes

The decrease in our effective tax rate for the year ended December 31, 2024, as compared to the prior year, is primarily due to the valuation allowance release against our federal and state deferred tax assets, which was partially offset by higher tax expense due to a significant increase in our pre-tax income.

As of December 31, 2024, we recorded an income tax benefit of $53.7 million, primarily due to the release of our valuation allowance of certain U.S. federal and state deferred tax assets. In evaluating the need for a valuation allowance at each reporting period, we consider the weighting of all available positive and negative evidence, which includes, among other things, the nature, frequency and severity of current and cumulative taxable income or losses, future projections of profitability, timing of the future reversal of existing temporary differences, and the duration of statutory carryforward periods. In assessing all available evidence, we determined that there was sufficient positive evidence to overcome the negative evidence, including our past and current financial results, growth demonstrated in our top-line performance, as well as projected profitability. Accordingly, we determined it is more likely than not that the deferred tax assets will be realized and we released our valuation allowance at December 31, 2024.

Liquidity and Capital Resources

Our principal sources of liquidity continue to be cash, cash equivalents, and investment securities, as well as cash flows generated from our operations. As of December 31, 2024, our cash and cash equivalents and investment securities had an aggregate balance of $278.2 million. We have financed our operations primarily through cash generated from operations. We believe that our existing cash and cash equivalents, investment securities, and cash generated from operating activities will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months.

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Capital Requirements

Our future capital requirements depend on many factors, including continued market acceptance of our software solutions; changes in the number of our customers, adoption and utilization of our Value Added Services by new and existing customers; the timing and extent of the introduction of new core functionality, products and Value Added Services; and the timing and extent of our investments across our organization.

As of December 31, 2024, our non-cancelable purchase commitments for business operations totaled $57.5 million, which are due primarily over the next three years. Operating lease obligations total $50.4 million as of December 31, 2024 associated with leased facilities and have varying maturities with $32.9 million due over the next five years.

We have in the past entered into, and may in the future enter into, arrangements to acquire or invest in new technologies or markets. We may, as a result of those arrangements or the general expansion of our business, be required to seek additional equity or debt financing, which may not be available on terms favorable to us or at all, impacting our ability to compete successfully, which would harm our business, results of operations, and financial condition.

Our Board of Directors has authorized the repurchase of up to $100.0 million of shares of our Class A common stock from time to time. To date, we have repurchased $4.2 million of our Class A common stock under the Share Repurchase Program. For additional information regarding our Share Repurchase Program, see Note 13, Stockholders' Equity, of the Notes to Consolidated Financial Statement included in Part II, Item 8 of this Annual Report.

Cash Flows

The following table presents our cash flows for the periods indicated (in thousands):

Cash Provided by Operating Activities

Our primary source of operating cash inflows is cash collected from our customers in connection with their use of our core solutions and Value Added Services. Our primary uses of cash from operating activities are for personnel-related expenditures and third-party costs incurred to support the delivery of our software solutions.

The net increase in cash provided by operating activities for the year ended December 31, 2024, compared to the prior year, was primarily due to a higher increase in cash collections from customers relative to the increase in operating expenditures during the year ended December 31, 2024.

Cash Used in Investing Activities

Cash used in investing activities is generally composed of the cash paid in business acquisition, net of cash acquired, purchases of investment securities, maturities and sales of investment securities, purchases of property and equipment, and additions to capitalized software development.

The net increase in cash used in investing activities for the year ended December 31, 2024, compared to the prior year, was primarily due to higher purchases of available-for-sale investment securities and the cash paid in business acquisition, net of cash acquired. For additional information regarding the business combination, see Note 7 Business Combination, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

Cash Used in Financing Activities

Cash used in financing activities is generally composed of net share settlements for employee tax withholdings associated with the vesting of equity awards offset by proceeds from the exercise of stock options.

The net increase in cash used in financing activities for the year ended December 31, 2024, compared to the prior year, was primarily due to an increase in net share settlements for employee tax withholdings associated with the vesting of equity awards.

Off-Balance Sheet Arrangements

As of December 31, 2024, we did not have any off-balance sheet arrangements.

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Critical Accounting Policies and Estimates

Our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of our Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

We believe that the following critical accounting policies involve a greater degree of judgment or complexity than our other accounting policies. Accordingly, these are the policies we believe are the most critical to a full understanding and evaluation of our Consolidated Financial Statements. For additional information, see Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report.

Revenue Recognition

Many of our contracts with customers contain multiple performance obligations. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require judgment. We account for individual performance obligations separately if they are distinct. The performance obligations for these contracts include access and use of our core solutions, implementation services, and customer support. Access and use of our core solutions and implementation services are considered distinct.

The transaction price is allocated to each performance obligation on a relative standalone selling price basis. Judgment is required to determine the standalone selling price for each distinct performance obligation. We typically have more than one standalone selling price for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we determine the standalone selling price based on our overall pricing objectives, taking into consideration customer demographics and other factors. Fees are fixed based on rates specified in the subscription agreements, which do not provide for any refunds or adjustments.

Income Taxes

We recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in our Consolidated Statements of Operations in the period that includes the enactment date. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance at each reporting period, we consider the weighting of all available positive and negative evidence, which includes, among other things, the nature, frequency and severity of current and cumulative taxable income or losses, future projections of profitability, timing of the future reversal of existing temporary differences, and the duration of statutory carryforward periods. In assessing all available evidence, we determined that there was sufficient positive evidence to overcome the negative evidence, including our past and current financial results, growth demonstrated in our top-line performance, as well as projected profitability. Accordingly, we determined it is more likely than not that the deferred tax assets will be realized and we released our valuation allowance at December 31, 2024.

Judgment is required to measure the amount of tax benefits that can be recognized in connection with uncertain tax positions. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. We recognize interest and penalties accrued with respect to uncertain tax positions, if any, in our provision for income taxes in our Consolidated Statements of Operations.

Business Combinations

The results of a business acquired in a business combination are included in our Consolidated Financial Statements from the date of acquisition. We allocate the purchase price, including the fair value of contingent consideration, to the identifiable assets and liabilities of the acquired business at their acquisition date fair values. The excess of the purchase price over the amount allocated to the identifiable assets and liabilities, if any, is recorded as goodwill.

Determining the fair value of assets acquired and liabilities assumed requires management to make significant judgments and estimates, including the selection of valuation methodologies and assumptions. Critical estimates used in valuing certain intangible assets include, but are not limited to, development costs, the time required to recreate the assets and profit margin a market participant would receive, and rate of return. These estimates are based on information obtained from the management of the acquired companies, our assessment of the information, and historical experience. Our estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period of up to one year from the acquisition date, we

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may record adjustments to the preliminary fair value of the assets acquired and liabilities assumed with a corresponding offset to goodwill for these business combinations.

Acquisition-related transaction costs are not included as a component of consideration transferred, but are accounted for as an operating expense in the period in which the costs are incurred.

The allocation of the purchase price in a business combination requires management to make significant estimates in determining the fair value of acquired assets and assumed liabilities, especially with respect to intangible assets. The excess of the purchase price in a business combination over the fair value of these tangible and intangible assets acquired and liabilities assumed is recorded as goodwill. Critical estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows, discount rates, revenue growth rates, the time and expense to recreate the assets and profit margin a market participant would receive. These estimates are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. We evaluate these estimates and assumptions as new information is obtained and may record adjustments to the fair value of the tangible and intangible assets acquired and liabilities assumed but not later than one year from the acquisition date.

Recent Accounting Pronouncements

For information regarding recent accounting pronouncements, refer to Note 2, Summary of Significant Accounting Policies of our Consolidated Financial Statements included elsewhere in this Annual Report.

ITEM 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report. This discussion and analysis contains forward-looking statements that are based on our current expectations and reflect our plans, estimates and anticipated future financial performance. These statements involve numerous risks and uncertainties. Our actual results may differ materially from those expressed or implied by these forward-looking statements as a result of many factors, including those set forth in the section of this Annual Report entitled "Risk Factors". See the section of this Annual Report entitled “Forward-Looking Statements” for additional information.

The following discussion and analysis of our financial condition and results of operations includes 2023 and 2022 items and year-over-year comparisons between 2023 and 2022. For discussion of 2021 items and year-over-year comparisons between 2022 and 2021, refer to Part II. Item 7. “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2022.

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Overview

We are a leading provider of cloud business management solutions for the real estate industry. Our solutions are designed to enable our property manager customers to digitally transform their businesses, address critical operations and deliver a better customer experience. Our products assist our customers with an interconnected and growing network of stakeholders in their business ecosystems, including property owners, real estate investment managers, rental prospects, residents, and vendors, and provide key functionality related to critical transactions across the real estate lifecycle, including screening potential tenants, sending and receiving payments and providing insurance-related risk mitigation services. AppFolio’s intuitive interface, streamlined workflows, and AI powered automation make it easier for our customers to eliminate redundant and manual processes so they can deliver a great experience for their network of stakeholders while improving financial and operational performance.

We rely heavily on our talented team of employees to execute our growth plans and achieve our long-term strategic objectives. We believe our people are at the heart of our success and our customers' success, and we have worked hard not only to attract and retain talented individuals, but also to provide a challenging and rewarding work environment designed to motivate and develop our valuable human capital. As we navigate the challenges of increased competition for talent, we continue to evolve our compensation and employee reward practices.

Key Business Metric

We monitor the key business metric set forth below to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions.

Property management units under management. We believe that our ability to increase the number of property management units under management is an indicator of our market penetration, growth, and potential future business opportunities. We define property management units under management as active or committed units under management at the period end date. We had 8.2 million and 7.3 million property management units under management, as of December 31, 2023 and 2022, respectively.

Seasonality

We have historically experienced seasonality in our Value Added Services revenue, primarily in our tenant screening revenue, due to seasonally higher leasing activities in the second quarter, which increase tenant screening transactions in that period. We generally experience decreased tenant screening revenue in the fourth quarter, when seasonally lower leasing activities occur. Corresponding to the higher tenant applications in the second quarter, our property manager customers typically experience an increase in new tenants in the third quarter, resulting in a higher demand for our insurance-related risk mitigation services in that period. As a result of the seasonality of the rental lifecycle and the growth of our business, we have typically experienced a sequential increase in revenue in the first, second and third quarters and a sequential decline in revenue in the fourth quarter of each of our most recent fiscal years. These seasonal factors could be heightened or lessened due to the impact of a change in macroeconomic factors that could impact tenant behavior or a change in our product portfolio mix or the adoption rate of our other less seasonally impacted Value Added Services. Although these seasonal factors are common in the real estate industry, historical patterns should not be considered a reliable indicator of our future sales activity or performance.

Key Components of Results of Operations

Revenue

Our core solutions and certain of our Value Added Services are offered on a subscription basis. Our core solutions subscription fees vary by property type and are designed to scale with the size of our customers’ businesses. We recognize revenue for subscription-based services on a straight-line basis over the contract term beginning on the date that our service is made available. We generally invoice monthly or, to a lesser extent, annually in advance of the subscription period.

We also offer certain Value Added Services, which are not covered by our subscription fees, on a per-use basis. Usage-based fees are charged either as a percentage of the transaction amount (e.g., for certain of our payment services) or on a flat fee per transaction basis with no minimum usage commitments (e.g., for our tenant screening and risk mitigation services). We recognize revenue for usage-based services in the period the service is rendered. Our payments services fees are recorded gross of the interchange and payment processing related fees. We generally invoice our usage-based services on a monthly basis or collect the fee at the time of service. A significant majority of our Value Added Services revenue comes from the use of our payment services, tenant screening services, and risk mitigation services.

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We charge our customers for onboarding assistance to our core solutions and certain other non-recurring services. We generally invoice for these other services in advance of the services being completed and recognize revenue in the period the service is rendered. We generate revenue from legacy customers of previously acquired businesses by providing services outside of our property management core solution platform. Revenue derived from these services is recorded in Other revenue. As of December 31, 2023 and 2022, we had 19,737 and 18,441 property management customers, respectively.

Costs and Operating Expenses

Cost of Revenue (Exclusive of Depreciation and Amortization). Many of our Value Added Services are facilitated by third-party service providers. Cost of revenue paid to these third-party service providers includes the cost of electronic interchange and payment processing-related services to support our payments services, the cost of credit reporting services for our tenant screening services, and various costs associated with our risk mitigation service providers. These third-party costs vary both in amount and as a percent of revenue for each Value Added Service offering. Cost of revenue also consists of personnel-related costs for our employees focused on customer service and the support of our operations (including salaries, performance-based compensation, benefits, and stock-based compensation), platform infrastructure costs (such as data center operations and hosting-related costs), and allocated shared and other costs. Cost of revenue excludes depreciation of property and equipment, amortization of capitalized software development costs and amortization of intangible assets.

Sales and Marketing. Sales and marketing expense consists of personnel-related costs for our employees focused on sales and marketing (including salaries, sales commissions, performance-based compensation, benefits, and stock-based compensation), costs associated with sales and marketing activities, and allocated shared and other costs. Marketing activities include advertising, online lead generation, lead nurturing, customer and industry events, and the creation of industry-related content and collateral. We focus our sales and marketing efforts on generating awareness of our software solutions, creating sales leads, establishing and promoting our brands, and cultivating an educated community of successful and vocal customers.

Research and Product Development. Research and product development expense consists of personnel-related costs for our employees focused on research and product development (including salaries, performance-based compensation, benefits, and stock-based compensation), fees for third-party development resources, and allocated shared and other costs. Our research and product development efforts are focused on expanding functionality and the ease of use of our existing software solutions by adding new core functionality, Value Added Services and other improvements, as well as developing new products and services. We capitalize our software development costs that meet the criteria for capitalization. Amortization of capitalized software development costs is included in depreciation and amortization expense.

General and Administrative. General and administrative expense consists of personnel-related costs for employees in our executive, finance, information technology, human resources, legal, compliance, corporate development and administrative organizations (including salaries, performance-based cash compensation, benefits, and stock-based compensation). In addition, general and administrative expense includes fees for third-party professional services (including audit, legal, compliance, and tax services), transaction costs related to sales of subsidiary businesses, regulatory fees or fines, other corporate expenses, impairment of long-lived assets, and allocated shared and other costs.

Depreciation and Amortization. Depreciation and amortization expense includes depreciation of property and equipment, amortization of capitalized software development costs, and amortization of intangible assets. We depreciate or amortize property and equipment, software development costs, and intangible assets over their expected useful lives on a straight-line basis, which approximates the pattern in which the economic benefits of the assets are consumed.

Other Income (Loss), Net. Other income, net includes gain on sale of our equity-method investments, gains and losses associated with the sale of businesses and property and equipment, and income from certain post-closing transition services provided by us to MyCase, Inc. during fiscal year 2021.

Interest Income, Net. Interest income includes interest earned on investment securities, amortization and accretion of the premium and discounts paid from the purchase of investment securities, and interest earned on cash deposited in our bank accounts.

Provision for Income Taxes. Provision for income taxes consists of federal and state income taxes in the United States.

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Results of Operations

Revenue

The increase in revenue for the year ended December 31, 2023, compared to the prior year, was primarily attributable to an increase in the usage of our payments, tenant screening, and risk mitigation services. During the year ended December 31, 2023, we experienced growth of 13% in the number of property management units under management compared to the prior year, which drove growth in users of our subscription and usage-based services.

Our payment services experienced increased usage during the comparative periods as residents, property managers, and owners transacted more business online. In addition, we stopped waiving the eCheck (ACH) transaction fee beginning in the third quarter of 2023. Our tenant screening and risk mitigation services usage also increased during the comparative periods in line with the increase in units under management.

The decrease in other revenue is primarily attributable to the WegoWise Transaction during the year ended December 31, 2022. For additional information regarding the WegoWise Transaction, refer to Note 3, Sale of Subsidiary Business, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this report.

We expect total revenue for the year ending December 31, 2024 to increase compared to the year ended December 31, 2023 as we continue to add new customers and property management units under management, along with increased adoption and usage of our Value Added Services.

Cost of Revenue (Exclusive of Depreciation and Amortization)

Cost of revenue (exclusive of depreciation and amortization) for the year ended December 31, 2023, increased primarily due to increases in expenditures to third-party service providers related to the delivery of our Value Added Services of $34.9 million compared to the prior year. This increase was directly associated with the increased adoption and utilization of our Value Added Services. Personnel-related costs, including stock-based and performance-based compensation, necessary to support growth and key investments, increased $9.6 million for the year ended December 31, 2023, compared to the prior year. Included in the increase in personnel-related costs was $2.4 million of severance and related personnel costs associated with the workforce reduction in the third quarter of 2023. For additional information, see Note 16, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

Allocated shared and other costs increased by $1.7 million for the year ended December 31, 2023, compared to the prior year, primarily related to platform infrastructure, software and other costs incurred in support of our overall growth.

We expect cost of revenue (exclusive of depreciation and amortization) for the year ending December 31, 2024, to decrease slightly as a percentage of revenue compared to the year ended December 31, 2023, as we continue to drive additional efficiencies.

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Sales and Marketing

Sales and marketing expense for the year ended December 31, 2023 was relatively flat compared to the prior year, reflecting a net increase in personnel-related costs, including stock-based and performance-based compensation, of $2.6 million, partially offset by a decrease in allocated shared and other costs of $1.9 million. Included in the increase in personnel-related costs was $3.8 million of severance and related personnel costs associated with the workforce reduction in the third quarter of 2023. For additional information, see Note 16, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

We expect sales and marketing expense for the year ending December 31, 2024 to decrease as a percentage of revenue compared to the year ended December 31, 2023, as we continue to leverage headcount efficiencies.

Research and Product Development

Research and product development expense for the year ended December 31, 2023 increased primarily due to an increase in personnel-related costs, including stock-based and performance-based compensation, net of capitalized software development costs, of $37.7 million, compared to the prior year. The increase in personnel-related costs was primarily due to headcount growth within our research and product development organization, higher salaries, and $3.4 million of severance and related personnel costs associated with the workforce reduction in the third quarter of 2023. For additional information, see Note 16, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

Allocated shared and other costs increased by $2.6 million year ended December 31, 2023 compared to the prior year, driven by costs supporting our overall growth.

We expect research and product development expenses for the year ending December 31, 2024 to decrease as a percentage of revenue compared to the year ended December 31, 2023, as we continue to leverage headcount efficiencies.

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General and Administrative

General and administrative expense for the year ended December 31, 2023 decreased compared to the same period in the prior year primarily due to lease-related asset impairment charges of $22.0 million recognized in the year ended December 31, 2022 that did not recur in 2023. In addition, there was a decrease of $4.3 million due to gains related to lease modifications for the year ended December 31, 2023, compared to the prior year. This was partially offset by an increase in personnel-related costs, including stock-based and performance-based compensation, in the year ended December 31, 2023 of $17.2 million compared to the prior year. The increase in personnel-related costs for the year ended December 31, 2023 was driven primarily by the separation costs associated with our former Chief Executive Officer's Separation Agreement of $14.9 million and the severance related costs associated with the workforce reduction in the third quarter of 2023 of $2.5 million. For further information, see Note 8, Accrued Employee Expenses, and Note 16, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this report.

For the year ended December 31, 2023, stock-based compensation increased due to additional grants to current and new employees and incremental expense associated with the workforce reduction in the third quarter of 2023.

We expect general and administrative expenses for the year ending December 31, 2024 to decrease as a percentage of revenue compared to the year ended December 31, 2023, as we continue to leverage headcount efficiencies.

Depreciation and Amortization

Depreciation and amortization expense for the year ended December 31, 2023 decreased, compared to the prior year, primarily due to decreased amortization expense associated with capitalized software development and intangible balances.

We expect depreciation and amortization expenses for the year ending December 31, 2024 to decrease as a percentage of revenue compared to the year ended December 31, 2023 due to a decrease in amortization of accumulated capitalized software development balances.

Interest Income, Net

Interest income for the year ended December 31, 2023 increased, compared to the prior year, primarily due to higher interest rates.

Other Income, net

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Other income, net for the year ended December 31, 2023 decreased, compared to the prior year, primarily due to a gain of $4.2 million associated with the WegoWise Transaction during the year ended December 31, 2022. For further information, see Note 3, Sale of Subsidiary Business, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this report.

Provision for Income Taxes

The increase in our effective tax rate for the year ended December 31, 2023, as compared to the prior year, is primarily due to the significant increase in our pre-tax income, change in valuation allowance against deferred tax assets, higher non-deductible officers’ compensation, partially offset by higher tax benefits from stock-based compensation and research and development credits.

Liquidity and Capital Resources

Our principal sources of liquidity continue to be cash, cash equivalents, and investment securities, as well as cash flows generated from our operations. As of December 31, 2023, our cash and cash equivalents and investment securities had an aggregate balance of $211.7 million. We have financed our operations primarily through cash generated from operations. We believe that our existing cash and cash equivalents, investment securities, and cash generated from operating activities will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months.

Capital Requirements

Our future capital requirements will depend on many factors, including continued market acceptance of our software solutions, changes in the number of our customers, adoption and utilization of our Value Added Services by new and existing customers, the timing and extent of the introduction of new core functionality, products and Value Added Services, and the timing and extent of our investments across our organization. Non-cancelable purchase commitments for business operations total $57.0 million as of December 31, 2023, due primarily over the next three years. Operating lease obligations totaling $55.5 million associated with leased facilities and have varying maturities with $31.1 million due over the next five years. Furthermore, our Board of Directors has authorized our management to repurchase up to $100.0 million of shares of our Class A common stock from time to time. To date, we have repurchased $4.2 million of our Class A common stock under the Share Repurchase Program. For additional information regarding our Share Repurchase Program, refer to Note 12, Stockholders' Equity.

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Cash Flows

The following table presents our cash flows for the periods indicated (in thousands):

Cash Provided by Operating Activities

Our primary source of operating cash inflows is cash collected from our customers in connection with their use of our core solutions and Value Added Services. Our primary uses of cash from operating activities are for personnel-related expenditures and third-party costs incurred to support the delivery of our software solutions.

The net increase in cash provided by operating activities for the year ended December 31, 2023, compared to the prior year, was primarily due to a higher increase in cash collections from customers relative to the increase in operating expenditures, partially offset by the payment of separation costs related to our former Chief Executive Officer's Separation Agreement and the severance costs associated with the workforce reduction during the year ended December 31, 2023. For additional information, see Note 16, Workforce Reduction, of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.

Cash Used in Investing Activities

Cash used in investing activities is generally composed of purchases of investment securities, maturities and sales of investment securities, purchases of property and equipment, and additions to capitalized software development.

The net increase in cash used in investing activities for the year ended December 31, 2023, compared to the prior year, was primarily due to higher purchases of available-for-sale investment securities.

Cash Used in Financing Activities

Cash used in financing activities is generally composed of net share settlements for employee tax withholdings associated with the vesting of equity awards offset by proceeds from the exercise of stock options.

The net increase in cash used in financing activities for the year ended December 31, 2023, compared to the prior year, was primarily due to an increase in net share settlements for employee tax withholdings associated with the vesting of equity awards.

Off-Balance Sheet Arrangements

As of December 31, 2023, we did not have any off-balance sheet arrangements.

Critical Accounting Policies and Estimates

Our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

We believe that the following critical accounting policies involve a greater degree of judgment or complexity than our other accounting policies. Accordingly, these are the policies we believe are the most critical to a full understanding and evaluation of our Consolidated Financial Statements. For additional information, refer to Note 2, Summary of Significant Accounting Policies of our Consolidated Financial Statements included elsewhere in this Annual Report.

Revenue Recognition

Many of our contracts with customers contain multiple performance obligations. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require judgment. We account for individual performance obligations separately if they are distinct. The performance obligations for

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these contracts include access and use of our core solutions, implementation services, and customer support. Access and use of our core solutions and implementation services are considered distinct.

The transaction price is allocated to each performance obligation on a relative standalone selling price basis. Judgment is required to determine the standalone selling price for each distinct performance obligation. We typically have more than one standalone selling price for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we determine the standalone selling price based on our overall pricing objectives, taking into consideration customer demographics and other factors. Fees are fixed based on rates specified in the subscription agreements, which do not provide for any refunds or adjustments.

Capitalized Software Development Costs

We believe there are two key estimates within the capitalized software balance, which are the determination of the useful life of the software and the determination of the amounts to be capitalized.

We determined that a three year life is appropriate for our internal-use software based on our best estimate of the useful life of the internally developed software after considering factors such as continuous developments in the technology, obsolescence and anticipated life of the service offering before significant upgrades. Based on our prior experience, internally generated software will generally remain in use for a minimum of three years before being significantly replaced or modified to keep up with evolving customer and company needs. While we do not anticipate any significant changes to this three year estimate, a change in this estimate could produce a material impact on our financial statements.

We determine the amount of internal software costs to be capitalized based on the amount of time spent by our software engineers on projects. Costs associated with building or significantly enhancing our software solutions and new internally built software solutions are capitalized, while costs associated with planning new developments and maintaining our software solutions are expensed as incurred. There is judgment involved in estimating the stage of development as well as estimating time allocated to a particular project. A significant change in the time spent on each project could have a material impact on the amount capitalized and related amortization expense in subsequent periods.

Impairment of long-lived assets

We assess the recoverability of our long-lived assets when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable or that the useful lives of those assets are no longer appropriate. An impairment charge would be recognized when the carrying amount of a long-lived asset or asset group is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset or asset group is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group.

Any impairments to operating lease right of use ("ROU") assets, leasehold improvements, or other assets as a result of a sublease, abandonment, or other similar factor are assessed for impairment when a decision to do so is made and recorded as an operating expense. Similar to other long-lived assets, management tests ROU assets for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. For ROU and other lease-related assets, such circumstances would include subleases that do not fully recover the costs of the associated leases or a decision to abandon the use of all or part of a leased asset. Significant judgment and estimates are required in assessing impairment of long-lived assets, including identifying whether events or changes in circumstances require an impairment assessment, estimating future cash flows, uncertainty associated with the time period it will take to obtain a sublessee, the anticipated sublease income and determining appropriate discount rates. Our estimates of fair value are based on assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates.

Income Taxes

We recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the Consolidated Statements of Operations in the period that includes the enactment date. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, we consider the weighting of all available positive and negative evidence, which includes, among other things, the nature, frequency and severity of current and cumulative taxable income or losses, future projections of profitability, and the duration of statutory carryforward periods. We give significant weight to objectively verified evidence, such as historical cumulative losses, in our overall assessment.

Judgment is required to measure the amount of tax benefits that can be recognized associated with uncertain tax positions. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. We recognize interest and

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penalties accrued with respect to uncertain tax positions, if any, in our provision for income taxes in the Consolidated Statements of Operations.

Recent Accounting Pronouncements

For information regarding recent accounting pronouncements, refer to Note 2, Summary of Significant Accounting Policies of our Consolidated Financial Statements included elsewhere in this Annual Report.

ITEM 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report. This discussion and analysis contains forward-looking statements that are based on our current expectations and reflect our plans, estimates and anticipated future financial performance. These statements involve numerous risks and uncertainties. Our actual results may differ materially from those expressed or implied by these forward-looking statements as a result of many factors, including those set forth in the section of this Annual Report entitled "Risk Factors". See the section of this Annual Report entitled “Forward-Looking Statements” for additional information.

The following discussion and analysis of our financial condition and results of operations discusses 2022 and 2021 items and year-over-year comparisons between 2022 and 2021. For discussion of 2020 items and year-over-year comparisons between 2021 and 2020, refer to Part II. Item 7. “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2021.

Overview

We are a leading provider of cloud business management solutions for the real estate industry. Our solutions are designed to enable our property manager customers to digitally transform their businesses, address critical business operations and deliver a better customer experience. Our products assist our customers with an interconnected and growing network of stakeholders in their business ecosystems, including property owners, real estate investment managers, rental prospects, residents, and service providers, and provide key functionality related to critical transactions across the real estate lifecycle, including screening potential tenants, sending and receiving payments and even providing insurance-related risk mitigation services. AppFolio’s intuitive interface, coupled with streamlined and automated workflows, make it easier for our customers to eliminate redundant and manual processes so they can deliver a great experience for their network of stakeholders while improving financial and operational performance.

We rely heavily on our talented team of employees to execute our growth plans and achieve our long-term strategic objectives. We believe our people are at the heart of our success and our customers' success, and we have worked hard not only to attract and retain talented individuals, but also to provide a challenging and rewarding work environment to motivate and develop our valuable human capital. As we navigate the challenges of increased competition for talent, we continue to evolve our compensation and employee reward practices.

Key Business Metric

Property management units under management. We believe that our ability to increase our number of property management units under management is an indicator of our market penetration, growth, and potential future business opportunities. We define property management units under management as active or committed units under management at the period end date. We had 7.3 million and 6.3 million property management units under management as of December 31, 2022 and 2021, respectively.

Seasonality

We have historically experienced seasonality in our Value Added Services revenue, primarily in our tenant screening services, due to seasonally higher leasing activities in the second quarter which increases tenant screening transactions in that period. We generally experience decreased tenant screening revenue in the fourth quarter, when seasonally lower leasing activities occur. Corresponding to the higher tenant applications in the second quarter, our property manager customers typically experience an increase in new tenants in the third quarter, resulting in a higher demand for our insurance-related risk mitigation services in that period. As a result of the seasonality of the rental lifecycle and the growth of our business, we have typically experienced a sequential increase in revenue in the first, second and third quarters and a sequential decline in revenue in the fourth quarter of each of our most recent fiscal years. These seasonal factors could be heightened or lessened due to the impact of a change in macroeconomic factors that could impact tenant behavior or a change in the adoption rate of our other less seasonally impacted Value Added Services. Although these seasonal factors are common in the real estate industry, historical patterns should not be considered a reliable indicator of our future sales activity or performance.

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Key Components of Results of Operations

Revenue

Our core solutions and certain of our Value Added Services are offered on a subscription basis. Our core solutions subscription fees vary by property type and are designed to scale with the size of our customers’ businesses. We recognize revenue for subscription-based services on a straight-line basis over the contract term beginning on the date that our service is made available. We generally invoice monthly or, to a lesser extent, annually in advance of the subscription period.

We also offer certain Value Added Services, which are not covered by our subscription fees, on a per-use basis. Usage-based fees are charged either as a percentage of the transaction amount (e.g., for certain of our payment services) or on a flat fee per transaction basis with no minimum usage commitments (e.g., for our tenant screening and risk mitigation services). We recognize revenue for usage-based services in the period the service is rendered. Our payments services fees are recorded gross of the interchange and payment processing related fees. We generally invoice our usage-based services on a monthly basis or collect the fee at the time of service. A significant majority of our Value Added Services revenue comes from the use of our payment services, tenant screening services, and risk mitigation services.

We charge our customers for onboarding assistance to our core solutions and certain other non-recurring services. We generally invoice for these other services in advance of the services being completed and recognize revenue in the period the service is rendered. We generate revenue from the legacy customers of previously acquired businesses by providing services outside of our property management core solution platform. Revenue derived from these services is recorded in Other revenue. As of December 31, 2022 and 2021, we had 18,441 and 17,215 property management customers, respectively.

Costs and Operating Expenses

Cost of Revenue (Exclusive of Depreciation and Amortization). Many of our Value Added Services are facilitated by third-party service providers. Cost of revenue paid to these third-party service providers includes the cost of electronic interchange and payment processing-related services to support our payments services, the cost of credit reporting services for our tenant screening services, and various costs associated with our risk mitigation service providers. These third-party costs vary both in amount and as a percent of revenue for each Value Added Service offering. Cost of revenue also consists of personnel-related costs for our employees focused on customer service and the support of our operations (including salaries, performance-based compensation, benefits, and stock-based compensation), platform infrastructure costs (such as data center operations and hosting-related costs), and allocated shared and other costs. Cost of revenue excludes depreciation of property and equipment, amortization of capitalized software development costs and amortization of intangible assets.

Sales and Marketing. Sales and marketing expense consists of personnel-related costs for our employees focused on sales and marketing (including salaries, sales commissions, performance-based compensation, benefits, and stock-based compensation), costs associated with sales and marketing activities, and allocated shared and other costs. Marketing activities include advertising, online lead generation, lead nurturing, customer and industry events, and the creation of industry-related content and collateral. We focus our sales and marketing efforts on generating awareness of our software solutions, creating sales leads, establishing and promoting our brands, and cultivating an educated community of successful and vocal customers.

Research and Product Development. Research and product development expense consists of personnel-related costs for our employees focused on research and product development (including salaries, performance-based compensation, benefits, and stock-based compensation), fees for third-party development resources, and allocated shared and other costs. Our research and product development efforts are focused on expanding functionality and the ease of use of our existing software solutions by adding new core functionality, Value Added Services and other improvements, as well as developing new products and services. We capitalize our software development costs that meet the criteria for capitalization. Amortization of capitalized software development costs is included in depreciation and amortization expense.

General and Administrative. General and administrative expense consists of personnel-related costs for employees in our executive, finance, information technology, human resources, legal, compliance, corporate development and administrative organizations (including salaries, performance-based cash compensation, benefits, and stock-based compensation). In addition, general and administrative expense includes fees for third-party professional services (including audit, legal, compliance, and tax services), transaction costs related to sales of subsidiary businesses, regulatory fees, other corporate expenses, impairment of long-lived assets, and allocated shared and other costs.

Depreciation and Amortization. Depreciation and amortization expense includes depreciation of property and equipment, amortization of capitalized software development costs, and amortization of intangible assets. We depreciate or amortize property and equipment, software development costs, and intangible assets over their expected useful lives on a straight-line basis, which approximates the pattern in which the economic benefits of the assets are consumed.

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Other Income, Net. Other income, net includes gain on sale of our equity-method investments, gains and losses associated with the sale of businesses and property and equipment, and income from certain post-closing transition services provided by us to MyCase, Inc. during fiscal year 2021.

Interest Income (Expense), Net. Interest income includes interest earned on investment securities, amortization and accretion of the premium and discounts paid from the purchase of investment securities, and interest earned on cash deposited in our bank accounts. Interest expense includes interest paid on any outstanding borrowings during the year ended December 31, 2020.

Provision for Income Taxes. Provision for income taxes consists of federal and state income taxes in the United States.

Results of Operations

Revenue

The increase in revenue for the year ended December 31, 2022, compared to the prior year, was primarily attributable to growth in our base of property management customers driving an increase in the number of property management units under management, and growth in users of our subscription and usage-based services. During the year ended December 31, 2022, we experienced growth of 15% in the number of property management units under management resulting from 7% growth in the number of property management customers, compared to the prior year.

Our payment services experienced increased adoption during the comparative periods as residents, property managers, and owners transacted more business online. Our tenant screening and risk mitigation services usage also increased during the comparative periods in line with the increase in units under management. A significant majority of our Value Added Services revenue comes from the use of our payment services, tenant screening services, and the risk mitigation services we make available to customers.

Cost of Revenue (Exclusive of Depreciation and Amortization)

Cost of revenue (exclusive of depreciation and amortization) for the year ended December 31, 2022, increased primarily due to increases in expenditures to third-party service providers related to the delivery of our Value Added Services of $34.1 million compared to the prior year. This increase was directly associated with the increased adoption and utilization of our Value Added Services. Personnel-related costs, including performance-based compensation, necessary to support growth and key investments, increased $12.5 million for the year ended December 31, 2022, compared to the prior year. Allocated shared and other costs increased by $1.2 million for the year ended December 31, 2022, compared to the prior year, primarily related to platform infrastructure, software and other costs incurred in support of our overall growth.

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As a percentage of revenue, cost of revenue (exclusive of depreciation and amortization) fluctuates primarily based on the mix of Value Added Services revenue in the period, given the varying percentage of revenue we pay to third-party service providers. We expect cost of revenue (exclusive of depreciation and amortization) for the year ending December 31, 2023 to decrease as a percentage of revenue compared to the year ended December 31, 2022, as we expect to leverage headcount efficiencies to offset an increase in expenditures to third-party service providers related to the delivery of our Value Added Services.

Sales and Marketing

Sales and marketing expense for the year ended December 31, 2022 increased primarily due to increases in personnel-related costs, including performance-based compensation, necessary to support growth in the business of $23.9 million compared to the prior year. Advertising and promotion costs increased by $2.1 million primarily due to increased advertising and promotion spending to support the growth and key investments in the business. Allocated shared and other costs increased by $8.2 million year ended December 31, 2022 compared to the prior year, primarily related to software and other costs incurred in support of our overall growth.

We expect sales and marketing expense for the year ending December 31, 2023 to decrease as a percentage of revenue compared to the year ended December 31, 2022, as we continue to leverage headcount efficiencies.

Research and Product Development

Research and product development expense for the year ended December 31, 2022 increased primarily due to an increase in personnel-related costs including performance-based compensation, net of capitalized software development costs, of $42.8 million, compared to the prior year. Allocated shared and other costs increased by $2.3 million year ended December 31, 2022 compared to the prior year, primarily related to software and other costs incurred in support of our overall growth.

We expect research and product development expenses for the year ending December 31, 2023 to increase as a percentage of revenue compared to the year ended December 31, 2022, as we continue to invest in our research and product development organization to support our strategy to expand the use cases of our product capabilities to the larger customer segment.

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General and Administrative

General and administrative expense for the year ended December 31, 2022 increased primarily due to a net ROU and other lease-related asset impairment of $22.0 million. Personnel-related costs, including performance-based compensation, increased $15.7 million for the year ended December 31, 2022, compared to the prior year. Allocated shared and other costs increased $3.9 million for the year ended December 31, 2022, compared to the prior year, for professional fees, education and training, insurance, software and other costs to support our growth. Additionally, offsetting general and administrative expense for the year ended December 31, 2021 was a $1.9 million insurance recovery related to our previously disclosed settlement with the Federal Trade Commission (the "FTC").

Excluding the impairment charge, we expect general and administrative expenses for the year ending December 31, 2023 to remain flat as a percentage of revenue compared to the year ended December 31, 2022.

Depreciation and Amortization

Depreciation and amortization expense for the year ended December 31, 2022 increased, compared to the prior year, primarily due to increased amortization expense associated with accumulated capitalized software development balances.

We expect depreciation and amortization expenses for the year ending December 31, 2023 to decrease as a percentage of revenue compared to the year ended December 31, 2022 due to a decrease in amortization of accumulated capitalized software development balances.

Other Income, net

Other income, net for the year ended December 31, 2022 decreased, compared to the prior year, primarily due to a gain of $12.8 million related to the sale of our investment in SecureDocs during the year ended December 31, 2021. The decrease was offset by a gain of $4.2 million associated with the WegoWise Transaction during the year ended December 31, 2022. For additional information regarding the WegoWise Transaction, refer to Note 3, Sale of Subsidiary Businesses.

Provision for Income Taxes

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The effective tax rate as compared to the U.S. federal statutory rate of 21% differs primarily due to change in valuation allowance against deferred taxes and non-deductible expenses, partially offset by state income taxes and tax benefits associated with stock-based compensation expense and research and development tax credits.

Liquidity and Capital Resources

Our principal sources of liquidity continue to be cash, cash equivalents, and investment securities, as well as cash flows generated from our operations. At December 31, 2022, our cash and cash equivalents and investment securities had an aggregate balance of $185.2 million. We have financed our operations primarily through cash generated from operations. We believe that our existing cash and cash equivalents, investment securities, and cash generated from operating activities will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months.

Capital Requirements

Our future capital requirements will depend on many factors, including continued market acceptance of our software solutions, changes in the number of our customers, adoption and utilization of our Value Added Services by new and existing customers, the timing and extent of the introduction of new core functionality, products and Value Added Services, and the timing and extent of our investments across our organization. Non-cancelable purchase commitments for business operations total $23.4 million as of December 31, 2022, due primarily over the next three years. Operating lease obligations totaling $65.1 million associated with leased facilities and have varying maturities with $30.1 million due over the next five years. Furthermore, our Board of Directors has authorized our management to repurchase up to $100.0 million of shares of our Class A common stock from time to time. To date, we have repurchased $4.2 million of our Class A common stock under the Share Repurchase Program. For additional information regarding our Share Repurchase Program, refer to Note 11, Stockholders' Equity.

Cash Flows

The following table presents our cash flows for the periods indicated (in thousands):

Cash Provided by Operating Activities

Our primary source of operating cash inflows is cash collected from our customers in connection with their use of our core solutions and Value Added Services. Our primary uses of cash from operating activities are for personnel-related expenditures and third-party costs incurred to support the delivery of our software solutions.

Net cash provided by operating activities was $25.4 million for the year ended December 31, 2022 compared to net cash provided by operating activities of $35.4 million for the year ended December 31, 2021. The net decrease in cash provided by operating activities was primarily due to an increase in employee related costs and the settlement of accounts payable offset by an increase in cash collections from customers due to higher revenue growth and a decrease in income taxes paid related to the sale of MyCase, Inc. during the year ended December 31, 2021.

Cash Used in Investing Activities

Cash used in investing activities is generally composed of purchases of investment securities, maturities and sales of investment securities, purchases of property and equipment, and additions to capitalized software development.

Net cash used in investing activities for the year ended December 31, 2022 was $6.5 million compared to $110.5 million for the year ended December 31, 2021. The net decrease in cash used in investing activities was primarily due to decreases in purchases of available-for-sale investment securities and capitalization of software development costs, offset by a decrease in proceeds from sales of available-for-sale investment securities and decrease in proceeds from sales of business and equity method investments.

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Cash Used in Financing Activities

Cash used in financing activities is generally composed of net share settlements for employee tax withholdings associated with the vesting of equity awards offset by proceeds from the exercise of stock options.

Net cash used in financing activities for the year ended December 31, 2022 was $6.2 million compared to $7.3 million for the year ended December 31, 2021. The decrease in cash used in financing activities was primarily due to an increase in proceeds from stock option exercises.

Off-Balance Sheet Arrangements

At December 31, 2022, we did not have any off-balance sheet arrangements.

Critical Accounting Policies and Estimates

Our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

We believe that the following critical accounting policies involve a greater degree of judgment or complexity than our other accounting policies. Accordingly, these are the policies we believe are the most critical to a full understanding and evaluation of our Consolidated Financial Statements. For additional information, refer to Note 2, Summary of Significant Accounting Policies of our Consolidated Financial Statements included elsewhere in this Annual Report.

Revenue Recognition

Many of our contracts with customers contain multiple performance obligations. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require judgment. We account for individual performance obligations separately if they are distinct. The performance obligations for these contracts include access and use of our core solutions, implementation services, and customer support. Access and use of our core solutions and implementation services are considered distinct.

The transaction price is allocated to each performance obligation on a relative standalone selling price basis. Judgment is required to determine the standalone selling price for each distinct performance obligation. We typically have more than one standalone selling price for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we determine the standalone selling price based on our overall pricing objectives, taking into consideration customer demographics and other factors. Fees are fixed based on rates specified in the subscription agreements, which do not provide for any refunds or adjustments.

Capitalized Software Development Costs

We believe there are two key estimates within the capitalized software balance, which are the determination of the useful life of the software and the determination of the amounts to be capitalized.

We determined that a three year life is appropriate for our internal-use software based on our best estimate of the useful life of the internally developed software after considering factors such as continuous developments in the technology, obsolescence and anticipated life of the service offering before significant upgrades. Based on our prior experience, internally generated software will generally remain in use for a minimum of three years before being significantly replaced or modified to keep up with evolving customer and company needs. While we do not anticipate any significant changes to this three year estimate, a change in this estimate could produce a material impact on our financial statements.

We determine the amount of internal software costs to be capitalized based on the amount of time spent by our software engineers on projects. Costs associated with building or significantly enhancing our software solutions and new internally built software solutions are capitalized, while costs associated with planning new developments and maintaining our software solutions are expensed as incurred. There is judgment involved in estimating the stage of development as well as estimating time allocated to a particular project. A significant change in the time spent on each project could have a material impact on the amount capitalized and related amortization expense in subsequent periods.

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Impairment of long-lived assets

We assess the recoverability of our long-lived assets when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable or that the useful lives of those assets are no longer appropriate. An impairment charge would be recognized when the carrying amount of a long-lived asset or asset group is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset or asset group is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group.

Any impairments to operating lease right of use ("ROU") assets, leasehold improvements, or other assets as a result of a sublease, abandonment, or other similar factor are assessed for impairment when a decision to do so is made and recorded as an operating expense. Similar to other long-lived assets, management tests ROU assets for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. For ROU and other lease-related assets, such circumstances would include subleases that do not fully recover the costs of the associated leases or a decision to abandon the use of all or part of a leased asset. We recorded a net impairment of $22.0 million consisting of $17.6 million related to ROU assets and $4.4 million related to property and equipment associated with our leased office spaces as described further in Note 9, Leases. Significant judgment and estimates are required in assessing impairment of long-lived assets, including identifying whether events or changes in circumstances require an impairment assessment, estimating future cash flows, uncertainty associated with the time period it will take to obtain a sublessee, the anticipated sublease income and determining appropriate discount rates. Our estimates of fair value are based on assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates.

Income Taxes

We recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the Consolidated Statements of Operations in the period that includes the enactment date. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, we consider the weighting of all available positive and negative evidence, which includes, among other things, the nature, frequency and severity of current and cumulative taxable income or losses, future projections of profitability, and the duration of statutory carryforward periods.

Judgment is required to measure the amount of tax benefits that can be recognized associated with uncertain tax positions. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. We recognize interest and penalties accrued with respect to uncertain tax positions, if any, in our provision for income taxes in the Consolidated Statements of Operations.

Recent Accounting Pronouncements

For information regarding recent accounting pronouncements, refer to Note 2, Summary of Significant Accounting Policies of our Consolidated Financial Statements included elsewhere in this Annual Report.

ITEM 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report. This discussion and analysis contains forward-looking statements that are based on our current expectations and reflect our plans, estimates and anticipated future financial performance. These statements involve numerous risks and uncertainties. Our actual results may differ materially from those expressed or implied by these forward-looking statements as a result of many factors, including those set forth in the section of this Annual Report entitled "Risk Factors". See the section of this Annual Report entitled “Forward-Looking Statements” for additional information.

The following discussion and analysis of our financial condition and results of operations discusses 2021 and 2020 items and year-over-year comparisons between 2021 and 2020. For discussion of 2019 items and year-over-year comparisons between 2020 and 2019, refer to Part II. Item 7. “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2020.

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Overview

We are a leading provider of cloud business management solutions for the real estate industry. Our solutions enable our customers to digitally transform their businesses, automate and streamline critical business operations and deliver a better customer experience. Our products assist an interconnected and growing ecosystem of users, including property managers, property owners, real estate investment managers, rental prospects, residents, and service providers with critical transactions across the real estate lifecycle, including screening potential tenants, sending and receiving payments and even providing insurance-related risk mitigation services. AppFolio’s intuitive interface, coupled with streamlined and automated workflows, make it easier for our customers to eliminate redundant and manual processes so they can deliver a great experience for their users while improving financial and operational performance.

We rely heavily on our talented team of employees to execute our growth plans and achieve our long-term strategic objectives. We believe our people are at the heart of our success and our customers' success, and we have worked hard not only to attract and retain talented individuals, but also to provide a challenging and rewarding environment to motivate and develop our valuable human capital. In March 2020, in an effort to protect our employees and comply with applicable government orders in response to the COVID-19 pandemic, we transitioned our employees to a remote work environment. We began transitioning our employees back to the office in 2021; however, our employees have the option to work remotely until further notice.

During certain periods covered by this Annual Report, we also provided software solutions and services to the legal industry via MyCase, a software solution primarily designed for small and mid-sized law firms. We completed our divestiture of MyCase, Inc. on September 30, 2020 (the "MyCase Transaction"). For additional details, see Note 3, Divestitures, of our Consolidated Financial Statements in this Annual Report.

Key Business Metric

Property management units under management. We believe that our ability to increase our number of property management units under management is an indicator of our market penetration, the growth of our business, and our potential future business opportunities. We define property management units under management as the number of active units on our core solutions. We had 6.35 million and 5.36 million property management units under management as of December 31, 2021 and 2020, respectively.

Seasonality

We have historically experienced seasonality in our Value Added Services revenue, primarily in our tenant screening services, due to seasonally higher leasing activities in the second quarter which increases tenant screening transactions in that period. We generally experience decreased tenant screening revenue in the fourth quarter, when seasonally lower leasing activities occur. Corresponding to the higher tenant applications in the second quarter, our property manager customers typically experience an increase in new tenants in the third quarter, resulting in a higher demand for our insurance-related risk mitigation services in that period. As a result of the seasonality of the rental lifecycle and the growth of our business, we have typically experienced a sequential increase in revenue in the first, second and third quarters and a sequential decline in revenue in the fourth quarter of each of our most recent fiscal years. These seasonal factors could be heightened or lessened due to the impact of a change in macroeconomic factors that could impact tenant behavior or a change in the adoption rate of our other less seasonally impacted Value Added Services. Although these seasonal factors are common in the real estate industry, historical patterns should not be considered a reliable indicator of our future sales activity or performance.

Key Components of Results of Operations

Revenue

Our core solutions and certain of our Value Added Services are offered on a subscription basis. Our core solutions subscription fees vary by property type and are designed to scale to the size of our customers’ businesses. We recognize revenue for subscription-based services over time on a straight-line basis over the contract term beginning on the date that our service is made available. We generally invoice monthly or, to a lesser extent, annually in advance of the subscription period.

We also offer Value Added Services, which are not covered by our subscription fees, on a per use basis. Usage-based fees are charged either as a percentage of the transaction amount (e.g., for certain of our electronic payment services) or on a flat fee per transaction basis with no minimum usage commitments (e.g., for our tenant screening and risk mitigation services). We recognize revenue for usage-based services in the period the service is rendered. Our electronic payments services fees are recorded gross of the interchange and payment processing related fees. We generally invoice our usage-based services on a monthly basis or collect the fee at the time of service. A significant majority of our Value Added Services revenue comes

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directly and indirectly from the use of our electronic payment services, tenant screening services, and risk mitigation services. Usage-based fees are paid either by customers or by users.

We charge our customers for on-boarding assistance to our core solutions and certain other non-recurring services. We generally invoice for these other services in advance of the services being completed and recognize revenue upon completion of the related service. We generate revenue from the legacy customers of previously acquired businesses by providing services outside of our property management core solution platform. Revenue derived from these services is recorded in Other revenue.

Costs and Operating Expenses

Cost of Revenue. Many of our Value Added Services are facilitated by third-party service providers. Cost of revenue paid to these third-party service providers includes the cost of electronic interchange and payment processing related services to support our electronic payments services, the cost of credit reporting services for our tenant screening services, and various costs associated with our risk mitigation service providers. These third-party costs vary both in amount and as a percent of revenue for each Value Added Service offering. Cost of revenue also consists of personnel-related costs for our employees focused on customer service and the support of our operations (including salaries, performance-based compensation, benefits, and stock-based compensation), platform infrastructure costs (such as data center operations and hosting-related costs), and allocated shared and other costs. Cost of revenue excludes depreciation of property and equipment, amortization of capitalized software development costs and amortization of intangible assets.

Sales and Marketing. Sales and marketing expense consists of personnel-related costs for our employees focused on sales and marketing (including salaries, sales commissions, performance-based compensation, benefits, and stock-based compensation), costs associated with sales and marketing activities, and allocated shared and other costs. Marketing activities include advertising, online lead generation, lead nurturing, customer and industry events, and the creation of industry-related content and collateral. Sales commissions and other incremental costs to acquire customers and grow adoption and utilization of our Value Added Services by our new and existing customers are deferred and then amortized on a straight-line basis over a period of benefit, which we have determined to be three years. We focus our sales and marketing efforts on generating awareness of our software solutions, creating sales leads, establishing and promoting our brands, and cultivating an educated community of successful and vocal customers.

Research and Product Development. Research and product development expense consists of personnel-related costs for our employees focused on research and product development (including salaries, performance-based compensation, benefits, and stock-based compensation), fees for third-party development resources, and allocated shared and other costs. Our research and product development efforts are focused on enhancing functionality and the ease of use of our existing software solutions by adding new core functionality, Value Added Services and other improvements, as well as developing new products and services for existing and adjacent markets. We capitalize our software development costs that meet the criteria for capitalization. Amortization of capitalized software development costs is included in depreciation and amortization expense.

General and Administrative. General and administrative expense consists of personnel-related costs for employees in our executive, finance, information technology, human resources, legal, compliance, corporate development and administrative organizations (including salaries, performance-based cash compensation, benefits, and stock-based compensation). In addition, general and administrative expense includes fees for third-party professional services (including audit, legal, compliance, tax, and consulting services), transaction costs related to business combinations and divestitures, regulatory fines and penalties, other corporate expenses, and allocated shared and other costs.

Depreciation and Amortization. Depreciation and amortization expense includes depreciation of property and equipment, amortization of capitalized software development costs, and amortization of intangible assets. We depreciate or amortize property and equipment, software development costs, and intangible assets over their expected useful lives on a straight-line basis, which approximates the pattern in which the economic benefits of the assets are consumed.

Other Income, Net. Other income, net includes the gain on sale of MyCase during fiscal year 2020, gain on sale of our equity-method investments, and gains and losses associated with the sale of property and equipment and investment securities.

Interest Income (Expense), Net. Interest expense includes interest paid on any outstanding borrowings. Interest income includes interest earned on investment securities, amortization and accretion of the premium and discounts paid from the purchase of investment securities, and interest earned on notes receivable and on cash deposited in our bank accounts.

Provision for Income Taxes. Provision for income taxes consists of federal and state income taxes in the United States.

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Results of Operations for the Years Ended December 31, 2021 and 2020

The following table presents our results of operations for the periods presented in dollars (in thousands) and as a percentage of revenue:

(1) The following table presents stock-based compensation expense included in each respective expense category:

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Revenue

Revenue for the years ended December 31, 2021 and 2020, was $359.4 million and $310.1 million, respectively, an increase of $49.3 million, or 16%. This increase was primarily attributable to the growth in the number of property management customers and units under management utilizing our core solutions and Value Added Services. Revenue in 2020 includes $25.4 million attributable to MyCase. Excluding this amount, revenue derived from the real estate industry for the years ended December 31, 2021 and 2020 increased $74.7 million, or 26%.

Core solutions revenue derived from the real estate industry for the years ended December 31, 2021 and 2020 was $105.1 million and $86.5 million, respectively, an increase of $18.6 million or 22%. Value Added Services revenue derived from the real estate industry for the years ended December 31, 2021 and 2020 was $241.3 million and $184.2 million, respectively, an increase of $57.1 million or 31%. These increases in core solutions and Value Added Services revenue for the years ended December 31, 2021 and 2020 were mainly attributable to growth in our base of property management customers and growth in users of our subscription and usage-based services. During the twelve month period ended December 31, 2021, we experienced growth of 17% in the average number of property management units under management resulting from 9% growth in the average number of property management customers.

Our electronic payment services experienced increased adoption during the comparative periods as residents, property managers, owners and customers transacted more business online. Our tenant screening and risk mitigation services usage also increased during the comparative periods in line with the increase in units under management. A significant majority of our Value Added Services revenue comes directly and indirectly from the use of our electronic payment services, tenant screening services, and the risk mitigation services we make available to customers.

Cost of Revenue (Exclusive of Depreciation and Amortization)

Cost of revenue (exclusive of depreciation and amortization) related to the real estate industry for the years ended December 31, 2021 and 2020 was $143.8 million and $109.7 million, respectively, an increase of $34.1 million, or 31%. For the years ended December 31, 2021 and 2020, expenditures to third-party service providers related to the delivery of our Value Added Services to the real estate industry increased $21.6 million, which was directly associated with the increased adoption and utilization of our Value Added Services, as evidenced by the $57.1 million increase in Value Added Services revenue to the real estate industry. Personnel-related costs, including performance-based compensation, necessary to support growth and key investments, increased $9.3 million. Allocated shared and other costs increased by $3.1 million primarily driven by an increase in software and other costs incurred in support of our overall growth.

As a percentage of revenue, cost of revenue (exclusive of depreciation and amortization) fluctuates primarily based on the mix of Value Added Services revenue in the period, given the varying percentage of revenue we pay to third-party service providers. For the year ended December 31, 2021, cost of revenue (exclusive of depreciation and amortization), as a percentage of revenue, increased to 40.0% from 38.5% for the year ended December 31, 2020. We expect the cost of revenues (exclusive of depreciation and amortization) for the year ending December 31, 2022, to increase as a percentage of revenue, as we expect expenditures to third-party service providers related to the delivery of our Value Added Services revenues to increase at a faster rate than total revenues as a result of a higher growth rate related to our Value Added Services revenues.

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Sales and Marketing

Sales and marketing expense related to the real estate industry for the years ended December 31, 2021 and 2020 was $73.1 million and $52.5 million, respectively, an increase of $20.6 million, or 39%. This increase was primarily due to a $12.6 million increase in personnel-related costs, including performance-based compensation, necessary to support growth and key investments in the business. Advertising and promotion costs increased by $6.3 million primarily due to increased advertising and promotion spending to support the growth and key investments in the business. In addition, there was an increase in allocated shared and other costs of $1.7 million primarily related to software and other costs incurred in support of our overall growth.

As a percentage of revenue, sales and marketing expense increased to 20.3% from 18.4% for the year ended December 31, 2021 compared to the year ended December 31, 2020. This increase was due in part to lower advertising and promotion costs in 2020 as a result of fewer events and lower online marketing spend, as well as increased spend in 2021 to support our growth.

Research and Product Development

Research and product development expense related to the real estate industry for the years ended December 31, 2021 and 2020 was $65.9 million and $43.8 million, respectively, an increase of $22.1 million, or 50%. This increase was the result of an increase in personnel-related costs, including performance based compensation, net of capitalized software development costs, of $20.5 million due to investments in headcount growth within our research and product development organization. Allocated shared and other costs increased $1.6 million primarily related to software and other costs to support our growth.

General and Administrative

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General and administrative expense related to the real estate industry and general corporate overhead expenses for the years ended December 31, 2021 and 2020 was $57.3 million and $46.1 million, respectively, an increase of $11.2 million, or 24%. The increase in general and administrative expense was primarily due to a $14.3 million increase in personnel-related costs for investments in headcount and an increase of $4.1 million in allocated shared and other costs for professional fees, education and training, insurance, software and other costs to support our growth. These increases were offset by a $1.9 million insurance recovery related to our previously disclosed settlement with the Federal Trade Commission (the "FTC") and a decrease in legal costs of $5.3 million related to our $4.3 million settlement with the FTC and a decrease in legal fees of $1.0 million related to the MyCase Transaction during the year ended December 31, 2020.

Depreciation and Amortization

Depreciation and amortization expense related to the real estate industry for the years ended December 31, 2021 and 2020 was $30.8 million and $25.0 million, respectively, an increase of $5.8 million, or 23%. The increase in depreciation and amortization expense was primarily due to increased amortization expense associated with higher accumulated capitalized software development balances.

Other Income, net

*Percentage not meaningful

Other income, net for the years ended December 31, 2021 and 2020 was $13.1 million and $188.9 million, respectively, a decrease of $175.8 million. The decrease in other income, net was primarily due to the gain of $187.6 million associated with the MyCase Transaction in September 2020. The decrease was offset by a gain of $12.8 million related to the sale of our investment in SecureDocs, a portion of which relates to the recovery of a $2.0 million note receivable which had been previously reserved.

Provision for Income Taxes

*Percentage not meaningful

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For the year ended December 31, 2021, we recorded income tax expense of $0.7 million. The effective tax rate as compared to the U.S. federal statutory rate of 21% differs primarily due to the significance of the benefits associated with stock-based compensation expense, research and development tax credits, and the change in the valuation allowance against deferred taxes.

For the year ended December 31, 2020 we recorded an income tax expense of $38.4 million. The tax provision for the year ended December 31, 2020 includes tax expense of $51.3 million relating to the MyCase Transaction which includes $52.3 million of current tax expense on the gain on the sale of MyCase, less a $1.0 million benefit on the reversal of deferred tax liabilities relating to MyCase. For tax purposes, we filed an election to treat the transaction as a sale of assets. As such, the tax impact takes into consideration the tax basis of the assets on the date of sale and the availability of net operating losses and research and development tax credits. The effective tax rate as compared to the U.S. federal statutory rate of 21% differs primarily due to state income taxes and the benefits associated with stock-based compensation expense and research and development tax credits.

Liquidity and Capital Resources

Our principal sources of liquidity continue to be composed of our cash, cash equivalents, and investment securities, as well as cash flows generated from our operations. At December 31, 2021, our cash and cash equivalents and investment securities had an aggregate balance of $183.5 million. We have financed our operations primarily through cash generated from operations. We believe that our existing cash and cash equivalents, investment securities, and cash generated from operating activities will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months.

Capital Requirements

Our future capital requirements will depend on many factors, including continued market acceptance of our software solutions, changes in the number of our customers, adoption and utilization of our Value Added Services by new and existing customers, the timing and extent of the introduction of new core functionality, products and Value Added Services, the timing and extent of our expansion into new or adjacent markets, the timing and extent of our investments across our organization, and the impact of the COVID-19 pandemic (and other actual or potential events outside of our control) on the customers we serve and on our business. Non-cancelable purchase commitments for business operations total $13.2 million as of December 31, 2021, due primarily over the next 3 years. Operating lease obligations totaling $66.6 million associated with leased facilities and have varying maturities with $24.3 million due over the next five years. In addition, we have in the past entered into, and may in the future enter into, arrangements to acquire or invest in new technologies or markets adjacent to those we serve today. Furthermore, our Board of Directors has authorized our management to repurchase up to $100.0 million of shares of our Class A common stock from time to time. To date, we have repurchased $4.2 million of our Class A common stock under the Share Repurchase Program. For additional information regarding our Share Repurchase Program, refer to Note 11, Stockholders' Equity.

Cash Flows

The following table presents our cash flows for the periods indicated (in thousands):

Cash Provided by Operating Activities

Our primary source of operating cash inflows is cash collected from our customers in connection with their use of our core solutions and Value Added Services. Our primary uses of cash from operating activities are for personnel-related expenditures and third-party costs incurred to support the delivery of our software solutions.

For the year ended December 31, 2021, cash provided by operating activities was $35.4 million resulting from income of $1.0 million, non-cash charges of $36.7 million and a net decrease in our operating assets and liabilities of $2.4 million. The non-cash charges primarily consist of $29.0 million of depreciation and amortization costs, stock-based compensation expense, including as amortized, of $17.2 million, a decrease in deferred taxes of $0.3 million, and $3.2 million of amortization of operating lease right-of-use ("ROU") assets. The net decrease in our operating assets and liabilities was mostly attributable to a $9.0 million decrease in income taxes payable primarily driven by income taxes paid due to the MyCase Transaction, a $2.2

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million increase in prepaid expenses and other current assets primarily attributable to increases in tenant improvement allowance receivable, deferred commission costs and prepaid expenses to support our overall growth, a $2.1 million increase in accounts receivable primarily driven by growth of our Value Added Services, and a $1.8 million decrease in accrued expenses which was primarily due to a $4.3 million legal expense accrued during the year ended December 31, 2020 and paid in the three months ended March 31, 2021 related to our settlement with the FTC. These decreases were partially offset by an $11.3 million increase in accrued employee expenses-current primarily due to an increase in short-term incentive compensation, an increase in payroll expense and accrued paid time off due to an increase in headcount, a $1.3 million increase in operating lease liabilities, a $0.6 million increase in accrued employee expenses-noncurrent due to an increase in accrued long-term management bonuses, and a $0.5 million increase in accounts payable.

For the year ended December 31, 2020, cash provided by operating activities was $48.3 million resulting from our net income of $158.4 million, adjusted by the gain related to the MyCase Transaction of $187.7 million, non-cash charges of $68.6 million and a net increase in our operating assets and liabilities of $8.9 million. The non-cash charges primarily consist of a decrease in deferred taxes of $29.0 million, depreciation and amortization costs of $25.5 million, stock-based compensation expense, including as amortized, of $10.3 million, and amortization of operating lease right-of-use assets of $3.7 million. The net increase in our operating assets and liabilities was mostly attributable to a $9.4 million increase in other liabilities primarily driven by income taxes payable due to the MyCase Transaction, a $6.9 million increase in accrued expenses which includes a $4.3 million accrual related to legal loss reserves, a $2.8 million increase in accrued employee expenses related to an overall increase in personnel-related costs, and a $0.5 million increase in deferred revenue. These increases were partially offset by a $2.8 million increase in accounts receivable primarily driven by growth of our Value Added Services, an increase in prepaid expenses and other current assets of $5.9 million primarily driven by an increase in prepaid expenses to support the growth in our business, an increase in deposits held with a third party related to requirements to maintain collateral for our risk mitigation services, and an increase in deferred costs, and a $0.9 million decrease in accounts payable due to timing of payments.

Cash (Used in) Provided by Investing Activities

Cash (used in) provided by investing activities is generally composed of purchases of investment securities, maturities and sales of investment securities, purchases of property and equipment, and additions to capitalized software development.

For the year ended December 31, 2021, investing activities used $110.5 million in cash primarily due to purchases of investment securities of $241.2 million, capitalized software development costs of $24.6 million and capital expenditures of $8.1 million to purchase property and equipment for the continued growth and expansion of our business. These uses of cash were partially offset by maturities and sales of investment securities of $107.4 million and $43.2 million, respectively, and proceeds from the sale of our equity-method investment of $12.5 million.

For the year ended December 31, 2020, investing activities provided $146.5 million in cash primarily due to net proceeds from the MyCase Transaction of $191.4 million and the proceeds from maturities and sales of investment securities of $27.3 million and $16.7 million, respectively. These sources of cash were partially offset by purchases of investment securities of $43.9 million, capitalized software development costs of $26.0 million, and capital expenditures of $19.0 million to purchase property and equipment primarily related to the growth and expansion of our headquarters in Santa Barbara, CA, a portion of which was reimbursed through tenant improvement allowances.

Cash Used in Financing Activities

Cash used in financing activities is generally comprised of net share settlements for employee tax withholdings associated with the vesting of restricted stock units ("RSUs"), the payment of contingent consideration under acquisition arrangements, activities associated with our former credit facility, activities related to the repurchase of our Class A common stock offset by proceeds from the exercise of stock options.

For the year ended December 31, 2021, financing activities used $7.3 million in cash primarily as a result of net share settlements for employee tax withholdings associated with the vesting of RSUs of $10.0 million, offset by proceeds from stock option exercises of $2.6 million.

For the year ended December 31, 2020, financing activities used $70.4 million in cash primarily as a result of the payment of all outstanding amounts due under the former credit facility of $99.6 million, net share settlements for employee tax withholdings associated with the vesting of RSUs of $12.2 million, payment of contingent consideration related to the 2019 acquisition of Dynasty Marketplace, Inc. of $6.0 million, and the repurchase of outstanding shares of Class A common stock in the amount of $4.2 million. These uses of cash were partially offset by proceeds from the Revolving Facility of $50.8 million.

Off-Balance Sheet Arrangements

At December 31, 2021, we did not have any off-balance sheet arrangements.

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Critical Accounting Policies and Estimates

Our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report are prepared in accordance with generally accepted accounting principles in the United States. The preparation of our Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

We believe that the following critical accounting policies involve a greater degree of judgment or complexity than our other accounting policies. Accordingly, these are the policies we believe are the most critical to a full understanding and evaluation of our Consolidated Financial Statements. For additional information, refer to Note 2, Summary of Significant Accounting Policies of our Consolidated Financial Statements included elsewhere in this Annual Report.

Revenue Recognition

Many of our contracts with customers contain multiple performance obligations. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require judgment. We account for individual performance obligations separately if they are distinct. The performance obligations for these contracts include access and use of our core solutions, implementation services, and customer support. Access and use of our core solutions and implementation services are considered distinct.

The transaction price is allocated to each performance obligation on a relative standalone selling price basis. Judgment is required to determine the standalone selling price for each distinct performance obligation. We typically have more than one standalone selling price for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we determine the standalone selling price based on our overall pricing objectives, taking into consideration customer demographics and other factors. Fees are fixed based on rates specified in the subscription agreements, which do not provide for any refunds or adjustments.

Capitalized Software Development Costs

We believe there are two key estimates within the capitalized software balance, which are the determination of the useful life of the software and the determination of the amounts to be capitalized.

We determined that a three year life is appropriate for our internal-use software based on our best estimate of the useful life of the internally developed software after considering factors such as continuous developments in the technology, obsolescence and anticipated life of the service offering before significant upgrades. Based on our prior experience, internally generated software will generally remain in use for a minimum of three years before being significantly replaced or modified to keep up with evolving customer and company needs. While we do not anticipate any significant changes to this three year estimate, a change in this estimate could produce a material impact on our financial statements.

We determine the amount of internal software costs to be capitalized based on the amount of time spent by our software engineers on projects. Costs associated with building or significantly enhancing our software solutions and new internally built software solutions are capitalized, while costs associated with planning new developments and maintaining our software solutions are expensed as incurred. There is judgment involved in estimating the stage of development as well as estimating time allocated to a particular project. A significant change in the time spent on each project could have a material impact on the amount capitalized and related amortization expense in subsequent periods.

Income Taxes

We recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the Consolidated Statements of Operations in the period that includes the enactment date. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, management considers the weighting of all available positive and negative evidence, which includes, among other things, the nature, frequency and severity of current and cumulative taxable income or losses, future projections of profitability, and the duration of statutory carryforward periods.

Judgment is required to measure the amount of tax benefits that can be recognized associated with uncertain tax positions. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in our Consolidated Financial Statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized. We recognize interest and penalties accrued with respect to uncertain tax positions, if any, in our provision for income taxes in the Consolidated Statements of Operations.

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Recent Accounting Pronouncements

For information regarding recent accounting pronouncements, refer to Note 2, Summary of Significant Accounting Policies of our Consolidated Financial Statements included elsewhere in this Annual Report.