IMPINJ INC (PI) FY 2023 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis together with our consolidated financial statements and the related notes to those statements included elsewhere in this report. This discussion contains forward-looking statements that involve risks and uncertainties. As a result of many factors, such as those set forth under “Risk Factors” and elsewhere in this report, our actual results may differ materially from those anticipated in these forward-looking statements.

Overview

We envision a world in which every item that enterprises manufacture, transport and sell, and that people own, use and recycle, is wirelessly and ubiquitously connected to the cloud. And a world in which the ownership, history and linked information for every one of those items is seamlessly available to enterprises and people. We call our expansive vision a Boundless Internet of Things, or IoT, and we are well on our way to realizing it.

Our mission is to connect every thing. We use a type of radio-frequency identification, or RFID, technology known as RAIN for the ubiquitous, wireless item-to-cloud connectivity. We sell a suite of products that we and our partner ecosystem use to connect and deliver item data to enterprises. We have enabled connectivity for more than 95 billion items to date, delivering item visibility and improving operational efficiencies for retailers, supply chain and logistics, or SC&L, providers, restaurants and food-service providers, airlines, automobile manufacturers, healthcare companies and many more.

We are today focused on extending item connectivity from tens of billions to trillions of items, and delivering item data not just to enterprises but to people, so they too can derive value from their connected items. We believe the Boundless IoT we are enabling will, in the not-too-distant future, give people ubiquitous access to cloud-based digital twins of every item, each storing the item’s history and linked information and helping people explore and learn about the item. We believe that that connectivity will transform the world.

We and our partner ecosystem build item-visibility solutions using products that we design and either sell or license, including silicon RAIN radios; manufacturing, test, encoding and reading systems; and software and cloud services. Our platform comprises our products and supporting partner ecosystem. Our products include endpoint ICs that store a serialized number to wirelessly identify an item; reader ICs that our partners use in finished readers to wirelessly discover, inventory and engage endpoint ICs; manufacturing, test and encoding systems that enable partner products and facilitate enterprise deployments; finished readers and gateways for autonomous reading solutions; and software and cloud services for solutions enablement. We sell our products, either individually or as a whole platform offering, primarily with or through our partner ecosystem.

Factors Affecting Our Performance

Inventory Supply

Most of our revenue derives from endpoint ICs that our partners embed into or onto enterprise items and is therefore affected by macroeconomic trends. Further, we sell most of our products, both endpoint ICs and systems, through partners and distributors, limiting our visibility to enterprise demand. We work closely with those partners and distributors to gain as accurate a view as possible, however, correctly forecasting demand for our products and identifying market shifts in a timely manner remains a challenge. As a result, we sometimes experience inventory overages or shortages. Inventory overages can increase expenses, expose us to product obsolescence and/or increased reserves and negatively affect our business. Inventory shortages can cause long lead times, missed opportunities, market-share losses and/or damaged customer relationships, also negatively affecting our business.

In 2021 and 2022, demand for our endpoint ICs increased while worldwide wafer demand also increased, leading to wafer shortfalls for many semiconductor companies, including us. These wafer shortfalls prevented us from fully meeting customer demand and, in some cases, caused customers to cancel orders, qualify alternative suppliers or purchase from our competitors. In 2023, macroeconomic conditions led to softness in demand and inventory overages.

Product Adoption and Unit Growth Rates

Enterprises have significantly adopted RAIN in retail apparel, our largest market, and SC&L, but the rate of adoption and unit growth rates have been uneven and unpredictable. From 2010 to 2023, our overall endpoint IC

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sales volumes increased at a compounded annual growth rate of 26%; however. we have experienced declines in endpoint IC sales volumes during various periods.

Regardless of the uneven pace of retail, SC&L and other industry adoption and growth rates, we believe the long-term trend is continued RAIN adoption and growth and we intend to continue investing in developing new products and expanding our product offerings for the foreseeable future. However, we cannot predict whether historical annual growth rates are indicative of the pace of future growth.

Our systems business, at least for readers and gateways, depends significantly on large-scale deployments at discrete end users, and deployment timing causes large yearly variability in our systems revenue. For example, we generated 14% of total 2019 revenue from a gateway deployment at a large North American SC&L provider. We did not have comparable project-based revenue in 2020. Similarly, in 2021, we generated 13% of our quarterly revenue from a project-based gateway deployment for RAIN-based self-checkout and loss prevention at a large Europe-based global retailer. We did not have comparable project-based revenue in 2022 or 2023.

Seasonality and Pricing

We typically negotiate pricing with most of our endpoint IC OEMs with an effective date of the first quarter of the calendar year. In the past, this negotiation typically resulted in reduced revenue and gross margins in the first quarter compared to prior periods, which then normalized in subsequent quarters as we reduced costs and adjusted product mix by migrating those OEMs and end users to newer, lower-cost products.

Endpoint IC volumes tend to be lower in the fourth quarter than in the third quarter. System sales tend to be higher in the fourth quarter and lower in the first quarter, we believe due to the availability of residual funding for capital expenditures prior to the end of many end users’ fiscal years.

We did not see these seasonal trends in 2022 or 2023 and may not see them in 2024. Whether and when these trends will return is not clear. We do expect continued quarter-to-quarter revenue variability due to changing macroeconomic conditions.

Results of Operations

Year ended December 31, 2023 compared with year ended December 31, 2022

Revenue and gross profit increased, due primarily to higher endpoint IC and systems revenue. The endpoint IC revenue increase was driven primarily by higher shipment volumes partially offset by lower average ASP due to mix, and the systems revenue increase was due to higher shipment volumes. Gross margin decreased due primarily to decreased product margins and, to a lesser extent, higher excess and obsolescence charges and indirect costs. The lower product margins were driven by lower endpoint IC margins due to a smaller revenue contribution from industrial and specialty endpoint ICs as well as mix within those industrial and specialty endpoint ICs. Loss from operations increased due primarily to increased operating expenses partially offset by increased gross profit. The operating expense increase was due primarily to higher research and development, general and administrative costs and amortization of intangibles as a result of us acquiring Voyantic Oy.

Year ended December 31, 2022 compared with year ended December 31, 2021

Revenue and gross profit increased, due primarily to higher endpoint IC and systems revenue. The endpoint IC revenue increase was driven primarily by higher ASP and shipment volumes. Gross margin increased, due primarily to increased product margins. The increased product margins were driven primarily by an increase in endpoint IC margins due to product mix. Loss from operations decreased, due primarily to increased gross profit offset by increased operating expenses. The operating expense increase was due primarily to higher research and development and general and administrative costs.

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Revenue

We currently derive substantially all our revenue from sales of endpoint ICs, reader ICs, readers, gateways and test and measurement solutions. We sell our endpoint ICs and test and measurement solutions primarily to inlay manufacturers; our reader ICs primarily to OEMs and ODMs through distributors; and our readers and gateways to solutions providers, VARs and SIs, also primarily through distributors. We expect endpoint IC sales to represent the majority of our revenue for the foreseeable future.

Year ended December 31, 2023 compared with year ended December 31, 2022

Endpoint IC revenue increased $42.9 million, due primarily to a $68.9 million increase from higher shipment volumes offset by a $26.0 million decrease due to ASP, the latter due primarily to lower revenue contribution from industrial and specialty endpoint ICs as well mix within those industrial and specialty ICs.

Systems revenue increased $6.8 million. Test and measurement solutions and gateway revenue increased $8.1 million and $5.5 million respectively due primarily to increased shipment volume. These increases were offset by a decrease of $7.8 million in reader revenue as a result of decreased shipment volumes.

Year ended December 31, 2022 compared with year ended December 31, 2021

Endpoint IC revenue increased $52.3 million, due primarily to a $35.5 million increase from higher ASPs and a $16.8 million increase from higher shipment volumes. The ASP increase was due primarily to price increases we implemented to offset higher product costs as well as product mix, the latter from a higher contribution from industrial and specialty ICs.

Systems revenue increased $15.2 million, due primarily to increases of $7.6 million in reader IC revenue, $4.9 million in gateway revenue and $3.3 million in reader revenue offset by a decrease of $0.9 million in nonrecurring engineering, or NRE, revenue. The reader IC and gateway revenue increases were due primarily to higher shipment volumes; the reader revenue increase was due primarily to higher ASPs.

Gross Profit and Gross Margin

Cost of revenue includes costs associated with manufacturing our endpoint ICs, reader ICs, readers, gateways and test and measurement solutions, including direct materials and outsourced manufacturing costs as well as associated overhead costs such as logistics, quality control, planning and procurement. Cost of revenue also includes charges for excess and obsolescence and warranty costs. Our gross margin varies from period to period based on the mix of endpoint IC and systems; underlying product margins driven by changes in mix, ASPs or costs; as well as from inventory excess and obsolescence charges.

Year ended December 31, 2023 compared with year ended December 31, 2022

Gross profit increased $14.1 million, due primarily to increased endpoint IC and systems revenue. Gross margin decreased, due primarily to decreased product margins and to a lesser extent higher excess and obsolescence charges and indirect costs. The decreased product margins were driven primarily by lower endpoint IC margins due to product mix and a smaller contribution from industrial and specialty endpoint ICs as well as mix within those industrial and specialty endpoint ICs. Excess and obsolescence charges had an immaterial gross margin impact for the years ended December 31, 2023 and 2022.

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Year ended December 31, 2022 compared with year ended December 31, 2021

Gross profit increased $38.9 million, due primarily to increased endpoint IC and systems revenue. Gross margin increased, due primarily to increased product margins, with offsetting fluctuations from reduced sales of fully reserved inventory and higher indirect costs. The product-margin increase was due primarily to higher endpoint IC margins from a higher revenue contribution from industrial and specialty ICs. Excess and obsolescence charges had an immaterial gross margin impact for the year ended December 31, 2022, compared to a favorable gross margin impact of 1.5% due to the sale of fully reserved inventory for the year ended December 31, 2021.

Operating Expenses

Research and Development

Research and development expense comprises primarily personnel expenses (salaries, benefits and other employee related costs) and stock-based compensation expense for our product-development personnel; product development costs which include external consulting and service costs, prototype materials and other new-product development costs; and an allocated portion of infrastructure costs which include occupancy, depreciation and software costs. We expect research and development expense to increase in absolute dollars in future periods as we continue to focus on new product development and introductions.

Year ended December 31, 2023 compared with year ended December 31, 2022

Research and development expense increased $14.5 million, due primarily to increases of $6.0 million in personnel expenses from higher headcount, $3.3 million in stock-based compensation expense related primarily to increased outstanding equity grants, $3.1 million in product development costs, and $2.0 million in infrastructure costs primarily from increased depreciation and software costs.

Year ended December 31, 2022 compared with year ended December 31, 2021

Research and development expense increased $10.0 million, due primarily to increases of $6.6 million in personnel expenses from higher headcount and a change in bonus payment structure from 100% PSUs to 50% cash and 50% PSUs, $1.9 million in infrastructure costs primarily from increased software costs, and $0.8 million in stock-based compensation expense related primarily to increased outstanding equity grants.

Sales and Marketing

Sales and marketing expense comprises primarily personnel expenses (salaries, incentive sales compensation, or commission, benefits and other employee-related costs) and stock-based compensation expense for our sales and marketing personnel; travel, advertising and promotional expenses; and an allocated portion of infrastructure costs which include occupancy, depreciation and software costs.

Year ended December 31, 2023 compared with year ended December 31, 2022

Sales and marketing expense increased $3.2 million, due primarily to increases of $1.7 million in personnel expenses from higher headcount offset by lower commission expense, $0.8 million in stock-based compensation expense related primarily to increased outstanding equity grants, and $0.5 million in travel expenses.

Year ended December 31, 2022 compared with year ended December 31, 2021

Sales and marketing expense increased $3.6 million, due primarily to increases of $2.9 million in personnel expenses from higher headcount and the change in bonus payment structure from 100% PSUs to 50% cash and 50% PSUs, and $0.6 million in marketing and advertising expenses.

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General and Administrative

General and administrative expense comprises primarily personnel expenses (salaries, benefits and other employee related costs) and stock-based compensation expense for our executive, finance, human resources and information technology personnel; legal, accounting and other professional service fees; travel and insurance expense; and an allocated portion of infrastructure costs which include occupancy, depreciation and software costs.

Year ended December 31, 2023 compared with year ended December 31, 2022

General and administrative expense increased $15.4 million, due primarily to increases of $11.0 million in professional services related primarily to non-settlement-related legal fees and transaction expenses for the Voyantic Oy acquisition, $2.5 million in personnel expenses from higher headcount, $1.1 million in stock-based compensation expense related primarily to increased outstanding equity grants, and $0.5 million in infrastructure expenses primarily related to rent and facilities.

Year ended December 31, 2022 compared with year ended December 31, 2021

General and administrative expense increased $9.3 million, due primarily to a $4.4 million increase in non-settlement-related legal fees, $2.3 million in personnel expenses from higher headcount and the change in bonus payment structure from 100% PSUs to 50% cash and 50% PSUs, and $1.6 million in stock-based compensation expense related primarily to increased outstanding equity grants.

Amortization of intangibles

The increase in amortization expense relates to the intangibles acquired as part of our April 3, 2023 acquisition of Voyantic Oy, a global provider of RFID test and measurement solutions. See note 6 Goodwill and Intangible Assets, for further details.

Restructuring costs

On February 2, 2021, we restructured our go-to-market organization to strategically align our global sales, product, partner development and marketing teams. We eliminated approximately seven full-time positions in our go-to-market organization, representing roughly 2% of our workforce. We incurred restructuring charges of $1.7 million for employee termination benefits and other associated legal costs for the year ended December 31, 2021. Restructuring charges were immaterial for the year ended December 31, 2022 and there were no restructuring charges for the year ended December 31, 2023. For further information on this restructuring, please refer to Note 18 to our consolidated financial statements included elsewhere in this report.

Other Income, Net

Other income, net, comprises primarily interest income on our short-term investments.

Year ended December 31, 2023 compared with year ended December 31, 2022

Other income, net, increased $2.1 million, due primarily to higher interest rates on our short-term investments and cash and cash equivalents.

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Year ended December 31, 2022 compared with year ended December 31, 2021

Other income, net, increased $2.5 million, due primarily to higher interest rates on our short and long-term investments.

Induced Conversion Expense

In November 2021 and June 2022, we completed a privately negotiated repurchase of $76.4 million and $9.9 million principal amounts, respectively, of the 2019 Notes, also referred to as the 2019 Notes Repurchase. We accounted for the 2019 Notes Repurchase transactions as an induced conversion in accordance with Accounting Standards Codification 470-20, Debt with Conversion and Other Options (ASC 470-20). We recorded $11.3 million and $2.2 million in induced conversion expense in our Consolidated Statements of Operations for the years ended December 31, 2021 and December 31, 2022, respectively. The induced conversion expense represents the fair value of the consideration issued upon conversion in excess of the fair value of the securities issuable under the original terms of the 2019 Notes. For further information, please refer to Note 8 to our consolidated financial statements included elsewhere in this report.

Interest Expense

Interest expense comprises primarily cash interest, amortization of debt issuance costs and debt discount.

In August 2020, the Financial Accounting Standards Board, or FASB, issued guidance on debt with conversion and other options, or ASU 2020-06. On January 1, 2021, we adopted Accounting Standard Update, or ASU, 2020-06 using the modified retrospective transition method, accounting for the 2019 Notes on a whole-instrument basis. Our consolidated financial statements for the years ended December 31, 2021, December 21, 2022, and December 31, 2023 use the new standard and we no longer record amortization of debt discount.

Year ended December 31, 2023 compared with year ended December 31, 2022

Interest expense remained comparable to the prior period.

Year ended December 31, 2022 compared with year ended December 31, 2021

Interest expense increased $2.4 million, due primarily to us issuing the $287.5 million aggregate principal amount of the 2021 Notes in November 2021, due May 15, 2027. For further information on the 2021 Notes, please refer to Note 8 to our consolidated financial statements included elsewhere in this report.

Income Tax Expense

We are subject to federal and state income taxes in the United States and foreign jurisdictions.

Year ended December 31, 2023 compared with year ended December 31, 2022

Income tax expense decreased by $0.5 million. which resulted in a benefit for the year ended December 31, 2023. This benefit was due to our estimated effective tax rate which incorporated the acquisition of Voyantic Oy. For further information on Voyantic Oy acquisition, please refer to Note 6 to our consolidated financial statements included elsewhere in this report.

Year ended December 31, 2022 compared with year ended December 31, 2021

Income tax expense remained comparable to the prior period.

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Non-GAAP Financial Measures

Our key non-GAAP performance measures include adjusted EBITDA and non-GAAP net income (loss), as defined below. We use adjusted EBITDA and non-GAAP net income (loss) as key measures to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget and to develop short- and long-term operating plans. We believe these measures provide useful information for period-to-period comparisons of our business to allow investors and others to understand and evaluate our operating results in the same manner as our management and board of directors. Our presentation of these non-GAAP financial measures is not meant to be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP, and our non-GAAP measures may be different from similarly termed non-GAAP measures used by other companies.

Adjusted EBITDA

We define adjusted EBITDA as net income (loss) determined in accordance with GAAP, excluding, if applicable for the periods presented, the effects of stock-based compensation; depreciation and amortization; restructuring costs; settlement and related costs; induced conversion expense; other income, net; interest expense; acquisition-related expense and related purchase accounting adjustments; and income tax benefit (expense). During the year ended December 31, 2023, we revised our definition of adjusted EBITDA to exclude acquisition related-expenses, related purchase-accounting adjustments and amortization of intangibles in connection with our Voyantic Oy acquisition. We have excluded these costs and expenses because we do not believe they reflect our core operations and us excluding them enables more consistent evaluation of our operating performance. This revision to our definition of adjusted EBITDA did not impact adjusted EBITDA for any previously reported periods because there were no items of a similar nature in those prior periods.

The following table presents a reconciliation of net loss to adjusted EBITDA:

Non-GAAP Net Income (Loss)

We define non-GAAP net income (loss) as net income (loss) excluding, if applicable for the periods presented, the effects of stock-based compensation; depreciation and amortization; restructuring costs; settlement and related costs; induced conversion expense; acquisition-related expense and related purchase accounting adjustments; and the corresponding income tax impacts of adjustments to net income (loss).

During the year ended December 31, 2023, we revised our definition of non-GAAP net income (loss) to adjust for acquisition-related expenses, related purchase-accounting adjustments and amortization of intangibles in connection with our Voyantic Oy acquisition. The revision to our definition of non-GAAP net income did not impact non-GAAP net income for any previously reported periods because there were no items of a similar nature in those prior periods.

During the year ended December 31, 2023, we further revised our definition of non-GAAP net income (loss) to adjust for income tax effects of adjustments to net income (loss), calculated at the statutory rate for current and historical periods. We have revised the prior period amounts to conform to our current period presentation.

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The following table presents a reconciliation of net loss to non-GAAP net income (loss):

Liquidity and Capital Resources

As of December 31, 2023, we had cash, cash equivalents and short-term investments of $113.2 million, comprising cash deposits held at major financial institutions and short-term investments in a variety of securities, including U.S. government securities, treasury bills, corporate notes and bonds, commercial paper and money market funds. As of December 31, 2023, we had working capital of $238.8 million.

Historically, we have funded our operations primarily through cash generated from operations and by issuing equity securities, convertible-debt offerings and/or borrowing under our prior senior credit facility. In 2023, our principal uses of cash were increases in our inventory balance, our acquisition of Voyantic Oy and capital expenditures.

We believe, based on our current operating plan, that our existing cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for at least the next 12 months. Over the longer term, we plan to continue investing to enhance and extend our platform. If our available funds are insufficient to fund our future activities or execute our strategy, then we may raise additional capital through equity, equity-linked or debt financing, to the extent such funding sources are available. Alternatively, we may need to reduce expenses to manage liquidity; however, any such reductions could adversely impact our business and competitive position.

Sources of Funds

From time to time, we may explore additional financing sources and ways to reduce our cost of capital, including equity, equity-linked and debt financing. In addition, in connection with any future acquisitions, we may pursue additional financing which may be debt, equity or equity-linked financing or a combination thereof. We can provide no assurance that any additional financing will be available to us on acceptable terms.

2021 Notes

In November 2021, we issued the 2021 Notes in an aggregate principal amount of $287.5 million. The 2021 Notes are our senior unsecured obligation, bearing interest at a fixed rate of 1.125% per year, payable semi-annually in arrears on May 15 and November 15 of each year, beginning on May 15, 2022. The 2021 Notes are convertible into cash, shares of our common stock or a combination thereof, at our election, and will mature on May 15, 2027 unless earlier repurchased, redeemed or converted in accordance with the indenture terms.

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The net proceeds from the 2021 Notes were approximately $278.4 million after initial debt issuance costs, fees and expenses. We used approximately $183.6 million of the net proceeds to repurchase approximately $76.4 million aggregate principal amount of the 2019 Notes through individual privately negotiated transactions concurrent with the 2021 Notes offering. We used $17.6 million to repurchase the remaining $9.85 million aggregate principal of the 2019 Notes through individual privately negotiated transactions in June 2022. Please refer to the section “Repurchase of the Convertible Senior Notes – 2019” as described in Note 8 to our consolidated financial statements included elsewhere in this report. We will use the rest of the net proceeds for general corporate purposes.

For further information on the terms of this debt, please refer to Note 8 to our consolidated financial statements included elsewhere in this report.

Historical Cash Flow Trends

The following table shows a summary of our cash flows for the periods indicated:

Operating Cash Flows

For the year ended December 31, 2023, we used $49.4 million of net cash from operating activities. This net cash usage was due primarily to $68.2 million of working capital usage due primarily to higher inventory and lower accounts payable partially offset by $18.9 million of net loss adjusted for non-cash items.

For the year ended December 31, 2022, we generated $0.6 million of net cash from operating activities. These net cash proceeds were due primarily to $27.8 million of net loss adjusted for non-cash items, partially offset by $27.2 million of working capital usage due primarily to higher inventory and accounts receivable offset by higher accounts payable.

For the year ended December 31, 2021, we generated $6.5 million of net cash from operating activities. The net cash proceeds were driven primarily by $6.2 million of net loss adjusted for non-cash items and $0.3 million of working capital contribution.

Investing Cash Flows

For the year ended December 31, 2023, we generated $115.8 million of net cash from investing activities. These net cash proceeds were due primarily to investment maturities of $144.4 million and sale of investments of $13.4 million, partially offset by cash paid for the Voyantic Oy acquisition of $23.4 million and property and equipment purchases of $18.6 million.

For the year ended December 31, 2022, we used $102.8 million of net cash from investing activities. This net cash usage was due primarily to investments and equipment purchases of $205.8 million and $12.1 million, respectively, partially offset by investment maturities of $114.8 million.

For the year ended December 31, 2021, we used $18.6 million of net cash from investing activities. The net cash usage was driven primarily by investments and equipment purchases of $84.4 million and $16.2 million, respectively, partially offset by investment maturities of $82 million.

Financing Cash Flows

For the year ended December 31, 2023, we generated $8.7 million of net cash from financing activities. These net cash proceeds were due to $8.7 million from stock-option exercises and our employee stock purchase plan, or ESPP.

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For the year ended December 31, 2022, we used $2.2 million of net cash from financing activities. This net cash usage was due primarily to $17.6 million to repurchase the remaining $9.85 million aggregate principal amount of the 2019 Notes described in the section “Repurchase of the Convertible Senior Notes – 2019” as described in Note 8 to our consolidated financial statements included elsewhere in this report. Other major factors included $15.4 million from stock options exercises and our ESPP.

For the year ended December 31, 2021, we generated $112.4 million of net cash from financing activities. The net cash proceeds were driven primarily by $278.4 million net proceeds from issuing the 2021 Notes. This amount was offset by $183.6 million for the cash repurchase of approximately $76.4 million aggregate principal amount of the 2019 Notes through individual privately negotiated transactions concurrent with the offering of the 2021 Notes described in the section “Repurchase of the Convertible Senior Notes – 2019” as described in Note 8 to our consolidated financial statements included elsewhere in this report. Other major factors included $17.6 million from stock-option exercises and our ESPP.

Contractual Obligations

The following table reflects a summary of our contractual obligations as of December 31, 2023:

(1) The 2021 Notes include $11.3 million in interest payments.

(2) Purchase commitments comprise primarily noncancelable commitments to purchase $21.8 million of inventory as of December 31, 2023, noncancelable software license agreements with vendors and equipment purchases.

Off-Balance-Sheet Arrangements

Since inception, we have not had any relationships with unconsolidated entities, such as entities often referred to as structured finance or special-purpose entities, or financial partnerships that would have been established for the purpose of facilitating off-balance-sheet arrangements or for another contractually narrow or limited purpose.

Critical Accounting Policies and Significant Estimates

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements which we have prepared in accordance with GAAP. Our preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and related disclosure of contingent assets and liabilities, revenue and expenses at the date of the consolidated financial statements. Generally, we base our estimates on historical experience and on various other assumptions, in accordance with GAAP, that we believe to be reasonable under the circumstances. Our actual results may differ from these estimates under other assumptions or conditions.

Critical accounting policies and estimates are those we consider the most important to the portrayal of our financial condition and results of operations because they require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Our critical accounting policies and estimates include those related to:

•
revenue recognition;

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inventory;

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income taxes; and

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stock-based compensation.

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Revenue Recognition

We generate revenue primarily from sales of hardware products. We also generate revenue from software, extended warranties, enhanced maintenance, support services and NRE development services, none of which are material.

We recognize revenue when we transfer control of the promised goods or services to our customers, which for hardware sales is generally at the time of product shipment as determined by agreed-upon shipping terms. We measure revenue based on the amount of consideration we expect to be entitled-to in exchange for those goods or services. We expect the period between when we transfer control of promised goods or services and when we receive payment to be one year or less, and that expectation is consistent with our historical experience. As such, we do not adjust our revenue for the effects of a significant financing component. We recognize any variable consideration, which comprises primarily sales incentives, as revenue reduction at the time of revenue recognition. We estimate sales incentives based on our historical experience and current expectations at the time of revenue recognition and update them at the end of each reporting period as additional information becomes available.

Our reader and gateway products are highly dependent on embedded software and cannot function without this embedded software. We account for the hardware and embedded software as a single performance obligation and recognize revenue when control is transferred.

Our customer contracts with multiple performance obligations generally include a combination of hardware products, extended warranty, enhanced maintenance and support services. For these contracts, we account for individual performance obligations separately if they are distinct. We allocate the transaction price to the separate performance obligations on a relative standalone selling-price basis. In instances where the standalone selling price is not directly observable, such as when we do not sell the product or service separately, we determine the standalone selling price using one, or a combination of, the adjusted market assessment or expected cost-plus margin. We defer amounts allocated to extended warranty and enhanced maintenance sold with our reader and gateway products and recognize them on a straight-line basis over the term of the arrangement, which is typically from one to three years. We defer amounts allocated to support services sold with our reader and gateway products and recognize them when we transfer control of the promised services to our customers.

For NRE development agreements that involve significant production, modification or customization of our products, we generally recognize revenue over the performance period using the cost-input method because it best depicts the transfer of services to the customer. We receive payments under these agreements based on a billing schedule. Contract assets relate to our conditional right to consideration for our completed performance under these agreements. We record accounts receivable when the right to consideration becomes unconditional. For the periods presented in this report, our contract assets, deferred revenue and the value of unsatisfied performance obligations for NRE development agreements are not material.

If a customer pays consideration before we transfer a good or service under the contract, then we classify those amounts as contract liabilities, or deferred revenue. We recognize contract liabilities as revenue when we transfer control of the promised goods or services to our customers.

Payment terms typically range from 30 to 120 days. We present revenue net of sales tax in our consolidated statements of operations. We include shipping charges billed to customers in revenue and the related shipping costs in cost of revenue.

Practical Expedients and Exemptions: We expense sales commissions when incurred because we expect the amortization period to be one year or less. We record these costs within sales and marketing expenses. We do not disclose the value of unsatisfied performance obligations for (1) contracts with an original expected length of one year or less and (2) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed.

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Inventory

We state inventories at the lower of cost or estimated net realizable value using the average costing method, which approximates a first-in, first-out method. Inventories comprise raw materials, work-in-process and finished goods. We continuously assess our inventory value and write down its value for estimated excess and obsolete inventory. This evaluation includes an analysis of inventory on hand, current and forecasted demand, product development plans and market conditions. If future demand or market conditions are less favorable than our projections, or our product development plans change from current expectations, then a write-down of excess or obsolete inventory may be required and is reflected in cost of goods sold in the period the updated information is known.

Income Taxes

We use the asset and liability approach for accounting, which requires recognizing deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax bases. We measure deferred tax assets and liabilities using enacted tax rates expected to be in effect when the assets and liabilities are recovered or settled. We recognize the effects of a change in tax rates on deferred tax assets and liabilities in the year that of the enactment date. We determine deferred tax assets, including historical net operating losses and deferred tax liabilities, based on temporary differences between the book and tax bases of the assets and liabilities. We believe that it is currently more likely than not that our deferred tax assets will not be realized and, as such, we have recorded a full valuation allowance for these assets. We evaluate the likelihood of our ability to realize deferred tax assets in future periods on a quarterly basis, and if evidence indicates we will be able to realize some or all of our deferred tax assets then we will revise our valuation allowance accordingly.

We use a two-step approach for evaluating uncertain tax positions. First, we evaluate recognition, which requires us to determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes. If we consider a tax position more likely than not to be unsustained, then no benefits of the position are recognized. Second, we measure the uncertain tax position based on the largest amount of benefit which is more likely than not to be realized on effective settlement. This process involves estimating our actual current tax exposure, including assessing the risks associated with tax audits, together with assessing temporary differences resulting from the different treatment of items for tax and financial reporting purposes. If actual results differ from our estimates, then our net operating loss and credit carryforwards could be materially impacted.

Us realizing the benefits of the NOLs and credit carryforwards depends on sufficient taxable income in future years. We have established a valuation allowance against the carrying value of our deferred tax assets, as it is currently more likely than not we will be unable to realize these deferred tax assets. In addition, using NOLs and credits to offset future income subject to taxes may be subject to substantial annual limitations due to the “change in ownership” provisions of the Code and similar state provisions. Events that cause limitations in the amount of NOLs that we may use in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined by Code Sections 382 and 383, over a three-year period. Using our NOLs and tax credit carryforwards could be significantly reduced if a cumulative ownership change of more than 50% has occurred in our past or occurs in our future.

We do not anticipate that the amount of our existing unrecognized tax benefits will significantly increase or decrease within the next 12 months. Due to our NOLs, in most jurisdictions our tax years remain open for examination by taxing authorities back to 2004.

Stock-Based Compensation

We have various equity award plans, or Plans for granting share-based awards to employees, consultants and non-employee directors of the Company. The Plans provide for granting several forms of stock compensation such as stock option awards, restricted stock units, or RSUs, RSUs with performance conditions, or PSUs, and RSUs with market and service conditions, or MSUs.

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We measure stock-based compensation costs for all share-based awards at fair value on the measurement date, which is typically the grant date. We determine the fair value of stock options using the Black-Scholes option-pricing model, which considers, among other things, estimates and assumptions on the expected life of the options, stock price volatility and market value of the Company’s common stock. We determine the fair value of RSUs and PSUs based on the closing price of our common stock at grant date. Additionally, for awards with a market condition, we use a Monte Carlo simulation model to estimate grant date fair value, which takes into consideration the range of possible stock price of total stockholder return outcomes.

Recent Accounting Pronouncements

For information on recent accounting pronouncements, please refer to Note 2 in our consolidated financial statements included elsewhere in this report.