Edgar Filing: TRUPANION INC.

10-Q Q3 2014

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2014

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____ to ____

Commission File Number: 001-36537

TRUPANION, INC.

(Exact name of registrant as specified in its charter)



Delaware		83-0480694
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

907 NW Ballard Way

Seattle, Washington 98107

(Address of principal executive offices and zip code)

(855) 727 - 9079

(Registrant's telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.



Large accelerated filer	o		Accelerated filer	o
Non-accelerated filer	x	(Do not check if smaller reporting company)	Smaller reporting company	o

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

As of October 30, 2014, there were approximately 27,789,803 shares of the registrant's common stock outstanding.

TRUPANION, INC.

TABLE OF CONTENTS



		Page No.
Note About Forward-Looking Statements
PART I-FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)	1
	Condensed Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013	1
	Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2014 and 2013	2
	Condensed Consolidated Statements of Comprehensive Loss for the three months and nine months ended September 30, 2014 and 2013	3
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2014 and 2013	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32
Item 4.	Controls and Procedures	32
PART II-OTHER INFORMATION
Item 1.	Legal Proceedings	33
Item 1A.	Risk Factors	33
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	57
Item 6.	Exhibits	60
	SIGNATURES	59
	EXHIBIT INDEX	60

Note About Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements contained in this Quarterly Report on Form 10-Q other than statements of historical fact, including statements regarding our future results of operations and financial position, our business strategy and plans and our objectives for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “potentially,” “estimate,” “target,” “continue,” “anticipate,” “intend,” “could,” “would,” “project,” “plan” and “expect,” and similar expressions that convey uncertainty of future events or outcomes, are intended to identify forward-looking statements.

These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in Part II. Item 1A. “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment, and new risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.

You should not rely on forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. We undertake no obligation to update publicly any forward-looking statements for any reason, except as required by law.

Unless otherwise stated or the context otherwise indicates, references to “Trupanion,” “we,” “us,” “our” and similar references refer to Trupanion, Inc. and its subsidiaries taken as a whole.

PART I - FINANCIAL INFORMATION

Item 1. - Financial Statements

Trupanion, Inc. Condensed Consolidated Balance Sheets (in thousands, except for share data)

	SEPTEMBER 30,			DECEMBER 31,
	2014			2013
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	59,069		$	14,939
Investments in fixed maturities, at amortized cost (fair value: $19,297 and $16,088)	19,297			16,088
Accounts and other receivables	8,598			7,771
Prepaid expenses and other assets	1,386			935
Total current assets	88,350			39,733
Restricted cash	—			3,000
Investments in fixed maturities, at fair value (amortized cost: $1,000)	944			832
Property and equipment, net	6,355			3,124
Deferred offering costs	—			54
Intangible assets, net	4,863			4,910
Total assets	$	100,512		$	51,653
Liabilities, redeemable convertible preferred stock, and stockholders’ equity (deficit)
Current liabilities:
Accounts payable	$	1,641		$	1,263
Accrued liabilities	3,519			3,660
Claims reserve	5,411			5,612
Deferred revenue	9,291			8,468
Short-term debt	—			900
Warrant liabilities	—			4,900
Other payables	1,340			1,138
Deferred tax liabilities	82			82
Total current liabilities	21,284			26,023
Long-term debt	14,900			25,199
Deferred tax liabilities	1,542			1,540
Other liabilities	141			166
Total liabilities	37,867			52,928
Contingencies (Note 6)
Redeemable convertible preferred stock: $0.00001 par value per share, 0 and 15,648,723 authorized at September 30, 2014 and December 31, 2013, respectively, and 0 and 14,857,989 issued and outstanding at September 30, 2014 and December 31, 2013, respectively.	—			31,724
Stockholders’ equity:
Common stock, $0.00001 par value per share, 200,000,000 and 26,000,000 shares authorized at September 30, 2014 and December 31, 2013, respectively, 28,407,957 and 27,786,978 issued and outstanding at September 30, 2014; 2,857,620 and 2,236,641 shares issued and outstanding at December 31, 2013.	—			—
Preferred stock: $0.00001 par value per share, 10,000,000 and 0 authorized at September 30, 2014 and December 31, 2013, respectively, and 0 issued and outstanding at September 30, 2014 and December 31, 2013.	—			—
Special voting shares, $0.00001 par value per share, 0 and 2,500,030 shares authorized at September 30, 2014 and December 31, 2013, respectively, and 0 and 2,247,130 issued and outstanding at September 30, 2014 and December 31, 2013, respectively.	—			—
Additional paid-in capital	118,153			5,769
Accumulated other comprehensive loss	(3		)	(164		)
Accumulated deficit	(52,904		)	(36,003		)
Treasury stock, at cost: 620,979 shares at September 30, 2014 and December 31, 2013.	(2,601		)	(2,601		)
Total stockholders’ equity (deficit)	62,645			(32,999		)
Total liabilities, redeemable convertible preferred stock, and stockholders’ equity (deficit)	$	100,512		$	51,653

Trupanion, Inc. Condensed Consolidated Statement of Operations (in thousands, except for share and per share data) (unaudited)

	THREE MONTHS ENDED						NINE MONTHS ENDED
	SEPTEMBER 30,						SEPTEMBER 30,
	2014			2013			2014			2013
Revenue	$	30,312		$	22,134		$	84,042		$	59,818
Cost of revenue:
Claims expenses	21,808			14,810			57,819			40,320
Other cost of revenue	4,059			3,205			11,872			7,942
Gross profit	4,445			4,119			14,351			11,556
Operating expenses:
Sales and marketing	2,934			2,013			8,390			6,853
Technology and development	2,532			1,156			7,285			3,191
General and administrative	4,385			2,033			10,463			5,982
Total operating expenses	9,851			5,202			26,138			16,026
Operating loss	(5,406		)	(1,083		)	(11,787		)	(4,470		)
Interest expense	5,155			154			6,623			420
Other (income) expense, net	(2,066		)	(13		)	(1,545		)	168
Loss before income taxes	(8,495		)	(1,224		)	(16,865		)	(5,058		)
Income tax expense (benefit)	14			(2		)	36			(86		)
Net loss	$	(8,509	)	$	(1,222	)	$	(16,901	)	$	(4,972	)

Net loss per share:
Basic and diluted	$	(0.41	)	$	(0.87	)	$	(2.09	)	$	(3.84	)
Weighted-average shares used to compute net loss per share:
Basic and diluted	20,857,126			1,411,866			8,092,287			1,296,105

Trupanion, Inc. Condensed Consolidated Statements of Comprehensive Loss (in thousands) (unaudited)


	THREE MONTHS ENDED						NINE MONTHS ENDED
	SEPTEMBER 30,						SEPTEMBER 30,
	2014			2013			2014			2013
Net loss	$	(8,509	)	$	(1,222	)	$	(16,901	)	$	(4,972	)
Other comprehensive income (loss):
Foreign currency translation adjustments	25			(29		)	49			29
Change in unrealized losses on available-for-sale securities	17			(97		)	112			(131		)
Other comprehensive income (loss), net of taxes	42			(126		)	161			(102		)
Comprehensive loss	$	(8,467	)	$	(1,348	)	$	(16,740	)	$	(5,074	)

Trupanion, Inc. Condensed Consolidated Statements of Cash Flows (in thousands) (unaudited)


	NINE MONTHS ENDED
	SEPTEMBER 30,
	2014			2013
Operating activities
Net loss	$	(16,901	)	$	(4,972	)
Adjustments to reconcile net loss to cash used in operating activities:
Depreciation and amortization	1,234			663
Amortization of prepaid loan fee	108			—
Amortization of debt discount	4,925			14
Loss on disposal of equipment	48			—
Warrant (income) expense	(1,574		)	129
Stock-based compensation expense	3,194			1,364
Loss from equity method investment	—			52
Net amortization on bonds	8			12
Changes in operating assets and liabilities:
Accounts receivable	(828		)	(5,460		)
Prepaid expenses and other current assets	(456		)	98
Accounts payable	151			128
Accrued liabilities	(398		)	(41		)
Claims reserve	(201		)	2,565
Deferred revenue	823			4,276
Other payables	167			106
Net cash used in operating activities	(9,700		)	(1,066		)
Investing activities
Purchases of investment securities, held-to-maturity	(26,455		)	(15,697		)
Maturities of investment securities, held-to-maturity	23,239			15,055
Purchases of property and equipment	(4,013		)	(1,416		)
Other	—			(18		)
Net cash used in investing activities	(7,229		)	(2,076		)
Financing activities
Restricted cash	3,000			—
Proceeds from exercise of stock options	161			434
Proceeds from line of credit and debt financing	17,000			3,700
Payment of loan fee	(103		)	—
Repayment of debt financing	(32,000		)	—
Net proceeds from initial public offering	72,946			—
Net cash provided by financing activities	61,004			4,134
Effect of foreign exchange rates on cash, net	55			53
Net change in cash and cash equivalents	44,130			1,045
Cash and cash equivalents at beginning of period	14,939			4,234
Cash and cash equivalents at end of period	$	59,069		$	5,279
Supplemental disclosures
Income taxes paid	9			—
Interest paid	1,372			406
Noncash investing and financing activities:
Warrants issued in conjunction with debt issuance	1,123			43
Exchange of stock for equity method investment	—			448
Increase in payables for property and equipment	488			139
Increase in payables for deferred financing costs	136			—
Cashless exercise of preferred stock warrants	1,270			—

Trupanion, Inc.

Notes to Condensed Consolidated Financial Statements (unaudited)

(in thousands, except share and per share data)

1. Nature of Operations and Summary of Significant Accounting Policies

Description of Business

Trupanion, Inc. (collectively with its wholly-owned subsidiaries, the Company) is a direct-to-consumer monthly subscription service provider of a medical plan for cats and dogs throughout the United States, Canada and Puerto Rico.

Basis of Presentation

The condensed consolidated balance sheet data as of December 31, 2013 was derived from audited consolidated financial statements. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for unaudited condensed consolidated financial information. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. These unaudited condensed consolidated financial statements and notes should be read in conjunction with the Company's audited consolidated financial statements and accompanying notes for the year ended December 31, 2013 included in the Company's prospectus filed with the SEC pursuant to Rule 424(b) under the Securities Act of 1933 on July 18, 2014. The accompanying unaudited condensed consolidated financial statements reflect all adjustments consisting of normal recurring adjustments which, in the opinion of management, are necessary for a fair presentation of the Company's financial position and results of its operations, as of and for the periods presented. Operating results for the three and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014, or for any other period.

Reclassifications

Certain prior year amounts have been reclassified within the Company’s consolidated financial statements from their original presentation to conform with the current period presentation.

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingencies and the reported amounts of revenue and expenses. Significant items subject to such estimates and assumptions include the valuation of deferred tax assets, stock-based compensation, warrant liabilities, claims reserve, useful lives of software developed for internal use and income tax uncertainties. Actual results could differ from the estimates used in preparing the consolidated financial statements.

Income Taxes

The Company is subject to income taxes in the United States and in Canada. The provision for income taxes reflects the Company's estimated effective tax rate for the year. The difference between this rate and the U.S. federal income tax rate of 35% was primarily due to a full valuation allowance on its U.S. deferred tax assets. During the nine months ended September 30, 2014, the Company reduced its accrual for its existing uncertain tax positions by $53.

Offering Costs

Prior to the Company's initial public offering (IPO), deferred offering costs, including legal, accounting and other fees and costs related to the IPO, were capitalized and included as a noncurrent asset in the consolidated balance sheets. Upon completion of the IPO, the deferred offering costs were offset against IPO proceeds in additional paid-in capital in the consolidated balance sheet.

Initial Public Offering

On July 23, 2014 the Company completed IPO pursuant to which 8,193,750 shares of common stock were sold to the public at a price of $10.00 per share. The Company received net proceeds of approximately $72.8 million from the IPO. Upon the closing of the IPO, all shares of the outstanding convertible preferred stock and exchangeable shares automatically converted into 14,944,945 and 2,247,130 shares of common stock, respectively. If this transaction had taken place on January 1, 2014, the Company's weighted-average shares outstanding for the three and nine months ended September 30, 2014 would have been 27,135,340 and 26,900,033, respectively.

Upon completion of the IPO, 25,170 warrants to purchase preferred stock were converted into warrants for the purchase of common shares on a 1:1 basis. These warrants were classified as liabilities on the consolidated balance sheet due to terms allowing for a modification of the exercise price under certain circumstances. Upon completion of the IPO, these warrants were revalued resulting in a gain of $14 that was recorded in other (income) expense, net in the consolidated statement of operations. Immediately after the IPO, all of these warrants were exercised at the IPO price of $10.00 per share, resulting in an increase of 25,170 shares of common stock outstanding.

Immediately prior to the Company's IPO, there were warrants to purchase 1,164,085 shares of common stock outstanding, of which warrants to purchase 415,646 of shares of common stock were issued on July 2, 2014 in connection with an amended and restated credit agreement that contained terms modifying the exercise price and number of underlying shares upon completion of an IPO resulting in historical liability classification in the consolidated balance sheet. Upon the closing of the IPO, the number of shares underlying these warrants was adjusted to 869,999 shares, and the exercise price of each warrant was adjusted to $10.00 per share. These warrants were also revalued resulting in a gain of $2,040, which was recorded in other (income) expense, net in the statement of operations. Immediatly following the IPO, these warrants were no longer subject to contractual modification provisions and were reclassified from a liability classification to an equity classification on the consolidated balance sheet.

Accumulated Other Comprehensive Loss, net of tax

A rollforward of accumulated other comprehensive loss is as follows:



	ACCUMULATED OTHER COMPREHENSIVE LOSS
	UNREALIZED LOSSES ON AVAILABLE FOR SALE SECURITIES			FOREIGN CURRENCY GAIN
Balance at December 31, 2013	$	(168	)	$	4
Other comprehensive loss	35			51
Balance at March 31, 2014	(133		)	55
Other comprehensive loss	60			(27		)
Balance at June 30, 2014	(73		)	28
Other comprehensive loss	17			25
Balance at September 30, 2014	$	(56	)	$	53

There were no reclassifications out of accumulated other comprehensive loss during the three and nine months ended September 30, 2014 and 2013.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (FASB) issued an Accounting Standard Update (ASU) amending revenue recognition guidance and requiring more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Insurance contracts are excluded from the scope of this new guidance. The guidance is effective for annual and interim reporting periods beginning after December 15, 2016, with early adoption prohibited, and must be applied retrospectively or modified retrospectively. We are currently evaluating the impact this ASU will have on our consolidated financial statements.

2. Net Loss per Share

Basic net loss per share is calculated by dividing the net loss by the weighted-average number of shares of common stock outstanding for the period. Excluded from the weighted-average number of shares outstanding are shares that have been issued and are subject to future vesting and unvested restricted stock. Diluted net loss per share is calculated by dividing the net loss by the weighted-average number of common stock equivalents outstanding for the period determined using the treasury-stock method. Potentially dilutive common stock equivalents are comprised of convertible preferred stock, warrants for the purchase of convertible preferred stock and common stock, exchangeable shares, unvested restricted stock and stock options. For all periods presented, there is no difference in the number of shares used to calculate basic and diluted shares outstanding due to the Company’s net loss position.

The following potential dilutive equity securities are not included in the diluted net loss per common share calculation because they would have had an antidilutive effect:



	AS OF SEPTEMBER 30,
	2014	2013
Stock options	5,082,500	4,597,782
Restricted stock	595,665	730,149
Warrants	869,999	135,672
Series A convertible preferred stock	—	7,466,283
Series B convertible preferred stock	—	3,546,384
Series C convertible preferred stock	—	3,845,322
Exchangeable shares	—	2,247,130

Convertible preferred stock is presented on an as converted basis to reflect the applicable conversion ratio.

3. Investment Securities

The amortized cost, gross unrealized holding gains and losses, and fair value of available-for-sale and held-to-maturity fixed maturity securities by major security type and class of security were as follows:



	AMORTIZED COST		GROSS UNREALIZED HOLDING GAINS		GROSS UNREALIZED HOLDING LOSSES			FAIR VALUE
As of September 30, 2014
Available-for-sale:
Municipal bond	$	1,000	$	—	$	(56	)	$	944
	$	1,000	$	—	$	(56	)	$	944
Held-to-maturity:
U.S. Treasury securities	$	5,777	$	—	$	—		$	5,777
Certificates of deposit	700		—		—			700
U.S. government funds	12,820		—		—			12,820
	$	19,297	$	—	$	—		$	19,297

	AMORTIZED COST		GROSS UNREALIZED HOLDING GAINS		GROSS UNREALIZED HOLDING LOSSES			FAIR VALUE
As of December 31, 2013
Available-for-sale:
Municipal bond	$	1,000	$	—	$	(168	)	$	832
	$	1,000	$	—	$	(168	)	$	832
Held-to-maturity:
U.S. Treasury securities	$	5,778	$	—	$	—		$	5,778
Certificates of deposit	2,700		—		—			$	2,700
U.S. government funds	7,610		—		—			$	7,610
	$	16,088	$	—	$	—		$	16,088

Maturities of debt securities classified as available-for-sale were as follows:



	SEPTEMBER 30, 2014
	AMORTIZED COST		FAIR VALUE
Available-for-sale:
Due under one year	$	—	$	—
Due after one year through five years	—		—
Due after five years through ten years	1,000		944
Due after ten years	—		—
	$	1,000	$	944

Maturities of debt securities classified held-to-maturity were as follows:



	SEPTEMBER 30, 2014
	AMORTIZED COST		FAIR VALUE
Held-to-maturity:
Due under one year	$	19,297	$	19,297
Due after one year through five years	—		—
Due after five years through ten years	—		—
Due after ten years	—		—
	$	19,297	$	19,297

The Company had one investment with an unrealized loss of $56 and a fair value of $944 at September 30, 2014 and an unrealized loss of $168 and a fair value of $832 at December 31, 2013. The debt security has been in the unrealized loss position for more than 12 months. The Company has assessed the bond for credit impairment and has determined that there is no intent to sell this bond and it is likely that it will hold the investment for a period of time sufficient to allow for a recovery. Furthermore, future payments on this bond are insured by a financial guarantee insurer. Therefore, the Company believes that the unrealized loss on this bond constitutes a temporary impairment.

4. Fair Value

The Company determines fair value based on assumptions that market participants would use in pricing an asset or liability in the principal or most advantageous market. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible.

When considering market participant assumptions in fair value measurements, the following fair value hierarchy distinguishes between observable and unobservable inputs, which are categorized in one of the following levels:


•	Level 1 inputs: Unadjusted quoted prices in active markets for identical assets or liabilities accessible to the reporting entity at the measurement date.


•	Level 2 inputs: Valuations based on observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data.


•	Level 3 inputs: Unobservable inputs for the asset or liability used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

The following table presents the placement in the fair value hierarchy of assets and liabilities that are measured at fair value on a recurring basis:



	AS OF SEPTEMBER 30, 2014
	FAIR VALUE		LEVEL 1		LEVEL 2		LEVEL 3
Assets
Municipal bond	944		—		944		—
Money market funds	$	50,500	$	50,500	$	—	$	—
Total	$	51,444	$	50,500	$	944	$	—

	AS OF DECEMBER 31, 2013
	FAIR VALUE		LEVEL 1		LEVEL 2		LEVEL 3
Assets
Restricted cash	$	3,000	$	3,000	$	—	$	—
Municipal bond	832		—		832		—
Total	$	3,832	$	3,000	$	832	$	—
Liabilities
Warrant liabilities	$	4,900	$	—	$	—	$	4,900
Total	$	4,900	$	—	$	—	$	4,900

A rollforward of activity in liabilities valued using Level 3 inputs is as follows:



	WARRANT LIABILITIES
	2014			2013
Balance at January 1,	$	4,900		$	551
Issuance of warrants	—			44
Change in fair value upon remeasurement	1,219			98
Balance at March 31,	6,119			693
Settlement of warrant liability upon exercise	(999		)	—
Change in fair value upon remeasurement	(740		)	28
Balance at June 30,	$	4,380		$	721
Issuance of warrants	1,123			—
Settlement of warrant liability upon exercise	(270		)	—
Change in fair value upon remeasurement	(2,053		)	3
Reclassification to stockholders' equity	(3,180		)	—
Balance at September 30,	—			724

Changes in fair value upon remeasurement are recorded in other (income) expense, net on the consolidated statement of operations.

The Company estimates fair value for its long-term debt based upon rates currently available to the Company for debt with similar terms and remaining maturities. This is a Level 3 measurement. Based upon the terms of the debt, the carrying amount of the $3,000 and $12,000 term loans approximated fair value at December 31, 2013.

The Company’s accounting policy is to recognize transfers between levels of the fair value hierarchy on the date of the event or change in circumstances that caused the transfer. There were no transfers between levels for the three and nine months ended September 30, 2014.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments:


•	Investment securities: Debt securities classified as available-for-sale are measured using quoted market prices when quoted market prices are available. If quoted market prices in active markets for identical assets are not available to determine fair value, then the Company uses quoted prices of similar instruments and other significant inputs derived

from observable market data obtained from third-party data providers. Held-to-maturity securities are carried at amortized cost and the fair value is disclosed in Note 3. Fair value is determined in the same manner as available-for-sale securities and is considered a Level 2 measurement.

•

Warrant liabilities: These liabilities are valued using the Black-Scholes-Merton option-pricing model using certain unobservable inputs that are estimated by the Company. These inputs include a measure of volatility using an average of peer companies’ publicly traded stock volatility, expected dividend payments based on management’s assertion that no dividends will be paid in the near term, the remaining contractual term and a discount rate using an average equivalent bond yield calculation. The range of inputs used is as follows:



	THREE MONTHS ENDED SEPTEMBER 30,		NINE MONTHS ENDED SEPTEMBER 30,
	2014	2013	2014	2013
Expected volatility	40%-41%	38%-40%	34%-46%	35%-46%
Expected dividends	—%	—%	—%	—%
Risk-free rate	1.69%-1.71%	1.01%-2.02%	0.03%-2.02%	0.10%-2.02%
Term	3.5-5.0 years	4.3-6.5 years	0.1-6.0 years	0.6-7.0 years

An increase or decrease in any of these unobservable inputs would result in a change in the fair value measurement, which may be significant. The liabilities were revalued each period-end until exercised, expired or modified to exclude recurring fair value measurement. Gains and losses on revaluation of the liabilities were recorded in other (income) expense, net in the Company’s consolidated financial statements.

5. Debt

The Company's outstanding debt at September 30, 2014 was as follows:



	BALANCE	INTEREST RATE	MATURITY
Line of credit	$14,900	5%	July 23, 2016

The Company has a revolving line of credit with a bank, which is secured by any and all interest the Company has in assets that are not otherwise restricted. The revolving line of credit bore a variable interest rate as of September 30, 2014 and 2013, equal to the greater of 5.0% or 1.5% plus the prime rate. Interest expense is due monthly on the outstanding principal amount with all amounts outstanding under the revolving line of credit due upon maturity in July 2016. The credit agreement requires the Company to comply with various financial and non-financial covenants. As of September 30, 2014, the Company was in compliance with these covenants. This facility also has a compensating balance requirement of $500.

Borrowings on the revolving line of credit are limited to the lesser of $15,000 in 2014 and 2013, and the total amount of cash and securities held by American Pet Insurance Company, (APIC), less up to $500 for obligations the Company may have outstanding for other ancillary services.

On March 28, 2013, the Company obtained a term loan from the same bank of $3,000 in aggregate principal. The interest rate on the term loan was the greater of 5.5% or 2.0% plus the prime rate. All amounts outstanding under the term loan, including principal and accrued interest, were payable in 30 equal monthly installments beginning on April 28, 2014. During July 2014, this outstanding term loan was repaid in full, which also resulted in a release of the Company's restricted cash.

On December 23, 2013, the Company obtained a term loan in an aggregate principal amount of $12,000. This note was entered into at a discount of $3,801 related to the issuance of warrants being deducted from the principal amount. On July 2, 2014, the Company entered into an amended and restated credit agreement in relation to this existing $12,000 term loan for a secured subordinated term loan totaling $29,000, which reflected an increase of $17,000 from the prior agreement. The amended principal amount was entered into at an additional discount of $1,123 as a result of the issuance of warrants. The term loan bore a fixed interest rate of 11.0% per year and was due on the earlier of three years from the issue date or certain triggering events, including a qualifying initial public offering, which would result in a 1.5% prepayment premium on the $17,000 increase related to the amendment. The $29,000 term loan was repaid in full on July 23, 2014 including $895 in accrued interest and a prepayment fee of $255. The unamortized discount on debt totaling $4,418 was written-off and included in interest expense in the consolidated statement of operations.

6. Contingencies

During 2013, the Company determined that it owes goods and services tax (GST) and harmonized sales tax (HST) in Canada for certain intercompany fees charged to its Canadian entities from 2007 through 2013. The Company began a voluntary self-disclosure with the Canada Revenue Agency for these unpaid taxes in 2014 under the Canada Revenue Agency Voluntary Disclosures Program, which would, if successful, avoid the imposition of penalties for late payment. Interest will be due on the amounts owed. The Company submitted the completed voluntary self-disclosure during the second quarter of 2014. The Company has accrued $983 of GST/HST tax for the 2007 through 2013 tax years, including interest.

The Company’s subsidiary, APIC, a New York corporation, received an inquiry from the California Department of Insurance (CDOI) in 2011 alleging APIC’s trial insurance policies issued in California are in violation of California law. The Company has disputed this assertion. In July 2014, the CDOI filed a notice of non-compliance regarding this issue. APIC received an extension to request a hearing to contest the notice. As of September 30, 2014 and December 31, 2013, the Company had accrued liabilities of $100 for this matter. While the Company intends to defend this matter vigorously, adverse outcomes beyond recorded amounts are reasonably possible. At this stage in the matter, however, the Company is unable to estimate a possible loss or range of possible loss beyond amounts previously accrued.

The Company received an inquiry from the Washington State Office of the Insurance Commissioner (OIC) in December 2012 concerning whether a subsidiary of the Company was properly licensed, and whether certain of its employees were properly licensed, under Washington law. The Company responded to this letter in January of 2013, stating that the subsidiary is licensed, and its employees are not required to be licensed under Washington law. The Company received additional correspondence from the OIC in July 2014 informing it that the OIC is scheduling a regulatory examination to further assess the Company’s compliance, which was underway at September 30, 2014. Because of the inherent uncertainties of this matter, including the early stage and lack of specific claims, the Company currently believes the likelihood of a material loss is unlikely and cannot predict the impact (if any) that the matter may have on the Company’s business, results of operations, financial position or cash flows.

The Company is subject to a variety of other claims and suits that arise from time to time in the ordinary course of its business.

The Company makes a provision for a liability relating to legal matters when it is both probable that a liability beyond previously accrued amounts has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, estimated settlements, legal rulings, advice of legal counsel and other information and events pertaining to a particular matter. Although management currently believes that resolving outstanding matters, individually or in aggregate, will not have a material adverse impact on the Company’s financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

7. Stock-Based Compensation

The following table presents information regarding options granted, exercised and forfeited for the periods presented:



	NUMBER OF OPTIONS		WEIGHTED- AVERAGE EXERCISE PRICE		AGGREGATE INTRINSIC VALUE
December 31, 2013	4,663,445		$	2.12	$	30,406
Granted	665,100		10.04
Exercised	(138,878	)	1.16		1,020
Forfeited	(107,167	)	5.16
September 30, 2014	5,082,500		3.12		28,332

As of September 30, 2014, the stock options outstanding had a remaining contractual life of 7.0 years.



	NUMBER OF OPTIONS	WEIGHTED- AVERAGE FAIR VALUE		WEIGHTED- AVERAGE EXERCISE PRICE		WEIGHTED- AVERAGE REMAINING CONTRACTUAL TERM (IN YEARS)	AGGREGATE INTRINSIC VALUE
Vested and exercisable at December 31, 2013	2,719,609	$	1.32	$	1.38	6.03	$	19,908
Vested and exercisable at September 30, 2014	3,418,197	1.47		1.63		6.06	23,497

Stock-based compensation expense includes stock options and restricted stock granted to employees and non-employees and has been reported in the Company’s statements of operations in claims expenses, other cost of revenue, sales and marketing, technology and development, and general and administrative expenses depending on the function performed by the employee or non-employee. During the third quarter of 2014, 116,877 shares of restricted stock, which were subject to a performance condition relating to the Company's IPO, vested resulting in $1,433 of expense included in general and administrative expense in the consolidated statement of operations. The Company measures compensation expense on a straight-line basis except for the restricted stock with the performance condition which is measured on a graded vesting schedule. The remaining 584,385 shares of unvested restricted stock related to this agreement are expected to vest over the remaining service term of approximately 5 years.

As of September 30, 2014, the Company had unrecognized stock-based compensation of $8,169 related to stock options and restricted stock held by employees and non-employees, which is expected to vest over a weighted-average period of approximately 3.2 years. As of September 30, 2014, the Company had 1,664,303 unvested stock options and 595,665 restricted stock awards that are expected to vest. No net tax benefits related to the stock-based compensation costs have been recognized since the Company’s inception. The expense recognized in each category is provided in the table below:



	THREE MONTHS ENDED SEPTEMBER 30,				NINE MONTHS ENDED SEPTEMBER 30,
	2014		2013		2014		2013
Claims expenses	$	60	$	44	$	168	$	116
Other cost of revenue	18		12		55		28
Sales and marketing	115		147		408		492
Technology and development	110		84		306		249
General and administrative	1,698		191		2,257		479
Total stock-based compensation	$	2,001	$	478	$	3,194	$	1,364

8. Segments

The Company has two segments: subscription business and other business. The subscription business segment includes monthly subscriptions related to the Company’s medical plan, while the other business segment includes all other business, including policies written for third parties and policies written under a federal government program. The chief operating decision maker uses two measures to evaluate segment performance: revenue and gross profit. Corporate operating expenses, interest and other expenses, and income taxes are not allocated to the segments, nor included in the measure of segment profit or loss. The Company does not analyze discrete segment balance sheet information related to long-term assets.

Revenue and gross profit of the Company’s segments were as follows:



	THREE MONTHS ENDED						NINE MONTHS ENDED
	SEPTEMBER 30,						SEPTEMBER 30,
	2014			2013			2014			2013
Revenue:
Subscription business	$	27,517		$	20,007		$	75,965		$	55,392
Other business	2,795			2,127			8,077			4,426
	30,312			22,134			84,042			59,818
Claims expenses:
Subscription business	20,611			14,002			54,534			38,442
Other business	1,197			808			3,285			1,878
	21,808			14,810			57,819			40,320
Other cost of revenue:
Subscription business	2,793			2,115			7,990			5,847
Other business	1,266			1,090			3,882			2,095
	4,059			3,205			11,872			7,942
Gross profit:
Subscription business	4,113			3,890			13,441			11,103
Other business	332			229			910			453
	4,445			4,119			14,351			11,556
Sales and marketing	2,934			2,013			8,390			6,853
Technology and development	2,532			1,156			7,285			3,191
General and administrative	4,385			2,033			10,463			5,982
Operating loss	$	(5,406	)	$	(1,083	)	$	(11,787	)	$	(4,470	)

The following table presents the Company’s revenue by geographic region of the member:



	THREE MONTHS ENDED				NINE MONTHS ENDED
	SEPTEMBER 30,				SEPTEMBER 30,
	2014		2013		2014		2013
United States	$	22,609	$	15,765	$	62,430	$	41,467
Canada	7,703		6,369		21,612		18,351
Total revenue	$	30,312	$	22,134	$	84,042	$	59,818

Substantially all of the Company’s long-lived assets were located in the United States as of September 30, 2014.

Item 2. - Management's Discussion and Analysis of Financial Conditions and Results of Operations

Overview

We are a direct-to-consumer monthly subscription service providing a medical plan for cats and dogs throughout the United States, Canada and Puerto Rico. Our data-driven, vertically-integrated approach enables us to provide pet owners with what we believe is the highest value medical plan for their pets, priced specifically for each pet’s unique characteristics. Our growing and loyal member base provides us with highly predictable and recurring revenue. We operate our business with a focus on maximizing the lifetime value of each pet while sustaining a favorable ratio of lifetime value relative to acquisition cost.

We operate in two business segments: subscription business and other business. We generate revenue in our subscription business segment primarily from subscription fees for our medical plan, which we actively market to consumers. Our medical plan automatically renews on a monthly basis, and members pay the subscription fee at the beginning of each subscription period, in most cases by authorizing us to directly charge their credit card, debit card or bank account through automatic funds transfer. Subscription revenue is recognized on a pro rata basis over the monthly enrollment term. We generate revenue in our other business segment primarily from writing policies for an unaffiliated managing general agent that offers pet insurance and from writing policies under a federal government program. These policies provide different coverage and are subject to materially different terms and conditions than the Trupanion medical plan. Further, the unaffiliated managing general agent administers the policies we write for it and markets those policies to consumers.

We generate leads through both third-party referrals and online member acquisition channels, which we then convert into members through our website and contact center. Veterinary practices represent our largest referral source. While these referrals accounted for a majority of our enrollments in the third quarter of 2014, we do not pay commissions to or otherwise compensate veterinarians for their referrals. We engage a national referral network of independent contractors who are paid fees based on activity in their regions, which we refer to as our Territory Partners. Our Territory Partners are dedicated to cultivating direct veterinary relationships and building awareness of the benefits that our medical plan offers veterinarians and their clients. Veterinarians then educate pet owners, who visit our website or call our contact center to learn more about, and potentially enroll in, our medical plan. Our online member acquisition channels serve as important resources for pet owner education and drive new member leads and conversion. We also receive a significant number of new leads from existing members adding pets and referring their friends and family members. We constantly evaluate the effectiveness of our member acquisition channels and marketing initiatives based upon their return on investment, which we measure by comparing the ratio of the lifetime value of a pet generated through each specific channel or initiative to the related acquisition cost.

Our revenue increased from $59.8 million for the nine months ended September 30, 2013 to $84.0 million for the nine months ended September 30, 2014, representing 41% year-over-year growth. We have made and expect to continue to make substantial investments in member acquisition and in expanding our operations. For the nine months ended September 30, 2014 and 2013, we had a net loss of $16.9 million and $5.0 million, respectively. As of September 30, 2014, our accumulated deficit was $52.9 million.

Key Financial and Operating Metrics

We believe that one of the key operating drivers for any online subscription business is the amount of sales and marketing expenses incurred to drive new customer acquisition, which is typically evaluated in relation to the lifetime value of the customer. In order to assess this metric, we regularly review a number of financial and operating metrics, including per pet unit economics, to evaluate our subscription business, determine the allocation of resources and make decisions regarding business strategy.

The following tables set forth our key financial and operating metrics for our subscription business for the periods ended September 30, 2014 and 2013 and for each of the last 8 fiscal quarters:



	THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
	2014			2013			2014			2013
Total pets enrolled (at period end)	207,843			160,065			207,843			160,065
Monthly adjusted revenue per pet	$	44.98		$	42.59		$	44.04		$	42.37
Lifetime value of a pet (LVP)	$	584		$	617		$	584		$	617
Average pet acquisition cost (PAC)	$	113		$	80		$	112		$	102
Average monthly retention	98.67		%	98.64		%	98.67		%	98.64		%



	PERIOD ENDED
	DEC. 31, 2012			MAR. 31, 2013			JUN. 30, 2013			SEPT. 30, 2013			DEC. 31, 2013			MAR. 31, 2014			JUN. 30, 2014			SEPT. 30, 2014
Total Pets Enrolled (at period end)	125,387			136,027			147,868			160,065			169,570			181,634			194,617			207,843
Monthly adjusted revenue per pet	$	42.43		$	42.30		$	42.21		$	42.59		$	43.07		$	43.12		$	43.90		$	44.98
Lifetime value of a pet	$	557		$	604		$	641		$	617		$	611		$	610		$	605		$	584
Average pet acquisition cost	$	134		$	132		$	99		$	80		$	105		$	111		$	113		$	113
Average monthly retention	98.51		%	98.56		%	98.62		%	98.64		%	98.65		%	98.65		%	98.65		%	98.67		%

Total pets enrolled. Total pets enrolled reflects the number of pets subscribed to our plan at the end of each period presented. We monitor total pets enrolled because it provides an indication of the growth of our business.

Monthly adjusted revenue per pet. Monthly adjusted revenue per pet is calculated as adjusted revenue divided by the total number of pet months in the period. Adjusted revenue, a non-GAAP financial measure, is calculated as revenue, excluding sign-up fee revenue and the change in deferred revenue. We exclude sign-up fee revenue since it is collected at the time a new pet is enrolled and is used to partially offset initial setup costs, which are included in sales and marketing expenses. We exclude changes in deferred revenue in order to present monthly adjusted revenue per pet in a consistent manner across periods. Total pet months in a period represents the sum of all pets enrolled for each month during the period. We monitor monthly adjusted revenue per pet because it is an indicator of the per unit economics of our business.

Lifetime value of a pet. Lifetime value of a pet (LVP) is calculated in a reporting period as the average monthly contribution margin per pet over the 12 months prior to the period end date, multiplied by the implied average subscriber life in months. The average monthly contribution margin per pet is calculated by dividing gross profit for the period, excluding sign-up fee revenue, the change in deferred revenue and stock based compensation expense recorded in cost of revenue by the number of pet months in the 12-month period. Implied average subscriber life in months is calculated as the quotient obtained by dividing one by one minus the average monthly retention rate. We monitor LVP to assess how much lifetime contribution margin we might expect from new pets over their implied average subscriber life in months and to evaluate the amount of sales and marketing expenses we may want to incur to attract new pet enrollments.

Average pet acquisition cost. Pet acquisition cost (PAC) is calculated as acquisition cost divided by the total number of new pets enrolled in that period. Acquisition cost, a non-GAAP financial measure, is calculated in a reporting period as sales and marketing expenses, excluding stock-based compensation, offset by sign-up fee revenue. We offset sales and marketing expenses with sign-up fee revenue since it is a one-time charge to new members used to partially offset initial setup costs, which are included in sales and marketing expenses. We monitor average pet acquisition cost to evaluate the efficiency of our sales and marketing programs in acquiring new members and measure effectiveness using the ratio of our lifetime value of a pet to average pet acquisition cost.

Average monthly retention. Average monthly retention is measured as the monthly retention rate of enrolled pets for each applicable period averaged over the 12 months prior to the period end date. As such, our average monthly retention rate as of September 30, 2014 is an average of each month’s retention from October 1, 2013 through September 30, 2014. We calculate monthly retention as the number of pets that remain after subtracting all pets that cancel during a month, including pets that enroll and cancel within that month, divided by the total pets enrolled at the beginning of that month. We monitor average monthly retention because it provides a measure of member satisfaction and allows us to calculate the implied average subscriber life in months and manage our business.

Non-GAAP Financial Measures

We believe that using adjusted revenue, contribution margin and acquisition cost to calculate and present certain of our other key metrics is helpful to our investors. These measures, which are non-GAAP financial measures, are not prepared in accordance with U.S. GAAP. We define adjusted revenue as revenue from our subscription business segment excluding sign-up fee revenue and the change in deferred revenue between periods. We define contribution margin as gross profit from our subscription business segment for the 12 months prior to the period end date excluding stock-based compensation expense related to cost of revenue from our subscription business segment, sign-up fee revenue and the change in deferred revenue between periods. We define acquisition cost as sales and marketing expenses, excluding stock-based compensation expense, net of sign-up fee revenue.

Our non-GAAP financial measures may not provide information that is directly comparable to that provided by other companies in our industry as other companies in our industry may calculate or use non-GAAP financial measures differently. In addition, there are limitations in using non-GAAP financial measures because the non-GAAP financial measures are not prepared in accordance with GAAP, may be different from non-GAAP financial measures used by other companies and exclude expenses that may have a material impact on our reported financial results. The presentation and utilization of non-GAAP financial measures is not meant to be considered in isolation or as a substitute for the directly comparable financial measures prepared in accordance with GAAP. We urge our investors to review the reconciliation of our non-GAAP financial measures to the most directly comparable GAAP financial measures in our consolidated financial statements that is included below, and not to rely on any single financial or operating measure to evaluate our business.

Because of varying available valuation methodologies, subjective assumptions and the variety of equity instruments that can impact a company’s non-cash expenses, we believe that providing non-GAAP financial measures such as contribution margin and acquisition cost that exclude stock-based compensation expense allows for more meaningful comparisons between our operating results from period to period. We exclude sign-up fee revenue from the calculation of both adjusted revenue and contribution margin because we collect it from new members at the time of enrollment and consider it to be an offset to a portion of our sales and marketing expenses. For this reason, we also net sign-up fees with sales and marketing expenses in our calculation of acquisition cost. We exclude changes in deferred revenue from the calculation of both adjusted revenue and contribution margin in order to eliminate fluctuations caused by the timing of pet enrollment during the last month of any particular period in which such measures are being presented or utilized. We believe this allows us to calculate and present adjusted revenue, contribution margin and acquisition cost and the related financial measures we derive from them in a consistent manner across periods. Our non-GAAP financial measures and the related financial measures we derive from them are important tools for financial and operational decision-making and for evaluating our own operating results over different periods of time.

The following tables reflect the reconciliation of adjusted revenue to revenue:



	THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
	2014			2013			2014			2013

	(in thousands)
Revenue	$	30,312		$	22,134		$	84,042		$	59,818
Excluding:
Other business revenue	(2,795		)	(2,127		)	(8,077		)	(4,426		)
Change in deferred revenue	385			314			731			656
Sign-up fee revenue	(425		)	(386		)	(1,209		)	(1,074		)
Adjusted revenue	$	27,477		$	19,935		$	75,487		$	54,974



	THREE MONTHS ENDED
	DEC. 31, 2012			MAR. 31, 2013			JUN. 30, 2013			SEPT. 30, 2013			DEC. 31, 2013			MAR. 31, 2014			JUN. 30, 2014			SEPT. 30, 2014

	(in thousands)
Revenue	$	15,863		$	17,842		$	19,842		$	22,134		$	24,011		$	25,640		$	28,090		$	30,312
Excluding:
Other business revenue	(178		)	(825		)	(1,474		)	(2,127		)	(2,585		)	(2,551		)	(2,731		)	(2,795		)
Change in deferred revenue	218			124			218			314			452			262			84			385
Sign-up fee revenue	(282		)	(332		)	(356		)	(386		)	(345		)	(377		)	(407		)	(425		)
Adjusted revenue	$	15,621		$	16,809		$	18,230		$	19,935		$	21,533		$	22,974		$	25,036		$	27,477

The following tables reflect the reconciliation of contribution margin to gross profit:



	TWELVE MONTHS ENDED SEPTEMBER 30,
	2014			2013

	(in thousands)
Gross profit	$	18,439		$	14,788
Excluding:
Stock-based compensation expense	309			171
Other business segment gross profit	(1,189		)	(496		)
Sign-up fee revenue	(1,554		)	(1,356		)
Change in deferred revenue	1,183			874
Contribution margin	$	17,188		$	13,981



	TWELVE MONTHS ENDED
	DEC. 31, 2012			MAR. 31, 2013			JUN. 30, 2013			SEPT. 30, 2013			DEC. 31, 2013			MAR. 31, 2014			JUN. 30, 2014			SEPT. 30, 2014

	(in thousands)
Gross profit	$	11,211		$	12,841		$	14,263		$	14,788		$	15,644		$	16,792		$	18,113		$	18,439
Excluding:
Stock-based compensation expense	109			123			143			171			229			270			287			309
Other business segment gross profit	(44		)	(108		)	(267		)	(496		)	(730		)	(935		)	(1,086		)	(1,189		)
Change in deferred revenue	767			725			761			874			1,108			1,246			1,111			1,183
Sign-up fee revenue	(1,189		)	(1,229		)	(1,285		)	(1,356		)	(1,419		)	(1,464		)	(1,514		)	(1,554		)
Contribution margin	$	10,854		$	12,352		$	13,615		$	13,981		$	14,832		$	15,909		$	16,911		$	17,188

The following tables reflect the reconciliation of acquisition cost to sales and marketing expenses:



	THREE MONTHS ENDED SEPTEMBER 30,						NINE MONTHS ENDED SEPTEMBER 30,
	2014			2013			2014			2013

	(in thousands)
Sales and marketing expenses	$	2,934		$	2,013		$	8,390		$	6,853
Excluding:
Stock-based compensation expense	(115		)	(147		)	(408		)	(492		)
Net of:
Sign-up fee revenue	(425		)	(386		)	(1,209		)	(1,074		)
Acquisition cost	$	2,394		$	1,480		$	6,773		$	5,287



	THREE MONTHS ENDED
	DEC. 31, 2012			MAR. 31, 2013			JUN. 30, 2013			SEPT. 30, 2013			DEC. 31, 2013			MAR. 31, 2014			JUN. 30, 2014			SEPT. 30, 2014

	(in thousands)
Sales and marketing expenses	$	2,161		$	2,572		$	2,268		$	2,013		$	2,238		$	2,646		$	2,810		$	2,934
Excluding:
Stock-based compensation expense	(104		)	(143		)	(202		)	(147		)	(185		)	(149		)	(144		)	(115		)
Net of:
Sign-up fee revenue	(282		)	(332		)	(356		)	(386		)	(345		)	(377		)	(407		)	(425		)
Acquisition cost	$	1,775		$	2,097		$	1,710		$	1,480		$	1,708		$	2,120		$	2,259		$	2,394

Factors Affecting Our Performance

Average monthly retention. Our performance depends on our ability to continue to retain our existing and newly enrolled pets and is impacted by our ability to provide a best-in-class value and member experience. Our ability to maintain the retention rate of enrolled pets may be affected by a number of factors, including the actual and perceived value of our services and the quality of our member experience, our claims payment process and competitive environment. In addition, if the number of new pets enrolled increases at a faster rate than our historical experience, our average monthly retention rate could be adversely impacted, as our retention rate is generally lower during the first year of member enrollment.

Investment in pet acquisition. We have made and plan to continue to make significant investments to grow our member base. Our acquisition cost and the number of new members we enroll depends on a number of factors, including the amount we elect to invest in sales and marketing activities in any particular period in the aggregate and by channel, effectiveness of our sales execution and marketing initiatives, changes in costs of media, the mix of our sales and marketing expenditures and the competitive environment. Our average pet acquisition cost has in the past significantly varied and in the future may significantly vary from period to period based upon specific marketing initiatives and the actual or expected relationship to LVP. For example, veterinary trade show costs have traditionally increased our average pet acquisition costs in the first quarter of each year. We also periodically test new member acquisition channels and marketing initiatives, each of which impacts our average pet acquisition cost. We plan to expand the number of Territory Partners we use to reach veterinarians, which is likely to increase our average pet acquisition cost. We continually assess our sales and marketing activities by monitoring the ratio of LVP to PAC.

Geographic mix of sales. The relative mix of our business between the United States and Canada impacts the monthly adjusted revenue per pet we receive. Prices for our plan in Canada are generally higher than in the United States, which is consistent with the relative cost of veterinary care in each country. As our revenue has grown faster in the United States compared to Canada, this geographic shift in the mix of business has reduced the growth in our monthly adjusted revenue per pet. In addition, as our mix of revenue changes between the United States and Canada, our exposure to foreign exchange fluctuations will be impacted.

Investments to grow our business. We plan to continue to invest to grow our business. Any investments in the development of new technology and continued improvements to our member experience, and the costs associated with being a public company, will increase our operating expenses in the near term.

Timing of initiatives. Over time we plan to implement new initiatives to improve our member experience, make modifications to our medical plan and find other ways to maintain a strong value proposition for our members. These initiatives will sometimes be accompanied by price increases, in order to compensate for value delivered. The implementation of such initiatives may not always coincide with the timing of price increases resulting in fluctuations in revenue and gross profit in our subscription business segment.

Other business segment. Our other business segment includes revenue and expenses related to our writing of policies for an unaffiliated managing general agent. This relationship can be canceled by the unaffiliated managing general agent with 360 days' notice and we are unlikely to be able to replace it with a similar contract quickly, if at all. A cancellation of this contract would result in the policies and revenue being run off over a period of 12 months and could have a material impact on our results of operations. Our other business segment also includes revenue and expenses related to policies written under a federal government program. While we expect our other business segment to remain relatively stable over time and become a proportionately smaller component of our overall business as we continue to expand our subscription business, we may enter into additional relationships to the extent we believe they will be profitable to us, which could also impact our operating results.

Basis of Presentation

General

We operate in two business segments: subscription business and other business. Our subscription business segment includes revenue and expenses related to monthly subscriptions for our medical plan. Our other business segment includes revenue and expenses related to our other operations, including the writing of policies for an unaffiliated managing general agent and policies written under a federal government program. We report our financial information in accordance with U.S. GAAP.

Revenue

We generate revenue in our subscription business segment primarily from subscription fees for our medical plan. Our medical plan automatically renews on a monthly basis, and members pay the subscription fee at the beginning of each subscription period, in most cases by authorizing us to directly charge their credit card, debit card or bank account through automatic funds transfer. Subscription revenue is recognized on a pro rata basis over the monthly enrollment term. Membership may be canceled at any time without penalty, and we issue a refund for the unused portion of the canceled membership.

We generate revenue in our other business segment primarily from writing policies for an unaffiliated managing general agent that offers pet insurance and from writing policies under a federal government program. Revenue from our other business segment is recognized on a pro rata basis over the enrollment term for each policy.

Cost of Revenue

Cost of revenue in each of our segments is comprised of claims expenses and other cost of revenue.

Claims expenses

Claims expenses include claims incurred, the cost of personnel administering the claims and providing member service relating to the claims and other operating expenses directly or indirectly related to claims administration. Claims incurred are the claims approved for payment plus an accrual for claims incurred that have not yet been submitted or approved for payment. This accrual is based on our historical experience and developments in claims frequency and severity and the cost of veterinary care, and also includes the cost of administering such claims.

Other cost of revenue

Other cost of revenue for our subscription business segment includes direct and indirect member service expenses, renewal commissions to our independent referral network, credit card transaction fees and premium tax expenses. Other cost of revenue for our other business segment includes the commission we pay to the unaffiliated managing general agent.

For both our subscription business and our other business segments, we generally expect our cost of revenue to remain relatively constant as a percentage of revenue, although there may be some periodic variability due to a number of factors

including the rate of claims occurrences during such periods. Claims expenses as a percentage of our subscription business revenue may increase over time as part of our strategy to return more value to our members to further enhance our member experience, retention rates and lifetime value of a pet. We currently expect that, in the long-term, such increases generally will be offset by economies of scale in our other cost of revenue.

Gross Profit

Gross profit is total revenue less cost of revenue. We expect gross profit as a percentage of revenue in our subscription segment to remain relatively consistent in the long-term, although there has been and may be in the future some periodic variability due to a number of factors, including the rate of claims occurrences during such periods and in the timing and significance of our pricing adjustments. The timing of our implementation of various initiatives to improve the experience of our members also may affect gross profit in the short-term. Further, as the mix of subscription business and other business changes and as our other business segment changes, this may impact our total gross profit as a percentage of revenue.

Operating Expenses

Our operating expenses are classified into three categories: sales and marketing, technology and development, and general and administrative. For each category, the largest component is personnel costs, which include salaries, employee benefit costs, bonuses and stock-based compensation.

Sales and Marketing

Sales and marketing expenses primarily consist of referral fees paid with respect to newly enrolled pets, print, online and promotional advertising costs, and employee compensation and related costs. Sales and marketing expenses are driven primarily by investments to acquire new members and retain our existing members. We plan to continue to invest in existing and new member acquisition channels and marketing initiatives to grow our business. We expect sales and marketing expenses to increase in absolute dollars, although it may fluctuate as a percentage of revenue. We generally target a ratio of lifetime value of a pet to average pet acquisition cost of 5:1.

Technology and Development

Technology and development expenses primarily consist of personnel costs and related expenses for our operations staff, which includes information technology development and infrastructure support, third-party services and depreciation of hardware and amortization of capitalized software and intangible assets. We expect technology and development expenses to increase in absolute dollars and as a percentage of total revenue in the near term as we continue to devote significant resources to enhance our member experience and, thereafter, decrease as a percentage of revenue.

General and Administrative

General and administrative expenses consist primarily of personnel costs and related expenses for our finance, actuarial, human resources, general management functions, as well as facilities and professional services. We have recently incurred additional expenses as a result of expanding our management team and becoming a public company, and expect to continue to incur additional expenses associated with being a public company, including higher legal, corporate insurance and accounting expenses. We expect general and administrative expenses to continue to increase in the near term, both in absolute dollars and as a percentage of total revenue, and then decrease as a percentage of revenue over time.

Results of Operations

The following tables set forth our results of operations for the periods presented both in absolute dollars and as a percentage of our revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.



	THREE MONTHS ENDED						NINE MONTHS ENDED
	SEPTEMBER 30,						SEPTEMBER 30,
	2014			2013			2014			2013

	(in thousands)
Consolidated Statement of Operations Data:
Revenue:
Subscription business	$	27,517		$	20,007		$	75,965		$	55,392
Other business	2,795			2,127			8,077			4,426
Total revenue	30,312			22,134			84,042			59,818
Cost of revenue:
Subscription business⁽¹⁾	23,404			16,117			62,524			44,289
Other business	2,463			1,898			7,167			3,973
Total cost of revenue	25,867			18,015			69,691			48,262
Gross profit:
Subscription business	4,113			3,890			13,441			11,103
Other business	332			229			910			453
Total gross profit	4,445			4,119			14,351			11,556
Operating expenses:
Sales and marketing⁽¹⁾	2,934			2,013			8,390			6,853
Technology and development⁽¹⁾	2,532			1,156			7,285			3,191
General and administrative⁽¹⁾	4,385			2,033			10,463			5,982
Total operating expenses	9,851			5,202			26,138			16,026
Operating loss	(5,406		)	(1,083		)	(11,787		)	(4,470		)
Interest expense	5,155			154			6,623			420
Other (income) expense, net	(2,066		)	(13		)	(1,545		)	168
Loss before income taxes	(8,495		)	(1,224		)	(16,865		)	(5,058		)
Income tax expense (benefit)	14			(2		)	36			(86		)
Net loss	$	(8,509	)	$	(1,222	)	$	(16,901	)	$	(4,972	)


(1)	Includes stock-based compensation expense as follows:



	THREE MONTHS ENDED				NINE MONTHS ENDED
	SEPTEMBER 30,				SEPTEMBER 30,
	2014		2013		2014		2013

	(in thousands)
Cost of revenue	$	78	$	56	$	223	$	144
Sales and marketing	115		147		408		492
Technology and development	110		84		306		249
General and administrative	1,698		191		2,257		479
Total stock-based compensation expense	$	2,001	$	478	$	3,194	$	1,364



	THREE MONTHS ENDED				NINE MONTHS ENDED
	SEPTEMBER 30,				SEPTEMBER 30,
	2014		2013		2014		2013

	(as a percentage of revenue)
Revenue	100	%	100	%	100	%	100	%
Cost of revenue	85		81		83		81
Gross profit	15		19		17		19
Operating expenses:
Sales and marketing	10		9		10		11
Technology and development	8		5		9		5
General and administrative	14		9		12		10
Total operating expenses	32		24		31		27
Operating loss	(18	)	(5	)	(14	)	(7	)
Interest expense	17		1		8		1
Other (income) expense, net	(7	)	—		(2	)	—
Loss before income taxes	(28	)	(6	)	(20	)	(8	)
Income tax expense (benefit)	—		—		—		—
Net loss	(28	)%	(6	)%	(20	)%	(8	)%



	THREE MONTHS ENDED				NINE MONTHS ENDED
	SEPTEMBER 30,				SEPTEMBER 30,
	2014		2013		2014		2013

	(as a percentage of subscription revenue)
Subscription business revenue	100	%	100	%	100	%	100	%
Subscription business cost of revenue	85		81		82		80
Subscription business gross profit	15	%	19	%	18	%	20	%

Comparison of Three and Nine Months Ended September 30, 2014 and 2013

Revenue