10-Q


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, 2015
or
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
(855) 727 - 9079
(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)
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 31, 2015 there were approximately 28,280,046 shares of the registrant’s common stock outstanding.



TRUPANION, INC.
TABLE OF CONTENTS
 
 
Page
 
 
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
Item 1.
Item 1A.
Item 2.
Item 6.
 
 




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.
Investors and others should note that we announce material financial information to our investors using our investor relations website (http://investors.trupanion.com), SEC filings, press releases, public conference calls and webcasts. We use these channels, as well as social media, to communicate with our members and the public about our company, our services and other issues. It is possible that the information we post on social media could be deemed to be material information. Therefore, we encourage investors, the media, and others interested in our company to review the information we post on the United States ("U.S.") social media channels listed on our investor relations website.





PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Trupanion, Inc.
Consolidated Statements of Operations
(in thousands, except for share and per share data)
(unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Revenue
$
37,865

 
$
30,312

 
$
106,762

 
$
84,042

Cost of revenue:
 
 
 
 
 
 
 
Claims expenses
26,604

 
21,808

 
75,442

 
57,819

Other cost of revenue
4,670

 
4,059

 
13,361

 
11,872

Gross profit
6,591

 
4,445

 
17,959

 
14,351

Operating expenses:

 

 

 

Sales and marketing
4,128

 
2,934

 
11,312

 
8,390

Technology and development
3,005

 
2,532

 
8,683

 
7,285

General and administrative
4,067

 
4,385

 
11,760

 
10,463

Total operating expenses
11,200


9,851

 
31,755


26,138

Operating loss
(4,609
)

(5,406
)
 
(13,796
)

(11,787
)
Interest expense
14

 
5,155

 
298

 
6,623

Other expense (income), net
4

 
(2,066
)
 
8

 
(1,545
)
Loss before income taxes
(4,627
)

(8,495
)
 
(14,102
)

(16,865
)
Income tax expense
16


14

 
102

 
36

Net loss
$
(4,643
)
 
$
(8,509
)
 
$
(14,204
)

$
(16,901
)

 
 
 
 

 

Net loss per share:
 
 
 
 

 

Basic and diluted
$
(0.17
)
 
$
(0.41
)
 
$
(0.52
)
 
$
(2.09
)
Weighted-average shares used to compute net loss per share:
 
 
 
 
 
 
Basic and diluted
27,755,310

 
20,857,126

 
27,564,975

 
8,092,287



1


Trupanion, Inc.
Consolidated Statements of Comprehensive Loss
(in thousands)
(unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(4,643
)
 
$
(8,509
)
 
$
(14,204
)
 
$
(16,901
)
Other comprehensive (loss) income:
 
 
 
 
 
 
 
Foreign currency translation adjustments
(274
)
 
25

 
(347
)
 
49

Change in unrealized losses on available-for-sale securities
29

 
17

 
(12
)
 
112

Other comprehensive (loss) income, net of taxes
(245
)
 
42

 
(359
)
 
161

Comprehensive loss
$
(4,888
)
 
$
(8,467
)
 
$
(14,563
)
 
$
(16,740
)


2


Trupanion, Inc.
Consolidated Balance Sheets
(in thousands, except for share data)
 
September 30, 2015
 
December 31, 2014
Assets
(unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
21,688

 
$
53,098

Short-term investments
23,203

 
22,371

Accounts and other receivables
8,344

 
7,887

Prepaid expenses and other assets
2,157

 
1,299

Total current assets
55,392

 
84,655

Long-term investments, at fair value
2,420

 
942

Equity method investment
300

 
—

Property and equipment, net
9,614

 
7,862

Intangible assets, net
4,799

 
4,847

Other long term assets
29

 
—

Total assets
$
72,554

 
$
98,306

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
1,451

 
$
1,962

Accrued liabilities
4,327

 
4,607

Claims reserve
6,188

 
5,107

Deferred revenue
10,604

 
9,345

Other payables
668

 
1,523

Total current liabilities
23,238

 
22,544

Long-term debt
—

 
14,900

Deferred tax liabilities
1,495

 
1,495

Other liabilities
412

 
92

Total liabilities
25,145

 
39,031

Stockholders’ equity:
 
 
 
Common stock, $0.00001 par value per share, 200,000,000 shares authorized at September 30, 2015 and December 31, 2014, 28,898,227 and 28,277,248 issued and outstanding at September 30, 2015; 28,451,920 and 27,830,941 shares issued and outstanding at December 31, 2014.
—

 
—

Preferred stock: $0.00001 par value per share, 10,000,000 authorized at September 30, 2015 and December 31, 2014, and 0 issued and outstanding at September 30, 2015 and December 31, 2014.
—

 
—

Additional paid-in capital
121,741

 
119,045

Accumulated other comprehensive (loss) income
(348
)
 
11

Accumulated deficit
(71,383
)
 
(57,180
)
Treasury stock, at cost: 620,979 shares at September 30, 2015 and December 31, 2014.
(2,601
)
 
(2,601
)
Total stockholders’ equity
47,409

 
59,275

Total liabilities and stockholders’ equity
$
72,554

 
$
98,306



3


Trupanion, Inc.
Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
 
 
 
 
 
Nine Months Ended September 30,
 
2015
 
2014
Operating activities
 
 
 
Net loss
$
(14,204
)
 
$
(16,901
)
Adjustments to reconcile net loss to cash used in operating activities:
 
 
 
Depreciation and amortization
1,800

 
1,234

Amortization of debt discount and prepaid loan fees
5

 
5,033

Warrant income
—

 
(1,574
)
Stock-based compensation expense
2,349

 
3,194

Other, net
(91
)
 
56

Changes in operating assets and liabilities:
 
 
 
Accounts and other receivables
(504
)
 
(828
)
Prepaid expenses and other current assets
(868
)
 
(456
)
Accounts payable
(329
)
 
151

Accrued liabilities
53

 
(398
)
Claims reserve
1,127

 
(201
)
Deferred revenue
1,310

 
823

Other payables, net
(416
)
 
167

Net cash used in operating activities
(9,768
)
 
(9,700
)
Investing activities
 
 
 
Purchases of investment securities
(16,082
)
 
(26,455
)
Maturities of investment securities
13,580

 
23,239

Equity method investment
(300
)
 
—

Purchases of property and equipment
(3,816
)
 
(4,013
)
Net cash used in investing activities
(6,618
)
 
(7,229
)
Financing activities
 
 
 
Release of restricted cash
—

 
3,000

Tax withholding on restricted stock
(643
)
 
—

Repayment of debt financing and loan fees
(14,900
)
 
(32,103
)
Proceeds from exercise of stock options
914

 
161

Proceeds from line of credit
—

 
17,000

Net proceeds from initial public offering
—

 
72,946

Net cash (used in) provided by financing activities
(14,629
)
 
61,004

Effect of foreign exchange rates on cash, net
(395
)
 
55

Net change in cash and cash equivalents
(31,410
)
 
44,130

Cash and cash equivalents at beginning of period
53,098

 
14,939

Cash and cash equivalents at end of period
$
21,688

 
$
59,069

Supplemental disclosures
 
 
 
Income taxes paid
117

 
9

Interest paid
155

 
1,372

Noncash investing and financing activities:
 
 
 
Warrants issued in conjunction with debt issuance
—

 
1,123

Increase in payables for property and equipment
310

 
488

Increase in payables for deferred financing costs
—

 
136

Cashless exercise of preferred stock warrants
—

 
1,270



4


Trupanion, Inc.
Notes to the Consolidated Financial Statements (unaudited)

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 consolidated balance sheet data as of December 31, 2014 was derived from audited consolidated financial statements. The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for unaudited 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 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, 2014 included in the Company’s Annual Report on Form 10-K, filed with the U.S Securities and Exchange Commission on February 24, 2015. The accompanying unaudited 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, 2015 are not necessarily indicative of the results that may be expected for the year ending December 31, 2015, 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 to the current period presentation. In addition, amounts in note 9 related to segments have been recast to reflect a change in the composition of the Company’s segments as described in note 9.
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, claims reserve and useful lives of software developed for internal use. Actual results could differ from the estimates used in preparing the consolidated financial statements.
Advertising
Advertising costs are expensed as incurred, with the exception of television advertisements, which are expensed the first time each advertisement is aired.
Accumulated Other Comprehensive Loss
There were no reclassifications out of accumulated other comprehensive loss during the three and nine months ended September 30, 2015 and 2014.
Insurance Operations
Effective January 1, 2015, the Company formed a segregated account in Bermuda as part of Wyndham Insurance Company (SAC) Limited (WICL), and entered into a revised fronting and reinsurance arrangement with Omega General Insurance Company (Omega) to include its newly formed segregated account. The Company maintains all risk with the business written in Canada and consolidates the entity in its financial statements. Contractual requirements restrict dividends from this entity until after 2016, at which time dividends will be allowed subject to the Segregated Accounts Company Act of 2000, which allows for dividends only to the extent that the entity remains solvent and the value of its assets remain greater than the aggregate of its liabilities and its issued share capital and share premium accounts.

5


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, 2017, with early adoption permitted, and must be applied retrospectively or modified retrospectively. The Company does not believe this ASU will have a material impact on its consolidated financial statements.
In May 2015, the FASB issued an ASU amending short-term insurance contract disclosures and requiring more detailed disclosures to enable users of financial statements to understand information relating to liabilities for unpaid claims and claims adjustment expenses. Additionally, the amendments will also require insurance entities to disclose information about significant changes in methodologies and assumptions used to calculate these liabilities. This guidance is effective for annual reporting periods beginning after December 15, 2015 and interim periods beginning after December 15, 2016. Early adoption of this guidance is permitted, and must be applied retrospectively by providing comparative disclosures for each period presented. The Company plans to adopt this guidance in 2016.
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, restricted stock units, 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 potentially 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,
 
2015
 
2014
Stock options
4,991,047

 
5,082,500

Restricted stock awards and units
474,522

 
595,665

Warrants
869,999

 
869,999


6


3. Investment Securities
The amortized cost, gross unrealized holding losses, and fair value of available-for-sale and short-term investments by major security type and class of security were as follows as of September 30, 2015 and December 31, 2014 (in thousands):
 
Amortized
Cost
 
Gross
Unrealized
Holding
Losses
 
Fair
Value
As of September 30, 2015
 
 
 
 
 
       Available-for-sale:
 
 
 
 
 
Foreign deposits
$
1,490

 
$
—

 
$
1,490

              Municipal bond
1,000

 
(70
)
 
930

 
$
2,490

 
$
(70
)
 
$
2,420

       Short-term investments:
 
 
 
 
 
              U.S. Treasury securities
$
5,682

 
$
—

 
$
5,682

              Certificates of deposit
1,581

 
—

 
1,581

              U.S. government funds
15,940

 
—

 
15,940

 
$
23,203


$
—


$
23,203

 
 
 
 
 
 
 
Amortized
Cost
 
Gross
Unrealized
Holding
Losses
 
Fair
Value
As of December 31, 2014
 
 
 
 
 
Available-for-sale:
 
 
 
 
 
Municipal bond
$
1,000

 
$
(58
)
 
$
942

 
$
1,000


$
(58
)

$
942

Short-term investments:
 
 
 
 
 
U.S. Treasury securities
$
5,677

 
$
—

 
$
5,677

Certificates of deposit
800

 
—

 
$
800

U.S. government funds
15,894

 
—

 
$
15,894

 
$
22,371


$
—


$
22,371

Maturities of debt securities classified as available-for-sale were as follows (in thousands):
 
September 30, 2015
 
Amortized
Cost
 
Fair
Value
Available-for-sale:
 
 
 
Due under one year
$
—

 
$
—

Due after one year through five years
1,490

 
1,490

Due after five years through ten years
1,000

 
930

Due after ten years
—

 
—

 
$
2,490

 
$
2,420

The Company had one investment with an unrealized loss of $0.1 million and a fair value of $0.9 million at September 30, 2015 and December 31, 2014, respectively. 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.

7


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 (in thousands):
 
As of September 30, 2015
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
Foreign deposits
$
1,490

 
$
1,490

 
$
—

 
$
—

Municipal bond
930

 
—

 
930

 
—

Money market funds
10,412

 
10,412

 
—

 
—

Total
$
12,832

 
$
11,902

 
$
930

 
$
—

 
 
 
 
 
 
 
 
 
As of December 31, 2014
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
Municipal bond
$
942

 
$
—

 
$
942

 
$
—

Money market funds
44,575

 
44,575

 
—

 
—

Total
$
45,517

 
$
44,575

 
$
942

 
$
—

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 long term debt approximated fair value at December 31, 2014.
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, 2015 and 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. Short-term investments 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.
5. Equity Method Investment
During the three months ended September 30, 2015, the Company invested $0.3 million in DataPoint, LLC, in exchange for 300,000 units of Series A preferred stock resulting in a 13% equity interest. Additionally, if certain revenue and EBIT (Earnings before interest and taxes) targets are not met as of April 1, 2017, the Company's ownership interest will increase proportionately by the amount by which the targets were missed, up to a maximum of 28%. The Company's equity interest in DataPoint, LLC is accounted for under the equity method as the Company has the ability to exert significant influence. The equity method investment balance is adjusted each period on a one quarter lag to recognize the proportionate share of net income or loss, including adjustments to recognize certain differences between the carrying value and the equity in net assets.

8



6. Debt
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 bears a variable interest rate 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 2017. The credit agreement requires the Company to comply with various financial and non-financial covenants. This facility also currently has a compensating balance requirement of $1.6 million.
Borrowings on the revolving line of credit are limited to the lesser of $20.0 million in 2015 and 2014, and the total amount of cash and securities held by American Pet Insurance Company (APIC), less up to $3.0 million for obligations the Company may have outstanding for other ancillary services in the future. During the first quarter of 2015, the Company repaid its borrowings under this facility, and as of September 30, 2015, had no outstanding amounts under this facility.
The Company entered into a new lease agreement during the three months ended September 30, 2015 which required the Company to issue a security deposit in the form of an irrevocable standby letter of credit totaling $1.1 million which expires in August 2016 and renews annually thereafter. This amount reduces the Company's available revolving line of credit. As of September 30, 2015, the Company had $18.4 million available under its revolving line of credit.
7. Commitments and Contingencies
During 2015, the Company has entered into strategic marketing and service provider agreements, as well as other agreements with various parties. As of the September 30, 2015, these agreements resulted in an increase in future commitments of $0.5 million in the fourth quarter of 2015, $2.0 million in 2016 and $0.7 million in 2017.
During the third quarter of 2015, the Company entered into a lease agreement for a building located in Seattle, Washington. The initial, 10-year term of the lease is expected to commence in April 2016 and expire in March 2026. The Company is obligated to pay a total of $21.0 million in rent over the 10-year term.
The Company received an inquiry from the Washington State Office of the Insurance Commissioner (OIC) in December 2012 concerning whether subsidiaries of the Company were properly licensed, and whether certain of its employees were properly licensed, under Washington law. A regulatory examination took place during the third and fourth quarters of 2014. On September 22, 2015, the OIC issued its report and requesting a response from the Company within 90 days of its date. The Company is currently in the process of responding to this report. As of September 30, 2015 and December 31, 2014, the Company had accrued liabilities of $0.4 million and $0.2 million, respectively, for this matter. 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 accrued.
The outcomes of the Company’s legal proceedings are inherently unpredictable, subject to significant uncertainties, and could be material to the Company's operating results and cash flows for a particular period. 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.
8. Stock-Based Compensation
The following table presents information regarding stock options granted, exercised and forfeited for the periods presented:
 
Number Of Options
 
Weighted-Average Exercise Price
 
Aggregate Intrinsic Value
 
 
 
 
 
(in thousands)
December 31, 2014
5,112,556

 
$
3.19

 
$
21,116

Granted
615,273

 
7.78

 
 
Exercised
(514,431
)
 
1.78

 
3,167

Forfeited
(222,351
)
 
8.71

 
 
September 30, 2015
4,991,047

 
3.65

 
20,674

 
 
 
 
 
 
Vested and exercisable at September 30, 2015
3,589,654

 
$
2.28

 
$
19,306

As of September 30, 2015, the stock options outstanding had a remaining contractual life of 6.34 years.

9


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. The Company measures compensation expense on a straight-line basis except for restricted stock with a performance condition which is measured on a graded vesting schedule. The remaining 467,508 shares of unvested restricted stock measured on a graded vesting schedule are expected to vest over the remaining service term of approximately 4 years.
As of September 30, 2015, the Company had unrecognized stock-based compensation of $6.1 million 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 2.65 years. As of September 30, 2015, the Company had 1,359,351 unvested stock options and 474,522 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,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Claims expenses
$
58

 
$
60

 
$
160

 
$
168

Other cost of revenue
10

 
18

 
35

 
55

Sales and marketing
102

 
115

 
342

 
408

Technology and development
97

 
110

 
311

 
306

General and administrative
482

 
1,698

 
1,501

 
2,257

Total stock-based compensation
$
749

 
$
2,001

 
$
2,349

 
$
3,194


10


9. Segments
The Company operates in two segments: subscription business and other business. The subscription business segment includes monthly subscriptions related to the Company’s medical plan which are marketed directly to consumers, while the other business segment includes all other business which is not directly marketed to consumers. Prior to January 1, 2015, certain enrollments not marketed directly to consumers were included in the subscription business segment as they were not segregated in reporting used by the chief operating decision maker. As of January 1, 2015, the Company began reporting these pets in its other business segment due to the characteristics of this business being similar to other arrangements within the other business segment. In addition, the chief operating decision maker began using information related to the subscription business segment excluding these pets in order to evaluate the Company's business and operations and make decisions. As such, these pets have been considered a part of the other business segment after January 1, 2015. Prior period segment information presented below has been recast to reflect this change.
The chief operating decision maker uses two measures to evaluate segment performance: revenue and gross profit. Additionally, other operating expenses, such as sales and marketing expenses, are allocated to each segment and evaluated when material. 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 (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Revenue:
 
 
 
 
 
 
 
Subscription business
$
34,420

 
$
27,112

 
$
96,684

 
$
74,885

Other business
3,445

 
3,200

 
10,078

 
9,157

 
37,865

 
30,312

 
106,762

 
84,042

Claims expenses:
 
 
 
 
 
 
 
Subscription business
24,455

 
20,269

 
69,352

 
53,750

Other business
2,149

 
1,539

 
6,090

 
4,069

 
26,604

 
21,808

 
75,442

 
57,819

Other cost of revenue:
 
 
 
 
 
 
 
Subscription business
3,691

 
2,782

 
10,220

 
7,961

Other business
979

 
1,277

 
3,141

 
3,911

 
4,670

 
4,059


13,361


11,872

Gross profit:
 
 
 
 
 
 
 
Subscription business
6,274

 
4,061


17,112


13,174

Other business
317


384


847


1,177

 
6,591


4,445


17,959


14,351

Sales and marketing:
 
 
 
 
 
 
 
Subscription business
4,112

 
2,819

 
11,240

 
8,296

Other business
16

 
115

 
72

 
94

 
4,128

 
2,934

 
11,312

 
8,390

Technology and development
3,005

 
2,532

 
8,683

 
7,285

General and administrative
4,067

 
4,385

 
11,760

 
10,463

Operating loss
$
(4,609
)

$
(5,406
)

$
(13,796
)

$
(11,787
)
The following table presents the Company’s revenue by geographic region of the member (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
United States
$
30,009

 
$
22,609

 
$
83,607

 
$
62,430

Canada
7,856

 
7,703

 
23,155

 
21,612

Total revenue
$
37,865

 
$
30,312


$
106,762

 
$
84,042


11


Substantially all of the Company’s long-lived assets were located in the United States as of September 30, 2015.

12


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 available 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 pet 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 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 policies that are not marketed directly to consumers.
We generate leads for our subscription business 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. 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 continuously 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 $84.0 million for the nine months ended September 30, 2014 to $106.8 million for the nine months ended September 30, 2015, representing 27% 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, 2015 and 2014, we had a net loss of $14.2 million and $16.9 million respectively. As of September 30, 2015, our accumulated deficit was $71.4 million.

13


Key Financial and Operating Metrics
The following tables set forth our key financial and operating metrics for our subscription business for the periods ended September 30, 2015 and 2014 and for each of the last eight fiscal quarters. The prior period metrics have been recast to reflect the movement of pets from the subscription business segment to the other business segment in 2015. For more information on this change see "Basis of Presentation."
 
 
Nine Months Ended September 30,
 
 
2015
 
2014
Total pets enrolled (at period end)
 
276,988

 
221,479

Total subscription pets enrolled (at period end)
 
258,546

 
205,194

Monthly adjusted revenue per pet
 
$
44.88

 
$
43.89

Lifetime value of a pet (LVP)
 
$
591

 
$
580

Average pet acquisition cost (PAC)
 
$
132

 
$
114

Average monthly retention
 
98.66
%
 
98.67
%
Adjusted EBITDA (in thousands)
 
$
(9,711
)
 
$
(7,444
)
 
Three Months Ended
 
Sept. 30, 2015
 
Jun. 30, 2015
 
Mar. 31, 2015
 
Dec. 31, 2014
 
Sept. 30, 2014
 
Jun. 30, 2014
 
Mar. 31, 2014
 
Dec. 31, 2013
Total pets enrolled (at period end)
276,988

 
259,948

 
246,106

 
232,450

 
221,479

 
207,969

 
194,902

 
182,497

Total subscription pets enrolled (at period end)
258,546

 
241,808

 
228,409

 
215,491

 
205,194

 
192,338

 
179,819

 
168,405

Monthly adjusted revenue per pet
$
45.15

 
$
45.10

 
$
44.34

 
$
44.79

 
$
44.88

 
$
43.60

 
$
43.07

 
$
43.06

Lifetime value of a pet (LVP)
$
591

 
$
570

 
$
567

 
$
591

 
$
580

 
$
602

 
$
612

 
$
613

Average pet acquisition cost (PAC)
$
129

 
$
133

 
$
134

 
$
145

 
$
115

 
$
114

 
$
113

 
$
106

Average monthly retention
98.66
%
 
98.67
%
 
98.66
%
 
98.69
%
 
98.67
%
 
98.65
%
 
98.65
%
 
98.65
%
Adjusted EBITDA (in thousands)
$
(3,234
)
 
$
(3,165
)
 
$
(3,333
)
 
$
(2,903
)
 
$
(2,908
)
 
$
(2,459
)
 
$
(2,079
)
 
$
(1,780
)
Total pets enrolled. Total pets enrolled reflects the number of pets subscribed to either our plan or one of the plans offered in our other business segment at the end of each period presented. We monitor total pets enrolled because it provides an indication of the growth of our consolidated business.
Total subscription pets enrolled. Total subscription pets enrolled reflects the number of pets subscribed to our core plan at the end of each period presented. We monitor total subscription pets enrolled because it provides an indication of the growth of our subscription business.
Monthly adjusted revenue per pet. Monthly adjusted revenue per pet is calculated as adjusted revenue divided by the total number of subscription pet months in the period. Adjusted revenue, a non-GAAP financial measure, is calculated as subscription business 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 subscription 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.

14


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 our subscription business 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 subscription 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. Average pet acquisition cost (PAC) is calculated as acquisition cost divided by the total number of new subscription 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 and sales and marketing related to other business segment, 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 subscription 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, 2015 is an average of each month’s retention from October 1, 2014 through September 30, 2015. We calculate monthly retention as the number of subscription pets that remain after subtracting all subscription pets that cancel during a month, including subscription pets that enroll and cancel within that month, divided by the total subscription 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.
Adjusted EBITDA. Adjusted EBITDA is a non-GAAP financial measure that we define as net loss excluding stock-based compensation expense, depreciation and amortization expense, interest income, interest expense, change in fair value of warrant liabilities and income tax (benefit) expense. For more information about adjusted EBITDA and a reconciliation of net loss to adjusted EBITDA, see Non-GAAP Financial Measures below.
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 and sales and marketing expenses directly related to other business segment 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. Further, stock-based compensation expense and other items used in the calculation of adjusted EBITDA have been and will continue to be for the foreseeable future significant recurring expenses in our business. 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.

15


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, acquisition cost and adjusted EBITDA that exclude stock-based compensation expense and, in the case of adjusted EBITDA, the change in fair value of warrant liabilities 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 exclude revenue and expenses related to our other business segment from our calculation of contribution margin and acquisition cost as these metrics are only used to evaluate our subscription business. We exclude the change in fair value of warrant liabilities from our calculation of adjusted EBITDA in order to eliminate fluctuations caused by changes in our stock price. 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, as well as adjusted EBITDA, 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.

16


The following tables reflect the reconciliation of adjusted revenue to revenue:
 
 
Nine Months Ended September 30,
 
 
2015
 
2014
 
 
Revenue
 
$
106,762

 
$
84,042

Excluding:
 
 
 
 
Other business revenue
 
(10,078
)
 
(9,157
)
Change in deferred revenue
 
1,072

 
731

Sign-up fee revenue
 
(1,477
)
 
(1,209
)
Adjusted revenue
 
$
96,279

 
$
74,407

 
Three Months Ended
 
Sept. 30, 2015
 
Jun. 30, 2015
 
Mar. 31, 2015
 
Dec. 31, 2014
 
Sept. 30, 2014
 
Jun. 30, 2014
 
Mar. 31, 2014
 
Dec. 31, 2013
 
(in thousands)
Revenue
$
37,865

 
35,587

 
$
33,310

 
$
31,868

 
$
30,312

 
$
28,090

 
$
25,640

 
$
24,011

Excluding:
 
 

 
 
 
 
 
 
 

 
 
 
 
    Other business revenue
(3,445
)
 
(3,379
)
 
(3,254
)
 
(3,251
)
 
(3,200
)
 
(3,178
)
 
(2,779
)
 
(2,736
)
Change in deferred revenue
423

 
321

 
328

 
247

 
385

 
84

 
262

 
452

    Sign-up fee revenue
(542
)
 
(451
)
 
(484
)
 
(363
)
 
(425
)
 
(407
)
 
(377
)
 
(345
)
Adjusted revenue
$
34,301

 
$
32,078

 
$
29,900

 
$
28,501

 
$
27,072

 
$
24,589

 
$
22,746

 
$
21,382


The following table reflects the reconciliation of contribution margin to gross profit:
 
Twelve Months Ended
 
Sept. 30, 2015
 
Jun. 30, 2015
 
Mar. 31, 2015
 
Dec. 31, 2014
 
Sept. 30, 2014
 
Jun. 30, 2014
 
Mar. 31, 2014
 
Dec. 31, 2013
 
(in thousands)
Gross profit
$
23,483

 
$
21,337

 
$
20,701

 
$
19,874

 
$
18,439

 
$
18,113

 
$
16,792

 
$
15,644

Excluding:
 
 

 
 
 
 
 
 
 

 
 
 
 
Stock-based compensation expense
286

 
296

 
302

 
315

 
309

 
287

 
270

 
230

Other business segment gross profit
(1,211
)
 
(1,278
)
 
(1,549
)
 
(1,539
)
 
(1,468
)
 
(1,314
)
 
(967
)
 
(768
)
Change in deferred revenue
1,319

 
1,281

 
1,044

 
977

 
1,183

 
1,111

 
1,246

 
1,107

Sign-up fee revenue
(1,840
)
 
(1,723
)
 
(1,679
)
 
(1,572
)
 
(1,554
)
 
(1,514
)
 
(1,464
)
 
(1,418
)
Contribution margin
$
22,037

 
$
19,913

 
$
18,819

 
$
18,055

 
$
16,909

 
$
16,683

 
$
15,877

 
$
14,795



17


The following tables reflect the reconciliation of acquisition cost to sales and marketing expense:
 
 
Nine Months Ended September 30,
 
 
2015
 
2014
 
(in thousands)
Sales and marketing expense
 
$
11,312

 
$
8,390

Excluding:
 
 
 
 
    Stock-based compensation expense
 
(342
)
 
(408
)
    Other business segment sales and marketing expense
 
(72
)
 
(94
)
Net of:
 
 
 
 
    Sign-up fee revenue
 
(1,477
)
 
(1,209
)
Acquisition cost
 
$
9,421

 
$
6,679

 
Three Months Ended
 
Sept. 30, 2015
 
Jun. 30, 2015
 
Mar. 31, 2015
 
Dec. 31, 2014
 
Sept. 30, 2014
 
Jun. 30, 2014
 
Mar. 31, 2014
 
Dec. 31, 2013
 
(in thousands)
Sales and marketing expense
$
4,128

 
$
3,533

 
$
3,651

 
$
3,218

 
$
2,934

 
$
2,810

 
$
2,646

 
$
2,238

Excluding:
 
 

 
 
 
 
 
 
 
 
 
 
 
 
    Stock-based compensation expense
(102
)
 
(110
)
 
(130
)
 
(147
)
 
(115
)
 
(144
)
 
(149
)
 
(185
)
    Other business segment sales and marketing expense
(16
)
 
(30
)
 
(26
)
 
(30
)
 
(22
)
 
(28
)
 
(44
)
 
(6
)
Net of:
 
 

 
 
 
 
 
 
 
 
 
 
 
 
    Sign-up fee revenue
(542
)
 
(451
)
 
(484
)
 
(363
)
 
(425
)
 
(407
)
 
(377
)
 
(345
)
Acquisition cost
$
3,468

 
$
2,942

 
$
3,011

 
$
2,678

 
$
2,372

 
$
2,231

 
$
2,076

 
$
1,702

The following tables reflect the reconciliation of adjusted EBITDA to net loss:
 
 
Nine Months Ended September 30,
 
 
2015
 
2014
 
(in thousands)
Net loss
 
$
(14,204
)
 
$
(16,901
)
Excluding:
 
 
 
 
Stock-based compensation expense
 
2,349

 
3,194

Depreciation and amortization expense
 
1,800

 
1,234

Interest income
 
(56
)
 
(56
)
Interest expense
 
298

 
6,623

Change in fair value of warrant liabilities
 
—

 
(1,574
)
Income tax expense
 
102

 
36

Adjusted EBITDA
 
$
(9,711
)
 
$
(7,444
)


18


 
Three Months Ended
 
Sept. 30, 2015
 
Jun. 30, 2015
 
Mar. 31, 2015
 
Dec. 31, 2014
 
Sept. 30, 2014
 
Jun. 30, 2014
 
Mar. 31, 2014
 
Dec. 31, 2013
 
(in thousands)
Net loss
$
(4,643
)
 
(4,625
)
 
$
(4,936
)
 
$
(4,276
)
 
$
(8,509
)
 
$
(3,479
)
 
$
(4,913
)
 
$
(3,203
)
Excluding:
 
 

 
 
 
 
 
 
 
 
 
 
 
 
Stock-based compensation expense
749

 
897

 
703

 
890

 
2,001

 
626

 
567

 
574

Depreciation and amortization expense
649

 
563

 
566

 
441

 
505

 
419

 
310

 
229

Interest income
(19
)
 
(18
)
 
(19
)
 
(18
)
 
(20
)
 
(18
)
 
(18
)
 
(13
)
Interest expense
14

 
40

 
245

 
103

 
5,155

 
726

 
742

 
225

Change in fair value of warrant liabilities
—

 
—

 
—

 
—

 
(2,054
)
 
(740
)
 
1,219

 
414

Income tax expense (benefit)
16

 
(22
)
 
108

 
(43
)
 
14

 
7

 
14

 
(6
)
Adjusted EBITDA
$
(3,234
)
 
$
(3,165
)
 
$
(3,333
)
 
$
(2,903
)
 
$
(2,908
)
 
$
(2,459
)
 
$
(2,079
)
 
$
(1,780
)
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 the 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 and the timing of our Territory Partner conference can also increase our average pet acquisition cost in a given period. We also regularly test new member acquisition channels and marketing initiatives, which may include television advertising, that are more expensive than our traditional marketing channels and generally increase our average acquisition costs. We plan to expand the number of Territory Partners and their associates and continue testing new member acquisition channels and marking initiatives, 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.
Mix of enrolled pets. Changes in our mix of enrolled pets and the enrollment options each member chooses impact the monthly adjusted revenue per pet we receive. As existing members choose to change deductibles, add or remove riders to their policies or make other changes to their demographics which we use for pricing, the rate they pay us will change accordingly. Changes in trends related to the demographics of newly enrolled pets such as dog vs cat, breed or location can also have a material impact on the growth of monthly adjusted revenue per pet. Most significantly, the relative mix of our business between the United States and Canada can significantly impact adjusted revenue per pet as prices for our plan in Canada are generally higher in terms of local currency 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 can alter the growth in our monthly adjusted revenue per pet. In addition, as our revenues and operating costs are impacted by foreign exchange fluctuations of the Canadian dollar.
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 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 adjustments, in order to compensate for value delivered. The implementation of such initiatives may not always coincide with the timing of price adjustments resulting in fluctuations in revenue and gross profit in our subscription business segment.

19


Other business segment. Our other business segment includes our medical plans in Canada which are written by Omega, and we assume all premiums written by Omega and the related claims through an agency agreement and a fronting and administration agreement. These agreements will remain in effect until December 31, 2017 but may be terminated by either party with one year’s prior written notice. If Omega were to terminate our agreement or be unable to write insurance for regulatory or other reasons, we may have to terminate subscriptions with our existing members, or suspend member enrollment and renewals, in Canada until we entered into a relationship with another third party to write our medical plan, which may take a significant amount of time and require significant expense. We may not be able to enter into a new relationship, and any new relationship would likely be on less favorable terms. Any delay in entry into a new relationship or suspension of member enrollment and renewals could have a material adverse effect on our operating results and financial condition.

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, which we market to consumers. Our other business segment includes revenue and expenses related to our other operations that are not directly marketed to consumers. During the first quarter of 2015, we began reporting certain pets previously included in our subscription business segment in our other business segment due to the characteristics of this business being marketed to enterprises rather than consumers, similar to other arrangements within the other business segment. These pets were previously included in our subscription business segment. Segment information for prior periods has been recast to reflect this change. 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 which are not directly marketed to consumers. 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 fees 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 general agent and premium taxes on other policies in this segment.
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.

20


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 we add or modify relationships in our other business segment, 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, strategic partnership fees and employee compensation and related costs. Sales and marketing expenses are driven primarily by investments to acquire new members. We plan to continue to invest in existing and new member acquisition channels and marketing initiatives to grow our business. Investments in new member acquisition channels and marketing initiatives are generally more expensive than our traditional marketing channels and increase our average pet acquisition cost. 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 to 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 decrease as a percentage of revenue in the near term as we continue to devote significant resources to enhance our member experience.
General and Administrative
General and administrative expenses consist primarily of personnel costs and related expenses for our finance, actuarial, human resources, regulatory, legal, 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. We expect general and administrative expenses to increase in absolute dollars and decrease as a percentage of revenue over time.


21


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. Prior period results have been recast to incorporate the movement of certain pets from the subscription business segment to the other business segment in 2015. The period-to-period comparison of financial results is not necessarily indicative of future results.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Consolidated Statement of Operations Data:
 
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
 
Subscription business
$
34,420


$
27,112


$
96,684


$
74,885

Other business
3,445


3,200


10,078


9,157

Total revenue
37,865


30,312


106,762


84,042

Cost of revenue:
 
 
 
 
 
 
 
Subscription business(1)
28,145

 
23,051

 
79,572

 
61,711

Other business
3,129

 
2,816

 
9,231

 
7,980

Total cost of revenue
31,274

 
25,867

 
88,803

 
69,691

Gross profit:
 
 
 
 
 
 
 
Subscription business
6,274

 
4,061

 
17,112

 
13,174

Other business
317

 
384

 
847

 
1,177

Total gross profit
6,591


4,445

 
17,959

 
14,351

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing(1)
4,128

 
2,934

 
11,312

 
8,390

Technology and development(1)
3,005

 
2,532

 
8,683

 
7,285

General and administrative(1)
4,067

 
4,385

 
11,760

 
10,463

Total operating expenses
11,200

 
9,851

 
31,755

 
26,138

Operating loss
(4,609
)

(5,406
)
 
(13,796
)
 
(11,787
)
Interest expense
14

 
5,155

 
298

 
6,623

Other expense (income), net
4

 
(2,066
)
 
8

 
(1,545
)
Loss before income taxes
(4,627
)
 
(8,495
)
 
(14,102
)
 
(16,865
)
Income tax expense
16

 
14

 
102

 
36

Net loss
$
(4,643
)
 
$
(8,509
)

$
(14,204
)

$
(16,901
)
(1)
Includes stock-based compensation expense as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Cost of revenue
$
68

 
$
78

 
$
195

 
$
223

Sales and marketing
102

 
115

 
342

 
408

Technology and development
97

 
110

 
311

 
306

General and administrative
482

 
1,698

 
1,501

 
2,257

Total stock-based compensation expense
$
749

 
$
2,001

 
$
2,349

 
$
3,194



22


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
 
(as a % of revenue)
Revenue
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of revenue
83

 
85

 
83

 
83

Gross profit
17

 
15

 
17

 
17

Operating expenses:

 

 
 
 

Sales and marketing
11

 
10

 
11

 
10

Technology and development
8

 
8

 
8

 
9

General and administrative
11

 
14

 
11

 
12

Total operating expenses
30

 
32

 
30

 
31

Operating loss
(12
)
 
(18
)
 
(13
)
 
(14
)
Interest expense
—

 
17

 
—

 
8

Other (income) expense, net
—

 
(7
)
 
—

 
(2
)
Loss before income taxes
(12
)
 
(28
)
 
(13
)
 
(20
)
Income tax expense (benefit)
—

 
—

 
—

 
—

Net loss
(12
)%
 
(28
)%
 
(13
)%
 
(20
)%

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
 
(as a % of subscription revenue)
Subscription business revenue
100
%
 
100
%
 
100
%
 
100
%
Subscription business cost of revenue
82

 
85

 
82

 
82

Subscription business gross profit
18
%
 
15
%
 
18
%
 
18
%


23


Comparison of Three and Nine Months Ended September 30, 2015 and 2014
Prior period results have been recast to incorporate the movement of certain pets from the subscription business segment to the other business segment in 2015.
Revenue
 
Three Months Ended September 30,
 
% Change
 
Nine Months Ended September 30,
 
% Change
 
2015
 
2014
 
 
2015
 
2014
 
 
(in thousands, except percentages, pet and per pet data)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Subscription business
$
34,420

 
$
27,112

 
27
%
 
$
96,684

 
$
74,885

 
29
%
Other business
3,445

 
3,200

 
8

 
10,078

 
9,157

 
10

Total revenue
$
37,865

 
$
30,312

 
25

 
$
106,762

 
$
84,042

 
27

Percentage of Revenue by Segment:
 
 
 
 


 
 
 
 
 


Subscription business
91
%
 
89
%
 


 
91
%
 
89
%
 


Other business
9

 
11

 


 
9

 
11

 


Total revenue
100
%
 
100
%
 


 
100
%
 
100
%
 


Subscription Business:
 
 
 
 


 
 
 
 
 


Total pets enrolled (at period end)
276,988

 
221,479

 
25

 
276,988

 
221,479

 
25

Subscription pets enrolled (at period end)
258,546

 
205,194

 
26

 
258,546

 
205,194

 
26

Monthly adjusted revenue per pet
$
45.15

 
$
44.88

 
1

 
$
44.88

 
$
43.89

 
2

Average monthly retention
98.66
%
 
98.67
%
 
 
 
98.66
%
 
98.67
%
 
 
Three months ended September 30, 2015 compared to three months ended September 30, 2014. Total revenue increased by $7.6 million to $37.9 million for the three months ended September 30, 2015, or 25%. Revenue from our subscription business segment increased by $7.3 million to $34.4 million for the three months ended September 30, 2015, or 27%. This increase in subscription business revenue was primarily due to a 26% increase in subscription pets enrolled as of September 30, 2015 compared to September 30, 2014 and a 5% increase in monthly adjusted revenue per pet (before conversion of Canadian premiums into U.S. Dollars) during the three months ended September 30, 2015 as compared to the three months ended September 30, 2014 as a result of increases in our pricing due to increases in the cost of veterinary care and expansions of our coverage. This was partially offset by a $1.6 million negative impact on our Canadian revenue due to changes in foreign exchange rates when compared to the three months ended September 30, 2014. Revenue from our other business segment increased $0.2 million to $3.4 million for the three months ended September 30, 2015, or 8%, due to an increase in enrolled pets in this segment.
Nine months ended September 30, 2015 compared to nine months ended September 30, 2014. Total revenue increased by $22.7 million to $106.8 million for the nine months ended September 30, 2015, or 27%. Revenue from our subscription business segment increased by $21.8 million to $96.7 million for the nine months ended September 30, 2015, or 29%. This increase in subscription business revenue primarily was due to a 26% increase in subscription pets enrolled as of September 30, 2015 compared to September 30, 2014 and a 6% increase in monthly adjusted revenue per pet (before conversion of Canadian premiums into U.S. Dollars) during the nine months ended September 30, 2015 as compared to the nine months ended September 30, 2014 as a result of increases in our pricing due to increases in the cost of veterinary care and expansions of our coverage. This was partially offset by a $3.5 million negative impact on our Canadian revenue due to changes in foreign exchange rates when compared to the nine months ended September 30, 2014. Revenue from our other business segment increased $0.9 million to $10.1 million for the nine months ended September 30, 2015, or 10%, due to an increase in enrolled pets in this segment. Included in the increase of other business revenue is $0.4 million related to medical plans under a federal government program which started in March 2014 as well as $0.6 million related to employer-paid policies.

24


Cost of Revenue
 
Three Months Ended September 30,
 
% Change
 
Nine Months Ended September 30,
 
% Change
 
2015
 
2014
 
 
2015
 
2014
 
 
(in thousands, except percentages)
Cost of Revenue:
 
 
 
 
 
 
 
 
 
 
 
Subscription business:
 
 
 
 
 
 
 
 
 
 
 
Claims expenses
$
24,455

 
$
20,269

 
21
 %
 
$
69,352

 
$
53,750

 
29
 %
Other cost of revenue
3,691

 
2,782

 
33

 
10,220

 
7,961

 
28

Total cost of revenue
28,146

 
23,051

 
22

 
79,572

 
61,711

 
29

              Gross profit
6,274

 
4,061

 
54

 
17,112