UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED June 30, 2017

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 001-33197

GUIDANCE SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

Delaware		95-4661210
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

1055 E. Colorado Blvd.
Pasadena, California 91106		(626) 229-9191
(Address of principal executive offices)		Registrant’s telephone number, including area code

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, $0.001 par value per share.

Securities registered pursuant to Section 12(g) of the Act:

None.

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. Yes x No o

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). Yes x No o

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

Large accelerated filer o		Accelerated filer x
Non- accelerated filer o		Smaller reporting company o
		Emerging growth company o

If emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

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

As of August 2, 2017, there were approximately 33,431,000 shares of the registrant’s Common Stock outstanding.

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GUIDANCE SOFTWARE, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED June 30, 2017

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		Page

PART I - FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)	3
	Condensed Consolidated Balance Sheets at June 30, 2017 and December 31, 2016	3
	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2017 and 2016	4
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2017 and 2016	5
	Notes to the Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31
Item 4.	Controls and Procedures	31

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	32
Item 1A.	Risk Factors	32
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	32
Item 3.	Defaults upon Senior Securities	32
Item 4.	Removed and Reserved	32
Item 5.	Other Information	32
Item 6.	Exhibits	32

Signatures		33

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

(Unaudited)

	June 30, 2017			December 31, 2016
ASSETS
Current assets:
Cash and cash equivalents	$	13,648		$	12,619
Trade receivables, net of allowance for doubtful accounts of $684 and $554, respectively	14,399			22,236
Inventory	3,193			2,206
Prepaid expenses and other current assets	5,973			4,850
Total current assets	37,213			41,911

Long-term assets:
Property and equipment, net	8,677			11,044
Intangible assets, net	3,941			4,649
Goodwill	14,632			14,632
Other assets	2,736			2,180
Total long-term assets	29,986			32,505

Total assets	$	67,199		$	74,416

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable	$	5,686		$	4,722
Accrued liabilities	10,651			12,641
Bank line of credit	—			3,500
Deferred revenues	37,721			40,209
Total current liabilities	54,058			61,072

Long-term liabilities:
Deferred rent and other long-term liabilities	6,168			6,872
Deferred revenues	5,083			5,923
Deferred tax liabilities	649			604
Total long-term liabilities	11,900			13,399

Commitments and contingencies (Note 12)

Stockholders’ equity (deficit):
Preferred stock, $0.001 par value: 10,000,000 shares authorized; no shares issued or outstanding	—			—
Common stock, $0.001 par value; 100,000,000 shares authorized; 35,213,000 and 33,855,000 shares issued, respectively; and 33,434,000 and 32,079,000 shares outstanding, respectively	26			26
Additional paid-in capital	132,362			128,169
Treasury stock, at cost, 1,779,000 and 1,779,000 shares, respectively	(11,479		)	(11,479		)
Accumulated deficit	(119,668		)	(116,771		)
Total stockholders’ equity (deficit)	1,241			(55		)
Total liabilities and stockholders’ equity (deficit)	$	67,199		$	74,416

The accompanying notes are an integral part of these condensed consolidated financial statements

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GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
Revenues:
Product revenue	$	7,040		$	9,635		$	15,907		$	17,093
Services revenue	7,440			8,177			15,280			16,686
Maintenance revenue	10,183			9,744			20,262			19,576
Total revenues	24,663			27,556			51,449			53,355

Cost of revenues (excluding depreciation and amortization, shown below):
Cost of product revenue	1,861			2,415			3,624			4,371
Cost of services revenue	4,484			5,650			9,313			11,285
Cost of maintenance revenue	468			636			1,211			1,242
Total cost of revenues (excluding depreciation and amortization, shown below)	6,813			8,701			14,148			16,898

Operating expenses:
Selling and marketing	8,501			11,613			18,451			22,114
Research and development	4,707			6,500			10,189			12,742
General and administrative	4,676			9,133			9,208			15,323
Depreciation and amortization	1,115			1,307			2,273			2,722
Total operating expenses	18,999			28,553			40,121			52,901
Operating loss	(1,149		)	(9,698		)	(2,820		)	(16,444		)
Other income and expense:
Interest income	9			4			9			8
Interest expense	(1		)	(2		)	(5		)	(4		)
Other income, net	4			4			17			9
Total other income and expense	12			6			21			13
Loss before income taxes	(1,137		)	(9,692		)	(2,799		)	(16,431		)
Income tax provision	29			38			98			91
Net loss	$	(1,166	)	$	(9,730	)	$	(2,897	)	$	(16,522	)

Net loss per share:
Basic	$	(0.04	)	$	(0.33	)	$	(0.10	)	$	(0.58	)
Diluted	$	(0.04	)	$	(0.33	)	$	(0.10	)	$	(0.58	)

Weighted average number of shares used in per share calculation:
Basic	30,421			29,397			30,051			28,689
Diluted	30,421			29,397			30,051			28,689

The accompanying notes are an integral part of these condensed consolidated financial statements.

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GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

	Six Months Ended June 30,
	2017			2016
Operating Activities:
Net loss	$	(2,897	)	$	(16,522	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization	2,273			2,722
Provision for doubtful accounts	300			—
Share-based compensation	3,869			3,597
Deferred taxes	45			45
Loss on disposal of assets	1,199			96
Changes in operating assets and liabilities:
Trade receivables	7,537			6,033
Inventory	(987		)	(101		)
Prepaid expenses and other assets	(1,680		)	(2,490		)
Accounts payable	806			3,294
Accrued liabilities	(2,656		)	2,480
Deferred revenues	(3,328		)	(3,412		)
Net cash provided by (used in) operating activities	4,481			(4,258		)

Investing Activities:
Purchase of property and equipment	(238		)	(1,630		)
Net cash used in investing activities	(238		)	(1,630		)

Financing Activities:
Repayment of borrowing on line of credit	(3,500		)	—
Proceeds from the exercise of stock options	324			—
Principal payments on capital lease obligations and other obligations	(38		)	(39		)
Net cash used in financing activities	(3,214		)	(39		)
Net increase (decrease) in cash and cash equivalents	1,029			(5,927		)
Cash and cash equivalents, beginning of period	12,619			18,967
Cash and cash equivalents, end of period	$	13,648		$	13,040

Non-cash investing and financing activities:
Purchase of equipment included in accounts payable and accrued expenses	$	168		$	198

The accompanying notes are an integral part of these condensed consolidated financial statements

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GUIDANCE SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Description of the Business

General

Guidance Software, Inc. was incorporated in the state of California in 1997 and reincorporated in Delaware on December 11, 2006. Guidance and its subsidiaries are collectively referred to herein as “Guidance,” “we,” “our,” or the “Company.” Headquartered in Pasadena, California, Guidance is the leading global provider of digital investigative solutions. Our EnCase® platform provides an investigative infrastructure that enables our customers to search, collect and analyze electronically stored information in order to address human resources matters, litigation matters, allegations of fraud, suspicious network endpoint activity and to defend and secure their organization’s data assets.

Our main products and services are:

Our Forensic Security Suite of products:

· EnCase Endpoint Security provides crucial IT cybersecurity functionality to enterprises and government agencies through its incident response and sensitive data discovery capabilities. Integrated with security alerting tools from Hewlett Packard Enterprises (“HP”), Cisco, Blue Coat Systems, and FireEye, EnCase Endpoint Security helps automate the critical first steps in cybersecurity incident response from the moment of a first alert. It rapidly delivers forensic-level visibility of the relevant endpoint data, capturing a snapshot of valuable information from active memory that might otherwise expire which may serve as evidence for potential criminal prosecution.

· EnCase Endpoint Investigator provides an investigative platform that enables an organization to search, collect, preserve, and analyze data on the servers, desktops, and laptops across its network. EnCase Endpoint Investigator enables organizations to respond to electronic discovery requests and conduct internal investigations, including those related to human resources or those focused on compliance or fraud. Companies can also collect and preserve data in response to regulator requests or for civil litigation matters.

· EnForce Risk Manager is a new data risk and privacy solution. It allows organizations to implement a proactive approach to information governance, ensuring that sensitive data is identified, classified and remediated allowing organizations to reduce their cyber attack surface area, significantly mitigating potential damage from breaches and improving their ability to comply with global data protection mandates.

EnCase Forensic is a forensic investigation solution that enables forensic practitioners to conduct efficient, forensically sound digital data collection and investigations. The EnCase Forensic solution lets examiners acquire data from a wide variety of devices, unearth potential evidence with disk-level forensic analysis, and craft comprehensive reports on their findings, all while maintaining the integrity of the evidence in a forensically sound and court-proven manner.

EnCase eDiscovery is our enterprise-wide e-discovery solution addressing the end-to-end e-discovery needs of corporations and government agencies. The e-discovery product portfolio includes capabilities such as: legal hold, identification, collection, preservation, processing, first-pass review, and early case assessment (“ECA”) review.

EnCase eDiscovery Review is a highly secure, private cloud-hosted, multi-matter review platform with advanced analysis and technology assisted review (“TAR”) functionality, comprehensive production capabilities, and extensive project management and workflow features to enable efficient, effective, and defensible distributed review.

Forensic appliances include write blockers, forensic duplicators and storage devices. Write blockers and forensic duplicators are used to acquire forensically sound copies of digital storage devices such as hard disks and solid state drives.

In addition, we complement these offerings with a comprehensive array of professional, subscription and training services, including technical support and maintenance services to help our customers implement our solutions, conduct investigations and train their IT and legal professionals to effectively and efficiently use our products.

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Note 2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated balance sheet as of June 30, 2017 and the condensed consolidated statements of operations for the three and six months ended June 30, 2017 and 2016 and cash flows for the six months ended June 30, 2017 and 2016 are unaudited. These statements should be read in conjunction with the audited consolidated financial statements and related notes, together with management’s discussion and analysis of financial position and results of operations, contained in our Annual Report on Form 10-K for the year ended December 31, 2016, filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 1, 2017.

The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or (“GAAP”), and pursuant to the rules and regulations of the SEC for interim financial reporting. In the opinion of our management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2016 and include all normal and recurring adjustments necessary for the fair presentation of our financial position as of June 30, 2017 and our results of operations for the three and six months ended June 30, 2017 and 2016 and our cash flows for the six months ended June 30, 2017 and 2016. The condensed consolidated balance sheet as of December 31, 2016 has been derived from the December 31, 2016 audited financial statements. The operating results for the three and six month periods ended June 30, 2017 are not necessarily indicative of the results that will be achieved for the full fiscal year or for future periods.

The condensed consolidated financial statements include the accounts of Guidance and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated.

Use of Estimates and Assumptions

The preparation of financial statements in conformity with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an ongoing basis, we evaluate these estimates, including those related to revenue recognition, share-based compensation, bad debts, income taxes, commitments, impairment considerations, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.

Cash and Cash Equivalents

We invest excess cash in money market funds and highly liquid debt instruments of the US government and its agencies. Highly liquid investments with stated maturities of three months or less from the date of purchase are classified as cash and cash equivalents.

Fair Value of Financial Instruments

The carrying amounts of cash equivalents, accounts receivable and accounts payable approximate fair value because of the short-term maturities of these instruments. Based on borrowing rates currently available to us for borrowings with similar terms, the carrying values of our capital lease obligations also approximate fair value.

Trade Receivables

Trade receivables are carried at original invoice amount less an allowance for doubtful accounts. The allowance is established through a provision for bad debt expense, which is included in general and administrative expenses. We determine the adequacy of this allowance by evaluating individual customer accounts receivable, through consideration of the customer’s financial condition and credit history, and taking into account current economic conditions. In addition, we analyze our historical credit loss history and apply these loss rates to our current accounts receivable balances to verify the reasonableness of our allowance. Trade receivables are written off when deemed uncollectible. A trade receivable is generally considered past due if any portion of the receivable balance is outstanding for more than 30 days unless alternate terms are provided.

Inventory

Inventory is comprised of hardware components, packaged software components and finished goods and is valued at the lower of cost or market, using the weighted average cost method. We conduct quarterly inventory reviews for obsolescence, and inventory considered unlikely to be sold is adjusted to net realizable value.

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Amortization of Intangible Assets with Finite Lives

Intangible assets with finite lives are recorded at their fair value at the time of acquisition. With the exception of our customer relationships intangible asset, which is amortized on a double-declining basis, the acquisition date fair values of such assets are amortized on a straight-line basis over the estimated useful lives.

Goodwill and Indefinite-Lived Intangibles

We account for our goodwill and indefinite-lived intangible assets in accordance with Intangibles — Goodwill and Other (ASC 350). Goodwill represents the excess of purchase price over fair value of net assets acquired and is assigned to a reporting unit at the date the goodwill is initially recorded. Goodwill and indefinite-lived intangible assets are not amortized but evaluated for impairment annually, or whenever events or changes in circumstances indicate that the value may not be recoverable. The Company has the option to choose whether it will apply the qualitative assessment first before the quantitative assessment. We performed a quantitative assessment for our goodwill and indefinite-lived assets as of October 1, 2016, and determined they were not impaired.

Concentrations of Credit Risk

Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. We restrict our investments in cash and cash equivalents to financial institutions, US government or federal agency instruments and obligations of corporations with high credit ratings. At June 30, 2017, the majority of our cash balances were held at financial institutions located in California in accounts that are insured by the Federal Deposit Insurance Corporation for up to $250,000. Uninsured balances aggregate approximately $13.4 million as of June 30, 2017. At June 30, 2017 all of our cash equivalents consisted of financial institution obligations. We periodically perform credit evaluations of our customers and maintain reserves for potential losses on our accounts receivable. We do not believe we are subject to concentrations of credit risk with respect to such receivables.

Revenue Recognition

We generate revenues principally from the sale of our EnCase software products. Our software products include perpetual licenses and are related to our Forensic Security Suite (EnCase Endpoint Security, EnCase Endpoint Investigator and EnForce Risk Manager), EnCase eDiscovery, EnCase Forensic, and forensic appliance sales. Revenue associated with the sale of software licenses and revenue associated with forensic appliance sales are referred to as product revenue. Revenues are also generated from training courses and consulting services in which we assist customers with the performance of digital investigations and train their IT and legal professionals in the use of our software products, as well as subscription revenues associated with cloud-based document review and production SaaS, which we collectively refer to as services revenue. Our proprietary products are generally sold with one to three years of maintenance, which can be renewed at a stated renewal rate and is referred to as maintenance revenues.

We recognize revenue in accordance with ASU 2009-13 , Multiple-Deliverable Revenue Arrangements , (amendment to ASC Topic 605, Revenue Recognition ), Revenue Recognition - Software topic (ASC 985-605) and Revenue Recognition (ASC 605). While the standards govern the basis for revenue recognition, significant judgment and the use of estimates are required in connection with the allocation of revenue between product, services and maintenance revenues, as well as the amount of deferred revenue to be recognized in each accounting period.

Revenue Recognition Criteria: We recognize revenue when the following criteria have been met:

· Persuasive evidence of an arrangement: When we either enter into contracts or receive written purchase orders issued by a customer that legally bind us and the customer.

· Delivery: We deem delivery of products to have occurred when the title and risk of ownership have passed to the buyer. Services revenues are considered delivered as they are performed.

· Fixed or determinable fee: We consider the fee to be fixed or determinable if the fee is not subject to refund or adjustment and the payment terms are within normal established practices. If the fee is not fixed or determinable, we recognize revenues as amounts become due and payable with respect to transactions with extended payment terms, or as refund rights lapse with respect to transactions containing such provisions, provided all other revenue recognition criteria have been met.

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· Collection is deemed probable: We conduct a credit review for all significant transactions at the time of the arrangement to determine the credit-worthiness of the customer. Collection is deemed probable if we have a reasonable basis to expect that the customer will pay amounts under the arrangement as payments become due.

We report our revenues in three categories: product revenue, services revenue, and maintenance revenue. Product revenue includes revenues from software products and hardware products. Services revenue includes revenue from professional services, training, and subscriptions. Maintenance revenue includes maintenance revenue associated with our hardware and software products. Accounting treatment for each category of revenue and our most significant contract structures is further described below.

Revenue Recognition for Software Products and Software-Related Services (Software Elements)

Software product revenue. The timing of software product revenue recognition is dependent on the nature of the product sold or the structure of the license.

EnCase Software Products: Revenue associated with these arrangements, exclusive of amounts allocated to maintenance and other undelivered elements, for which we have vendor-specific objective evidence of fair value (“VSOE”), is recognized upon delivery, provided that all other criteria for revenue recognition have been met. Revenue associated with term licenses are recognized ratably over the term of the license because we have not established VSOE for post-contract customer support in term license arrangements.

Services revenue. The majority of our consulting and implementation services are performed under per hour or fixed fee arrangements. Revenue from such services is recognized as the services are provided or upon expiration of the contractual service period.

Training revenue is either recognized on a per-class basis upon a participant’s attendance or, for those customers who have subscribed to our Annual Training Passport program, revenue is recognized ratably over the annual period.

Maintenance revenue. Maintenance revenue includes technical support and software updates on a when-and-if-available basis. We recognize maintenance revenue ratably over the applicable maintenance period. We determine the amount of maintenance revenue to be allocated through reference to substantive maintenance renewal provisions contained in multiple element arrangements. We consider substantive maintenance provisions to be provisions where the cost of the maintenance renewal is stated in the contract with our customer as a percentage of the net license fee, provided the rate is substantive.

Revenue Recognition for Multiple-Element Arrangements — Software Products and Software-Related Services (Software Arrangements)

We often enter into arrangements with customers that purchase both software products and software-related services from us at the same time, or within close proximity of one another (referred to as software-related multiple-element arrangements). Such software-related multiple-element arrangements may include the sale of our software products, software maintenance services, which include license updates and product support, consulting/implementation services and training whereby the software license delivery is followed by the subsequent delivery of the other elements. For those software-related multiple-element arrangements, we have applied the residual method to determine the amount of software license revenues to be recognized pursuant to ASC 985-605. Under the residual method, if VSOE exists for the undelivered elements, this amount is deferred with the remaining, or residual, portion of the arrangement consideration recognized upon delivery of the software license, provided all other revenue recognition criteria are met.

Revenue Recognition for Hardware and Subscription Revenues (Nonsoftware Elements)

Hardware product revenue. Revenue associated with the sale of forensic appliances is recognized upon shipment to the customers, which include certain resellers, provided that all other criteria for revenue recognition have been met.

Subscription services revenue. Customers pay subscription fees to access our cloud-based document review and production software; however, they may not take possession of the software at any time during the term of the agreement. In general, we recognize revenue for subscription fees on a straight-line basis over the contract period commencing on the date the subscription is made available to the customer. Usage-based fees, which are determined monthly, are recognized when incurred.

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Revenue Recognition for Multiple-Element Arrangements — Hardware, Subscription, and Nonsoftware-Related Services (Nonsoftware Arrangements)

We enter into arrangements with customers that purchase both nonsoftware-related subscription services and nonsoftware-related services, such as consulting services, at the same time or within close proximity of one another (referred to as nonsoftware multiple-element arrangements). Each element within a nonsoftware multiple-element arrangement is accounted for as a separate unit of accounting provided the following criteria are met: the delivered products or services have value to the customer on a standalone basis; and for an arrangement that includes a general right of return relative to the delivered products or services, delivery or performance of the undelivered product or service is considered probable and is substantially controlled by us. We consider a deliverable to have standalone value if the product or service is sold separately by us or another vendor, or could be resold by the customer. Further, our revenue arrangements generally do not include a general right of return relative to the delivered products. Where the aforementioned criteria for a separate unit of accounting are not met, the deliverable is combined with the undelivered element and treated as a single unit of accounting for the purposes of allocation of the arrangement consideration and revenue recognition. For those units of accounting that include more than one deliverable but are treated as a single unit of accounting, we generally recognize revenues ratably over the delivery period. For the purposes of revenue classification of the elements that are accounted for as a single unit of accounting, we allocate revenue to the respective revenue line items within our consolidated statements of operations based on a rational and consistent methodology utilizing our best estimate of relative selling prices of such elements.

For our nonsoftware multiple-element arrangements, we allocate revenue to each element based on a selling price hierarchy at the arrangement’s inception. The selling price for each element is based upon the following selling price hierarchy: VSOE, if available; third party evidence (“TPE”) if VSOE is not available; or best estimate of selling price (“BESP”) if neither VSOE nor TPE are available. A description as to how we determine VSOE, TPE and BESP is provided below:

· VSOE . VSOE is determined based on its historical pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for these services fall within a reasonably narrow pricing range.

· TPE . When VSOE cannot be established for deliverables in a multiple element arrangement, judgment is applied with respect to whether we can establish a selling price based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from that of our peers, and our offerings contain a significant level of differentiation such that comparable pricing of services with similar functionality has not been obtained. Furthermore, we have been unable to reliably determine selling prices of similar competitive services on a stand-alone basis. As a result, we have not been able to establish selling prices based on TPE.

· BESP . When VSOE or TPE cannot be established, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the service were sold on a stand-alone basis. We determine BESP for deliverables by considering multiple factors including but not limited to prices we charge for similar offerings, market conditions, competitive landscape and pricing practices.

Revenue Recognition for Multiple-Element Arrangements — Arrangements with Software and Nonsoftware Elements

We also enter into multiple-element arrangements that may include a combination of our various software-related and nonsoftware-related products and services. In such arrangements, we first allocate the total arrangement consideration based on the relative selling prices to the software group of elements as a whole and to the nonsoftware group of elements. We then further allocate consideration allocated to the software group and nonsoftware group to the respective elements within that group following the guidance in ASC 985-605, ASC 605-25, and our policies described above. After the arrangement consideration has been allocated to the elements, we recognize revenue for each respective element in the arrangement as described above.

Recently Issued Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers: Topic 606 and issued subsequent amendments to the initial guidance in August 2015, March 2016, April 2016 and May 2016 within ASU 2015-04, ASU 2016-08, ASU 2016-10 and ASU 2016-12, respectively (ASU 2014-09, ASU 2015-04, ASU 2016-08, ASU 2016-10, ASU 2016-12, and ASU 2016-20 collectively, “Topic 606”). Topic 606 supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of Topic 606 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. Topic 606 defines a five-step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation, among others.

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We will adopt Topic 606 effective as of January 1, 2018 and currently expect to adopt Topic 606 using the modified retrospective approach described above.

We are using a comprehensive approach to evaluate the impact of the new standard on our accounting policies, processes, and systems to identify potential differences that would result from applying the new requirements to our revenue contracts, including evaluation of performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price, allocating the transaction price to each separate performance obligation and accounting treatment of costs to obtain and fulfill contracts.

We have assigned internal resources, in addition to the engagement of a third-party service provider, to assist in the evaluation of the impact of the standard and the implementation of software systems from third-party providers. We have made investments in systems to enable timely and accurate reporting under the new standard.

We have progressed with our project plan for adopting this standard, including gathering and evaluating the inventory of our revenue streams. We continue to evaluate the potential impact on our accounting policies, internal control processes including system readiness and the related disclosures that will be required under the new guidance.

We are also evaluating the treatment of upfront costs to obtain revenue contracts under the new guidance. As a result of this new guidance, we preliminarily believe that we will capitalize additional costs of obtaining revenue contracts, including sales commissions. Under our current accounting policy, we expense costs in the period we invoice the customer. Additionally, we preliminarily believe that the amortization period for our deferred commission costs will be longer than the contract term, as the new cost guidance requires entities to determine whether the costs relate to specific anticipated contracts.

We are continuing to evaluate the impact of our adoption of Topic 606 and our preliminary assessments are subject to change. While we continue to assess the potential impacts of the new standard, including the areas described above, we anticipate this standard will not have a material impact on our consolidated financial statements, we do not know or cannot reasonably estimate quantitative information related to the impact of the new standard on our financial statements at this time.

In February 2016, the FASB issued ASU No. 2016-02, Leases (“Topic 842”), which requires lessees to recognize on the balance sheet a right-of-use asset, representing their right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. The guidance also requires qualitative and quantitative disclosures designed to assess the amount, timing and uncertainty of cash flows arising from leases. The standard requires the use of a modified retrospective transition approach, which includes a number of optional practical expedients that entities may elect to apply. ASU 2016-02 is effective for the Company beginning January 1, 2019 and we are currently evaluating the impact that ASU 2016-02 will have on our consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (“Topic 718”), Improvements to the Employee Share-Based Payment Accounting. The standard is intended to simplify several areas of accounting for share-based compensation arrangements, including the income tax impact, classification on the statement of cash flows and forfeitures. We have adopted the pronouncement on a prospective basis making it effective for the Company as of January 1, 2017. Upon adoption, excess tax benefits from share-based award activity are reflected in the consolidated statements of income as a component of the provision for income taxes, whereas previously such income tax benefits were recognized as part of additional paid-in capital and could not be recognized until they were realized through a reduction in income taxes payable. The previously unrecognized excess tax benefits do not have an impact to the Company as they increase our net operating losses and valuation allowance by the same amount. We have elected to continue to record our stock compensation expense net of estimated forfeitures and not to account for forfeitures as they occur. The cash flow presentation of employee taxes paid will not apply to our Company as we do not withhold shares to cover employee taxes incurred relating to their stock transactions.

In January 2017, the Financial Accounting Standards Board (FASB) issued ASU 2017-04, Intangibles—Goodwill and Other (“Topic 350”): Simplifying the Test for Goodwill Impairment (ASU 2017-04), which eliminates step two from the goodwill impairment test. Under the amendments in ASU 2017-04, an entity should recognize an impairment charge for the amount by which the carrying amount of a reporting unit exceeds its fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. ASU 2017-04 is effective for us in our first quarter of fiscal 2020 on a prospective basis, and earlier adoption is permitted for goodwill impairment tests performed on testing dates after January 1, 2017. We are currently evaluating the impact of our pending adoption of ASU 2017-04 on our consolidated financial statements.

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Realignment Expense

We incurred realignment expense for the three and six months ended June 30, 2017 of $0.7 million and $2.1 million, respectively, primarily resulting from the consolidation of leased space at our corporate headquarters, as compared to $0.9 million and $3.1 million, respectively, for the same periods in 2016, as a result of reducing headcount and the closing of our Orlando and Houston offices. Severance costs are included in cost of services revenue, selling and marketing expense, research and development expense and general and administrative expense, based on the employees’ cost center assignments prior to termination. Lease termination costs are included in cost of services revenue, selling and marketing expense, research and development expense and general and administrative expense, based on the size of the space occupied by the department.

Note 3. Net Loss Per Share

Earnings Per Share (ASC 260) defines unvested share-based payment awards that contain non-forfeitable rights to dividends as participating securities that should be included in computing EPS using the two-class method. The Company’s unvested restricted stock awards qualify as participating securities.

Basic net loss per common share is calculated by dividing net loss allocated to common stockholders by the weighted average number of common shares outstanding during the reporting period. Diluted net loss allocated to common stockholders per share is calculated based on the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of the shares issuable upon the exercise of stock options and upon the vesting of restricted stock awards under the treasury stock method. In net loss periods, basic net loss per share and diluted net loss per share are identical since the effect of potential common shares is anti-dilutive and therefore excluded.

The following table sets forth the computation of basic and diluted net loss allocated to common stockholders per share (in thousands, except per share amounts):

	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
Basic loss per common share:
Numerator:
Net loss	$	(1,166	)	$	(9,730	)	$	(2,897	)	$	(16,522	)
Net loss allocated to common stockholders	$	(1,166	)	$	(9,730	)	$	(2,897	)	$	(16,522	)
Denominator:
Basic weighted average shares outstanding	30,421			29,397			30,051			28,689
Net loss per basic common share	$	(0.04	)	$	(0.33	)	$	(0.10	)	$	(0.58	)

Diluted loss per common share:
Numerator:
Net loss	$	(1,166	)	$	(9,730	)	$	(2,897	)	$	(16,522	)
Net loss allocated to common stockholders	$	(1,166	)	$	(9,730	)	$	(2,897	)	$	(16,522	)
Denominator:
Basic weighted average shares outstanding	30,421			29,397			30,051			28,689
Effect of dilutive share-based awards	—			—			—			—
Diluted weighted average shares outstanding	30,421			29,397			30,051			28,689
Net loss per diluted common share	$	(0.04	)	$	(0.33	)	$	(0.10	)	$	(0.58	)

Antidilutive securities, which consist of stock options and restricted stock awards that are not included in the diluted net loss per share calculation, consisted of an aggregate of approximately 1,686,000 and 1,499,000 shares for the three and six months ended June 30, 2017, respectively, and 2,385,000 and 2,816,000 shares for the three and six months ended June 30, 2016, respectively.

Note 4. Inventory

Inventory is comprised of hardware components, packaged software components and finished goods and is valued at the lower of cost or market, using the weighted average cost method. The following table sets forth, by major classes, inventory as of June 30, 2017 and December 31, 2016 (in thousands):

	June 30, 2017		December 31, 2016
Inventory:
Components	$	1,636	$	1,004
Finished goods	1,557		1,202
Total inventory	$	3,193	$	2,206

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Note 5. Prepaid Expense and Other Current Assets

Prepaid expenses and other current assets consist of the following (in thousands):

	June 30, 2017		December 31, 2016

Software licenses	$	2,516	$	1,529
Prepaid software maintenance	1,740		1,091
Payroll and employee-related expenses	209		394
Insurance	153		460
Other prepaid expenses and other current assets	1,355		1,376
Total prepaid expenses and other current assets	$	5,973	$	4,850

Note 6. Goodwill and Other Intangibles

We evaluate goodwill and indefinite-lived intangible assets for impairment on an annual basis, or more frequently if circumstances indicate impairment may have occurred, and there have been no impairment charges related to such assets through June 30, 2017. We expect the balance of goodwill assigned to our products segment to be deductible for tax purposes while the balance of goodwill assigned to our subscription and professional services segments will not be deductible for tax purposes.

Intangible assets are amortized on a straight-line basis over their estimated useful lives, with the exception of customer relationships, which are amortized on a double-declining basis. Amortization expense for intangible assets with finite lives was $0.4 million and $0.7 million for the three and six months ended June 30, 2017, respectively, and $0.4 million and $0.8 million for the three and six months ended June 30, 2016, respectively. The following table summarizes cumulative amortization expense related to intangible assets subject to amortization as of June 30, 2017 and December 31, 2016 (in thousands):

	June 30, 2017							December 31, 2016
	Gross Costs		Accumulated Amortization			Net		Gross Costs		Accumulated Amortization			Net
Core technology	$	5,800	$	(4,383	)	$	1,417	$	5,800	$	(3,993	)	$	1,807
Customer relationships	6,475		(4,493		)	1,982		6,475		(4,276		)	2,199
Trade names	2,100		(1,587		)	513		2,100		(1,497		)	603
Covenant not-to-compete	200		(200		)	—		200		(194		)	6
Domain name	45		(16		)	29		45		(11		)	34
Total	$	14,620	$	(10,679	)	$	3,941	$	14,620	$	(9,971	)	$	4,649

The following table summarizes the estimated remaining amortization expense through 2021 and thereafter (in thousands):

Year ending	Amortization Expense
2017	$	700
2018	1,401
2019	825
2020	539
2021	431
Thereafter	45
Total amortization expense	$	3,941

Note 7. Debt Obligations

On August 29, 2014, we entered into a three year, Senior Secured Revolving Line of Credit (“Revolver”) with a bank. We are obligated to pay a commitment fee of $0.2 million over the three-year term of the Revolver.

The maximum principal amount that may be outstanding at any given time under the Revolver, which includes up to $3.0 million of standby letters of credit, is $10.0 million. Borrowing availability is calculated as 80% of eligible accounts receivable, with a maximum of $10.0 million. Any borrowings under the Revolver would be collateralized by substantially all of our assets, as well as pledges of capital stock.

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The Revolver requires that, if we suffer an event of default or have borrowed more than 75% of the maximum principal amount permitted to be outstanding, the Company maintains an adjusted quick ratio of at least 1.15:1. The adjusted quick ratio is calculated by dividing quick assets (cash less restricted cash plus accounts receivable) by current liabilities (current liabilities plus outstanding standby letter of credit less the current portion of deferred revenue). Borrowings under the Revolver bear interest at a floating rate ranging from 1.25% to 3.25% above the prime rate depending on the Company’s adjusted quick ratio.

As of June 30, 2017, the Company was in compliance with all the covenants of the Revolver. The Company had letters of credit outstanding against the Revolver in the amount of $1.2 million, resulting in the maximum available borrowing under the Revolver to be $8.7 million. As of June 30, 2017, the balance outstanding under the Revolver was zero. The Company’s adjusted quick ratio was 1.61:1. During periods when the adjusted quick ratio is below 1.5:1, any collections received by the Company in its collateral account would be applied to outstanding loan balances before being remitted to the Company’s operating account. Amounts in the collateral account would be transferred to the Company’s operating account after any loan balance has been paid in full. The Company is currently in discussions with the bank to extend the Revolver through October 31, 2017.

Note 8. Employee Benefit Plans

On May 3, 2017, stockholders approved the Guidance Software, Inc. 2017 Incentive Award Plan (the “2017 Plan”) and the Board of Directors approved 2,000,000 shares be made available for issuance pursuant to awards granted under the 2017 Plan. The 2017 Plan is not intended to supersede or otherwise replace the Guidance Software, Inc. Second Amended and Restated 2004 Equity Incentive Plan (the “2004 Plan”) as we may continue to grant awards under the 2004 Plan using the shares available for issuance thereunder until the share reserve for the 2004 Plan has been exhausted or the 2004 Plan expires on November 10, 2018.

At June 30, 2017, approximately 1.9 million shares were available for grant as options or nonvested share awards under the 2004 Plan and the 2017 Plan (collectively, the “Plans”).

Stock Options

The terms of the options granted under the Plans are determined at the time of grant, and generally vest 25% annually over a four-year service period and typically must be exercised within 10 years from the date of grant. A summary of stock option activity follows:

	Number of Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Outstanding, December 31, 2016	1,765,000		$	6.17	7.3	$	2,909,000
Granted	578,000		$	5.80
Exercised	(81,000	)	$	4.01
Forfeited or expired	(117,000	)	$	6.05
Outstanding, June 30, 2017	2,145,000		$	6.16	7.6	$	2,247,000

Exercisable, June 30, 2017	728,000		$	7.54	4.9	$	580,000

We define in-the-money options at June 30, 2017 as options that had exercise prices that were lower than the $6.61 fair market value of our common stock at that date. The aggregate intrinsic value of options outstanding at June 30, 2017 is calculated as the difference between the exercise price of the underlying options and the fair market value of our common stock for the 1,931,000 shares that were in-the-money at that date, 522,000 of which were exercisable.

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Restricted Stock Awards

We issue restricted stock awards to certain directors, officers and employees. Compensation expense for such awards, based on the fair market value of the awards on the grant date, is recorded during the vesting period. Restricted stock awards generally vest 25% annually over a four-year service period. A summary of restricted stock awards activity follows:

	Number of Shares		Weighted Average Fair Value
Outstanding, December 31, 2016	2,888,000		$	5.25

Granted (February 2017 performance-based restricted stock)	586,000		4.37
Granted	579,000		5.88
Granted (April 2017 performance-based restricted stock)	205,000		5.98
Vested	(1,295,000	)	5.16
Forfeited	(96,000	)	5.53
Outstanding, June 30, 2017	2,867,000		5.28

The total grant date fair value of shares vested under such grants during the three months ended June 30, 2017 was $6,685,000.

In March 2016, we granted approximately 586,000 performance-based restricted stock awards to certain members of our executive team, with a fair market value of $4.37 per share. The performance criteria were based on the achievement of certain revenue levels for the year ending December 31, 2016. Depending on the revenue level achieved, the number of shares that would vest ranged from 10% to 200% of the approximately 586,000 shares granted. As of December 31, 2016, the Company achieved 200% of the revenue target level and as a result approximately 586,000 shares vested and another approximately 586,000 shares were granted in February, 2017. The February grant is included in our restricted stock awards outstanding as of June 30, 2017 and will vest on December 31, 2017, subject to continued employment of the executive. These performance-based restricted stock awards were considered for calculating the diluted shares outstanding balance at June 30, 2017. However, as the Company is in a net loss position for the three and six months ended June 30, 2017, the performance-based restricted stock awards were considered anti-dilutive and therefore excluded from the calculation.

In April 2017, we granted approximately 205,000 performance-based restricted stock awards to certain members of our executive team, with a fair market value of $5.98 per share. The performance criteria were based on the achievement of certain revenue and/or EBITDA levels for the year ending December 31, 2017. Depending on the revenue and/or EBITDA level achieved, the number of shares that would vest range from 50% to 150% of the approximately 205,000 shares granted. As of June 30, 2017, the Company has not achieved the minimum levels for either metric and as a result no stock compensation expense has been booked during the three months ended June 30, 2017, nor have any of the performance-based restricted stock awards granted in April 2017 been considered for calculating the diluted shares outstanding.

In May 2017, we granted approximately 579,000 restricted stock awards that vest 25% per year over four years.

Share-Based Compensation

We account for share-based compensation in accordance with Compensation-Stock Compensation (ASC 718). Compensation expense for stock options is recognized using the Black-Scholes option pricing model to determine the grant date fair value of share-based payments and recognize that cost, net of an estimated forfeiture rate, as compensation expense on a straight-line basis over the vesting period. Stock awards generally vest 25% annually over a four-year service period. The determination of the grant date fair value of share-based awards using that model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the estimated number of years that we expect employees to hold their stock options (the option “expected term”) and our expected stock price volatility, risk-free interest rates and dividends to be paid on our stock over that term.

The fair values of stock options granted under the Plans were estimated at the date of grant using the Black-Scholes option pricing model and the following weighted average:

	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
Risk-free interest rate	2.0		%	1.3		%	2.0		%	1.3		%
Dividend yield	—			—			—			—
Expected life (years)	5.78			5.73			5.78			5.73
Volatility	47.34		%	47.42		%	47.34		%	47.42		%
Weighted average grant date fair value	$	2.68		$	2.38		$	2.68		$	2.38

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When historical data is available and relevant, the expected term of options granted is determined by calculating the average term from historical stock option exercise experience. The volatility of our common stock is estimated at the date of grant based on the volatility of our publicly traded common stock over the expected term of the options granted. The volatility is calculated based on the adjusted close price each day from a composite index. The risk-free interest rate used in option valuation is based on the implied yield in effect at the time of each option grant, based on US Treasury zero-coupon issues with equivalent expected terms. We use a dividend yield of zero in the Black-Scholes model, as we have no expectation we will pay any cash dividends on our common stock in the foreseeable future. Compensation-Stock Compensation (ASC 718) also requires that we estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. Quarterly changes in the estimated forfeiture rate can potentially have a significant effect on reported share-based compensation, as the cumulative effect of adjusting the forfeiture rate for all expense amortization after the grant date is recognized in the period the forfeiture estimate is changed.

The following table summarizes the share-based compensation expense we recorded (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2017		2016		2017		2016
Stock option awards	$	231	$	197	$	429	$	357
Restricted stock awards	1,505		2,078		3,440		3,240
Share-based compensation expense	$	1,736	$	2,275	$	3,869	$	3,597

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The following table summarizes where the share-based compensation expense was recorded by income statement line item (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2017		2016		2017		2016
Cost of product revenue	$	10	$	14	$	20	$	29
Cost of services revenue	86		205		159		376
Cost of maintenance revenue	18		37		38		75
Selling and marketing expense	692		714		1,550		824
Research and development expense	476		701		1,042		1,128
General and administrative expense	454		604		1,060		1,165
Total share-based compensation expense	$	1,736	$	2,275	$	3,869	$	3,597

There is $0.4 million and $1.1 million of share-based compensation expense related to the performance-based restricted stock awards in our total restricted stock awards share-based compensation expense for the three and six months ended June 30, 2017, respectively, as compared to $0.6 million for both the three and six months ended June 30, 2016.

As of June 30, 2017, there was approximately $2.6 million of total unrecognized share-based compensation cost related to stock options that we expect to be recognized over a weighted-average period of 3.0 years and approximately $7.4 million of total unrecognized share-based compensation cost related to restricted stock awards that is expected to be recognized over a weighted-average period of 2.5 years. For awards outstanding at June 30, 2017, we expect to record approximately $0.6 million and $3.1 million in share-based compensation for the remainder of fiscal year 2017 related to stock options and restricted stock awards, respectively.

Note 9. Income Taxes

We account for income taxes in accordance with Income Taxes (ASC 740). Deferred income taxes are recorded for the expected tax consequences of temporary differences between the tax bases of assets and liabilities for financial reporting purposes and amounts recognized for income tax purposes. We record a valuation allowance to reduce our deferred tax assets to the amount of future tax benefit that is more likely than not to be realized. As of June 30, 2017, we have recorded a valuation allowance against our net U.S. deferred tax assets resulting in a carrying value of zero.

We have recorded an income tax provision for the three and six months ended June 30, 2017 of $29,000 and $98,000, respectively, as compared to $38,000 and $91,000, respectively for the same periods in 2016. Our income tax provision for the three and six months ended June 30, 2017 differs from the U.S. statutory rate of 34% primarily due to state taxes, foreign taxes, the tax impact of certain share-based compensation charges, and the impact of providing a valuation allowance against research and development credits and the net United States deferred tax assets. For the three and six months ended June 30, 2016, our income tax provision differs from the U.S. statutory rate of 34% primarily due to state taxes, foreign taxes, the tax impact of certain share-based compensation charges, and the impact of providing a valuation allowance against research and development credits and the net U.S. deferred tax assets.

Note 10. Accrued Liabilities

Accrued liabilities consist of the following (in thousands):

	June 30, 2017		December 31, 2016

Payroll and related benefits	$	4,735	$	7,138
Sales tax audit accrual	1,079		1,243
Software licenses	2,081		1,111
Deferred rent and rent incentives	690		808
Lease obligations	1,008		562
Professional fees	317		522
Insurance	115		345
Other accrued liabilities	626		912
Total accrued liabilities	$	10,651	$	12,641

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Note 11. Fair Value Measurements

In accordance with Fair Value Measurements and Disclosures (ASC 820), we measure our financial assets and liabilities at fair value on a recurring basis. ASC 820 requires disclosure that establishes a framework for measuring fair value and expands disclosure about fair value measurements. Under this standard, fair value is defined as the price that would be received in exchange for selling an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. ASC 820 establishes a hierarchy for inputs used in measuring fair value that minimizes the use of unobservable inputs by requiring the use of observable market data when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on active market data. Unobservable inputs would be inputs that reflect our assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. The statement requires fair value measurements be classified and disclosed in one of the following three categories:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities.

Level 2: Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly, and corroborated by market data.

Level 3: Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

The following table sets forth, by level within the fair value hierarchy, financial assets and liabilities that are accounted for at fair value on a recurring basis as of June 30, 2017 and December 31, 2016 (in thousands):

	Fair Value Measurements at June 30, 2017
	Total		Level 1		Level 2		Level 3
Assets:
Money market accounts	$	188	$	188	$	—	$	—
Total assets	$	188	$	188	$	—	$	—

	Fair Value Measurements at December 31, 2016
	Total		Level 1		Level 2		Level 3
Assets:
Money market accounts	$	205	$	205	$	—	$	—
Total assets	$	205	$	205	$	—	$	—

Note 12. Commitments and Contingencies

Third-party Software Licenses

In April 2017, the Company entered into a three year subscription software license agreement for a cloud-based e-Discovery platform that customers of our EnCase eDiscovery Review product can migrate to. The agreement provides for initial payments by the company for the first year beginning April 1, 2017 totaling approximately $477,000, payable in four quarterly installments, $1.0 million payable at the beginning of the second year, and $1.8 million payable at the beginning of the third year. There is an early termination provision that makes the third year’s payment contingent on the successful completion of the development of an integration product by October 1, 2017. As of June 30, 2017, the remaining payable was $1.4 million.

In February 2016, the Company entered into a $1.7 million third-party software license agreement authorizing the Company to integrate software as a component of its products through February 2020. The agreement also provides for payment by the Company of $0.3 million for two years of maintenance and support. The $2.0 million is payable in five installments, of which $1.5 million was payable during the year ending December 31, 2016 and $0.5 million is payable during the first six months of 2017. As of June 30, 2017, the outstanding balance was zero.

Letter of Credit

As of June 30, 2017 we had a $1.2 million letter of credit outstanding against our Senior Secured Revolving Line of Credit related to the lease of our corporate headquarters.

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Legal Matters

On May 20, 2011, MyKey Technology Inc. (“MyKey”) filed a complaint against the Company for patent infringement in the United States District Court for the District of Delaware (the “District Court Case”). The complaint alleged that certain of our data acquisition forensic hardware products that we acquired as a result of our acquisition of certain assets of Tableau, LLC (“Tableau”) infringe three of MyKey’s patents relating to write blocking, duplication and data removal technologies, respectively.

On July 22, 2011, MyKey also filed a complaint with the United States International Trade Commission (the “ITC Case”), alleging infringement by the Company and certain other parties of the three patents discussed in the preceding paragraph and requesting that the ITC commence an investigation pursuant to Section 337 of the Tariff Act of 1930. On December 28, 2012, the ITC released a final determination and Order holding that no violation of Section 337 of the Tariff Act of 1930 occurred. This Order effectively ended the ITC Case in the Company’s favor.

On June 16, 2016, MyKey and the Company agreed to a settlement agreement for $2.3 million, whereby in exchange for a payment by the Company, which the Company has paid, the Company received a full release of all claims for patent infringement against the Company. The settlement payment was recorded to general and administrative expenses.

On July 29, 2016, the Company entered into a settlement agreement with TEFKAT LLC (formerly known as Tableau LLC) and its sole shareholder, Robert Botchek, related to a breach of contract stemming from the MyKey matter. The agreement requires TEFKAT LLC to pay the Company a settlement amount of $1.2 million, which has been received by the Company. The settlement received was recorded as an offset to the $2.3 million MyKey settlement payment, resulting in a net effect of $1.1 million recorded in general and administrative expenses.

From time to time, we may become involved in various other lawsuits and legal proceedings that arise in the ordinary course of business. Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are not currently aware of any such other legal proceedings or claims that are likely to have a material impact on our business.

Indemnifications

We have agreed to indemnify our directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by them in any action or proceeding to which any of them is, or is threatened to be, made a party by reason of their services in their role as a director or officer.

Note 13. Segment Information

We have adopted Segment Reporting (ASC 280) requiring segmentation based on our internal organization and reporting of revenue and other performance measures. Our segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which discrete financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. We have five operating segments, as summarized below:

· Products segment—Includes EnCase® Endpoint Investigator, EnCase® Endpoint Security, EnCase® eDiscovery, EnCase® Risk Manager, EnCase® Forensic and appliance sales.

· Subscription segment—Includes subscription services for cloud-based document review and production software.

· Professional services segment—Performs consulting services and implementations.

· Training segment—Provides training classes by which we train our customers to effectively and efficiently use our software products.

· Maintenance segment—Includes maintenance related services.

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We do not separately allocate operating expenses to these segments, nor do we allocate specific assets, with the exception of goodwill, to these segments. Therefore, the segment information reported includes only revenues, cost of revenues and segment profit. The following tables present the results of operations for each operating segment (in thousands):

	Three Months Ended June 30, 2017
	Products		Subscription		Professional services		Training		Maintenance		Total

Revenues	$	7,040	$	1,598	$	3,971	$	1,871	$	10,183	$	24,663
Cost of revenues	1,862		729		2,760		995		467		6,813
Segment profit	$	5,178	$	869	$	1,211	$	876	$	9,716	$	17,850
Total operating expenses											18,999
Operating loss											$	(1,149	)

	Three Months Ended June 30, 2016
	Products		Subscription		Professional services		Training		Maintenance		Total

Revenues	$	9,635	$	1,606	$	4,514	$	2,057	$	9,744	$	27,556
Cost of revenues	2,415		666		3,502		1,482		636		8,701
Segment profit	$	7,220	$	940	$	1,012	$	575	$	9,108	18,855
Total operating expenses											28,553
Operating loss											$	(9,698	)

	Six Months Ended June 30, 2017
	Products		Subscription		Professional services		Training		Maintenance		Total

Revenues	$	15,907	$	3,185	$	8,354	$	3,741	$	20,262	$	51,449
Cost of revenues	3,624		1,299		5,663		2,351		1,211		14,148
Segment profit	$	12,283	$	1,886	$	2,691	$	1,390	$	19,051	$	37,301
Total operating expenses											40,121
Operating loss											$	(2,820	)

	Six Months Ended June 30, 2016
	Products		Subscription		Professional services		Training		Maintenance		Total

Revenues	$	17,093	$	3,185	$	9,341	$	4,160	$	19,576	$	53,355
Cost of revenues	4,371		1,322		6,996		2,967		1,242		16,898
Segment profit	$	12,722	$	1,863	$	2,345	$	1,193	$	18,334	36,457
Total operating expenses											52,901
Operating loss											$	(16,444	)

Revenues, classified by the major geographic areas in which we operate, are as follows (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2017		2016		2017		2016
Revenues
United States	$	19,084	$	20,344	$	40,064	$	40,159
Europe	3,267		4,698		7,105		8,153
Asia	1,268		1,022		2,100		2,385
Other	1,044		1,492		2,180		2,658
	$	24,663	$	27,556	$	51,449	$	53,355

Note 14. Subsequent Event

On July 25, 2017, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with OpenText Corporation, a corporation incorporated under the federal laws of Canada (“OpenText”), and Galileo Acquisition Sub Inc., a Delaware corporation and a direct wholly-owned subsidiary of OpenText (“Purchaser”). Pursuant to the Merger Agreement, and on the terms and subject to the conditions thereof, among other things, Purchaser will commence a tender offer (“Offer”) to acquire all of the outstanding shares of common stock of the Company, par value $0.001 per share, at a purchase price of $7.10 per share in cash, net of any applicable withholding taxes and without interest. The Offer is not subject to any financing condition. The merger is expected to close in the third quarter of calendar 2017.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes that are included elsewhere in this Quarterly Report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this Quarterly Report under “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2016 under “Risk Factors” and in other parts of this Quarterly Report.

Overview

We develop and provide leading software and hardware solutions for digital investigations, including EnCase Endpoint Security, EnCase eDiscovery, and EnCase Endpoint Investigator, which are network-enabled products primarily for corporations and government agencies, and EnCase Forensic, a desktop-based product primarily for law enforcement agencies and digital investigators.

Factors Affecting Our Results of Operations

There are a number of trends that may affect our business and our industry. Some of these trends or other factors include:

· Legislative and regulatory developments. Our digital investigation solutions allow law enforcement agencies, government organizations and corporations to conduct investigations within the legal and regulatory framework. Historically, the implementation of new laws and regulations surrounding digital investigations has helped create demand for our products. Future changes in applicable laws or regulations could enhance or detract from the desirability of our products.

· Information technology budgets. Deployment of our solutions may require substantial capital expenditures by our customers. Budgets for information technology-related capital expenditures at corporations and all levels of government organizations are typically cyclical in nature, with generally higher budgets in times of improving economic conditions and lower budgets in times of economic slowdowns.

· Law enforcement agency budgets. We sell our EnCase® Forensic products and training services primarily to law enforcement agencies. Because of the limited nature of law enforcement budgets, funds are typically initially allocated toward solving issues perceived to be the most pressing. Sales of our products could be impacted by changes in the budgets of law enforcement agencies or in the relative priority assigned to digital law enforcement investigations.

· Prevalence and impact of hacking incidents and spread of malicious software. The increasing sophistication of hacking attacks on government and private networks and the global spread of malicious software, such as viruses, worms and rootkits, have increased the focus of corporations and large government organizations on digital investigations and other aspects of network security, which has, in turn, increased demand for our products. Future changes in the number and severity of such attacks or the spread of malicious software could have an effect on the demand for our products.

· Unpredictability of revenues. We experience unpredictability in our revenues, primarily from our customers’ budgeting cycles. The federal government’s budget year ends in the third calendar quarter of the year and a majority of corporate budget years end in the fourth calendar quarter of the year. In addition, our customers also tend to make software purchases near the end of a particular quarter, which tends to make our revenues for a particular quarter unpredictable for a significant portion of that quarter. We expect that this unpredictability in our revenues within particular quarterly periods will continue for the foreseeable future.

· Amount of commercial litigation. Because commercial litigation often involves eDiscovery, an increase in commercial litigation could increase demand for our products and services, while a decrease in commercial litigation could decrease demand.

Critical Accounting Policies and Estimates

In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2016 have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates.

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Results of Operations

The following table sets forth our results of operations for the three and six months ended June 30, 2017 and 2016, respectively, expressed as a percentage of total revenues:

	Three Months Ended June 30,				Six Months Ended June 30,
	2017		2016		2017		2016
Revenues:
Product revenue	28.5	%	35.0	%	30.9	%	32.0	%
Services revenue	30.2		29.6		29.7		31.3
Maintenance revenue	41.3		35.4		39.4		36.7
Total revenues	100.0		100.0		100.0		100.0

Cost of revenues:
Cost of product revenue	7.5		8.7		7.0		8.2
Cost of services revenue	18.2		20.5		18.1		21.2
Cost of maintenance revenue	1.9		2.3		2.4		2.3
Total cost of revenues	27.6		31.5		27.5		31.7
Gross profit	72.4		68.5		72.5		68.3

Operating expenses:
Selling and marketing	34.4		42.2		35.9		41.5
Research and development	19.1		23.6		19.8		23.9
General and administrative	19.0		33.2		17.9		28.7
Depreciation and amortization	4.5		4.7		4.4		5.1
Total operating expenses	77.0		103.7		78.0		99.2
Operating loss	(4.7	)%	(35.2	)%	(5.5	)%	(30.9	)%

Other income and expense:
Interest income	—		—		—		—
Interest expense	—		—		—		—
Other income, net	—		—		—		0.1
Total other income and expense	—		—		—		0.1
Loss before income taxes	(4.7	)%	(35.2	)%	(5.5	)%	(30.8	)%
Income tax provision	0.1		0.1		0.2		0.2
Net loss	(4.8	)%	(35.3	)%	(5.7	)%	(31.0	)%

The following table sets forth share-based compensation expense recorded in each of the respective periods (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2017		2016		2017		2016
Non-cash Share-Based Compensation Data (1):
Cost of product revenue	$	10	$	14	$	20	$	29
Cost of services revenue	86		205		159		376
Cost of maintenance revenue	18		37		38		75
Selling and marketing	692		714		1,550		824
Research and development	476		701		1,042		1,128
General and administrative	454		604		1,060		1,165
Total non-cash share-based compensation	$	1,736	$	2,275	$	3,869	$	3,597

(1) Non-cash share-based compensation recorded in the three and six month periods ended June 30, 2017 and 2016 relates to stock options and restricted share awards granted to employees measured under the fair value method. See Note 8 to the condensed consolidated financial statements.

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Comparison of Results of Operations for the Three and Six Months Ended June 30, 2017 and 2016

Sources of Revenue

Our software product sales transactions typically include the following elements: (i) a software license fee paid for the use of our products under a perpetual license term, or for a specific term; (ii) an arrangement for first-year support and maintenance, which includes unspecified software updates, upgrades and post-contract support; and (iii) professional services for installation, implementation, consulting and training. We also generate revenues from cloud-based document review and production software sold as subscription services. We sell our software products and services through a combination of our direct sales force and resellers. We sell our hardware products primarily through resellers.

	Three Months Ended June 30,					Six Months Ended June 30,
(Dollars in thousands)	2017		Change %	2016		2017		Change %	2016
Product revenue	$	7,040	(27)%	$	9,635	$	15,907	(7)%	$	17,093
Services revenue	7,440		(9)%	8,177		15,280		(8)%	16,686
Maintenance revenue	10,183		5%	9,744		20,262		4%	19,576
Total revenues	$	24,663	(10)%	$	27,556	$	51,449	(4)%	$	53,355

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Product Revenue

We generate product revenue principally from two product categories: enterprise products and forensic products. Revenue from our enterprise products includes sales related to licenses from our Forensic Security Suite of products which are comprised of EnCase Endpoint Security, EnCase Endpoint Investigator and EnForce Risk Manager, as well as sales of our EnCase eDiscovery product. Revenue of our forensic products includes sales related to EnCase Forensic and forensic appliance sales. During the first two quarters of each fiscal year, we typically experience lower levels of product sales due to the seasonal budgetary cycles of our customers. The third quarter is typically the strongest quarter for sales to our federal government customers. Typically, sales to our corporate customers are highest in the fourth quarter.

Product revenue decreased $2.6 million, or 27%, from $9.6 million to $7.0 million, and decreased $1.2 million, or 7%, from $17.1 million to $15.9 million for the three and six months ended June 30, 2017, respectively, compared to the same periods in 2016.

The decrease in product revenue for the three months ended June 30, 2017 as compared to the same period in 2016 was primarily a result of a $1.2 million decrease in Enterprise revenue due to a decrease in our sales of EnCase Endpoint Security Product. A new version of EnCase Endpoint Security, version 6, was released in the last week of second quarter 2017, and the lateness of the release in the quarter may have delayed customer spending. It is uncertain if we can completely replace that potentially delayed revenue in the current 2017 year. In addition, the decrease in product revenue was attributable to a $1.0 million decrease in Forensic hardware revenue due to strong sales in Q2 2016 related to some newly released products, and a $0.4 million decrease in Forensic software due to an increasingly competitive forensic market.

The decrease in product revenue for the six months ended June 30, 2017 as compared to the same period in 2016 was primarily due to a $1.1 million decrease in Forensic software due to an increasingly competitive forensic market and a decrease $0.9 million in Forensic hardware revenue due to strong sales in the first half 2016 related to some newly released products and a $0.8 million decrease in Enterprise revenue due to a decrease in our sales of EnCase Endpoint Security Product. A new version of EnCase Endpoint Security, version 6, was released in the last week of second quarter 2017, and the lateness of the release in the quarter may have delayed customer spending. It is uncertain if we can completely replace that potentially delayed revenue in the current 2017 year.

Services Revenue

We generate services revenue from professional services, training and subscriptions of our EnCase eDiscovery Review product. Our professional services provides various consulting services to our clients, including network security incident response, e-discovery, civil/criminal digital investigation, implementation services, as well as a software advisory program. Our training services educate students in computer forensics principles and the use of our EnCase software products and methodology. Subscription service customers have the right to access our cloud-based document review and production software; however, they may not take possession of the software at any time during the term of the agreement. We generate subscription revenue primarily from corporate or large enterprise customers who typically use our cloud-based software to host multiple legal cases on an ongoing basis.

Services revenue decreased $0.7 million, or 9%, from $8.2 million to $7.4 million and decreased $1.4 million, or 8%, from $16.7 million to $15.3 million for the three and six months ended June 30, 2017, respectively, compared to the same periods in 2016.

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The decreases are primarily related to a $0.5 million and $1.0 million decrease in our professional services revenue for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016, and a $0.2 million and $0.4 million decrease in training revenue for the three and six months ended June 30, 2017, respectively, compared to the same periods in 2016. The decrease in professional services revenue is due to fewer service personnel and a decline in ediscovery service engagements. The decrease in training is primarily due to lower Forensic software sales resulting in lower demand for training.

Maintenance Revenue

Maintenance revenue is generated from customers who purchase software maintenance services with new product licenses and maintenance renewals for on-premise products. Software maintenance includes software updates and upgrades, telephone and e-mail support, as well as self-service on our website.

Maintenance revenue increased $0.5 million, or 5%, from $9.7 million to $10.2 million and increased $0.7 million, or 4%, from $19.6 million to $20.3 million for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016. The increases were primarily due a greater number of maintenance contracts renewing during the periods as compared to the same periods in 2016.

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Cost of Revenues

	Three Months Ended June 30,							Six Months Ended June 30,
(Dollars in thousands)	2017			Change %	2016			2017			Change %	2016
Cost of product revenue	$	1,861		(23)%	$	2,415		$	3,624		(17)%	$	4,371
Cost of services revenue	4,484			(21)%	5,650			9,313			(17)%	11,285
Cost of maintenance revenue	468			(26)%	636			1,211			(3)%	1,242
Total cost of revenues	$	6,813		(22)%	$	8,701		$	14,148		(16)%	$	16,898

Share-based compensation included above:
Cost of product revenue	$	10			$	14		$	20			$	29
Cost of services revenue	$	86			$	205		$	159			$	376
Cost of maintenance revenue	$	18			$	37		$	38			$	75

*Gross Margin Percentage*
Products	73.6		%		75.0		%	77.2		%		74.5		%
Services	39.7		%		30.9		%	39.0		%		32.4		%
Maintenance	95.4		%		93.5		%	94.0		%		93.7		%
Total	72.4		%		68.5		%	72.5		%		68.4		%

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Cost of Product Revenue

Cost of product revenue consists principally of the cost of producing our software products, including third party software royalties, the cost of manufacturing our hardware appliances and product distribution costs, including the cost of packaging, shipping, customs duties, and, to a lesser extent, compensation and related overhead expenses. While these costs are primarily variable with respect to sales volumes, they remain low in relation to the revenues generated and result in higher gross margins than our services and training businesses. Our gross margins can be affected by product mix, as our enterprise products are generally higher margin products than our forensic products, which include software and hardware.

Cost of product revenue decreased $0.6 million, or 23%, from $2.4 million to $1.9 million and decreased $0.7 million, or 17%, from $4.4 million to $3.6 million for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016. The decreases are primarily due to lower appliance costs as a result of lower appliance sales during the three and six months ended June 30, 2017, as compared to the same periods in 2016.

Cost of Services Revenue

Cost of services revenue consists principally of employee compensation costs, including share-based compensation and related overhead, travel, facilities cost, software maintenance paid to third party vendors, and SaaS hosting infrastructure costs associated with professional services, training, and subscription services.

Cost of services revenue decreased $1.2 million, or 21%, from $5.7 million to $4.5 million and decreased $2.0 million, or 17%, from $11.3 million to $9.3 million for the three and six months ended June 30, 2017, as compared to the same periods in 2016.

For the three and six months ended June 30, 2017, compared to the same periods in 2016, the decrease in cost of services revenue was primarily due to a decrease of $1.0 million and $1.4 million, respectively, in compensation and employee-related costs associated with the reduction in headcount and a decrease of $0.2 million and $0.5 million, respectively, in realignment expenses associated with the closure of our Orlando training center.

Cost of Maintenance Revenue

Cost of maintenance revenue includes third-party outsourcing fees, employee compensation costs for customer technical support and related overhead costs.

Total cost of maintenance revenue remained essentially flat at $0.5 million and $1.2 million for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016.

Operating Expenses

	Three Months Ended							Six Months Ended
	June 30,							June 30,
(Dollars in thousands)	2017			Change %	2016			2017			Change %	2016
Selling and marketing expenses	$	8,501		(27)%	$	11,613		$	18,451		(17)%	$	22,114
Research and development expenses	$	4,707		(28)%	$	6,500		$	10,189		(20)%	$	12,742
General and administrative expenses	$	4,676		(49)%	$	9,133		$	9,208		(40)%	$	15,323
Depreciation and amortization expenses	$	1,115		(15)%	$	1,307		$	2,273		(16)%	$	2,722

Share-based compensation included above:
Selling and marketing expenses	$	692			$	714		$	1,550			$	824
Research and development expenses	$	476			$	701		$	1,042			$	1,128
General and administrative expenses	$	454			$	604		$	1,060			$	1,165
As a percentage of revenue:
Selling and marketing expenses	34.5		%		42.2		%	35.9		%		41.5		%
Research and development expenses	19.1		%		23.6		%	19.8		%		23.9		%
General and administrative expenses	19.0		%		33.2		%	17.9		%		28.7		%
Depreciation and amortization expenses	4.5		%		4.7		%	4.4		%		5.1		%

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Selling and Marketing Expenses

Selling and marketing expenses consist primarily of personnel costs and costs related to our sales force and marketing staff. Selling and marketing expenses also include expenses relating to advertising, brand building, marketing promotions and trade show events (net of amounts received from sponsors and participants), product management, and travel and allocated overhead.

Selling and marketing expenses decreased $3.1 million, or 27%, from $11.6 million to $8.5 million, and decreased $3.7 million, or 17%, from $22.1 million to $18.5 million for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016.

The decrease in selling and marketing expenses for the three months ended June 30, 2017 compared to the same period in 2016, was primarily due to a $1.3 million decrease in sales commissions as a result of lower revenue in the current quarter compared to the prior year quarter and a $1.6 million decrease in compensation and employee-related costs due to lower headcount.

The decrease in selling and marketing expenses for the six months ended June 30, 2017 compared to the same periods in 2016, was primarily due to $1.3 million decrease in realignment expense due to the reduction in headcount in the prior year period, a $1.0 million decrease in sales commissions as a result of lower revenue in the current year compared to the prior year, a $1.0 million decrease in compensation and employee-related costs due to the reduction in headcount, as well as a $0.3 million decrease in consultants and professional services due to our cost savings efforts.

Research and Development Expenses

Research and development expenses consist primarily of compensation, including share-based compensation and related overhead expenses.

Research and development expenses decreased $1.8 million, or 28%, from $6.5 million to $4.7 million, and decreased $2.6 million, or 20%, from $12.7 million to $10.2 million for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016.

The decrease in research and development expenses for the three months ended June 30, 2017 compared to the same period in 2016 was primarily related to a decrease of $1.6 million in compensation and employee-related costs due to a decrease in headcount.

The decrease in research and development expenses for the six months ended June 30, 2017 compared to the same period in 2016 was primarily related to a decrease of $2.0 million in compensation and employee-related costs due to a decrease in headcount and a $0.3 million decrease in realignment expense primarily consisting of severance paid related to a leadership change in the 2016 period that did not reoccur in 2017.

General and Administrative Expenses

General and administrative expenses consist of personnel and related costs for accounting, legal, information systems, human resources and other administrative functions. In addition, general and administrative expenses include professional service fees, bad debt expense, and other corporate expenses and related overhead.

General and administrative expenses decreased $4.5 million, or 49%, from $9.1 million to $4.7 million, and decreased $6.1 million, or 40%, from $15.3 million to $9.2 million for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016.

The decrease in general and administrative expenses for the three months ended June 30, 2017 compared to the same period in 2016 was primarily due to a decrease of $2.3 million related to the settlement of our patent infringement litigation in the prior year period, a decrease of $1.6 million in various consulting and legal fees related to the proxy contest with the Company’s founder, former Chief Technology Officer and former Chairman of the Board of Directors in the prior year period, and a decrease of $0.4 million in compensation and employee-related costs related to decreased headcount.

The decrease in general and administrative expenses for the six months ended June 30, 2017 compared to the same period in 2016 was primarily due to a decrease of $2.3 million related to the settlement of our patent infringement litigation in the prior year period, a decrease of $2.5 million in various consulting and legal fees related to the proxy contest with the Company’s founder, former Chief Technology Officer and former Chairman of the Board of Directors in the prior year period, a decrease of $1.8 million in compensation and employee-related costs due to headcount reduction, and a $0.5 million decrease in rent expense due to our corporate headquarters consolidation, offset by an increase of $1.2 million in expenses related to fixed assets written off in the current year as a result of the consolidation of our corporate headquarters.

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Depreciation and Amortization Expenses

Depreciation and amortization expenses consist of depreciation and amortization of our leasehold improvements, furniture, computer hardware and software, and intangible assets.

Depreciation and amortization expenses consist of depreciation and amortization of our leasehold improvements, furniture, computer hardware and software, and intangible assets. Depreciation and amortization expenses decreased $192,000, or 15%, from $1.3 million to $1.1 million, and decreased $0.4 million, or 17%, from $2.7 million to $2.3 million for the three and six months ended June 30, 2017, respectively, as compared to the same periods in 2016. The decrease is primarily due to certain assets being fully depreciated.

Other Income and Expense

Total other income and expense consists of interest earned on cash balances, interest expense paid and other miscellaneous income and expense items. Other income and expense increased $8,000, or 136%, from $6,000 to $14,000, and increased $8,000, or 64%, from $13,000 to $21,000 for the three and six months ended June 30, 2017, compared to the same period in 2016.

Income Tax Provision

We have recorded an income tax provision for the three and six months ended June 30, 2017 of $29,000 and $98,000, respectively, as compared to $38,000 and $91,000 for the same periods in 2016. Our income tax provision for the three and six months ended June 30, 2017 differs from the U.S. statutory rate of 34% primarily due to state taxes, foreign taxes, the tax impact of certain share-based compensation charges, and the impact of providing a valuation allowance against research and development credits and the net United States deferred tax assets. Our income tax provision for the three and six months ended June 30, 2016 differs from the U.S. statutory rate of 34% primarily due to state taxes, foreign taxes, the tax impact of certain share-based compensation charges, and the impact of providing a valuation allowance against research and development credits and deferred tax assets.

Liquidity and Capital Resources

Since inception, we have largely financed our operations from the cash flow generated from the sale of our products and services, as well as proceeds from our initial public offering. As of June 30, 2017, we had $13.6 million in cash and cash equivalents. We believe that our cash flow from operations and our cash and cash equivalents are sufficient to fund our working capital and capital expenditure requirements for at least the next twelve months.

Changes in Cash Flow

We generate cash from operating activities from cash collections related to the sale of our products and services.

Net cash provided by operating activities was $4.5 million for the six months ended June 30, 2017 as compared to net cash used in operating activities of $4.3 million for the same period in 2016. The net cash provided by operating activities for the six months ended June 30, 2017 included a net loss of $2.9 million, a $7.5 million decrease in trade receivables and a $2.7 million decrease in accrued liabilities, while net cash used in operating activities in the same period in 2016 included a net loss of $16.5 million, a $6.0 million decrease in trade receivables and a $2.5 million increase in accrued liabilities.

Net cash used in investing activities was $238,000 for the six months ended June 30, 2017, as compared to $1.6 million for the same period in 2016. The decrease in cash used in investing activities was primarily due to the purchase of property and equipment related to technology equipment during the six months ended June 30, 2016, that did not reoccur during the same period in 2017.

Net cash used in financing activities was $3.2 million for the six months ended June 30, 2017, as compared to $39,000 for the same period in 2016. The increase in cash used in financing activities was primarily due to the repayment of $3.5 million of borrowings on the line of credit during the six months ended June 30, 2017, which did not occur in the same period in 2016.

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Contractual Obligations and Commitments

In April 2017, the Company entered into a three year subscription software license agreement for a cloud-based e-Discovery platform that customers of our EnCase eDiscovery Review product can migrate to. The agreement provides for initial payments by the Company for the first year beginning April 1, 2017 totaling approximately $477,000, payable in four quarterly installments, $1.0 million payable at the beginning of the second year, and $1.8 million payable at the beginning of the third year. There is an early termination provision that makes the third year’s payment contingent on the successful completion of the development of an integration product by October 1, 2017. As of June 30, 2017, the remaining payable was $1.4 million.

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Off-Balance Sheet Arrangements

At June 30, 2017, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of the SEC’s Regulation S-K. We do not have material relationships or transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed in this report.

Item 3. Quantitative and Qualitative Disclosure about Market Risk

Market Risk. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign exchange rates, interest rates and credit risk. We do not hold or issue financial instruments for trading purposes.

Foreign Currency Risk. To date, substantially all of our international sales have been denominated in US dollars, and therefore, the majority of our revenues are not subject to foreign currency risk. Our operating expenses and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, but such changes have historically had relatively little impact on our operating results and cash flows. A strengthening of the dollar could make our products and services less competitive in foreign markets and therefore could reduce our revenues. In the future, an increased portion of our revenues and costs may be denominated in foreign currencies. We do not enter into derivative instrument transactions for trading or speculative purposes.

Interest Rate Risk. Our investment portfolio, consisting of highly liquid debt instruments of the US government at June 30, 2017, is subject to interest rate risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of our investment portfolio.

Item 4. Controls and Procedures

Management, with the participation of the President and Chief Executive Officer and Chief Financial Officer, has performed an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934). This evaluation includes consideration of the controls, processes and procedures that are designed to ensure that information required to be disclosed by us in the reports we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our President and Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on such evaluation, our President and Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2017, our disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting during the three months ended June 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The information contained in Note 12 to the Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated by reference herein.

Item 1A. Risk Factors

The announcement and pendency of our agreement to be acquired by OpenText Corporation could have an adverse effect on our business.

On July 25, 2017 we entered into an Agreement and Plan of Merger, or the Merger Agreement, with OpenText Corporation, or OpenText, pursuant to which a wholly-owned subsidiary of OpenText will, upon the terms and subject to the conditions set forth in the Merger Agreement, commence a tender offer for all outstanding shares of Guidance Software, Inc., followed by a merger to acquire any untendered shares. Upon the terms and subject to the conditions set forth in the Merger Agreement, at the effective time of the merger, each share of common stock of Guidance Software issued and outstanding immediately prior to the effective time of the merger will be cancelled and automatically converted into the right to receive $7.10 in cash, without interest and subject to any applicable withholding taxes.

Uncertainty about the effect of the proposed merger on our employees, customers and technology partners may have a significant adverse impact our business and operations. Our employees may experience uncertainty about their positions with the company following the merger. We may be unable to attract and retain key talent as we had prior to announcement of the Merger Agreement. Any loss or distraction of such employees could have a material adverse effect on our business and operations. Management resources have been, and will continue to be, directed towards the completion of the merger, which could materially adversely affect our business and operations.

As a result of the merger, our customers may experience uncertainty concerning our products, services and their existing or anticipated business relationships with us. Uncertainty may cause customers to discontinue purchasing our products and services, and vendors may seek to modify or terminate their existing business relationships with us, which could result in a material adverse effect on our business.

Pursuant to the terms of the Merger Agreement, we are subject to certain restrictions on the conduct of our business, including the ability in certain cases to enter into contracts, acquire or dispose of assets, incur indebtedness or incur capital expenditures, until the merger becomes effective or the Merger Agreement is terminated. These restrictions may prevent us from taking actions that we would otherwise consider to be in the best interests of the company and may hinder our ability to remain competitive with our industry peers.

The failure to complete the merger with OpenText could adversely affect our business.

Completion of the merger with OpenText is subject to conditions beyond our control that may prevent, delay or otherwise adversely affect its completion in a material way, including the expiration or termination of applicable waiting periods under antitrust and competition laws, national security laws relating to foreign ownership of American companies, and similar approvals or consents that must be obtained from regulatory entities and government agencies. If the merger or a similar transaction is not completed, the share price of our common stock may drop to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. In addition, under circumstances specified in the Merger Agreement, we may be required to pay a termination fee of $6,014,095.55 in the event the merger is not consummated or if a proposal by a third party competitive to the Merger Agreement is publicly disclosed or consummated. Further, a failure to complete the merger may result in negative public opinion of us by customers and investors. Any disruption to our business and increased competition resulting from the proposed merger could continue or accelerate in the event of a failure to complete the merger. No assurances can be given that our business will not be adversely affected if the merger is not consummated.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

There have been no material changes to the Unregistered Sales of Equity Securities and Use of Processed as presented in our Annual Report on Form 10-K for the year ended December 31, 2016, filed with the U.S. Securities and Exchange Commission on March 1, 2017.

Item 3. Defaults upon Senior Securities

No information is required in response to this item.

Item 4. [Removed and Reserved]

No information is required in response to this item.

Item 5. Other Information

No information is required in response to this item.

Item 6. Exhibits

Exhibit Number		Description of Documents

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1†		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2†		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema Document
101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF		XBRL Taxonomy Extension Definition Linkbase Document
101.LAB		XBRL Taxonomy Extension Label Linkbase Document
101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

† These certifications are being furnished solely to accompany this Quarterly Report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of Guidance Software, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Guidance Software, Inc.

	By:	/s/ Barry J. Plaga
		Barry J. Plaga
		Chief Financial and Operating Officer
		(Principal Financial Officer)

Dated: August 7, 2017

Guidance Software, Inc. 10-Q