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TMCNet:  BLACKBAUD INC - 10-K - Management's discussion and analysis of financial condition and results of operations

[February 27, 2013]

BLACKBAUD INC - 10-K - Management's discussion and analysis of financial condition and results of operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Item 1.A Risk Factors and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements reflect our current view with respect to future events and financial performance and are subject to risks and uncertainties, including those set forth under "Item 1.A. Risk Factors" and elsewhere in this report, that could cause actual results to differ materially from historical or anticipated results. Except as required by law, we do not intend, and undertake no obligation to revise or update these forward-looking statements, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.



Executive summary We provide on-premise and cloud-based software solutions and related services designed specifically for nonprofit organizations. Our products and services enable nonprofit organizations to increase donations, reduce fundraising costs, improve communications with constituents, manage their finances and optimize internal operations. As of December 31, 2012, we had more than 27,000 active customers distributed across multiple verticals within the nonprofit market including education, foundations, health and human services, religion, arts and cultural, public and societal benefits, environment and animal welfare as well as international foreign affairs.

We derive revenue from selling perpetual licenses or charging for the use of our software products in a hosted environment and providing a broad offering of services, including consulting, training, installation and implementation services, as well as ongoing customer support and maintenance. Consulting, training and implementation are generally not essential to the functionality of our software products and are sold separately. Furthermore, we derive revenue from providing hosting services, performing donor prospect research engagements, selling lists of potential donors, and providing transaction processing services, benchmarking studies and data modeling services.

We completed our acquisition of Convio in May 2012 for $335.7 million in consideration. We funded the acquisition through both cash on hand and borrowings under our amended credit facility. During 2012, we remained focused on: • integrating the Convio operations and managing expenses to enable us to realize synergies while making investments for future growth of our combined operations; • making initial post-merger product roadmap decisions, which included the decision to sunset the Convio Common Ground solution and our move to a single event fundraising module; and • continuing the shift in our offerings towards subscription-based pricing to meet the needs and preferences of our customers.

Overall, revenue in 2012 increased 21% compared to 2011. When removing the impact of revenue from acquired companies, revenue increased by 6% during 2012.

This increase was principally the result of continued growth in our subscriptions revenue as a result of an increase in demand for our subscription-based offerings as our business shifts towards hosted solutions as well as an increase in transaction fees associated with our payment processing services. Maintenance revenue also contributed to the increase in revenue from maintaining high renewal rates, new maintenance contracts associated with new license arrangements and existing client increases.

Income from operations for 2012 decreased by $31.5 million when compared to 2011. The decrease was attributable to: (i) a $23.1 million increase in costs associated with our acquisition of Convio related to transaction costs, integration and restructuring costs, amortization of acquired intangibles from business combinations and stock-based compensation expense; (ii) a $4.3 million increase in costs related to strategic investments we have made in our business optimization efforts and the re-engineering of our accounting processes; and (iii) an increase of $8.3 million in hosting costs due to incremental investments to improve our hosting services and additional hosting capacity required as a result of the growth in demand for our hosted applications and other online services. Also contributing to the decrease in income from operations was our continued shift from a license-based model with upfront revenue recognition to a subscription-based model, which recognizes revenue ratably over the agreement term. These decreases were partially offset by an increase in gross margin from our payment processing operations.

31-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) We ended 2012 with cash and cash equivalents totaling $13.5 million and $215.5 million in outstanding borrowings on our credit facility. During 2012, we used $20.8 million of cash on hand and net borrowings of $259.6 million towards acquiring Convio. Additionally, we generated $68.7 million in cash flow from operations, paid $21.7 million in dividends and used $20.6 million to purchase computer equipment and software.

During 2012, we continued to experience growth in overall revenue primarily driven by the growing demand for our subscription-based offerings. However, we continue to believe the pace and impact of economic recovery on the nonprofit market remains uncertain. Additionally, we continue to experience a greater level of caution by our existing and prospective customers in their expenditure decisions. We expect that our operating environment will continue to be challenging in the near term. Notwithstanding these conditions, we plan to further increase our focus on subscription-based offerings as we execute on our key growth initiatives and strengthen our leadership position, while achieving our targeted level of profitability. In the near term, we expect there will continue to be a dilutive impact on our profitability as we shift from a license-based model with upfront revenue recognition to a subscription-based model, which recognizes revenue ratably over the agreement term.

We also plan to continue to invest in our back-office processes, the infrastructure that supports our subscription-based offerings and certain product development initiatives to achieve optimal scalability of our operations as we execute on our key growth initiatives.

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Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Results of operations During 2012, 2011 and 2010, we acquired companies that provided us with strategic opportunities to expand our share of the nonprofit market through the integration of complementary products and services to serve the changing needs of our customers. The following are the companies we acquired and their respective acquisition date: • NOZA, Inc. - October 1, 2010; • Public Interest Data, LLC, or PIDI - February 1, 2011; • Everyday Hero Pty. Ltd., or EDH - October 6, 2011; and • Convio, Inc., or Convio - May 4, 2012.

We have included the results of operations of acquired companies in our consolidated results of operations from the date of their respective acquisition, which impacts the comparability of our results of operations when comparing 2012 to 2011 and 2011 to 2010. We have noted in the discussion below, to the extent meaningful, the impact on the comparability of our consolidated results of operations due to the inclusion of acquired companies for only a partial year in the year of acquisition.

From the date of acquisition through December 31, 2012, Convio's total revenue was $50.7 million. Because we have integrated a substantial amount of the Convio operations, it is impracticable to determine the operating costs attributable solely to the acquired business.

Comparison of the years ended December 31, 2012 and 2011 Revenue The table below compares revenue from our consolidated statements of comprehensive income for the years ended December 31, 2012 and 2011.

Year ended December 31, (in millions) 2012 2011 Change % Change License fees $ 20.6 $ 19.5 $ 1.1 6 % Subscriptions 162.1 103.5 58.6 57 % Services 119.6 108.8 10.8 10 % Maintenance 136.1 130.6 5.5 4 % Other 9.0 8.5 0.5 6 % Total revenue $ 447.4 $ 370.9 $ 76.5 21 % When removing the impact of revenue from acquired companies, revenue increased by $21.9 million, or 6% in 2012. This increase in revenue was primarily attributable to growth in our subscriptions revenue as a result of both an increase in demand for an our online fundraising offerings as well as an increase in transaction fees associated with our payment processing services.

The increase in demand for our subscription offerings was primarily driven by the ongoing evolution of our product offerings from a license-based to subscription-based model. Although we continue to experience a shift in our emerging (first-time users) and mid-sized customers' buying preference away from perpetual licenses towards hosted solutions, license revenue increased in 2012 when compared to 2011 as a result of an increase in sales of our Blackbaud CRM offering to large and/or strategic customers. The increase in maintenance revenue is attributable to maintaining high renewal rates, new maintenance contracts associated with new license agreements and increases in contracts with existing customers during 2012 when compared to 2011. Services revenue grew in 2012 principally as a result of increased demand for our education services.

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Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Operating results License fees Year ended December 31, (in millions) 2012 2011 Change % Change License fees revenue $ 20.6 $ 19.5 $ 1.1 6 % Cost of license fees 3.0 3.3 (0.3 ) (9 )% License fees gross profit $ 17.6 $ 16.2 $ 1.4 9 % License fees gross margin 85 % 83 % We derive revenue from license fees from the sale of our software products, under a perpetual license agreement. We are increasingly experiencing a shift in our emerging and mid-sized customers' buying preference away from solutions offered under perpetual license arrangements towards subscription-based hosted applications, while our large and/or strategic customers continue to be an area of growth, particularly as it relates to our Blackbaud CRM offering. Our larger perpetual license transactions have long sales cycles, and their timing can result in significant period-to-period variations. Revenue from license fees increased in 2012 primarily due to a greater contribution of revenue from larger Blackbaud CRM arrangements when compared to 2011.

Cost of license fees is principally comprised of third-party software royalties, variable reseller commissions, amortization of software development costs and amortization of intangibles from business combinations. The decrease in cost of license fees in 2012 when compared to 2011 is principally attributable to a decrease in third-party software royalties. Third-party software royalties associated with our license-based products have decreased as the demand for our perpetual license arrangements has decreased and subscription-based offerings has increased.

The increase in license fees gross margin during 2012 is the result of fewer sales of products that have third party software royalty costs associated with them. Additionally, the increase in revenue from Blackbaud CRM arrangements contributed to the increase in license fees gross margin during 2012.

Subscriptions Year ended December 31, (in millions) 2012 2011 Change % Change Subscriptions revenue $ 162.1 $ 103.5 $ 58.6 57 % Cost of subscriptions 68.8 42.5 26.3 62 % Subscriptions gross profit $ 93.3 $ 61.0 $ 32.3 53 % Subscriptions gross margin 58 % 59 % Revenue from subscriptions is principally comprised of revenue from providing access to hosted applications and hosting services, access to certain data services and our online subscription training offerings, as well as variable transaction fees associated with the use of our products to fundraise online. We continue to experience growth in our hosted applications business and are increasingly experiencing a shift in our emerging and mid-sized customers' buying preference away from perpetual licenses towards subscription-based offerings. There will continue to be a dilutive impact on our profitability as we shift from a license-based model with upfront revenue recognition to a subscription-based model, which recognizes revenue ratably over the agreement term.

Included in subscriptions revenue for 2012 and 2011 is $45.6 million and $0.7 million of revenue attributable to acquired companies, respectively. Excluding the revenue from acquired companies, the increase in subscriptions revenue of $13.7 million, or 13%, is principally attributable to an increase in demand for our online fundraising and data management offerings as well as an increase in transaction fees associated with our payment processing services.

Cost of subscriptions is primarily comprised of human resource costs, stock-based compensation expense, third-party royalty and data expenses, hosting expenses, allocated depreciation, facilities and IT support costs, amortization of intangibles from 34-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) business combinations and other costs incurred in providing support and services to our customers. The increase in cost of subscriptions in 2012 is principally attributable to increases in hosting costs, human resource costs and amortization of intangibles from business combinations.

Hosting costs increased by $8.3 million during 2012 as a result of incremental costs due to the inclusion of acquired companies. Additionally, hosting costs increased due to incremental investments to improve our hosting services and additional hosting capacity required as a result of the growth in demand for our hosted applications and other online services. Human resource costs increased $6.6 million during 2012. The increase in human resource costs is attributable to additional headcount due to the inclusion of acquired companies and additional resources needed to support the growth in demand for our subscription-based offerings.

Amortization of intangibles from business combinations increased $8.6 million in 2012 primarily due to the amortization expense for the acquired Convio intangible assets.

The decrease in subscriptions gross margin during 2012 compared to 2011 is primarily due to investments we are making in our infrastructure, including additional headcount, expanded facilities, improved operational processes and computer equipment to support the growth in our subscription offerings.

Services Year ended December 31, (in millions) 2012 2011 Change % Change Services revenue $ 119.6 $ 108.8 $ 10.8 10 % Cost of services 97.2 79.1 18.1 23 % Services gross profit $ 22.4 $ 29.7 $ (7.3 ) (25 )% Services gross margin 19 % 27 % We derive services revenue from consulting, installation, implementation, education and analytic services. Consulting, installation and implementation services involve converting data from a customer's existing system, assistance in file set up and system configuration, and/or process re-engineering.

Education services involve customer training activities. Analytic services are comprised of donor prospect research, selling lists of potential donors, benchmarking studies and data modeling services. These services involve the assessment of current and prospective donor information of the customer and are performed using our proprietary analytical tools. The end product enables organizations to more effectively target their fundraising activities. We recognize services revenue attributable to consulting services for implementation of our hosted applications and subscription offerings ratably over the period the customer benefits from those services. We also recognize the direct and incremental costs associated with consulting services revenue ratably over the same period. However, we continue to expense indirect costs in the period the implementation services are provided.

Included in services revenue in 2012 and 2011 is $9.8 million and $0.1 million of revenue attributable to acquired companies, respectively. Excluding the revenue from acquired companies, the increase in services revenue of $1.1 million, or 1%, is principally due to an increase in education services revenue of $1.4 million, partially offset by a decrease in analytic services revenue of $0.6 million. The rates we charge for our education service offerings have remained relatively constant year over year and, as such, the increase in revenue is the result of a change in volume. The increase in revenue from education services is the result of higher demand for subscription-based training. Consulting services revenue remained relatively unchanged in 2012 compared to 2011 primarily due to a greater portion of our service engagements being with larger enterprise customers as our mid-market moves to subscription-based offerings. These larger enterprise engagements can experience volatility in utilization due to the complex nature of these engagements.

Cost of services is principally comprised of human resource costs, stock-based compensation expense, third-party contractor expenses, classroom rentals, costs incurred in providing customer training, data expense incurred to perform analytic services, allocated depreciation, facilities and IT support costs and amortization of intangibles from business combinations. The increase in cost of services in 2012 is primarily attributable to an increase in human resource costs. Human resource costs increased $12.7 million in 2012 as a result of an increase in headcount. The increase in headcount was attributable to the inclusion of additional resources from acquired companies.

35-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) An increase in allocated depreciation, facilities and IT support costs also contributed to the increase in cost of services in 2012 when compared to 2011 due to the inclusion of allocable costs from the Convio operations.

The services gross margin decreased in 2012 primarily as a result of the increases in headcount and allocated costs discussed above.

Maintenance Year ended December 31, (in millions) 2012 2011 Change % Change Maintenance revenue $ 136.1 $ 130.6 $ 5.5 4 % Cost of maintenance 26.0 25.2 0.8 3 % Maintenance gross profit $ 110.1 $ 105.4 $ 4.7 4 % Maintenance gross margin 81 % 81 % Revenue from maintenance is comprised of annual fees derived from maintenance contracts associated with new software licenses and annual renewals of existing maintenance contracts. These contracts provide customers with updates, enhancements and upgrades to our software products and online, telephone and email support. The increase in maintenance revenue in 2012 compared to 2011 is principally comprised of (i) $12.7 million of maintenance from new customers associated with new license agreements and increases in contracts with existing customers and (ii) $4.1 million from maintenance contract inflationary rate adjustments, partially offset by (iii) $11.3 million from maintenance contracts that were not renewed and reductions in contracts with existing customers.

Cost of maintenance is primarily comprised of human resource costs, stock-based compensation expense, third-party contractor expenses, third-party royalty costs, allocated depreciation, facilities and IT support costs, amortization of intangibles from business combinations and other costs incurred in providing support and services to our customers. Cost of maintenance increased during 2012 when compared to 2011 primarily as a result of increases in allocated costs and proprietary software costs. The increase in proprietary software costs is attributable to increases in maintenance contracts with existing customers for software products which include third-party royalty costs associated with the maintenance revenue. Maintenance gross margin in 2012 remained relatively unchanged when compared to 2011.

Other revenue Year ended December 31, (in millions) 2012 2011 Change % Change Other revenue $ 9.0 $ 8.5 $ 0.5 6 % Cost of other revenue 7.5 7.0 0.5 7 % Other gross profit $ 1.5 $ 1.5 $ - - % Other gross margin 17 % 18 % Other revenue includes the sale of business forms that are used in conjunction with our software products, reimbursement of travel-related expenses primarily incurred during the performance of services at customer locations, fees from user conferences and third-party software referral fees. Other revenue increased in 2012 when compared to 2011 primarily due to an increase in fees from user conferences. Additionally, an increase in revenue from reimbursement of travel-related expenses associated with services revenue contributed to the increase in other revenue during 2012.

Cost of other revenue includes human resource costs, costs of business forms, costs of user conferences, reimbursable expenses relating to the performance of services at customer locations, allocated depreciation, facilities and IT support costs and amortization of intangibles from business combinations. Cost of other revenue increased in 2012 primarily due to increases in reimbursable expenses related to services provided at customer locations. Other gross margin in 2012 remained relatively unchanged when compared to 2011.

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Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Operating expenses Sales and marketing Year ended December 31, (in millions) 2012 2011 Change % ChangeSales and marketing expense $ 95.2 $ 75.4 $ 19.8 26 % % of revenue 21 % 20 % Sales and marketing expense includes salaries and related human resource costs, stock-based compensation expense, travel-related expenses, sales commissions, advertising and marketing materials, public relations costs and allocated depreciation, facilities and IT support costs.

Sales and marketing expense increased in 2012 primarily due to increases in human resource costs and commission expense. Human resource costs increased primarily due to the inclusion of additional headcount from acquired companies as well as incremental headcount to support the increase in sales and marketing efforts of our growing operations. The increase in commission expense is principally due to an increased amount of commissionable revenue in 2012.

Research and development Year ended December 31, (in millions) 2012 2011 Change % Change Research and development expense $ 64.7 $ 47.7 $ 17.0 36 % % of revenue 14 % 13 % Research and development expense includes human resource costs, stock-based compensation expense, third-party contractor expenses, software development tools and other expenses related to developing new products, upgrading and enhancing existing products, and allocated depreciation, facilities and IT support costs.

Research and development expense increased during 2012 primarily due to increased human resource and third-party contractor costs. Human resource and third-party contractor costs increased primarily due to the inclusion of additional headcount from acquired companies as well as investments we continue to make in our product development efforts, including our direct marketing offerings. Additionally, research and development costs increased during 2012 due to an increase in allocated business costs.

General and administrative Year ended December 31, (in millions) 2012 2011 Change % Change General and administrative expense $ 63.3 $ 36.9 $ 26.4 72 % % of revenue 14 % 10 % General and administrative expense consists primarily of human resource costs for general corporate functions, including senior management, finance, accounting, legal, human resources, corporate development, stock-based compensation expense, third-party professional fees, insurance, allocated depreciation, facilities and IT support costs, acquisition-related expense and other administrative expenses.

General and administrative expense increased during 2012 primarily due to increases in acquisition transaction costs, acquisition integration and restructuring costs, acquisition-related stock-based compensation, professional fees and human resource costs. The increase in costs associated with our acquisition of Convio including transaction costs, acquisition integration and restructuring costs and stock-based compensation expense was $13.2 million during 2012. Professional fees increased $4.3 million during 2012 compared to 2011, primarily due to strategic investments we are making in our business optimization efforts and the re-engineering of our accounting processes. The remaining increase was primarily attributable to an 37-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) increase in human resource costs from additional headcount to support our growing operations and increased skills and competencies of our support resources.

Non-GAAP income from operations The operating results analyzed below are presented on a non-GAAP basis in that the results exclude the impact of (i) the writedown of Convio's deferred revenue balance, (ii) stock-based compensation expense, (iii) amortization expense, (iv) acquisition-related expenses, (v) acquisition integration and restructuring costs, (vi) a write-off of prepaid proprietary software licenses, (vii) an impairment of cost method investment, and (viii) a gain on sale of assets. We believe that the exclusion of these amounts allows us and investors to better understand our operating expenses and cash needs, particularly when evaluating current performance against prior periods.

Year ended December 31, (in millions) 2012 2011 Change % Change GAAP income from operations $ 19.4 $ 50.9 $ (31.5 ) (62 )% Non-GAAP adjustments: Add: Convio deferred revenue writedown 5.6 - 5.6 100 % Add: Stock-based compensation expense 19.2 14.9 4.3 29 % Add: Amortization of intangibles from business combinations 17.4 7.6 9.8 129 % Add: Acquisition-related expenses 6.4 1.8 4.6 256 % Add: Acquisition integration and restructuring costs 6.9 - 6.9 100 % Add: Write-off of prepaid proprietary software licenses 0.4 - 0.4 100 % Add: Impairment of cost method investment 0.2 1.8 (1.6 ) (89 )% Less: Gain on sale of assets - (0.5 ) 0.5 (100 )% Total Non-GAAP adjustments 56.1 25.6 30.5 119 % Non-GAAP income from operations $ 75.5 $ 76.5 $ (1.0 ) (1 )% Non-GAAP operating margin 17 % 21 % The decrease in non-GAAP income from operations and non-GAAP operating margin during 2012 was principally due to: (i) the continued shift from a license-based model with upfront revenue recognition to a subscription-based model, which recognizes revenue ratably over the agreement term; (ii) incremental investments we are making in our product development efforts and as well as investments to improve the performance of our hosting services; and (iii) strategic investments we are making in our business optimization efforts and the re-engineering of our accounting processes. Contributing to the decrease in 2012 is the growth of cost of services exceeding the growth of our services revenue.

38-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Comparison of the years ended December 31, 2011 and 2010 Revenue The table below compares revenue from our consolidated statements of comprehensive income for the years ended December 31, 2011, with the same period in 2010.

Year ended December 31, (in millions) 2011 2010 Change % Change License fees $ 19.5 $ 23.7 $ (4.2 ) (18 )% Subscriptions 103.5 83.9 19.6 23 % Services 108.8 87.7 21.1 24 % Maintenance 130.6 124.6 6.0 5 % Other 8.5 6.7 1.8 27 % Total revenue $ 370.9 $ 326.6 $ 44.3 14 % Total revenue increased $44.3 million, or 14%, in 2011 compared to 2010. This increase in revenue was primarily attributable to growth in our subscriptions and services revenue. The increase in subscriptions revenue was primarily attributable to an increase in demand for our hosted offerings, hosting services, online fundraising and data management offerings. This increase was driven by the ongoing evolution of our product offerings from a license-based to subscription-based business model. Services revenue growth was primarily due to an increase in demand for consulting services associated with our Blackbaud CRM offering and online fundraising offerings.

The increase in maintenance revenue was attributable to new maintenance contracts associated with new license agreements sold over the last twelve months and increases in contracts with existing customers. These increases were offset by a decrease in license fees which was principally attributable to a smaller contribution in 2011 from Blackbaud CRM perpetual license arrangements with upfront revenue recognition than in 2010. Additionally, we continued to experience a shift in our customers' buying preference away from perpetual licenses towards hosted solutions.

Operating results License fees Year ended December 31, (in millions) 2011 2010 Change % Change License fees revenue $ 19.5 $ 23.7 $ (4.2 ) (18 )% Cost of license fees 3.3 3.0 0.3 10 % License fees gross profit $ 16.2 $ 20.7 $ (4.5 ) (22 )% License fees gross margin 83 % 87 % Revenue from license fees during 2011 and 2010 was derived from the sale of our software products, under a perpetual license agreement. During 2011, we increasingly experienced a shift in our customers' buying preference away from solutions offered under perpetual license arrangements towards subscription-based hosted applications. In addition, we continued to experience longer sales cycle times, delays and postponements of purchasing decisions and overall caution exercised by existing and prospective customers as a result of continued challenges posed by the weak economic environment. During 2011, revenue from license fees to existing customers decreased by $0.9 million and sales to new customers decreased by $3.3 million. The decrease in license fees was largely the result of a smaller contribution in 2011 from Blackbaud CRM sales with upfront revenue recognition when compared to 2010 due to credits provided to certain Blackbaud CRM early adopters.

Cost of license fees was principally comprised of third-party software royalties, variable reseller commissions, amortization of software development costs and amortization of intangibles from business combinations. The increase in cost of license fees in 2011 compared to 2010 was principally attributable to an increase in reseller commissions. A greater portion of our software license sales in 2011 were completed through our reseller channels when compared to 2010.

39-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) The decrease in license fees gross margin in 2011 compared to 2010 was the result of an increase in the sale of products that are sold through our reseller channels.

Subscriptions Year ended December 31, (in millions) 2011 2010 Change % Change Subscriptions revenue $ 103.5 $ 83.9 $ 19.6 23 % Cost of subscriptions 42.5 31.2 11.3 36 % Subscriptions gross profit $ 61.0 $ 52.7 $ 8.3 16 % Subscriptions gross margin 59 % 63 % Revenue from subscriptions for 2011 and 2010 was principally comprised of revenue from providing access to hosted applications and hosting services, access to certain data services and our online subscription training offerings, and variable transaction fees associated with the use of our products to fundraise online. Revenue from acquired companies contributed $6.2 million to the growth in subscriptions revenue during 2011. The remaining increase in subscriptions revenue during 2011 was principally attributable to the increase in demand for online fundraising offerings, data management offerings and hosting services. Additionally, revenue from our hosting services continued to increase as the demand for these services continued to grow from both our existing and new perpetual license customers. We continued to experience growth in our hosted applications business and increasingly experienced a shift in our customers' buying preference away from perpetual licenses towards subscription based-offerings.

Cost of subscriptions for 2011 and 2010 was primarily comprised of human resource costs, stock-based compensation expense, third-party royalty and data expenses, hosting expenses, an allocation of depreciation, facilities and IT support costs, amortization of intangibles from business combinations and other costs incurred in providing support and services to our customers. The increase in cost of subscriptions in 2011 when compared to 2010 was principally attributable to an increase in headcount. The increase in headcount was due to both the inclusion of acquired companies and the investments we were making in our infrastructure to support the growth in our subscription offerings. Human resource costs increased $6.9 million as a result of an increase in headcount, of which $3.6 million related to our acquisition of PIDI in February 2011.

Hosting costs also increased by $2.8 million due to the increase in required hosting capacity as a result of the increase in demand for hosting and other online services.

The decrease in subscriptions gross margin 2011 compared to 2010 was due to an increase in the investments we made in the infrastructure to support the growth in our subscription offerings.

Services Year ended December 31, (in millions) 2011 2010 Change % Change Services revenue $ 108.8 $ 87.7 $ 21.1 24 % Cost of services 79.1 66.8 12.3 18 % Services gross profit $ 29.7 $ 20.9 $ 8.8 42 % Services gross margin 27 % 24 % Services revenue for 2011 and 2010 consisted of consulting, installation, implementation, education and analytic services. Consulting, installation and implementation services involve converting data from a customer's existing system, assistance in file set up and system configuration, and/or process re-engineering. Education services involve customer training activities.

Analytic services are comprised of donor prospect research, selling lists of potential donors, benchmarking studies and data modeling services. These services involve the assessment of current and prospective donor information of the customer and are performed using our proprietary analytical tools. The end product enables organizations to more effectively target their fundraising activities. We recognize services revenue attributable to consulting services for implementation of our hosted applications and subscription offerings ratably over the period the customer benefits from those services. We also recognize the 40-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) direct and incremental costs associated with consulting services revenue ratably over the same period. However, we continue to expense indirect costs in the period the implementation services are provided.

The increase in services revenue during 2011 when compared to 2010 was principally attributable to an increase in consulting services revenue of $14.4 million, analytic services of $3.8 million and education services of $2.9 million. Revenue from acquired companies represented $0.8 million of consulting services and $1.9 million of analytic services revenue growth during 2011 compared to 2010. The increase in consulting services revenue was primarily due to an increase in the demand for consulting, installation and implementation services associated with our Blackbaud CRM offering and our internet based fundraising offerings. This increase in consulting services revenue resulting from an increase in volume was partially offset by an increase in our investment, in the form of non-billable implementation hours, in early adopters of our Blackbaud CRM offering and a reduction in the rates we charged as a result of a higher level of discounts on the consulting services provided during 2011 compared to 2010. The rates we charged for our education and analytic service offerings have remained relatively constant year over year and, as such, the change in revenue was principally the result of an increase in the volume of services provided.

Cost of services was principally comprised of human resource costs, stock-based compensation expense, third-party contractor expenses, classroom rentals, other costs incurred in providing consulting, installation and implementation services and customer training, data expense incurred to perform analytic services, an allocation of depreciation, facilities and IT support costs and amortization of intangibles from business combinations.

The increase in cost of services in 2011 when compared to 2010 was primarily attributable to an increase in human resource costs and third-party contractor costs. The increase in human resource costs and third-party contractor costs was principally attributable to the need for additional resource capacity to meet the increasing consulting services demands of our customers and the additional headcount from acquired companies.

The services gross margin increased in 2011 compared to 2010 primarily as a result of an increase in demand for consulting services associated with our Blackbaud CRM offering and a shift in the mix of consulting engagements to higher margin projects.

Maintenance Year ended December 31, (in millions) 2011 2010 Change % Change Maintenance revenue $ 130.6 $ 124.6 $ 6.0 5 % Cost of maintenance 25.2 24.1 1.1 5 % Maintenance gross profit $ 105.4 $ 100.5 $ 4.9 5 % Maintenance gross margin 81 % 81 % Revenue from maintenance for 2011 and 2010 was comprised of annual fees derived from maintenance contracts associated with new software licenses and annual renewals of existing maintenance contracts. These contracts provide customers with updates, enhancements and upgrades to our software products and online, telephone and email support. During 2011, the increase in maintenance revenue was principally comprised of $11.3 million of maintenance from new customers associated with new license agreements and increases in contracts with existing customers and $3.8 million from maintenance contract inflationary rate adjustments, offset by $9.1 million from maintenance contracts that were not renewed.

Cost of maintenance for 2011 and 2010 was primarily comprised of human resource costs, stock-based compensation expense, third-party contractor expenses, third-party royalty costs, an allocation of depreciation, facilities and IT support costs, amortization of intangibles from business combinations and other costs incurred in providing support and services to our customers. The increase in cost of maintenance in 2011 when compared to 2010 was principally attributable to an increase in human resource costs of $1.5 million partially offset by a $0.2 million decrease in third-party royalty costs and $0.2 million decrease in amortization of intangibles from business combinations. Human resource costs increased due to salary merit increases and an increase in headcount associated with the continued growth in our customer support function commensurate with maintenance revenue growth. Additionally, we continued to experience a shift to higher skilled support resources that carry a higher cost to meet the needs of our enterprise customers.

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Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Other revenue Year ended December 31, (in millions) 2011 2010 Change % Change Other revenue $ 8.5 $ 6.7 $ 1.8 27 % Cost of other revenue 7.0 7.1 (0.1 ) (1 )% Other gross profit $ 1.5 $ (0.4 ) $ 1.9 (475 )% Other gross margin 18 % (6 )% Other revenue for 2011 and 2010 included the sale of business forms that are used in conjunction with our software products, reimbursement of travel-related expenses, primarily incurred during the performance of services at customer locations, fees from user conferences and third-party software referral fees.

Other revenue increased in 2011 when compared to 2010 primarily due to an increase in revenue from third-party software referral fees and in reimbursement of travel-related expenses associated with the growth in services revenue.

Cost of other revenue for 2011 and 2010 included human resource costs, costs of business forms, costs of user conferences, reimbursable expenses relating to the performance of services at customer locations, an allocation of depreciation, facilities and IT support costs and amortization of intangibles from business combinations. In total, cost of other revenue in 2011 when compared to 2010 decreased by $0.1 million due to a reduction in user conference expenses offset by an increase in reimbursable expenses.

Other gross margin increased in 2011 when compared to 2010 due to an increase in revenue from third-party software referral fees and a reduction in the cost of user conferences.

Operating expenses Sales and marketing Year ended December 31, (in millions) 2011 2010 Change % Change Sales and marketing expense $ 75.4 $ 69.5 $ 5.9 8 % % of revenue 20 % 21 % Sales and marketing expense for 2011 and 2010 included salaries and related human resource costs, stock-based compensation expense, travel-related expenses, sales commissions, advertising and marketing materials, public relations and an allocation of depreciation, facilities and IT support costs. During 2011, sales and marketing expense increased by $5.9 million when compared to 2010 primarily due to an increase of $3.6 million in human resource costs and $2.0 million in commission expense. The increase in human resource costs was a result of additional headcount to support the increase in selling and marketing efforts of our growing operations. The increase in commission expense was principally attributable to an increase in commissionable revenue in 2011. Additionally, marketing programs increased by $0.3 million relating to the launch of our new corporate branding and an increase in marketing costs associated with our new packaged offerings.

As a percentage of revenue, sales and marketing expense in 2011 when compared to 2010 decreased principally as a result of our ability to leverage our sales support and marketing resources as we standardized and simplified our packaged offerings.

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Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Research and development Year ended December 31, (in millions) 2011 2010 Change % Change Research and development expense $ 47.7 $ 45.5 $ 2.2 5 % % of revenue 13 % 14 % Research and development expense for 2011 and 2010 included human resource costs, stock-based compensation expense, third-party contractor expenses, software development tools and other expenses related to developing new products, upgrading and enhancing existing products, and an allocation of depreciation, facilities and IT support costs. During 2011, human resource and third-party costs increased by $3.0 million partially offset by an increase in the amount of software development costs that were capitalized of $0.8 million.

Human resource and third-party contractor costs increased as we continued to invest in our product development efforts. The increase in amount of costs that are capitalized was primarily due to development efforts with our events management solution.

Research and development costs as a percentage of revenue decreased in 2011 when compared to 2010 principally due to the increase in the amount of development costs that were capitalized in 2011 as compared to 2010.

General and administrative Year ended December 31, (in millions) 2011 2010 Change % Change General and administrative expense $ 36.9 $ 32.6 $ 4.3 13 % % of revenue 10 % 10 % General and administrative expense for 2011 and 2010 consisted primarily of human resource costs for general corporate functions, including senior management, finance, accounting, legal, human resources, corporate development, stock-based compensation expense, third-party professional fees, insurance, an allocation of depreciation, facilities and IT support costs, acquisition related expense and other administrative expenses. During 2011, general and administrative expense increased primarily due to $1.3 million and $1.1 million increases in stock-based compensation expense and human resource costs, respectively, a $0.8 million increase in acquisition-related expenses, $0.5 million in third-party professional consulting fees and $0.3 million in recruiting costs associated with hiring key executives in 2011.

Acquisition-related costs related primarily to the acquisition of PIDI, EDH and the pending acquisition of Convio. Stock-based compensation increased due to a change in the type of equity awards granted to certain executives to be performance-based, for which expense is recognized on an accelerated basis.

43-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Non-GAAP income from operations The operating results analyzed below are presented on a non-GAAP basis in that the results exclude the impact of stock-based compensation expense, amortization expense, acquisition-related expenses, impairment of cost method investment and gain on sale of assets. We believe that the exclusion of these costs allows us and investors to better understand our operating expenses and cash needs, particularly when evaluating current performance against prior periods.

Year ended December 31, (in millions) 2011 2010 Change % Change GAAP income from operations $ 50.9 $ 46.0 $ 4.9 11 % Non-GAAP adjustments: Add: Stock-based compensation expense 14.9 13.1 1.8 14 % Add: Amortization of intangibles from business combinations 7.6 7.1 0.5 7 % Add: Acquisition-related expenses 1.8 1.0 0.8 80 % Add: Impairment of cost method investment 1.8 - 1.8 100 % Less: Gain on sale of assets (0.5 ) - (0.5 ) 100 % Total Non-GAAP adjustments 25.6 21.2 4.4 21 % Non-GAAP income from operations $ 76.5 $ 67.2 $ 9.3 14 % Non-GAAP operating margin 21 % 21 % The increase in non-GAAP income from operations was consistent with the overall increase in revenue of 14% and was principally attributable to the growth in gross profit in our subscriptions and services operations as discussed above, partially offset by investments, in the form of non-billable implementation hours, we made during 2011 in early adopters of our Blackbaud CRM offering.

Interest expense Interest expense increased $5.7 million during 2012 when compared to 2011. This increase in interest expense is directly related to the borrowings we incurred to fund our acquisition of Convio in May 2012.

Income tax provision The following is our effective tax rate for the years ended December 31: 2012 2011 2010 Effective tax rate 50.6 % 35.2 % 36.5 % The effective rate in 2012 increased when compared to 2011 primarily due to a decrease in pre-tax income, reduction in federal research and development credits and nondeductible transaction costs associated with the Convio acquisition. In January 2013, the federal research and development credit was reinstated with retrospective application to the 2012 tax year. Our estimated 2012 tax credit will be recorded as a discrete benefit in the first quarter of 2013. The effective tax rate in 2011 decreased when compared to 2010 due to the change in our valuation allowances. In 2011, we reversed $1.0 million of valuation allowance for certain state net operating loss carryforwards in connection with the completion of certain state tax planning strategies.

We record our deferred tax assets and liabilities at an amount based upon a U.S.

federal income tax rate of 35.0% and appropriate statutory tax rates of various foreign, state and local jurisdictions in which we operate. If our tax rates change in the future, we would adjust our deferred tax assets and liabilities to an amount reflecting those income tax rates. Any change will affect the provision for income taxes during the period that the determination is made.

44-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) We file income tax returns in the U.S. for federal and various state jurisdictions as well as in foreign jurisdictions including Canada, United Kingdom, Australia and the Netherlands. We are generally subject to U.S. federal income tax examination for calendar tax years ending 2009 through 2011 as well as state and foreign income tax examinations for various years depending on statute of limitations of those jurisdictions.

We have taken federal tax positions in certain taxing jurisdictions related for which it is reasonably possible that the total amount of unrecognized tax benefits may decrease within the next twelve months. The possible decrease could result from the expiration of statutes of limitations. The reasonably possible decrease approximates $0.9 million at December 31, 2012.

Liquidity and capital resources At December 31, 2012, cash and cash equivalents totaled $13.5 million, compared to $52.5 million at December 31, 2011. During 2012, we generated $68.7 million of cash flow from operations and borrowed $315.0 million under our credit facility. We used our cash flow from operations, borrowings under the credit facility and cash on hand to fund the $280.4 million acquisition of Convio, pay dividends of $21.7 million and purchase $20.6 million of computer software and equipment. Additionally, we repaid $99.5 million of borrowings during 2012.

Our principal source of liquidity is our operating cash flow, which depends on continued customer renewal of our maintenance, support and subscription agreements and market acceptance of our products and services. Based on current estimates of revenue and expenses, we believe that the currently available sources of funds and anticipated cash flows from operations will be adequate for at least the next 12 months to finance our operations, fund anticipated capital expenditures, meet our debt obligations and pay dividends. Dividend payments are not guaranteed and our Board of Directors may decide, in its absolute discretion, at any time and for any reason, not to declare or pay further dividends and/or repurchase our common stock.

We have drawn on our credit facility from time to time to help us meet financial needs, such as business acquisitions and purchases of common stock under our repurchase program. In February 2012, we amended and restated our credit facility to increase the available borrowing capacity to $325.0 million. The amended credit facility matures in February 2017. We believe our credit facility will provide us with sufficient flexibility to meet our future financial needs.

At December 31, 2012, we had $215.5 million of outstanding borrowings under our credit facility. Our average daily borrowings were $244.9 million during the period we had debt outstanding during 2012.

Following is a summary of the financial covenants as defined by credit facility: Ratio as of December Financial Covenant Requirement 31, 2012 Leverage Ratio < 3.00 to 1.00 2.31 to 1.00 Interest Coverage Ratio > 3.50 to 1.00 16.61 to 1.00 Maximum Capital Expenditures $40.0 million for the $22.6 million fiscal year ended December 31, 2012 Under our credit facility, we also have restrictions on our ability to declare and pay dividends and our ability to repurchase shares of our common stock. In order to pay any cash dividends and/or repurchase shares of stock: (1) no default or event of default shall have occurred and be continuing under the credit facility, and (2) we must be in compliance with the leverage ratio set forth in the credit agreement. At December 31, 2012, we were in compliance with all debt covenants under our credit facility.

At December 31, 2012, our total cash and cash equivalents balance includes approximately $4.7 million of cash that was held by operations outside the U.S.

While these funds may not be needed to fund our U.S. operations for at least the next 12 months, if we need these funds, we would be required to accrue and pay taxes to repatriate the funds. Our current plans anticipate repatriating undistributed earnings in Canada. We currently do not anticipate a need to repatriate our other cash held outside the U.S.

Operating cash flow Net cash provided by operating activities of $68.7 million decreased by $16.8 million during 2012. Throughout both 2012 and 2011, our cash flows from operations were derived principally from: (i) our earnings from on-going operations prior to non-cash expenses such as depreciation, amortization and stock-based compensation and adjustments to our provision for sales 45-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) returns and allowances; (ii) the tax benefit associated with our deferred tax asset, which reduces our cash outlay for income tax expense; and (iii) changes in our working capital.

Working capital changes as they impact the statement of cash flows are composed of changes in accounts receivable, prepaid expenses and other assets, accounts payable, accrued expenses and other liabilities and deferred revenue. Cash flow from operations associated with working capital decreased $8.9 million in 2012 when compared to 2011. This net decrease is principally due to an increase in the amount of cash paid for income taxes, fluctuations in the timing of vendor payments, partially offset by a decrease in the amount of deferred commissions and other deferred costs.

Investing cash flow Net cash used in 2012 for investing activities was $302.5 million compared to $41.7 million in 2011. The increase is due to the acquisition of Convio in May 2012. Additionally, we increased the amount spent on computer equipment and software associated with the infrastructure that supports our subscription-based offerings from $18.2 million in 2011 to $20.6 million in in 2012.

Financing cash flow During 2012, we received proceeds from borrowings of $315.0 million under our credit facility to fund the acquisition of Convio and made debt repayments of $99.5 million. We paid dividends of $21.7 million which was relatively consistent with the amount paid in 2011.

Commitments and contingencies As of December 31, 2012, we had future minimum commitments as follows: Payments due by period More than 5 (in millions) Total Less than 1 year 1-2 years 3-5 years years Operating leases $ 83.8 $ 10.3 $ 17.9 $ 14.7 $ 40.9 Debt and interest(1) 237.2 16.0 39.4 181.8 - Total $ 321.0 $ 26.3 $ 57.3 $ 196.5 $ 40.9 (1) Included in the table above is $21.7 million of interest. The actual interest expense recognized in our consolidated statements of comprehensive income will depend on the amount of debt, the length of time the debt is outstanding and the interest rate, which could be different from our assumptions used in the above table.

The term loans under our credit facility require periodic principal payments.

The balance of the term loans and any amounts drawn on the revolving credit loans are due upon maturity of the credit facility in February 2017. Our commitments related to operating leases have not been reduced by the future minimum lease commitments under sublease agreements, incentive payments and reimbursement of leasehold improvements.

We utilize third-party relationships in conjunction with our products. The contractual arrangements vary in length from one to three years. In certain cases, these arrangements require a minimum annual purchase commitment. The total remaining minimum purchase commitments under these arrangements at December 31, 2012, were approximately $4.5 million through 2015. We incurred expense under these arrangements of $1.3 million, $3.2 million and $1.7 million for the years ended December 31, 2012, 2011 and 2010, respectively.

In February 2013, our Board of Directors approved our annual dividend rate of $0.48 per share for 2013. Dividends at the annual rate would aggregate to $22.1 million assuming 46.0 million shares of common stock are outstanding. Our ability to continue to declare and pay dividends quarterly this year and beyond might be restricted by, among other things, the terms of our credit facility, general economic conditions and our ability to generate adequate operating cash flow.

46-------------------------------------------------------------------------------- Off-balance sheet arrangements We do not have any off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons.

Foreign currency exchange rates Approximately 14% of our total net revenue for the year ended December 31, 2012 was derived from operations outside the United States. We do not have significant operations in countries in which the economy is considered to be highly inflationary. Our consolidated financial statements are denominated in U.S. dollars and, accordingly, changes in the exchange rate between foreign currencies and the U.S. dollar will affect the translation of our subsidiaries' financial results into U.S. dollars for purposes of reporting our consolidated financial results. The accumulated currency translation adjustment, recorded within other comprehensive loss as a component of stockholders' equity, was a loss of $1.2 million and $1.1 million at December 31, 2012 and December 31, 2011, respectively.

The vast majority of our contracts are entered into by our U.S., Canadian or U.K. entities. The contracts entered into by the U.S. entity are almost always denominated in U.S. dollars, contracts entered into by our Canadian subsidiary are generally denominated in Canadian dollars, and contracts entered into by our U.K., Australian and the Netherlands subsidiaries are generally denominated in pounds sterling, Australian dollars and Euros, respectively. Historically, as the U.S. dollar weakened, foreign currency translation resulted in an increase in our revenues and expenses denominated in non-U.S. currencies. During 2012, foreign translation resulted in a decrease in our revenues and expenses denominated in non-U.S. currencies. Though we do not believe our exposure to currency exchange rates has had a material impact on our consolidated results of operations or financial position, we intend to continue to monitor such exposure and take action as appropriate.

Critical accounting policies and estimates Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. On an ongoing basis, we reconsider and evaluate our estimates and assumptions, including those that impact revenue recognition, long-lived and intangible assets and goodwill, stock-based compensation, the provision for income taxes, capitalization of software development costs, our allowance for sales returns and doubtful accounts, deferred sales commissions, accounting for business combinations and loss contingencies.

We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from any of our estimates under different assumptions or conditions. We believe the critical accounting policies listed below affect significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue recognition Our revenue is primarily generated from the following sources: (i) charging for the use of our software products in a hosted environment; (ii) selling perpetual licenses of our software products; (iii) providing professional services including implementation, training, consulting, analytic, hosting and other services; and (iv) providing software maintenance and support services.

We recognize revenue when all of the following conditions are met: •Persuasive evidence of an arrangement exists; •The product or services has been delivered; •The fee is fixed or determinable; and •Collection of the resulting receivable is probable.

47-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Determining whether and when these criteria have been met can require significant judgment and estimates. We deem acceptance of an agreement to be evidence of an arrangement. Delivery for our products occurs when the product is shipped or transmitted, and title and risk of loss have transferred to the customers. Our typical agreements do not include customer acceptance provisions; however, if acceptance provisions are provided, delivery is deemed to occur upon acceptance. We consider the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within our standard payment terms. Payment terms greater than 90 days are considered to be beyond our customary payment terms. Collection is deemed probable if we expect that the customer will be able to pay amounts under the arrangement as they become due.

If we determine that collection is not probable, we defer revenue recognition until collection. Revenue is recognized net of sales returns and allowances.

Subscriptions We provide hosting services to customers who have purchased perpetual rights to certain of our software products (hosting services). Revenue from hosting services, as well as data enrichment services, data management services and online training programs is recognized ratably beginning on the activation date over the term of the agreement, which generally ranges from one to three years.

Any related set-up fees are recognized ratably over the estimated period that the customer benefits from the related hosting service.

We make certain of our software products available for use in hosted application arrangements without licensing perpetual rights to the software (hosted applications). Revenue from hosted applications is recognized ratably beginning on the activation date over the term of the agreement, which generally ranges from one to three years. Any revenue related to upfront activation, set-up or implementation fees is recognized ratably over the estimated period that the customer benefits from the related hosted application. Direct and incremental costs relating to activation, set-up and implementation for hosted applications are capitalized until the hosted application is deployed and in use, and then expensed over the estimated period that the customer benefits from the related hosted application.

For arrangements that have multiple elements and do not include software licenses, we allocate arrangement consideration at the inception of the arrangement to those elements that qualify as separate units of accounting. The arrangement consideration is allocated to the separate units of accounting based on relative selling price method in accordance with the selling price hierarchy, which includes: (i) vendor specific objective evidence (VSOE) if available; (ii) third-party evidence (TPE) if VSOE is not available; and (iii) best estimate of selling price if neither VSOE nor TPE is available. In general, we use VSOE to allocate the selling price to subscription and service deliverables.

Revenue from transaction processing fees is recognized when the amounts are determined, reported and billed. Credit card fees directly associated with processing donations for customers are included in subscriptions revenue, net of related transaction costs.

License fees We sell software licenses with maintenance, varying levels of professional services and, in certain instances, with hosting services. We allocate revenue to each of the elements in these arrangements using the residual method under which we first allocate revenue to the undelivered elements, typically the non-software license components, based on objective evidence of the fair value of the various elements. We determine the fair value of the various elements using different methods. Fair value for maintenance services associated with software licenses is based upon renewal rates stated in the agreements with customers, which vary according to the level of support service provided under the maintenance program. Fair value of professional services and other products and services is based on sales of these products and services to other customers when sold on a stand-alone basis. Any remaining revenue is allocated to the delivered elements which is normally the software license in the arrangement.

When a software license is sold with software customization services, generally the services are to provide customer support for assistance in creating special reports and other enhancements that will assist with efforts to improve operational efficiency and/or to support business process improvements. These services are not essential to the functionality of the software. However, when software customization services are considered essential to the functionality of the software, we recognize revenue for both the software license and the services using the percentage-of-completion method.

48-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Services We generally bill consulting, installation and implementation services based on hourly rates plus reimbursable travel-related expenses. Revenue is recognized for these services over the period the services are performed.

We recognize analytic services revenue from donor prospect research engagements, the sale of lists of potential donors, benchmarking studies and data modeling service engagements upon delivery. In arrangements where we provide customers the right to updates to the lists during the contract period, revenue is recognized ratably over the contract period.

We sell training at a fixed rate for each specific class at a per attendee price or at a packaged price for several attendees, and recognize the related revenue upon the customer attending and completing training. Additionally, we sell fixed-rate programs, which permit customers to attend unlimited training over a specified contract period, typically one year, subject to certain restrictions, and revenue is recognized ratably over this contract period.

Maintenance We recognize revenue from maintenance services ratably over the contract term, typically one year. Maintenance contracts are at rates that vary according to the level of the maintenance program and are generally renewable annually.

Maintenance contracts also include the right to unspecified product upgrades on an if-and-when available basis. Certain support services are sold in prepaid units of time and recognized as revenue upon their usage.

Deferred revenue To the extent that our customers are billed for the above described services in advance of delivery, we record such amounts in deferred revenue.

Valuation of long-lived and intangible assets and goodwill We review identifiable intangible and other long-lived assets for impairment when events change or circumstances indicate the carrying amount may not be recoverable. Events or changes in circumstances that indicate the carrying amount may not be recoverable include, but are not limited to, a significant decrease in the market value of the business or asset acquired, a significant adverse change in the extent or manner in which the business or asset acquired is used or significant adverse change in the business climate. If such events or changes in circumstances occur, we use the undiscounted cash flow method to determine whether the asset is impaired. Cash flows would include the estimated terminal value of the asset and exclude any interest charges. To the extent that the carrying value of the asset exceeds the undiscounted cash flows over the estimated remaining life of the asset, we measure the impairment using discounted cash flows. The discount rate utilized would be based on our best estimate of our risks and required investment returns at the time the impairment assessment is made.

Goodwill is assigned to our five reporting units, which are defined as our four operating segments (see Note 16 to our consolidated financial statements), and Blackbaud Payment Services. We test goodwill for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. We first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Significant judgment is required in the assessment of qualitative factors. To the extent the qualitative factors indicate that the fair value is likely less than the carrying amount, we compare the fair value of the reporting unit with its carrying amount.

We estimate fair value for each reporting unit based on projected future cash flows discounted using our weighted average cost of capital. A number of significant assumptions and estimates are involved in estimating the fair value of each reporting unit, including revenue growth rates, operating margins, capital spending, discount rate, and working capital changes. Additionally, we make certain judgments and assumptions in allocating assets and liabilities to determine the carrying values for each of our reporting units. We believe the assumptions we use in estimating fair value of our reporting units are reasonable, but are also unpredictable and inherently uncertain. Actual future results may differ from those estimates.

If the carrying amount exceeds its fair value, impairment is indicated. If an impairment is indicated, the impairment is measured as the excess of the recorded goodwill over its fair value, which could materially adversely impact our consolidated financial position and results of operations. The 2012 annual impairment test of our goodwill indicated there was no impairment.

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Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Stock-based compensation We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense over the requisite service period, which is the vesting period. We determine the fair value of stock options and stock appreciation rights using a Black-Scholes option pricing model, which requires us to use significant judgment to make estimates regarding the life of the award, volatility of our stock price, the risk-free interest rate and the dividend yield of our stock over the life of the award. We determine the fair value of awards that contain market conditions using a Monte Carlo simulation model. Changes to these estimates would result in different fair values of awards.

We estimate the number of awards that will be forfeited and recognize expense only for those awards that ultimately vest. Significant judgment is required in determining the adjustment to compensation expense for estimated forfeitures.

Compensation expense in a period could be impacted, favorably or unfavorably, by differences between estimated and actual forfeitures.

Income taxes We make estimates and judgments in accounting for income taxes. The calculation of income tax provision requires estimates due to transactions, credits and calculations where the ultimate tax determination is uncertain. Uncertainties arise as a consequence of the actual source of taxable income between domestic and foreign locations, the outcome of tax audits and the ultimate utilization of tax credits. To the extent actual results differ from estimated amounts recorded, such differences will impact the income tax provision in the period in which the determination is made.

We make estimates in determining tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. We record valuation allowances to reduce our deferred tax assets to the amount expected to be realized. In assessing the adequacy of a recorded valuation allowance significant judgment is required. We consider all positive and negative evidence and a variety of factors including the scheduled reversal of deferred tax liabilities, historical and projected future taxable income, and prudent and feasible tax planning strategies. If we determine there is less than a 50% likelihood that we will be able to use a deferred tax asset in the future in excess of its net carrying value, then an adjustment to the deferred tax asset valuation allowance is made to reduce income tax expense, thereby increasing net income in the period such determination was made.

We measure and recognize uncertain tax positions. To recognize such positions we must first determine if it is more likely than not that the position will be sustained on audit. We must then measure the benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. Significant judgment is required in the identification and measurement of uncertain tax positions.

Software Development Costs The costs incurred in the preliminary stages of internal use software development are expensed as incurred. Once an application has reached the development stage, internal and external costs, if direct and incremental, are capitalized until the software is substantially complete and ready for its intended use. Judgment is required in determining when the development stage of a product has been reached. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Capitalized costs are recorded as part of computer software costs. Internal use software is amortized on a straight line basis over its estimated useful life, generally three years.

Costs for the development of software to be sold are expensed as incurred until technological feasibility has been established, at which time such costs are capitalized until the product is available for general release to customers.

Judgment is required in determining when technological feasibility of a product is established. Technological feasibility is considered to be achieved when a working model of the software product has been completed. Capitalized software development costs include direct labor costs and fringe benefit costs attributed to programmers, software engineers and quality control teams working on products after they reach technological feasibility but before they are generally available to customers for sale. Capitalized software development costs are typically amortized over the estimated product life of generally three years, on a straight-line basis.

50-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Sales returns and allowance for doubtful accounts We provide customers a 30-day right of return and under certain circumstances we provide service related credits to our customers. We maintain a reserve for returns and credits which is estimated based on several factors including historical experience, known credits yet to be issued, the aging of customer accounts and the nature of service level commitments. A considerable amount of judgment is required in assessing these factors. Provisions for sales returns are charged against the related revenue items.

We maintain an allowance for doubtful accounts at an amount we estimate to be sufficient to provide adequate protection against losses resulting from extending credit to our customers. In judging the adequacy of the allowance for doubtful accounts, we consider multiple factors including historical bad debt experience, the general economic environment, the need for specific customer reserves and the aging of our receivables. A considerable amount of judgment is required in assessing these factors and if any receivables were to deteriorate, an additional provision for doubtful accounts could be required. Any necessary provision is reflected in general and administrative expense.

Deferred sales commissions We pay sales commissions at the time contracts with customers are signed or shortly thereafter, depending on the size and duration of the sales contract. To the extent that these commissions relate to revenue not yet recognized, the amounts are recorded as deferred sales commission costs. Subsequently, the commissions are recognized as expense as the revenue is recognized.

Business combinations We are required to allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed at the acquisition date based upon their estimated fair values. Goodwill as of the acquisition date represents the excess of the purchase consideration of an acquired business over the fair value of the underlying net tangible and intangible assets acquired and liabilities assumed. This allocation and valuation require management to make significant estimates and assumptions, especially with respect to long-lived and intangible assets.

Critical estimates in valuing intangible assets include but are not limited to estimates about: future expected cash flows from customer contracts, proprietary technology and non-compete agreements; the acquired company's brand awareness and market position, assumptions about the period of time the brand will continue to be; as well as expected costs to develop the in-process research and development into commercially viable products and estimated cash flows from the projects when completed, and discount rates. Our estimates of fair value are based upon assumptions we believe to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.

Contingencies We are subject to the possibility of various loss contingencies in the normal course of business. We record an accrual for a contingency when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Often these issues are subject to substantial uncertainties and, therefore, the probability of loss and the estimation of damages are difficult to ascertain. These assessments can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions that have been deemed reasonable by us. Although we believe we have substantial defenses in these matters, we could incur judgments or enter into settlements of claims that could have a material adverse effect on our consolidated financial position, results of operations or cash flows in any particular period.

Recently adopted accounting pronouncements Effective January 1, 2012, we adopted ASU 2011-05, Presentation of Comprehensive Income, which (i) eliminates the option to present components of other comprehensive income, or OCI, as part of the statement of changes in stockholders' equity and (ii) requires the presentation of each component of net income and each component of OCI either in a single continuous statement or in two separate but consecutive statements. The adoption of ASU 2011-05 did not have a material impact on our consolidated financial statements. We have presented each component of net income and OCI in a single continuous statement.

Effective January 1, 2012, we adopted ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards, which amends ASC 820, Fair Value 51-------------------------------------------------------------------------------- Table of Contents Blackbaud, Inc.Item 7. Management's discussion and analysis of financial condition and results of operations (continued) Measurement. ASU 2011-04 provides common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and International Financial Reporting Standards (IFRS) and improves the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRS. ASU 2011-04 is effective for entities prospectively for interim and annual periods beginning after December 15, 2011. The adoption of ASU 2011-04 did not have a material impact on our consolidated financial statements.

Recently issued accounting pronouncements In February 2013, the FASB issued ASU 2013-02, Comprehensive Income (Topic 220) Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. ASU 2013-02 is effective prospectively for reporting periods beginning after December 15, 2012. We do not anticipate any material impact from the adoption of ASU 2013-02.

In July 2012, the FASB issued ASU 2012-02, Intangibles - Goodwill and Other (Topic 350) Testing Indefinite-Lived Intangible Assets for Impairment, which simplifies how entities test indefinite-lived intangible assets for impairment.

ASU 2012-02 permits an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test currently required by ASC Topic 350-30 on general intangibles other than goodwill. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012.

Early adoption is permitted, provided that the entity has not yet issued its financial statements. We do not anticipate any material impact from the adoption of ASU 2012-02.

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