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Section 1: 10-Q (10-Q)

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Table of Contents

 

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 September 30, 2016

or
 
¨     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: 001-35198
Pandora Media, Inc.
(Exact name of registrant as specified in its charter)
Delaware
94-3352630
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
2101 Webster Street, Suite 1650
Oakland, CA
94612
(Address of principal executive offices)
(Zip Code)
(510) 451-4100
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o
 
Indicate by check mark whether the registrant has submitted electronically and posted to 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, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
(Do not check if a smaller reporting company)
 
 
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
 
The number of shares of registrant’s common stock outstanding as of October 25, 2016 was: 233,335,503.

 

Table of Contents

Pandora Media, Inc.
 
FORM 10-Q Quarterly Report
 
Table of Contents
 
 
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2

Table of Contents

PART I. FINANCIAL INFORMATION
 
Item 1. Financial Statements

Pandora Media, Inc.
Condensed Consolidated Balance Sheets
(in thousands, except share and per share amounts)
 (unaudited)
 
As of December 31,
2015
 
As of September 30,
2016
Assets
 
 
 
Current assets
 

 
 

Cash and cash equivalents
$
334,667

 
$
207,695

Short-term investments
35,844

 
50,052

Accounts receivable, net of allowance of $2,165 at December 31, 2015 and $3,023 at September 30, 2016
277,075

 
282,802

Prepaid content acquisition costs
2,099

 
102,623

Prepaid expenses and other current assets
33,821

 
34,166

Total current assets
683,506

 
677,338

Long-term investments
46,369

 
6,273

Property and equipment, net
66,370

 
118,453

Goodwill
303,875

 
306,706

Intangible assets, net
110,745

 
95,565

Other long-term assets
29,792

 
32,528

Total assets
$
1,240,657

 
$
1,236,863

Liabilities and stockholders’ equity
 

 
 

Current liabilities
 

 
 

Accounts payable
$
17,897

 
$
13,983

Accrued liabilities
37,185

 
33,968

Accrued content acquisition costs
97,390

 
106,275

Accrued compensation
43,788

 
52,089

Deferred revenue
19,939

 
31,971

Other current liabilities
15,632

 
20,739

Total current liabilities
231,831

 
259,025

Long-term debt, net
234,577

 
337,429

Other long-term liabilities
30,862

 
33,402

Total liabilities
497,270

 
629,856

Stockholders’ equity
 

 
 

Common stock: 224,970,412 shares issued and outstanding at December 31, 2015 and 233,312,446 at September 30, 2016
23

 
23

Additional paid-in capital
1,110,539

 
1,227,197

Accumulated deficit
(366,658
)
 
(619,627
)
Accumulated other comprehensive loss
(517
)
 
(586
)
Total stockholders’ equity
743,387

 
607,007

Total liabilities and stockholders’ equity
$
1,240,657

 
$
1,236,863

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

3

Table of Contents

Pandora Media, Inc.
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts)
(unaudited)
 
 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
 
2015
 
2016
 
2015
 
2016
Revenue
 
 
 
 
 
 
 
Advertising
$
254,656

 
$
273,716

 
$
664,316

 
$
759,150

Subscription and other
56,906

 
56,100

 
163,570

 
165,957

Ticketing service

 
22,085

 

 
67,121

Total revenue
311,562

 
351,901

 
827,886

 
992,228

Cost of revenue
 
 
 
 
 
 
 
Cost of revenue - Content acquisition costs
211,272

 
174,334

 
467,429

 
522,231

Cost of revenue - Other
21,414

 
25,556

 
57,690

 
71,388

Cost of revenue - Ticketing service

 
15,318

 

 
45,223

Total cost of revenue
232,686

 
215,208

 
525,119

 
638,842

Gross profit
78,876

 
136,693

 
302,767

 
353,386

Operating expenses
 
 
 
 
 
 
 
Product development
21,849

 
33,657

 
56,466

 
103,311

Sales and marketing
107,286

 
116,475

 
285,595

 
357,909

General and administrative
35,603

 
41,768

 
111,169

 
128,626

Total operating expenses
164,738

 
191,900

 
453,230

 
589,846

Loss from operations
(85,862
)
 
(55,207
)
 
(150,463
)
 
(236,460
)
Interest expense
(131
)
 
(6,494
)
 
(386
)
 
(18,916
)
Other income, net
95

 
579

 
803

 
1,696

Total other income (expense), net
(36
)
 
(5,915
)
 
417

 
(17,220
)
Loss before benefit from (provision for) income taxes
(85,898
)
 
(61,122
)
 
(150,046
)
 
(253,680
)
Benefit from (provision for) income taxes
(32
)
 
(412
)
 
(206
)
 
711

Net loss
$
(85,930
)
 
$
(61,534
)
 
$
(150,252
)
 
$
(252,969
)
Weighted-average common shares outstanding used in computing basic and diluted net loss per share
212,760

 
232,139

 
211,487

 
229,524

Net loss per share, basic and diluted
$
(0.40
)
 
$
(0.27
)
 
$
(0.71
)
 
$
(1.10
)
 
The accompanying notes are an integral part of the condensed consolidated financial statements.


4

Table of Contents

Pandora Media, Inc.
Condensed Consolidated Statements of Comprehensive Loss
(in thousands)
(unaudited)
 
 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
 
2015
 
2016
 
2015
 
2016
Net loss
$
(85,930
)
 
$
(61,534
)
 
$
(150,252
)
 
$
(252,969
)
Change in foreign currency translation adjustment
(127
)
 
(129
)
 
(274
)
 
(417
)
Change in net unrealized gains (loss) on marketable securities
50

 
(45
)
 
324

 
348

Other comprehensive income (loss)
(77
)
 
(174
)
 
50

 
(69
)
Total comprehensive loss
$
(86,007
)
 
$
(61,708
)
 
$
(150,202
)
 
$
(253,038
)
 
The accompanying notes are an integral part of the condensed consolidated financial statements.


5

Table of Contents

Pandora Media, Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited) 
 
Nine months ended 
 September 30,
 
2015
 
2016
Operating activities
 

 
 

Net loss
$
(150,252
)
 
$
(252,969
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities
 

 
 

Depreciation and amortization
15,194

 
43,480

Stock-based compensation
79,473

 
103,841

Amortization of premium on investments, net
1,712

 
339

Other operating activities
1,610

 
2,884

Amortization of debt discount

 
13,587

Changes in operating assets and liabilities
 

 
 
Accounts receivable
(45,796
)
 
(8,338
)
Prepaid content acquisition costs
(167
)
 
(100,524
)
Prepaid expenses and other assets
(6,397
)
 
(12,655
)
Accounts payable, accrued and other current liabilities
29,601

 
(4,990
)
Accrued content acquisition costs
89,423

 
8,875

Accrued compensation
4,333

 
10,370

Other long-term liabilities
1,500

 
598

Deferred revenue
7,689

 
12,032

Reimbursement of cost of leasehold improvements
1,014

 
4,397

Net cash provided by (used in) operating activities
28,937

 
(179,073
)
Investing activities
 

 
 

Purchases of property and equipment
(21,336
)
 
(46,400
)
Internal-use software costs
(5,997
)
 
(22,339
)
Changes in restricted cash

 
(250
)
Purchases of investments
(138,721
)
 
(12,413
)
Proceeds from maturities of investments
179,799

 
34,816

Proceeds from sale of investments
41,317

 
3,507

Payments related to acquisitions, net of cash acquired
(23,028
)
 
(676
)
Net cash provided by (used in) investing activities
32,034

 
(43,755
)
Financing activities
 

 
 

Borrowings under debt arrangements

 
90,000

Proceeds from employee stock purchase plan
5,089

 
6,395

Proceeds from exercise of stock options
3,718

 
3,011

Payment of debt issuance costs

 
(32
)
Tax payments from net share settlements of restricted stock units
(2,295
)
 
(3,126
)
Net cash provided by financing activities
6,512

 
96,248

Effect of exchange rate changes on cash and cash equivalents
(459
)
 
(392
)
Net increase (decrease) in cash and cash equivalents
67,024

 
(126,972
)
Cash and cash equivalents at beginning of period
175,957

 
334,667

Cash and cash equivalents at end of period
$
242,981

 
$
207,695

Supplemental disclosures of cash flow information
 
 
 
Cash paid during the period for interest
$
343

 
$
3,336

Purchases of property and equipment recorded in accounts payable and accrued liabilities
$
1,328

 
$
8,321

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


6

Table of Contents
Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements
(unaudited)


1.                       Description of Business and Basis of Presentation
 
Pandora

Pandora is the world’s most powerful music discovery platform, offering a personalized experience for each of our listeners wherever and whenever they want to listen to music—whether through earbuds, car speakers or live on stage. Our vision is to be the definitive source of music discovery and enjoyment for billions. The majority of our listener hours occur on mobile devices, with the majority of our revenue generated from advertising on these devices. We offer both local and national advertisers the opportunity to deliver targeted messages to our listeners using a combination of audio, display and video advertisements. We also generate revenue by offering an advertising-free subscription service which we call Pandora Plus. We were incorporated as a California corporation in January 2000 and reincorporated as a Delaware corporation in December 2010. Our principal operations are located in the United States, and we also operate in Australia, New Zealand and Canada.

Ticketing Service

Ticketfly is a leading live events technology company that provides ticketing and marketing software and services for venues and event promoters across North America. Ticketfly's ticketing, digital marketing and analytics software helps promoters book talent, sell tickets and drive in-venue revenue, while Ticketfly's consumer tools help fans find and purchase tickets to events. Ticketfly’s revenue primarily consists of service and merchant processing fees from ticketing operations. We completed the acquisition of Ticketfly on October 31, 2015.

As used herein, "Pandora," "we," "our," "the Company" and similar terms include Pandora Media, Inc. and its subsidiaries, unless the context indicates otherwise.
 
Basis of Presentation
 
The interim unaudited condensed consolidated financial statements and accompanying notes have been prepared in accordance with United States generally accepted accounting principles ("U.S. GAAP") along with the instructions to Form 10-Q and Article 10 of Securities and Exchange Commission ("SEC") Regulation S-X, and include the accounts of Pandora and our wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. In the opinion of our management, the interim unaudited condensed consolidated financial statements include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of our financial position for the periods presented. These interim unaudited condensed consolidated financial statements are not necessarily indicative of the results expected for the full fiscal year or for any subsequent period and should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2015.
 
Certain changes in presentation have been made to conform the prior period presentation to current period reporting. We have reclassified certain amounts from the accounts payable, accrued and other current liabilities line item to the long-term liabilities line item of our condensed consolidated statements of cash flows. We have also reclassified internal-use software costs from the purchases of property and equipment line item to the internal-use software costs line item of our condensed consolidated statements of cash flows. We have also reclassified prepaid content acquisition costs from the prepaid expenses and other assets line item to the prepaid content acquisition costs line item of our condensed consolidated balance sheets and our condensed consolidated statements of cash flows. Lastly, we have reclassified interest expense from the other income (expense), net line item to the interest expense line item of our condensed consolidated statements of operations.
 
Use of Estimates
 
The preparation of financial statements in conformity with U.S. GAAP requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the related disclosures at the date of the financial statements, as well as the reported amounts of revenue and expenses during the periods presented. Estimates are used in several areas including, but not limited to determining accrued content acquisition costs, amortization of minimum guarantees under content acquisition agreements, selling prices for elements sold in multiple-element arrangements, the allowance for doubtful accounts, the fair value of stock options, market stock units ("MSUs"), stock-settled performance-based RSUs ("PSUs") and the Employee Stock Purchase Plan ("ESPP"), the provision for (benefit from) income taxes and the impact of forfeitures on stock-based compensation. To the extent there are material differences between these estimates, judgments

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements
(unaudited)

or assumptions and actual results, our financial statements could be affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result.
 
2.                        Summary of Significant Accounting Policies
 
Other than discussed below, there have been no material changes to our significant accounting policies as compared to those described in our Annual Report on Form 10-K for the year ended December 31, 2015.

Prepaid Content Acquisition Costs

Prepaid content acquisition costs are primarily comprised of minimum guarantees under content acquisition agreements. From November 2015 through September 2016, we signed direct license agreements for recorded music with major and independent labels, distributors and publishers. Certain of these license agreements include minimum guarantee payments, some of which are paid in advance. These minimum guarantees may take the form of either a contractually obligated minimum over a specified period of time that requires a true-up payment at the end of the specified period if the cumulative payments have not met or exceeded the specified minimum, or cash advance payments made at the beginning of, or at intervals during, the specified period, which cash payments are then recoupable against content acquisition costs over the specified period. On a quarterly basis, we record the greater of the cumulative actual content acquisition costs incurred or the cumulative minimum guarantee based on forecasted usage for the minimum guarantee period. The minimum guarantee period is the period of time that the minimum guarantee relates to, as specified in each agreement, which may be annual or a longer period. The cumulative minimum guarantee, based on forecasted usage considers factors such as listening hours, revenue, subscribers and other terms of each agreement that impact our expected attainment or recoupment of the minimum guarantees on a non-straight line basis.

Concentration of Credit Risk
 
For the three and nine months ended September 30, 2015 and 2016, we had no customers that accounted for more than 10% of our total revenue. As of December 31, 2015 and September 30, 2016, we had no customers that accounted for more than 10% of our total accounts receivable.
 
Recently Issued Accounting Standards

In March 2016, the Financial Accounting Standards Board ("the FASB") issued Accounting Standards Update No. 2016-09, Compensation - Stock Compensation (Topic 718) ("ASU 2016-09"). ASU 2016-09 requires all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. Additionally, it allows an employer to repurchase more of an employee's shares for tax withholding purposes without triggering liability accounting and to make a policy election to account for forfeitures as they occur. The guidance is effective for fiscal years beginning after December 15, 2016, and interim periods within that fiscal year, although early adoption is permitted. We are currently evaluating implementation methods and the effect that implementation of this standard will have on our consolidated financial statements upon adoption.

In August 2014, the FASB issued Accounting Standards Update No. 2014-15, Going Concern (Subtopic 205-40) ("ASU 2014-15"). ASU 2014-15 requires management of all entities to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued (or available to be issued when applicable). The guidance is effective for fiscal years beginning after December 15, 2016 and for interim periods within that fiscal year. We do not expect the adoption of this guidance to have a material effect on our consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update No. 2014-9, Revenue from Contracts with Customers (Topic 606) ("ASU 2014-9"). ASU 2014-9 outlines a single comprehensive model for entities to use in accounting for revenue. Under the guidance, revenue is recognized when a company transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The standard may be effective for public entities with annual and interim reporting periods beginning after December 15, 2017. Entities have the option of using either a full retrospective or a modified retrospective approach to adopt the guidance. We are

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


currently evaluating implementation methods and the effect that implementation of this standard will have on our consolidated financial statements upon adoption.

In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases (Topic 842) ("ASU 2016-02"). ASU 2016-02 requires lessees to put most leases on their balance sheets but recognize expenses on their income statement and eliminates the real estate-specific provisions for all entities. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are currently evaluating implementation methods and the effect that implementation of this standard will have on our consolidated financial statements upon adoption.

3.                        Cash, Cash Equivalents and Investments
 
Cash, cash equivalents and investments consisted of the following:
 
 
As of 
 December 31, 
 2015
 
As of 
 September 30, 
 2016
 
(in thousands)
Cash and cash equivalents
 

 
 

Cash
$
104,361

 
$
130,132

Money market funds
180,021

 
33,446

Commercial paper
31,089

 
35,904

Corporate debt securities
2,000

 
8,213

U.S. government and government agency debt securities
17,196

 

Total cash and cash equivalents
$
334,667

 
$
207,695

Short-term investments
 

 
 

Commercial paper
$
4,792

 
$
1,000

Corporate debt securities
31,052

 
49,052

Total short-term investments
$
35,844

 
$
50,052

Long-term investments
 

 
 

Corporate debt securities
$
46,369

 
$
6,273

Total long-term investments
$
46,369

 
$
6,273

Cash, cash equivalents and investments
$
416,880

 
$
264,020


 
Our short-term investments have maturities of twelve months or less and are classified as available-for-sale. Our long-term investments have maturities of greater than twelve months and are classified as available-for-sale.
 
The following tables summarize our available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category as of December 31, 2015 and September 30, 2016.
 
 
As of December 31, 2015
 
Adjusted
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
 
(in thousands)
Money market funds
$
180,021

 
$

 
$

 
$
180,021

Commercial paper
35,881

 

 

 
35,881

Corporate debt securities
79,760

 
8

 
(347
)
 
79,421

U.S. government and government agency debt securities
17,198

 

 
(2
)
 
17,196

Total cash equivalents and marketable securities
$
312,860

 
$
8

 
$
(349
)
 
$
312,519



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Table of Contents
Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


 
As of September 30, 2016
 
Adjusted
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
 
(in thousands)
Money market funds
$
33,446

 
$

 
$

 
$
33,446

Commercial paper
36,904

 

 

 
36,904

Corporate debt securities
63,531

 
26

 
(19
)
 
63,538

Total cash equivalents and marketable securities
$
133,881

 
$
26

 
$
(19
)
 
$
133,888


 
The following table presents available-for-sale investments by contractual maturity date as of December 31, 2015 and September 30, 2016.
 
 
As of December 31, 2015
 
Adjusted
Cost
 
Fair Value
 
(in thousands)
Due in one year or less
$
266,205

 
$
266,150

Due after one year through three years
46,655

 
46,369

Total
$
312,860

 
$
312,519

 
As of September 30, 2016
 
Adjusted
Cost
 
Fair Value
 
(in thousands)
Due in one year or less
$
127,629

 
$
127,615

Due after one year through three years
6,252

 
6,273

Total
$
133,881

 
$
133,888


 
The following tables summarize our available-for-sale securities’ fair value and gross unrealized losses aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position as of December 31, 2015 and September 30, 2016.

 
As of December 31, 2015
 
Twelve Months or Less
 
More than Twelve Months
 
Total
 
Fair
Value
 
Gross Unrealized Losses
 
Fair
Value
 
Gross Unrealized Losses
 
Fair
Value
 
Gross Unrealized Losses
 
(in thousands)
Corporate debt securities
$
64,804

 
$
(293
)
 
$
8,531

 
$
(54
)
 
$
73,335

 
$
(347
)
U.S. government and government agency debt securities
16,241

 
(2
)
 

 

 
16,241

 
(2
)
Total
$
81,045

 
$
(295
)
 
$
8,531

 
$
(54
)
 
$
89,576

 
$
(349
)


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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


 
As of September 30, 2016
 
Twelve Months or Less
 
More than Twelve Months
 
Total
 
Fair
Value
 
Gross Unrealized Losses
 
Fair
Value
 
Gross Unrealized Losses
 
Fair
Value
 
Gross Unrealized Losses
 
(in thousands)
Corporate debt securities
$
33,240

 
$
(12
)
 
$
8,843

 
$
(7
)
 
$
42,083

 
$
(19
)
Total
$
33,240

 
$
(12
)
 
$
8,843

 
$
(7
)
 
$
42,083

 
$
(19
)


Our investment policy requires investments to be investment grade, primarily rated "A1" by Standard & Poor’s or "P1" by Moody’s or better for short-term investments and rated "A" by Standard & Poor’s or "A2" by Moody’s or better for long-term investments, with the objective of minimizing the potential risk of principal loss. In addition, the investment policy limits the amount of credit exposure to any one issuer.
 
The unrealized losses on our available-for-sale securities as of September 30, 2016 were primarily a result of unfavorable changes in interest rates subsequent to the initial purchase of these securities. As of September 30, 2016, we owned 32 securities that were in an unrealized loss position. Based on our cash flow needs, we may be required to sell a portion of these securities prior to maturity. However, we expect to recover the full carrying value of these securities. As a result, no portion of the unrealized losses at September 30, 2016 is deemed to be other-than-temporary and the unrealized losses are not deemed to be credit losses. When evaluating the investments for other-than-temporary impairment, we review factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer and any changes thereto, and our intent to sell, or whether it is more likely than not we will be required to sell, the investment before recovery of the investment’s amortized cost basis. During the three and nine months ended September 30, 2016, we did not recognize any impairment charges. During the three and nine months ended September 30, 2016, we had proceeds from the sale of available-for-sale securities of $3.0 million and $3.5 million. We did not recognize a realized gain or loss in connection with these sales.


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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


4.                        Fair Value
 
We record cash equivalents and short-term investments at fair value. Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. Fair value measurements are required to be disclosed by level within the following fair value hierarchy:
 
Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
 
Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.
 
Level 3 — Inputs lack observable market data to corroborate management’s estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
 
When determining fair value, whenever possible we use observable market data and rely on unobservable inputs only when observable market data is not available.
 
The fair value of these financial assets and liabilities was determined using the following inputs at December 31, 2015 and September 30, 2016:
 
 
As of December 31, 2015
 
Fair Value Measurement Using
 
Quoted Prices in Active Markets
for Identical
Instruments
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Total
 
(in thousands)
Assets
 

 
 

 
 

Money market funds
$
180,021

 
$

 
$
180,021

Commercial paper

 
35,881

 
35,881

Corporate debt securities

 
79,421

 
79,421

U.S. government and government agency debt securities

 
17,196

 
17,196

Total assets measured at fair value
$
180,021

 
$
132,498

 
$
312,519


 
As of September 30, 2016
 
Fair Value Measurement Using
 
Quoted Prices in Active Markets
for Identical
Instruments
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Total
 
(in thousands)
Assets
 

 
 

 
 

Money market funds
$
33,446

 
$

 
$
33,446

Commercial paper

 
36,904

 
36,904

Corporate debt securities

 
63,538

 
63,538

Total assets measured at fair value
$
33,446

 
$
100,442

 
$
133,888


 

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


Our money market funds are classified as Level 1 within the fair value hierarchy because they are valued primarily using quoted market prices. Our other cash equivalents and short-term investments are classified as Level 2 within the fair value hierarchy because they are valued using professional pricing sources for identical or comparable instruments, rather than direct observations of quoted prices in active markets. As of December 31, 2015 and September 30, 2016, we held no Level 3 assets or liabilities.

Refer to Note 7, "Debt Instruments," for the carrying amount and estimated fair value of our convertible senior notes, which are not recorded at fair value as of September 30, 2016.

5.                       Commitments and Contingencies

Minimum Guarantees - Content Acquisition Costs

Certain of our content acquisition agreements contain minimum guarantees, and require that we make upfront minimum guarantee payments. As of September 30, 2016, we have future minimum guarantee commitments of $780.1 million, of which $18.1 million will be paid in the three months ended December 31, 2016, $354.9 million will be paid in 2017 and the remainder will be paid thereafter. On a quarterly basis, we record the greater of the cumulative actual content acquisition costs incurred or the cumulative minimum guarantee based on forecasted usage for the minimum guarantee period. The minimum guarantee period is the period of time that the minimum guarantee relates to, as specified in each agreement, which may be annual or a longer period. The cumulative minimum guarantee, based on forecasted usage considers factors such as listening hours, revenue, subscribers and other terms of each agreement that impact our expected attainment or recoupment of the minimum guarantees on a non-straight line basis.

Legal Proceedings
 
We have been in the past, and continue to be, a party to various legal proceedings, which have consumed, and may continue to consume, financial and managerial resources. We record a liability when we believe that it is both probable that a loss has been incurred and the amount can be reasonably estimated. Our management periodically evaluates developments that could affect the amount, if any, of liability that we have previously accrued and make adjustments as appropriate. Determining both the likelihood and the estimated amount of a loss requires significant judgment, and management’s judgment may be incorrect. We do not believe the ultimate resolution of any pending legal matters is likely to have a material adverse effect on our business, financial position, results of operations or cash flows.

Pre-1972 copyright litigation

On April 17, 2014, UMG Recordings, Inc., Sony Music Entertainment, Capitol Records, LLC, Warner Music Group Corp. and ABKCO Music and Records, Inc. filed suit against Pandora Media Inc. in the Supreme Court of the State of New York. The complaint claims common law copyright infringement and unfair competition arising from allegations that Pandora owes royalties for the public performance of sound recordings recorded prior to February 15, 1972.

In October 2015, the parties reached an agreement ("pre-1972 settlement") whereby we agreed to pay the plaintiffs a total of $90 million. The settlement resolves all past claims as to our use of pre-1972 recordings owned or controlled by the plaintiffs and enables us, without any additional payment, to reproduce, perform and broadcast such recordings in the United States through December 31, 2016. This agreement was approved by our board of directors and executed on October 21, 2015. Pursuant to this settlement, we paid the plaintiffs $60 million in October 2015 and the plaintiffs dismissed the case with prejudice. As a result, cost of revenue - content acquisition costs increased by $65.4 million in the twelve months ended December 31, 2015, of which $57.9 million was related to a one-time cumulative charge to cost of revenue - content acquisition costs related to pre-1972 spins played through September 30, 2015. The remaining charge of $24.6 million will be recorded in cost of revenue - content acquisition costs in 2016 based on the allocation of pre-1972 listening throughout the remainder of the settlement period. The pre-72 settlement further required that we make four additional installment payments of $7.5 million each. The first was paid in December 2015, the second was paid in March 2016, the third was paid in June 2016 and the final installment was paid in September 2016.

On October 2, 2014, Flo & Eddie Inc. filed a class action suit against Pandora Media Inc. in the federal district court for the Central District of California. The complaint alleges misappropriation and conversion in connection with the public performance of sound recordings recorded prior to February 15, 1972. On December 19, 2014, Pandora filed a motion to strike

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


the complaint pursuant to California’s Anti-Strategic Lawsuit Against Public Participation ("Anti-SLAPP") statute. This motion was denied, and we have appealed the ruling to the Ninth Circuit Court of Appeals. As a result, the district court litigation has been stayed pending the Ninth Circuit's review. The Ninth Circuit has scheduled oral argument on December 8, 2016.

On September 14, 2015, Arthur and Barbara Sheridan, et al. filed a class action suit against Pandora Media, Inc. in the federal district court for the Northern District of California. The complaint alleges common law misappropriation, unfair competition, conversion, unjust enrichment and violation of California rights of publicity arising from allegations that we owe royalties for the public performance of sound recordings recorded prior to February 15, 1972. On October 28, 2015, the Court granted the parties’ stipulation to stay the district court action pending the Ninth Circuit’s review of Pandora’s appeal in Flo & Eddie et al. v. Pandora Media, Inc., which involves similar allegations.

On September 16, 2015, Arthur and Barbara Sheridan, et al. filed a second class action suit against Pandora Media, Inc. in the federal district court for the Southern District of New York. The complaint alleges common law copyright infringement, violation of New York right of publicity, unfair competition and unjust enrichment arising from allegations that we owe royalties for the public performance of sound recordings recorded prior to February 15, 1972. On October 28, 2015 the Court granted the parties’ stipulation to stay the district court action pending the Second Circuit’s review of Sirius XM’s appeal in the Flo & Eddie et al. v. Sirius XM matter, which involves similar allegations.

On October 17, 2015, Arthur and Barbara Sheridan, et al. filed a third class action suit against Pandora Media, Inc. in the federal district court for the Northern District of Illinois. The complaint alleges common law copyright infringement, violation of the Illinois Uniform Deceptive Trade Practices Act, conversion, and unjust enrichment arising from allegations that we owe royalties for the public performance of sound recordings recorded prior to February 15, 1972. On December 29, 2015, Pandora filed a motion to dismiss and a motion to stay the case pending the Second Circuit’s decision. The motion to stay was denied, and the motion to dismiss remains pending.

On October 19, 2015, Arthur and Barbara Sheridan, et al. filed a fourth class action suit against Pandora Media, Inc. in the federal district court for the District of New Jersey. The complaint alleges common law copyright infringement, unfair competition and unjust enrichment arising from allegations that we owe royalties for the public performance of sound recordings recorded prior to February 15, 1972. On December 29, 2015, Pandora filed a motion to dismiss and motion to stay the case pending the Second Circuit’s decision. On March 16, 2016, the district court granted the motion to stay. The motion to dismiss remains pending.

On September 7, 2016, Ponderosa Twins Plus One et al. filed a class action suit against Pandora Media, Inc. in the federal district court for the Southern District of California. The complaint alleges common law copyright infringement, violation of the California Civil Code, misappropriation, unfair business practices and conversion arising from allegations that we owe royalties for the public performance of sound recordings recorded prior to February 15, 1972. On October 5, 2016, the district court transferred the case to the federal district court for the Northern District of California. On October 21, 2016, the Court granted the parties’ stipulation to stay the district court action pending the Ninth Circuit’s review of Pandora’s appeal in Flo & Eddie et al. v. Pandora Media, Inc., which involves similar allegations.

The outcome of any litigation is inherently uncertain. Except as noted above, we do not believe it is probable that the final outcome of the matters discussed above will, individually or in the aggregate, have a material adverse effect on our business, financial position, results of operations or cash flows; however, in light of the uncertainties involved in such matters, there can be no assurance that the outcome of each case or the costs of litigation, regardless of outcome, will not have a material adverse effect on our business. In particular, rate court proceedings could take years to complete, could be very costly and may result in current and past rates for content acquisition costs that are materially less favorable than rates we currently pay or have paid in the past.
 
Indemnification Agreements, Guarantees and Contingencies
 
In the ordinary course of business, we are party to certain contractual agreements under which we may provide indemnifications of varying scope, terms and duration to customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of breach of such agreements, services to be provided by us or from intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with directors and certain officers and employees that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees. Such

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


indemnification provisions are accounted for in accordance with guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others. To date, we have not incurred, do not anticipate incurring and therefore have not accrued for, any costs related to such indemnification provisions.
 
While the outcome of these matters cannot be predicted with certainty, we do not believe that the outcome of any claims under indemnification arrangements will have a material adverse effect on our financial position, results of operations or cash flows.

6.                       Goodwill and Intangible Assets

During the nine months ended September 30, 2016, we completed a business combination that was not material to our condensed consolidated financial statements. During the nine months ended September 30, 2016, we made an adjustment to goodwill and deferred tax liabilities as a result of the impact of final pre-acquisition Ticketfly income tax returns filed. The changes in the carrying amount of goodwill for the nine months ended September 30, 2016, are as follows:

 
Goodwill
 
(in thousands)
Balance as of December 31, 2015
$
303,875

Goodwill resulting from business combination and purchase price adjustments
2,831

Balance as of September 30, 2016
$
306,706



 The following summarizes information regarding the gross carrying amounts and accumulated amortization of intangible assets.
 
 
As of December 31, 2015
 
As of September 30, 2016
 
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Value
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Value
 
 
(in thousands)
 
(in thousands)
Finite-lived intangible assets
 
 
 
 
 
 
 
 
 
 
 
 
Patents
 
$
8,030

 
$
(1,824
)
 
$
6,206

 
$
8,030

 
$
(2,373
)
 
$
5,657

Developed technology
 
56,050

 
(1,265
)
 
54,785

 
56,165

 
(10,515
)
 
45,650

Customer relationships - clients
 
37,300

 
(777
)
 
36,523

 
37,399

 
(4,309
)
 
33,090

Customer relationships - users
 
1,940

 
(318
)
 
1,622

 
1,940

 
(1,046
)
 
894

Trade names
 
11,720

 
(304
)
 
11,416

 
11,735

 
(1,654
)
 
10,081

Total finite-lived intangible assets
 
$
115,040

 
$
(4,488
)
 
$
110,552

 
$
115,269

 
$
(19,897
)
 
$
95,372

 
 
 
 
 
 
 
 
 
 
 
 
 
Indefinite-lived intangible assets
 
 
 
 
 
 
 
 
 
 
 
 
FCC license - Broadcast Radio
 
$
193

 
$

 
$
193

 
$
193

 
$

 
$
193

 
 
 
 
 
 
 
 
 
 
 
 
 
Total intangible assets
 
$
115,233

 
$
(4,488
)
 
$
110,745

 
$
115,462

 
$
(19,897
)
 
$
95,565



Amortization expense of intangible assets was $0.4 million and $5.1 million for the three months ended September 30, 2015 and 2016. Amortization expense of intangible assets was $0.8 million and $15.4 million for the nine months ended September 30, 2015 and 2016.

The following is a schedule of future amortization expense related to finite-lived intangible assets as of September 30, 2016.


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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


 
As of 
 September 30, 
 2016
 
(in thousands)
Remainder of 2016
$
5,138

2017
20,116

2018
17,654

2019
17,129

2020
15,896

Thereafter
19,439

Total future amortization expense
$
95,372



7.                       Debt Instruments

Long-term debt, net consisted of the following:

 
As of December 31,
 
As of September 30,
 
2015
 
2016
 
(in thousands)
1.75% convertible senior notes due 2020
$
345,000

 
$
345,000

Credit facility

 
90,000

Unamortized discount and deferred issuance costs
(110,423
)
 
(97,571
)
Long-term debt, net
$
234,577

 
$
337,429


 
Convertible Debt Offering

On December 9, 2015, we completed an unregistered Rule 144A offering for the issuance of $345.0 million aggregate principal amount of our 1.75% Convertible Senior Notes due 2020 (the "Notes"). In connection with the issuance of the Notes, we entered into capped call transactions with the initial purchaser of the Notes and an additional financial institution ("capped call transactions").

The net proceeds from the sale of the Notes were approximately $336.5 million, after deducting the initial purchasers' fees and other estimated expenses. We used approximately $43.2 million of the net proceeds to pay the cost of the capped call transactions.

The Notes are unsecured, senior obligations of Pandora, and interest is payable semi-annually at a rate of 1.75% per annum. The Notes will mature on December 1, 2020, unless earlier repurchased or redeemed by Pandora or converted in accordance with their terms prior to such date. Prior to July 1, 2020, the Notes are convertible at the option of holders only upon the occurrence of specified events or during certain periods as further described below; thereafter, until the second scheduled trading day prior to maturity, the Notes will be convertible at the option of holders at any time.

The conversion rate for the Notes is initially 60.9050 shares of common stock per $1,000 principal amount of the Notes, which is equivalent to an initial conversion price of approximately $16.42 per share of our common stock, and is subject to adjustment in certain circumstances.

We will not have the right to redeem the Notes prior to December 5, 2018. We may redeem all or any portion of the Notes for cash at our option on or after December 5, 2018 if the last reported sale price of our common stock is at least 130% of the conversion price then in effect for at least 20 trading days, whether or not consecutive, during any 30 consecutive trading day period, including the last trading day of such period, ending on, and including, any of the five trading days immediately preceding the date on which we provide notice of redemption. Any optional redemption of the Notes will be at a redemption price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. The maximum number of shares of common stock the Notes are convertible into is approximately

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


27.3 million, and is subject to adjustment under certain circumstances.

The Notes will be convertible at the option of holders only under the following circumstances:

Prior to the close of business on the business day immediately preceding July 1, 2020, during any calendar quarter commencing after the calendar quarter ending on March 31, 2016 (and only during such calendar quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive), during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;

Prior to the close of business on the business day immediately preceding July 1, 2020, during the five business day period after any ten consecutive trading day period (the "measurement period") in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day;

Prior to the business day immediately preceding July 1, 2020, upon the occurrence of specified corporate events; or

At any time on or after July 1, 2020 until the close of business on the second scheduled trading day immediately preceding the December 1, 2020 maturity date.

Upon the occurrence of a make-whole fundamental change or if we call all or any portion of the Notes for redemption prior to July 1, 2020, we will, in certain circumstances, increase the conversion rate by a number of additional shares for a holder that elects to convert its Notes in connection with such make-whole fundamental change or during the related redemption period.

The Notes were separated into debt and equity components and assigned a fair value. The value assigned to the debt component is the estimated fair value as of the issuance date of similar debt without the conversion feature. The difference between the cash proceeds and this estimated fair value represents the value which has been assigned to the equity component and recorded as a debt discount. The debt discount is being amortized using the effective interest method over the period from the date of issuance through the December 1, 2020 maturity date.

The initial debt component of the Notes was valued at $233.5 million, based on the contractual cash flows discounted at an appropriate market rate for non-convertible debt at the date of issuance. The carrying value of the permanent equity component reported in additional paid-in-capital was initially valued at $103.0 million, which is net of $2.6 million of fees and expenses allocated to the equity component.

The following table outlines the effective interest rate, contractually stated interest expense and costs related to the amortization of the discount for the Notes:

 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
 
2016
 
(in thousands except for effective interest rate)
Effective interest rate
10.18
%
 
10.18
%
Contractually stated interest expense
$
1,505

 
$
4,536

Amortization of discount
$
4,649

 
$
13,587



The capped call transactions are expected to reduce the potential dilution to our common stock and/or offset the cash payments we would be required to make in excess of the principal amount of the converted Notes in the event that the market price of our common stock, as measured under the terms of the capped call transaction, is greater than the strike price of the capped call transaction, with such reduction and/or offset subject to a cap based on the cap price of the capped call transactions.

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


The strike price of the capped call transactions corresponds to the initial conversion price of the Notes and is subject to certain adjustments under the terms of the capped call transactions. The capped call transactions have an initial cap price of $25.26 per share and are subject to certain adjustments under the terms of the capped call transactions. The capped call transactions have been included as a net reduction to additional paid-in capital within stockholders’ equity.

The total estimated fair value of the Notes as of September 30, 2016 was $362.1 million. The fair value was determined using a methodology that combines direct market observations with quantitative pricing models to generate evaluated prices. We consider the fair value of the Notes to be a Level 2 measurement due to the limited trading activity of the Notes.

The closing price of our common stock was $14.33 on September 30, 2016, which was less than the initial conversion price for the Notes of approximately $16.42 per share. As such, the if-converted value of the Notes was less than the principal amount of $345.0 million.

Credit Facility

We are party to a $120.0 million credit facility with a syndicate of financial institutions, which expires on September 12, 2018. In September 2016, we borrowed $90.0 million from the credit facility to enhance our working capital position. The amount borrowed is included in long-term debt on our balance sheet. Interest is payable quarterly at the applicable annual interest rate of 3.81% through September 2017. The applicable interest rate will be adjusted in September 2017.

As of September 30, 2016, we had $1.2 million in letters of credit outstanding and $28.8 million of available borrowing capacity under the credit facility. We are in compliance with all financial covenants associated with the credit facility as of September 30, 2016.


8.                       Stock-based Compensation Plans and Awards
 
ESPP
 
The ESPP allows eligible employees to purchase shares of our common stock through payroll deductions of up to 15% of their eligible compensation. The ESPP provides for six-month offering periods, commencing in February and August of each year.

We estimate the fair value of shares to be issued under the ESPP on the first day of the offering period using the Black-Scholes valuation model. The determination of the fair value is affected by our stock price on the first date of the offering period, as well as other assumptions including the risk-free interest rate, the estimated volatility of our stock price over the term of the offering period, the expected term of the offering period and the expected dividend rate. Stock-based compensation expense related to the ESPP is recognized on a straight-line basis over the offering period, net of estimated forfeitures.
 
The following assumptions for the Black-Scholes option pricing model were used to determine the per-share fair value of shares to be granted under the ESPP:


Three months ended September 30,
 
Nine months ended September 30,
 
2015

2016
 
2015
 
2016
Expected life (in years)
0.5

 
0.5

 
0.5

 
0.5

Risk-free interest rate
0.07 - 0.24%

 
0.41 - 0.44%

 
0.05 - 0.24%

 
0.24 - 0.44%

Expected volatility
29 - 42%

 
41 - 52%

 
29 - 42%

 
41 - 52%

Expected dividend yield
0
%
 
0
%
 
0
%
 
0
%

 
During the three months ended September 30, 2015 and 2016, we withheld $1.8 million and $2.6 million in contributions from employees and recognized $0.6 million and $0.9 million of stock-based compensation expense related to the ESPP, respectively. During the nine months ended September 30, 2015 and 2016, we withheld $5.1 million and $6.4 million in contributions from employees and recognized $1.9 million and $2.3 million of stock-based compensation expense related to the ESPP, respectively. In the three months ended September 30, 2015 and 2016, 255,432 and 643,562 shares of common stock

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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


were issued under the ESPP. In the nine months ended September 30, 2015 and 2016, 538,398 and 1,254,910 shares of common stock were issued under the ESPP.
 
Employee Stock-Based Awards
 
Our 2011 Equity Incentive Plan (the "2011 Plan") provides for the issuance of stock options, restricted stock units and other stock-based awards to our employees. The 2011 Plan is administered by the compensation committee of our board of directors.
 
Stock options
 
We measure stock-based compensation expense for stock options at the grant date fair value of the award and recognize expense on a straight-line basis over the requisite service period, which is generally the vesting period. We estimate the fair value of stock options using the Black-Scholes option-pricing model. During the three months ended September 30, 2015 and 2016, we recorded stock-based compensation expense from stock options of approximately $2.3 million and $2.2 million. During the nine months ended September 30, 2015 and 2016, we recorded stock-based compensation expense from stock options of approximately $7.5 million and $11.3 million.

There were no options granted in the three and nine months ended September 30, 2016.

Restricted stock units ("RSUs")
 
The fair value of RSUs is expensed ratably over the vesting period. RSUs typically have an initial annual cliff vest and then vest quarterly thereafter over the service period, which is generally four years. During the three months ended September 30, 2015 and 2016, we recorded stock-based compensation expense from RSUs of approximately $25.4 million and $28.2 million. During the nine months ended September 30, 2015 and 2016, we recorded stock-based compensation expense from RSUs of approximately $69.1 million and $87.2 million.
 
MSUs

In March 2015, the compensation committee of the board of directors granted performance awards consisting of market stock units to certain key executives under our 2011 Plan.

MSUs granted in March 2015 are earned as a function of Pandora’s total stock return ("TSR") measured against that of the Russell 2000 Index across three performance periods:

One-third of the target MSUs are eligible to be earned for a performance period that is the first calendar year of the MSU grant (the "One-Year Performance Period");
One-third of the target MSUs are eligible to be earned for a performance period that is the first two calendar years of the MSU grant (the "Two-Year Performance Period"); and
Any remaining portion of the total potential MSUs are eligible to be earned for a performance period that is the entire three calendar years of the MSU grant (the "Three-Year Performance Period").

For each performance period, a "performance multiplier" is calculated by comparing Pandora’s TSR for the period to the Russell 2000 Index TSR for the same period, using the average adjusted closing stock price of Pandora stock, and the Russell 2000 Index, for ninety calendar days prior to the beginning of the performance period and the last ninety calendar days of the performance period. In each period, the target number of shares will vest if the Pandora TSR is equal to the Russell 2000 Index TSR. For each percentage point that the Pandora TSR falls below the Russell 2000 Index TSR for the period, the performance multiplier is decreased by three percentage points. The performance multiplier is capped at 100% for the One-Year and Two-Year Performance Periods. However, the full award is eligible for a payout up to 200% of target, less any shares earned in prior periods, in the Three-Year Performance Period. Specifically, for each percentage point that the Pandora TSR exceeds the Russell 2000 Index TSR for the Three-Year Performance Period, the performance multiplier is increased by 2%. As such, the ability to exceed the target number of shares is determined exclusively with respect to Pandora's three-year TSR during the term of the award.


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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


We have determined the grant-date fair value of the MSUs using a Monte Carlo simulation performed by a third-party valuation firm. We recognize stock-based compensation for the MSUs over the requisite service period, which is approximately three years, using the accelerated attribution method.

During the nine months ended September 30, 2015 we granted 776,000 MSUs at a total grant-date fair value of $4.3 million. There were no MSUs granted in the three or nine months ended September 30, 2016. During the three months ended September 30, 2015 and 2016, we recorded stock-based compensation expense from MSUs of approximately $0.5 million and $0.2 million. During the nine months ended September 30, 2015 and 2016, we recorded stock-based compensation expense from MSUs of approximately $1.0 million and $0.6 million.

In February 2016, the compensation committee of the board of directors certified the results of the One-Year Performance Period of the 2015 MSU grant, which concluded December 31, 2015. During the One-Year Performance Period, our relative TSR declined 26 percentage points relative to the Russell 2000 Index TSR for the period, which resulted in the vesting of the One-Year Performance Period at 22% of the one-third vesting opportunity for the period.

PSUs

In April 2016, the compensation committee of the board of directors granted 2016 Performance Awards consisting of stock-settled performance-based RSUs to certain key executives under our 2011 Plan.

PSUs granted in April 2016 have a vesting period that includes a four year service period, during which one fourth of the awards will vest after one year and the remainder will vest quarterly thereafter. The PSUs are earned when our trailing average ninety-day stock price is equal to or greater than $20.00. If the trailing average ninety-day stock price does not equal or exceed $20.00 on the applicable vesting date, then the portion of the award that was scheduled to vest on such vesting date shall not vest but shall vest on the next vesting date on which the trailing average ninety-day stock price equals or exceeds $20.00. Any portion of the award that remains unvested as of the final vesting date shall be canceled and forfeited.

We have determined the grant-date fair value of the PSUs granted in April 2016 using a Monte Carlo simulation performed by a third-party valuation firm. We recognize stock-based compensation for the PSUs over the requisite service period, which is approximately four years, using the accelerated attribution method.

During the nine months ended September 30, 2016 we granted 1,725,000 PSUs at a total grant-date fair value of $8.7 million. There were no PSUs granted in the three or nine months ended September 30, 2015. During the three and nine months ended September 30, 2016, we recorded stock-based compensation expense from PSUs of approximately $1.3 million and $2.4 million. There was no stock-based compensation expense from PSUs in the three or nine months ended September 30, 2015.

Stock-based Compensation Expense
 
Stock-based compensation expense related to all employee and non-employee stock-based awards was as follows:
 
 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
 
2015
 
2016
 
2015
 
2016
 
(in thousands)
 
(in thousands)
Stock-based compensation expense
 

 
 

 
 
 
 
Cost of revenue - Other
$
1,427

 
$
1,538

 
$
4,040

 
$
4,559

Cost of revenue - Ticketing service

 
27

 

 
154

Product development
6,189

 
7,347

 
16,148

 
23,091

Sales and marketing
13,732

 
14,932

 
38,403

 
43,673

General and administrative
7,446

 
8,910

 
20,882

 
32,364

Total stock-based compensation expense
$
28,794

 
$
32,754

 
$
79,473

 
$
103,841




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Pandora Media, Inc. 
Notes to Condensed Consolidated Financial Statements - Continued
(unaudited)


In the nine months ended September 30, 2016, we recorded stock-based compensation expense of $6.8 million related to accelerated awards in connection with executive severance. This amount is included in the general and administrative line item of our condensed consolidated statements of operations.

9.                       Net Loss Per Share
 
Basic net loss per share is computed by dividing the net loss by the weighted-average number of shares of common stock outstanding during the period.
 
Diluted net loss per share is computed by giving effect to all potential shares of common stock, including stock options, restricted stock units, market stock units and performance-based RSUs, to the extent dilutive. Basic and diluted net loss per share were the same for the three and nine months ended September 30, 2015 and 2016, as the inclusion of all potential common shares outstanding would have been anti-dilutive.
 
The following table sets forth the computation of historical basic and diluted net loss per share:
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
2015
 
2016
 
2015
 
2016
 
(in thousands except per share amounts)
 
(in thousands except per share amounts)
Numerator
 
 
 
 
 
 
 
Net loss
$
(85,930
)
 
$
(61,534
)
 
$
(150,252
)
 
$
(252,969
)
Denominator
 
 
 
 
 
 
 
Weighted-average common shares outstanding used in computing basic and diluted net loss per share
212,760

 
232,139

 
211,487

 
229,524

Net loss per share, basic and diluted
$
(0.40
)
 
$
(0.27
)
 
$
(0.71
)
 
$
(1.10
)

 
The following potential common shares outstanding were excluded from the computation of diluted net loss per share because including them would have been anti-dilutive:
 
 
As of September 30,
 
2015
 
2016
 
(in thousands)
Options to purchase common stock
10,492

 
9,665

Restricted stock units
16,653

 
23,554

Performance awards*
776

 
2,315

Total common stock equivalents
27,921

 
35,534

*Includes potential common shares outstanding for MSUs and PSUs

 
On December 9, 2015, we completed an offering of our 1.75% convertible senior notes due 2020. Under the treasury stock method, the Notes will generally have a dilutive impact on earnings per share if our average stock price for the period exceeds approximately $16.42 per share of our common stock, the conversion price of the Notes. For the period from the issuance of the offering of the Notes through September 30, 2016, the conversion feature of the Notes was anti-dilutive.

In connection with the pricing of the Notes, we entered into capped call transactions which increase the effective conversion price of the Notes, and are designed to reduce potential dilution upon conversion of the Notes. Since the beneficial impact of the capped call is anti-dilutive, it is excluded from the calculation of earnings per share. Refer to Note 7 "Debt Instruments" for further details regarding our Notes.


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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")
 
You should read the following discussion of our financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2015 filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended (the "Exchange Act").
 
This Quarterly Report on Form 10-Q contains "forward-looking statements" that involve substantial risks and uncertainties. The statements contained in this Quarterly Report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Exchange Act, including, but not limited to, statements regarding our expectations, beliefs, intentions, strategies, future operations, future financial position, future revenue, projected expenses, plans and objectives of management and economic, competitive and technological trends. In some cases, you can identify forward-looking statements by terms such as "anticipate," "believe," "estimate," "expect," "intend," "may," "might," "plan," "project," "will," "would," "should," "could," "can," "predict," "potential," "continue," "objective," or the negative of these terms, and similar expressions intended to identify forward-looking statements. However, not all forward-looking statements contain these identifying words. These forward-looking statements reflect our current views about future events and involve known risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievement to be materially different from those expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2015. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. We qualify all of our forward-looking statements by these cautionary statements. These and other factors could cause our results to differ materially from those expressed in this Quarterly Report on Form 10-Q.
 
Some of the industry and market data contained in this Quarterly Report on Form 10-Q are based on independent industry publications, including those generated by Triton Digital Media ("Triton") or other publicly available information. This information involves a number of assumptions and limitations. Although we believe that each source is reliable as of its respective date, we have not independently verified the accuracy or completeness of this information.
 
As used herein, "Pandora," the "Company," "we," "our," and similar terms refer to Pandora Media, Inc., unless the context indicates otherwise.
 
"Pandora" and other trademarks of ours appearing in this report are our property. This report may contain additional trade names and trademarks of other companies. We do not intend our use or display of other companies’ trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies.

Overview
 
Pandora - Internet Radio Service

Pandora is the world’s most powerful music discovery platform, offering a personalized experience for each of our listeners wherever and whenever they want to listen to music—whether through earbuds, car speakers or live on stage. Our vision is to be the definitive source of music discovery and enjoyment for billions. The majority of our listener hours occur on mobile devices, with the majority of our revenue generated from advertising on these devices. We offer both local and national advertisers the opportunity to deliver targeted messages to our listeners using a combination of audio, display and video advertisements. Founded by musicians, Pandora also empowers artists with valuable data and tools to help grow their careers and connect with their fans.
 
For the three months ended September 30, 2016, we streamed 5.40 billion hours of radio, and as of September 30, 2016, we had 77.9 million active users during the prior 30-day period. Since we launched our non-subscription, ad-supported radio service in 2005 our listeners have created over 10 billion stations.
 
At the heart of our service is our set of proprietary personalization technologies, including the Music Genome Project and our playlist generating algorithms. The Music Genome Project is a database of over 1,000,000 uniquely analyzed songs from over 150,000 artists, spanning over 600 genres and sub-genres, which we develop one song at a time by evaluating and cataloging each song’s particular attributes. When a listener enters a single song, artist, comedian or genre to start a station, the Pandora service instantly generates a station that plays music or comedy we think that listener will enjoy. Based on listener

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reactions to the recordings we pick, we further tailor the station to match the listener's preferences. Listeners also have the ability to add variety to and rename stations, which further allows for the personalization of our service.
 
We currently provide the Pandora service through two models:
 
Ad-Supported Service. Our advertising-supported service allows listeners to access our music and comedy catalogs and personalized playlist generating system for free across all of our delivery platforms.
 
Subscription Service. Our new subscription service, Pandora Plus, launched on September 15, 2016. Prior to September 15, 2016, our subscription service was Pandora One. Our subscription service is a premium monthly or annual paid version of the Pandora service, which currently includes advertisement-free access, higher quality audio on supported devices and longer timeout-free listening. Pandora Plus also includes additional features such as replays, unlimited skips and offline listening.

A key element of our strategy is to make the Pandora service available everywhere that there is internet connectivity. To this end, we make the Pandora service available through a variety of distribution channels. In addition to streaming our service to computers, we have developed Pandora mobile device applications ("apps") for smartphones and mobile operating systems, such as the iPhone, Android and the Windows Phone and for tablets including the iPad and Android tablets. We distribute those mobile apps free to listeners via app stores.

Our new subscription service, Pandora Plus, launched on September 15, 2016 and we intend to unveil a subscription-based on-demand music streaming service in the coming months. The development and launch of our recent and planned new service offerings have and will continue to require significant engineering effort, as well as marketing, and other resources. In addition, to support the launch of these services we have entered into direct license agreements with the major and independent record labels, some of which include substantial minimum guarantee payments. To successfully launch such additional service offerings, we will need to attract subscribers to these new service offerings. The market for subscription-based music services, including on-demand services, is intensely competitive, and our ability to realize a return on our investments in these new service offerings will depend on our ability to leverage the existing audience of our ad-supported service, our brand awareness and deliver differentiated subscription services with features and functionality that listeners find attractive. Refer to our discussion of these matters in Item 1A - "Risk factors".

Ticketing Service

Our ticketing service consists of Ticketfly, a leading live events technology company that provides ticketing and marketing software and services for venues and event promoters across North America. Ticketfly's ticketing, digital marketing and analytics software helps promoters book talent, sell tickets and drive in-venue revenue, while Ticketfly's consumer tools help fans find and purchase tickets to events. Tickets are primarily sold through the Ticketfly platform but are also sold through other channels such as box offices. In the three months ended September 30, 2016, Ticketfly had approximately 40 thousand live events on sale, for which approximately 3.9 million tickets, excluding box office sales, were sold to approximately 1.7 million unique ticket buyers, which resulted in more than $155 million in gross transaction value, excluding box office sales. We completed the acquisition of Ticketfly on October 31, 2015.

Ticketfly's platform provides ticketing and marketing services for venues and event promoters across North America and makes it easy for fans to find and purchase tickets to events, and also gives artists a means to more effectively promote their events. We intend to expand our ticketing service by connecting our listeners to events through our internet radio service.

Recent Events

Content Acquisition License Agreements
From November 2015 to September 2016, we signed direct license agreements for recorded music with major and independent labels, distributors and publishers. These agreements allow us to provide new and improved products to the market that include enhanced features such as replays, offline stations and on-demand listening. Certain of these license agreements include minimum guarantee payments, some of which are paid in advance. These minimum guarantee payments resulted in a material impact to the prepaid content acquisition costs line item in our condensed consolidated balance sheets. Refer to Note 2 "Summary of Significant Accounting Policies" in the Notes to Condensed Consolidated Financial Statements for further details on our prepaid content acquisition costs policy and minimum guarantees.

Pandora Plus and New Ad-Supported Service Features

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On September 15, 2016, we announced the launch of Pandora Plus, an updated version of our subscription service. The updated service includes replays, additional skipping and offline listening. In addition, new features were also added to our ad-supported service, allowing listeners to skip more songs and replay songs by viewing a video ad.
Factors Affecting our Business Model

Content Acquisition Costs
Prior to the launch of Pandora Plus on September 15, 2016, we paid performance rates for the sound recordings we streamed on our ad-supported service and our Pandora One subscription service according to the Web IV rates set by the Copyright Royalty Board on December 16, 2015. The rates for non-subscription services were set at $0.0017 per play and the rates for subscription services were set at $0.0022 per play for 2016.
During the three and nine months ended September 30, 2016, we entered into direct license agreements with major and independent music labels. Subsequent to the launch of Pandora Plus on September 15, 2016, we began paying content acquisition costs based on the terms of these license agreements for the significant majority of the sound recordings we stream on our ad-supported service and Pandora Plus. These agreements are structured so that content acquisition costs for our ad-supported service are based on the number of sound recordings we transmit or a percentage of advertising revenue, subject to certain discounts, and content acquisition costs for our subscription service are determined as the greater of a percentage of subscription revenue or a per subscriber minimum amount, subject to certain discounts. Certain of these license agreements require minimum guarantee payments, some of which are paid in advance. Refer to Note 2 "Summary of Significant Accounting Policies" in the Notes to Condensed Consolidated Financial Statements for further details on our prepaid content acquisition costs policy and minimum guarantees.
If we have not entered into a license agreement with the copyright owner of a particular sound recording that is streamed on our ad-supported service or our subscription service, our content acquisition costs for such sound recordings are calculated based on the number of sound recordings streamed at the per-performance rates that apply to commercial webcasters under the Web IV rates set by the Copyright Royalty Board on December 16, 2015.
Content acquisition costs for musical works are most often negotiated with and paid to performing rights organizations ("PROs") such as ASCAP, BMI, SESAC and Global Music Rights ("GMR") and directly to publishing companies. During the twelve months ended December 31, 2015 and the nine months ended September 30, 2016, we entered into direct licenses with ASCAP, BMI, SESAC and thousands of music publishers. These licenses are structured so that, for our ad-supported service, each publisher or PRO receives its usage-based share of a content acquisition cost pool equal to 20% of the content acquisition costs paid by us for sound recordings. Prior to the launch of Pandora Plus on September 15, 2016, these licenses were structured so that, for our subscription service, each publisher or PRO receives its usage-based share of a content acquisition cost pool equal to 20% of the content acquisition costs paid by us for sound recordings. Subsequent to the launch of Pandora Plus, content acquisition costs for our subscription services are determined in accordance with the statutory license set forth in 17 U.S.C. Sec. 115 based on a percentage of revenue or a per subscriber minimum amount. 
Ad-Supported Service
Our ad-supported service is monetized through the sale of display, audio and video advertisements to national, regional and local advertisers. We compete with digital advertising networks such as Google and Facebook, other digital media companies and local broadcast radio stations in our advertising business.
Our total number of listener hours is a key driver for both advertising revenue generation opportunities and content acquisition costs, which are the largest component of our expenses.
Advertising Revenue. Listener hours define the number of opportunities we have to sell advertisements, which we refer to as inventory. Our ability to attract advertisers depends in large part on our ability to offer sufficient inventory within desired demographics.
 
Cost of Revenue—Content Acquisition Costs—Ad-Supported Service. We pay content acquisition costs to the copyright owners and performers, or their agents, of each sound recording that we stream, as well as to the publishers and songwriters, or their agents, for the musical works embodied in each of those sound recordings, subject to certain exclusions. Subsequent to the launch of Pandora Plus on September 15, 2016, the majority of the content acquisition costs related to our ad-supported service are driven by license agreements that require us to pay fees based on the number of sound recordings we transmit to users of the Pandora service or a percentage of advertising revenue, subject to certain discounts. These license agreements include minimum guarantee payments of content acquisition costs, some of which are paid in advance. Refer to Note 2 "Summary of Significant

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Accounting Policies" in the Notes to Condensed Consolidated Financial Statements for further details on our prepaid content acquisition costs policy and minimum guarantees.

Given the per-play cost structure of our license agreements for our ad-supported service, our content acquisition costs related to our ad-supported service increase with each additional listener hour, regardless of whether we are able to generate more revenue. As such, our ability to achieve and sustain profitability and operating leverage on our ad-supported service depends on our ability to increase our revenue per hour of streaming through increased advertising revenue across all of our delivery platforms.
Subscription Service
We monetize our subscription service through subscription payments made by users of the service. We drive subscriber growth in our subscription service by providing the world's most powerful music discovery platform, offering a personalized experience for each of our listeners. In addition, we invest in marketing and free-trials to promote our service.
Our total number of paid subscriptions is a key driver for both subscription revenue and, subsequent to the launch of Pandora Plus on September 15, 2016, for content acquisition costs related to our subscription service, which is the largest component of our subscription-related expenses. In order to drive greater subscription revenue, we must increase the number of new subscribers to our subscription service and minimize the number of current subscribers who discontinue their subscriptions.
Subscription Revenue. Our subscription revenue depends upon the number of paid subscriptions we are able to sell and the price that our subscribers pay for those subscriptions. Our ability to attract subscribers depends in large part on our ability to offer features and functionality on our subscription service that are valued by consumers within desired demographics, on terms that are attractive to those consumers, and still enable us to maintain adequate gross margins.

Cost of Revenue—Content Acquisition Costs—Subscription Service. We pay content acquisition costs to the copyright owners, performers, songwriters, or their agents, subject to certain exclusions. Subsequent to the launch of Pandora Plus on September 15, 2016, the majority of our content acquisition costs for our subscription service are calculated based on subscription revenue earned and subject to per subscriber minimum amounts, both of which are subject to certain discounts. These license agreements include minimum guarantee payments, some of which are paid in advance. Refer to Note 2 "Summary of Significant Accounting Policies" in the Notes to Condensed Consolidated Financial Statements for further details on our prepaid content acquisition costs policy and minimum guarantees.

Given the structure of our license agreements for our subscription service, the majority of our content acquisition costs increase as subscription revenue increases and are subject to minimum guarantee payments. As such, our ability to achieve and sustain profitability and operating leverage on our subscription service depends on our ability to increase our revenue through increased paid subscriptions on terms that maintain an adequate gross margin. Refer to our discussion of these matters in Item 1A - "Risk factors".

Key Metrics
 
The below key metrics do not include amounts related to our ticketing service, unless otherwise specifically stated.

Listener Hours

We track listener hours because it is a key indicator of the growth of our business. Beginning with the listener hours disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015, we include listener hours related to our non-radio content offerings in the definition of listener hours. These offerings include non-music content such as podcasts, as well as custom music content such as Pandora Premiers and artist mixtapes. Historically, listener hours related to non-radio content represented a negligible number of listener hours. Including non-radio content in the listener hours we have previously reported for the three and nine months ended September 30, 2015 would not have changed the reported listener hours. We calculate listener hours based on the total bytes served for each track that is requested and served from our servers, as measured by our internal analytics systems, whether or not a listener listens to the entire track. For non-music content such as podcasts, episodes are divided into approximately track-length parts, which are treated as tracks under this definition. To the extent that third-party measurements of listener hours are not calculated using a similar server-based approach, the third-party measurements may differ from our measurements.


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The table below sets forth our total listener hours for the three and nine months ended September 30, 2015 and 2016.

 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
 
2015
2016
 
2015
2016
 
(in billions)
 
(in billions)
Listener hours
5.14

5.40

 
15.74

16.57


Active Users
We track the number of active users as an additional indicator of the breadth of audience we are reaching at a given time. We define active users as the number of distinct registered users, including subscribers, that have requested audio from our servers within the trailing 30 days to the end of the final calendar month of the period. The number of active users may overstate the number of unique individuals who actively use our service within a month as one individual may register for, and use, multiple accounts. Beginning with the active users disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015, we are also including active users who only request non-radio content offerings in the definition of active users. Including users who only request non-radio content in the calculation of active users would not have materially changed the reported active users as of September 30, 2015.
The table below sets forth our total active users as of September 30, 2015 and 2016.
 
As of September 30,
 
2015
2016
 
(in millions)
Active users
78.1

77.9

We define advertising-based active users ("ad-based active users") as the number of users, excluding subscribers, that have requested audio from our servers within the trailing 30 days to the end of the final calendar month of the period. We define subscribers as the number of distinct users at the end of the period that have paid for our service. Inactive subscribers are included as they contribute towards RPMs, which are described in further detail below.

The table below sets forth our users on an advertising and subscription basis as of September 30, 2015 and 2016.

 
As of September 30,
 
2015
2016
User type
Users (in millions)
Ad-based active users
74.7

74.5

Subscribers*
3.9