PEGASYSTEMS INC - Annual Report: 2016 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2016

Commission File No. 1-11859

PEGASYSTEMS INC.

(Exact name of Registrant as specified in its charter)

Massachusetts

(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification No. 04-2787865)

(617) 374-9600

(Registrant’s telephone number, including area code)

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

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

None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☒    No  ☐

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ☐    No  ☒

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  ☒    No  ☐

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☐

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.

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

The aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant based on the closing price (as reported by NASDAQ) of such common stock on the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2016) was approximately $965 million.

There were 76,643,096 shares of the Registrant’s common stock, $0.01 par value per share, outstanding on February 10, 2017.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive proxy statement related to its 2017 annual meeting of stockholders to be filed subsequently are incorporated by reference into Part III of this report.

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PART I

Forward-looking statements

This Annual Report on Form 10-K, including without limitation, the sections entitled “Business”, “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains or incorporates 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. These forward-looking statements are based on current expectations, estimates, forecasts, and projections about the industry and markets in which we operate and on management’s beliefs and assumptions. Other written or oral statements that constitute forward-looking statements may be made by us or on our behalf. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “could,” “estimate,” “may,” “target,” “strategy,” “is intended to,” “project,” “guidance,” “likely,” “usually,” or variations of such words and similar expressions are intended to identify such forward-looking statements. These statements include, among other things, statements regarding:

These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions that are difficult to predict. We have identified certain risk factors included in Item 1A of this Annual Report on Form 10-K that we believe could cause our actual results to differ materially from those expressed in forward-looking statements we make. Except as required by law, we do not intend to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.

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Pegasystems Inc. was incorporated in Massachusetts in 1983. Our stock is traded on the NASDAQ Global Select Market under the symbol PEGA. Our Website address is www.pega.com. We are not including the information contained on our Website as part of, or incorporating it by reference into, this Annual Report on Form 10-K. Unless the context otherwise requires, references in this Annual Report on Form 10-K to “the Company,” “Pega,” “we,” “us,” or “our” refer to Pegasystems Inc. and its subsidiaries.

Our Business: Empowering People. Revolutionizing Engagement

We are dedicated to helping our clients realize exceptional customer engagement and achieve operational excellence. Our adaptive, cloud-architected applications—built on our unified Pega^® Platform—empower businesses with comprehensive visual tools to build, extend, and evolve applications to meet strategic business needs.

Products

We develop, market, license, and support software applications for marketing, sales, service, and operations, in addition to licensing our Pega Platform for clients that wish to build and extend their own applications. Our software is designed to assist clients in building, deploying, and evolving enterprise applications, creating an environment in which business and IT can collaborate to manage back-office operations, front office sales, marketing, and/or customer service needs.

Our applications are built on the Pega Platform, our unified platform. The Pega Platform uses a comprehensive set of visual models to build applications, including process models, predictive analytics, user experience (“UX”) designs, decision logic, and others. This visual, model-based approach is designed to be faster in building, deploying, and evolving applications than traditional programming, and to empower our clients to better engage their customers, simplify processes, and turn the power of change into a competitive advantage.

Our applications and platform intersect with and encompass several traditional software markets, including: Customer Relationship Management (“CRM”), Business Process Management (“BPM”), Business Rules Management Systems (“BRMS”), Dynamic Case Management (“DCM”), Decision Management, including Predictive and Adaptive analytics, and the Vertical Specific Software (“VSS”) market of industry solutions and packaged applications.

Services

Our Pega^® Cloud Services provide Pega Platform environments that are provisioned, monitored, and maintained for individual clients to create and deploy Pega-based applications using an Internet-based infrastructure. We also provide consulting services and implementation support, training, and technical support services to help clients maximize our software’s business value.

Our clients include Global 3000 companies and government agencies that seek to manage complex enterprise systems and customer service issues with greater agility and cost-effectiveness. Our strategy is to sell a client a series of licenses, each focused on a specific purpose or area of operations, in support of longer term enterprise-wide digital transformation initiatives.

Our Products

The Pega Platform and applications help streamline business operations, connect enterprises to their customers in real-time across channels, and adapt to meet changing requirements. Our applications can be

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deployed on Pega-managed, partner-managed, or customer-managed cloud architectures, providing our clients with the flexibility to operate the software according to their own preferences.

Pega Platform

The Pega Platform is a unified platform that enables clients to build enterprise applications in a fraction of the time it would take using traditional programming technologies. The Pega Platform is engineered to support complex, global enterprises, allowing for application development and deployment on a patented, layered architecture that supports reuse across lines of business, geographies, and customer segments. Our platform features a model-driven, code-free approach to application development that enables business and IT to collaborate, using a visual “language” that models the requirements and design of the application through readily understandable metaphors. This agile approach facilitates continuous improvement methodologies, such as Lean Six Sigma, to effectively manage individual projects or help drive a complete enterprise transformation. All aspects of the application are captured in the model, including business strategy mapping, business processes, data models, case definitions, rules, artificial intelligence (“AI”) constructs such as predictive and machine-learning analytics, decisions, reporting, interfaces, intelligent work management capabilities, business activity monitoring, and the UX across both web and mobile devices. Once defined this way, the finished application and documentation are generated and ready for use.

Our approach bypasses the error-prone and time-consuming process of manually translating requirements into code. The software application is created automatically and directly from the model, helping to close the costly gap between vision and execution. Changes to the code are made by changing the model, and application documentation is generated directly from the model. The Pega Platform is standards-based and can leverage a client’s existing technology to create new business applications that cross technology silos and bridge front and back-office. The Pega Platform was previously marketed as Pega 7 or the Pega 7 platform, PegaRULES Process Commander, and the Build for Change^® Platform.

Pega Platform—Key Technical Capabilities

The Pega Platform includes key technical capabilities that are available to Pega’s CRM and operations applications. Our case management, business process, and robotic automation technology facilitates the fulfillment of customer requests.

Real-time decision management is incorporated into these applications to guide actions and optimize process outcomes based on business objectives. Our Pega^® Next-Best-Action analytics leverage AI technologies that

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predict and adapt to customer behavior to improve both business outcomes and the customer experience. Capabilities for cross-sell/up-sell, retention, service recommendations, and collections can be changed with model-driven tools or intelligence, helping businesses deploy automated decision-making quickly. The predictive and adaptive analytics incorporated into these applications support the creation and refinement of decision models to improve outcomes.

Pega^® Robotic Desktop Automation and Pega^® Workforce Intelligence technologies are designed to allow our clients to optimize productivity by enabling their employees to work faster and more efficiently. These technologies are designed to simplify and automate business processes and transactions and provide insightful information into employee productivity for effective decision-making.

Social listening, text analytics, and natural language processing capabilities are also available in our Pega customer relationship management applications. These allow our clients to collect social content in tweets, blogs, and posts on Facebook or in other social communities, and enrich it by detecting language, topic, taxonomy, and sentiment. Using this capability, our clients are able to monitor, triage, and respond to social content across multiple channels, and turn it into actionable social intelligence.

Pega^® Co-Browse collaboration technology enables users to provide fast service by simultaneously “co-browsing” web pages with their customers. The technology is designed to allow our clients to engage customers in real time, and can also be used to enable employees to collaborate across physical locations.

Pega^® Mobility capabilities in our Pega Platform are designed to help clients efficiently build, manage, and deploy mobile applications as part of a unified omni-channel experience. By using Pega Mobility, enterprises can deploy Pega applications as packaged, branded mobile applications and manage the complex elements of the mobile application life cycle including security, integration, testing, and management of mobile applications and devices. Our mobile application development solutions are designed to help businesses to reduce the development time, deployment cost, and complexity associated with run-the-business mobile applications.

The Pega Platform also supports the creation of and interface with chatbots, virtual assistants, and other “conversational user experiences”, allowing our CRM applications to work across new interaction channels such as chatbots, Facebook Messenger, or Amazon Alexa.

Pega Applications

Pegasystems also offers purpose or industry-specific software applications built on the Pega Platform. These applications for marketing, sales automation, customer service, and operations provide business best practices tailored for specific industries. As they are built on the Pega Platform, these applications deliver flexibility beyond traditional, “commercial,” “off the shelf” products. We believe our applications allow our clients to offer differentiated service and value to their customers. The Pega Platform enables organizations to implement new processes quickly, refine customer experiences, bring new offerings to market, and provide customized or specialized processing to help meet the needs of different customers, departments, geographies, or regulatory requirements.

Pega Customer Relationship Management Applications

Pega customer relationship management applications are designed to evolve to meet changing business needs. Our applications offer process-driven, customer-centric CRM software that maximizes the lifetime value of customers and helps reduce the costs of serving customers. We provide marketing, sales automation, and customer service applications to optimize marketing engagement, sales processes and customer service interactions. Our CRM applications work seamlessly together to ensure a consistent and unified customer experience.

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Pega^® Marketing applications enable enterprises to improve customer experiences across inbound and outbound channels. They incorporate AI in the form of predictive and machine-learning analytics, as well as business rules, and execute these decisions in real time to evaluate the context of each customer interaction, and dynamically recommend the most relevant action, offer, content, and channel.

Pega^® Sales Automation applications automate and manage the entire sales process from prospecting to product fulfillment. Our software allows enterprises to capture best practices, and guides sales teams through the sales and customer onboarding processes.

Pega^® Customer Service applications provide a contact center desktop, case management for customer service, mobile field service, digital, self-service, and industry specific processes and data models. They allow enterprises to deliver consistent interactions across channels, proactively address service needs, and improve employee productivity.

Pega Operations Applications

Pega provides Operations Applications to support a variety of business needs including risk, fraud, and compliance management; exceptions and investigations; order fulfillment; claims processing; insurance underwriting; and product development.

Pega Cloud Services

Our Pega Cloud Services allow clients to develop, test, and deploy, on an accelerated basis, our applications and Pega Platform using a secure, flexible Internet-based infrastructure. Pega Cloud provides production, development, and testing (“Dev/Test”) services to accelerate the development and deployment of Pega applications and the Pega Platform. This allows our clients to minimize infrastructure cost while focusing on their core revenue generating competencies.

Additionally, the Pega Platform and Pega applications can be deployed on other cloud architectures, including customer- or partner-managed clouds. We believe this cloud-choice gives our customers the ability to select the best cloud architecture for the security, data access, speed-to-market, and budget requirements of each application they deploy.

Our Services and Support

We offer services and support through our Global Customer Success group, our Global Customer Support group, and our Pega^® Academy training services group. We also utilize third party contractors to assist us in providing these services.

Global Customer Success

Our Global Customer Success group combines our sales and Pega consulting groups and provides guidance and implementation services to our clients and partners on how to best apply our technology and develop strong implementation expertise.

Global Customer Support

Our Global Customer Support group is responsible for technical support of our products, including Pega Cloud. Support services include managing the online support community, proactive problem prevention through information and knowledge sharing, and problem tracking, prioritization, escalation, diagnosis, and resolution.

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PegaAcademy—Training Services

The success of our sales strategy for multiple follow-on sales to target clients depends on our ability to train a large number of partners and clients to implement our technology. We offer instructor-led and online training for our staff, clients, and partners. Instructor-led training is offered at our regional training facilities in North America, the United Kingdom (the “U.K.”), Asia Pacific, and at third-party facilities in numerous other locations, including client sites. Online training is a convenient and cost-effective way to learn our software anytime, anywhere. We expect online training to continue to help expand the number of trained and certified experts globally. We have also partnered with universities to offer Pega courseware as part of the student curriculum, taught by Pega instructors and university professors to expand our ecosystem. Our courses are designed to meet the specific requirements of various project implementation roles to include both business and system architects, system administrators, and project leaders.

Our Partners

We collaborate with global systems integrators and technology consulting firms that provide consulting services to our clients. Strategic partnerships with technology consulting firms and systems integrators are important to our sales efforts because they influence buying decisions, help us to identify sales opportunities, and complement our software with their domain expertise and services capabilities. These partners may deliver strategic business planning, consulting, project management, and implementation services to our clients. Currently, our partners include well respected, major firms such as Accenture PLC, Atos SE, Capgemini SA, Cognizant Technology Solutions Corporation, EY, Infosys Limited, PricewaterhouseCoopers LLP, Tata Consultancy Services Limited, Tech Mahindra Limited, Virtusa Corporation, and Wipro Limited.

Our Markets

Our target clients are industry-leading Global 3000 organizations that require applications to differentiate themselves in the markets they serve by increasing business agility, driving growth, improving productivity, attracting and retaining customers, and reducing risk. We deliver applications tailored to our clients’ specific industry needs. We also enable enterprise transformation initiatives by providing an application development platform that digitizes end-to-end processes and allows for multi-channel customer interactions, all enhanced by Pega Next-Best-Action analytics.

Our clients are in the financial services, healthcare, insurance, communications and media, public sector, manufacturing, and life sciences markets, as well as other industries.

Financial Services

Financial services organizations rely on software to market, onboard, cross-sell, retain, and service their customers as well as automate the operations that support these customer interactions. Our customer service, sales and new account onboarding, Know Your Customer (“KYC”), marketing, collections, and dispute management applications allow clients to be responsive to changing business requirements.

Healthcare

Healthcare organizations seek software that integrates their front and back-offices and helps them deliver personalized care and customer service while reducing cost, automating processes, and increasing operational efficiency. Our applications allow healthcare clients to address sales, service, operations, financial, administrative, and coverage requirements of healthcare consumerism and reform.

Insurance

Insurance companies, whether competing globally or nationally, need software to automate the key activities of distribution management, quoting, underwriting, claims, and policy servicing. Insurers are also

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becoming increasingly sensitive to ways to improve customer service and the overall customer experience. Our applications for insurance carriers are designed to help increase business value by delivering customer-focused experiences and personalized interactions that help drive higher sales, lower expense ratios, and mitigate risk.

Communications and Media

Communications and media organizations need to address high levels of customer churn, growing pressure to increase revenue, and an ability to respond quickly to changing market conditions. Our applications enable organizations to reshape the way they market and sell to customers, streamline onboarding and fulfillment operations, and bring new services and products to market.

Public Sector

Government agencies need to modernize legacy systems and processes to meet the growing demands for improved constituent service, lower costs, reduced fraud and greater levels of transparency. Our applications deliver advanced capabilities to help streamline operations and optimize service delivery through an agile, omni-channel approach.

Manufacturing

Manufacturers worldwide are transforming their businesses to better engage customers and suppliers, as well as to directly manage product performance throughout the product life-cycle. Our manufacturing applications address field service; help reduce supplier risk; manage warranties, recalls, repairs, and returns; and extend existing enterprise resource planning system capabilities.

Life Sciences

Life sciences organizations are looking for solutions to improve customer engagement as well as increase efficiencies and transparency across the product development life-cycle. Our customer engagement, clinical, and pharmacovigilance applications are designed to deliver customer engagement, safety and risk management, and regulatory transparency.

Other Industries

We offer software to a broad range of other types of companies and industries. For example, we sell our applications and platform to clients in travel, transportation, energy, retail, utilities, and other services.

Competition

We compete in the CRM (which includes marketing, sales, and customer service), BPM, case management, decision management, robotic automation, co-browsing, social engagement, and mobile application development platform software markets, as well as in markets for the vertical applications we provide (e.g. Pega^® KYC for Financial Services, Pega^® Underwriting for Insurance). These markets are intensely competitive, rapidly changing, and highly fragmented, as current competitors expand their product offerings and new companies enter the market. We encounter competition from:

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Competitors vary in size and in the scope and breadth of the products and services they offer and include some of the largest and most competitive companies in the world, such as International Business Machines Corporation (IBM), Salesforce.com, Oracle Corporation, Microsoft Corporation, and SAP SE.

We have been most successful competing for clients whose businesses are characterized by a high degree of change, complexity, or regulation. We believe that the principal competitive factors within our market include:

We believe we are competitively differentiated as our unified Pega Platform is designed to allow both client business and IT staff, using a single, intuitive user interface, to build and evolve enterprise applications in a fraction of the time it would take with the types of disjointed architectures and tools offered by our competitors. In addition, our applications, built on the Pega Platform, provide the same level of flexibility and ability to adapt to our clients’ needs. We believe we compete favorably due to our expertise in our target industries and our long-standing client relationships. We believe we compete less favorably on the basis of some of these factors with respect to our larger competitors, many of which have greater sales, marketing, and financial resources, more extensive geographical presence, and greater name recognition than we do. In addition, we may be at a disadvantage with respect to our ability to provide expertise outside our target industries. See “Risk Factors—The market for our offerings is intensely and increasingly competitive, rapidly changing, and highly fragmented.” in Item 1A of this Annual Report on Form 10-K.

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Intellectual Property

We rely primarily on a combination of copyright, patent, trademark, and trade secrets laws, as well as confidentiality and intellectual property agreements to protect our proprietary rights. We have obtained patents relating to our system architecture and products in strategic global markets. We enter into confidentiality, intellectual property ownership, and license agreements with our employees, partners, clients, and other third parties and control access to and ownership of software, services, documentation, and other proprietary information as means to protect our proprietary rights.

Sales and Marketing

We market our software and services primarily through a direct sales force. In addition, strategic partnerships with management consulting firms and major systems integrators are important to our sales efforts because they influence buying decisions, help us identify sales opportunities, and complement our software and services with their domain expertise and professional services capabilities. We also partner with technology providers and application developers.

To support our sales efforts, we conduct a broad range of marketing programs, including awareness advertising, client and industry-targeted solution campaigns, trade shows, including our PegaWorld^® user conference, solution seminars and webinars, industry analyst and press relations, Web and digital marketing, community development, social media, and other direct and indirect marketing efforts. Our consulting staff, business partners, and other third parties also conduct joint and separate marketing campaigns that generate sales leads.

Sales by Geography

Sales to clients based outside of the United States of America (“U.S.”) represented an average of 44% of our total revenue for the last three fiscal years. We have derived substantially all of our revenue from the sale and support of one group of similar products and services during each of the last three fiscal years. The majority of our long-lived assets were located within the U.S. at the end of each of the last three fiscal years. See Note 17, “Geographic Information and Major Clients,” included in the Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K. See “Risk Factors—We face risks from operations and clients based outside of the U.S.” in Item 1A of this Annual Report on Form 10-K.

Research and Development

Our development organization is responsible for product architecture, core technology development, product testing, and quality assurance. Our product development priority is to continue expanding the capabilities of our technology. We intend to maintain and extend the support of our existing applications, and we may choose to invest in additional strategic applications which incorporate the latest business innovations. We also intend to maintain and extend the support of popular hardware platforms, operating systems, databases, and connectivity options to facilitate easy and rapid deployment in diverse information technology infrastructures. Our goal with all of our products is to enhance product capabilities, ease of implementation, long-term flexibility, and the ability to provide improved client service.

During 2016, 2015, and 2014, research and development expenses were approximately $145.5 million, $126.4 million, and $108.6 million, respectively. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K for further discussion. We expect that we will continue to commit significant resources to our product research and development in the future to maintain our leadership position.

Employees

As of January 31, 2017, we had 3,908 employees worldwide, of which 1,675 were based in North America, 762 were based in Europe, and 1,471 were based in Asia Pacific.

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Backlog of License, Maintenance, and Services

As of December 31, 2016, we had software license, maintenance, cloud, and services agreements with clients expected to result in future revenue (“backlog”) of approximately $707.8 million, of which we expect approximately $376.9 million to be recognized in 2017. As of December 31, 2015, we had approximately $580.9 million in backlog. Under some of these agreements, we must fulfill certain conditions prior to recognizing revenue, and there can be no assurance when, if ever, we will be able to satisfy all such conditions in each instance. Backlog may vary in any given period depending on the amount and timing of when arrangements are executed, as well as the mix between perpetual license, term license, and cloud arrangements. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K for a discussion on license and cloud backlog, which excludes future revenue from maintenance and service arrangements, that management considers as one of the key performance factors.

Available Information

We make available our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, and amendments to these reports, free of charge through our Website (www.pega.com/about/investors) as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission (“SEC”). The SEC maintains a Website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov. We make available on our Website reports filed by our executive officers and Directors on Forms 3, 4, and 5 regarding their ownership of our securities. Our Code of Conduct, and any amendments to our Code of Conduct, are also available on our Website at www.pega.com/about/leadership on the “Governance” tab.

The following important factors could cause our actual business and financial results to differ materially from those contained in forward-looking statements made in this Annual Report on Form 10-K or elsewhere by management from time to time. The risks and uncertainties described below are not the only ones facing us. Other events that we do not currently anticipate or that we currently deem immaterial may also affect our results of operations, cash flows, and financial condition.

Factors relating to our financial results

The timing of our license and cloud revenue is difficult to predict accurately, which may cause our quarterly operating results to vary considerably. A change in the number or size of high value license arrangements, or a change in the mix between perpetual licenses, term licenses, and Pega Cloud subscriptions can cause our revenues to fluctuate materially from quarter to quarter. In the event that our clients choose term licenses or Pega Cloud subscriptions, we typically recognize the revenue over the license term or Pega Cloud subscription term, which may adversely affect our profitability in any period due to sales commissions being paid at the time of signing and the corresponding revenue being recognized over time. Other factors which may influence the predictability of our license revenue include: changes in customer budgets and decision-making processes that could affect both the timing and size of transactions; the deferral of license revenue to future periods due to the timing of the execution of an agreement or our ability to deliver the products or services; changes in our business model; and/or our ability to execute on our marketing and sales strategies.

We budget for our selling and marketing, product development, and other expenses based on anticipated future revenue. If the timing or amount of revenue fails to meet our expectations in any given quarter, our financial performance is likely to be adversely affected because only small portions of expenses vary with revenue. Other factors which may cause our quarterly operating results to vary considerably include changes in foreign currency exchange rates, income tax effects, and the impact of new accounting pronouncements.

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As a result, period-to-period comparisons of our operating results are not necessarily meaningful and should not be relied upon to predict future performance. If our revenues and operating results do not meet the expectations of our investors or securities analysts or fall below guidance we may provide to the market or due to other factors discussed elsewhere in this section, the price of our common stock may decline.

The number of our license arrangements has been increasing, and we may not be able to sustain this growth unless we and our partners can provide sufficient high quality consulting services, training, and maintenance resources to enable our clients to realize significant business value from our software. Our clients typically request consulting services and training to assist them in implementing our products. Our clients also purchase maintenance on our products in almost all cases. As a result, an increase in the number of license arrangements is likely to increase demand for consulting services, training, and maintenance relating to our products. Given that the number of our license arrangements has been increasing, we will need to provide our clients with more consulting services, training, and maintenance to enable our clients to realize significant business value from our software. We have been increasingly enabling our partners and clients through training to create an expanded ecosystem of people that are skilled in the implementation of our products. However, if we and our partners are unable to provide sufficient high quality consulting services, training, or maintenance resources to our clients, our clients may not realize sufficient business value from our products to justify follow-on sales, which could impact our future financial performance. In addition, the growth required to meet the increased demand for our consulting services could strain our ability to deliver our services engagements at desired levels of profitability, thereby impacting our overall profitability and financial results.

We frequently enter into a series of licenses that are focused on a specific purpose or area of operations. If we are not successful in obtaining follow-on business from these clients, our financial performance could be adversely affected. We frequently enter into a series of licenses with our new clients that are focused on a specific purpose or area of operations. Once a client has realized the value of our software, we work with the client to identify opportunities for follow-on sales. However, we may not be successful in demonstrating this value to some clients, for reasons relating to the performance of our products, the quality of the services and support we provide for our products, or external reasons. Also, some of our smaller clients may have limited additional sales opportunities available. For any of these clients, we may not obtain follow-on sales or the follow-on sales may be delayed, and our license revenue could be limited. This could lower the total value of all transactions and adversely affect our financial performance.

Our consulting services revenue is dependent to a significant extent on closing new license transactions with clients. We derive a substantial portion of our consulting services revenue from implementations of new software licenses led by our consulting services staff and where we provide consulting services for our partner-led and client-led implementation efforts. Accordingly, if we do not continue to close more license transactions with our clients, we may not be able to maintain or grow our consulting services revenue, which could have an adverse effect on our results of operations.

If we are unable to maintain vendor-specific objective evidence (“VSOE”) of fair value of our time and materials (“T&M”) consulting services arrangements, we may be required to delay the recognition of a portion of our revenue to future periods. We have established VSOE of fair value of our T&M consulting services in the Americas, in most of Europe, and certain regions of Asia, based on the price charged when these services are sold separately. Significant competition within our industry has created pricing pressure on consulting services provided by technology companies. If we elect to discount our pricing of T&M consulting services or otherwise introduce variability in our T&M consulting services arrangements to attract or retain clients, this could lead to an insufficient number of consistently priced T&M consulting services arrangements for us to maintain VSOE. If we do not have VSOE of fair value of our T&M consulting services, we may be required to recognize all revenue for these consulting services arrangements, including any bundled license, maintenance, and other services revenue, ratably over the longer of the software maintenance period or the service period. This delay in revenue recognition could have an adverse effect on our results of operations.

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Our financial results may be adversely affected if we are required to change certain estimates, judgments, and/or positions relative to our income and other taxes. In the ordinary course of conducting our global business enterprise, we cannot be certain of the ultimate tax outcome related to many transactions and calculations. Some of these uncertainties arise as a consequence of positions we have taken regarding valuation of deferred tax assets, transfer pricing for transactions with our subsidiaries, and potential challenges to nexus and tax credit estimates. We estimate our exposure to unfavorable outcomes related to these uncertainties and estimate the probability of such outcomes. Future realization of our deferred tax assets ultimately depends on the existence of sufficient taxable income within the available carryback or carryforward periods. We record a valuation allowance to reduce our deferred tax assets to an amount we believe is more likely than not to be realized. If our taxable income is not consistent with our expectations or the timing of income is not within the applicable carryforward period, we may be required to establish a valuation allowance on all or a portion of these deferred tax assets. Changes in our valuation allowance impact our income tax expense in the period of adjustment. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters or our current estimates regarding these matters will not be different from what is reflected in our historical income tax provisions, returns, and accruals. Such differences, or changes in estimates relating to potential differences, could have a material impact, unfavorable or favorable, on our income tax provisions and effective tax rate, require us to change the recorded value of deferred tax assets, and adversely affect our financial results. Our effective tax rate may also be adversely affected by changes in the mix of taxable income derived by jurisdictions with varied statutory tax rates, changes in tax laws, regulations and interpretations, changes to the financial accounting rules for income taxes and assessments, and any interest or penalties, by taxing authorities.

We are also subject to non-income taxes such as payroll, sales, use, value-added, net worth, property, and goods and services taxes in the U.S. and in various foreign jurisdictions. We are regularly under audit by tax authorities with respect to these non-income taxes and may have exposure to additional non-income tax liabilities which could have an adverse effect on our results of operations and financial condition.

If it became necessary to repatriate any of our foreign cash balances to the United States, we may be subject to increased income taxes, other restrictions, and limitations. As of December 31, 2016, approximately $51.8 million of our cash and cash equivalents was held in our foreign subsidiaries. If we are unable to reinvest this cash outside of the U.S., we may have to repatriate some of our foreign cash to the U.S. which would increase our income tax liability. If it became necessary to repatriate these funds, we may be required to pay U.S. tax, net of any applicable foreign tax credits, upon repatriation. We consider the earnings of our foreign subsidiaries to be permanently reinvested and, as a result, U.S. taxes on such earnings have not been provided. It is impractical to estimate the amount of U.S. tax we could have to pay upon repatriation due to the complexity of the foreign tax credit calculations and other factors.

We are investing heavily in sales and marketing, research and development, and support in anticipation of a continued increase in license arrangements, and we may experience decreased profitability or losses if we do not continue to increase the value of our license arrangements to balance our growth in expenses. We have been expanding our sales and marketing capacity to meet increasing demand for our software and to broaden our market coverage by hiring additional sales and marketing personnel. We anticipate that we will need to provide our clients with more maintenance support as a result of this increase in demand, and also have been hiring additional personnel in this area. We continue to invest significantly in research and development to expand and improve the Pega Platform and applications. These investments have resulted in increased fixed costs that do not vary with the level of revenue. If the increased demand for our products does not continue, we could experience decreased profitability or losses as a result of these increased fixed costs. Conversely, if we are unable to hire sales and marketing personnel to meet future demand or research and development personnel to enhance our current or develop new products, we may not be able to achieve our sales and profitability targets.

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Factors relating to our products and markets

We will need to acquire or develop new products, evolve existing ones, address any defects or errors, and adapt to technology change. Technical developments, client requirements, programming languages, and industry standards change frequently in our markets. As a result, success in current markets and new markets will depend upon our ability to enhance current products, address any product defects or errors, acquire or develop and introduce new products that meet client needs, keep pace with technology changes, respond to competitive products, and achieve market acceptance. Product development requires substantial investments for research, refinement, and testing. We may not have sufficient resources to make necessary product development investments. We may experience technical or other difficulties that will delay or prevent the successful development, introduction, or implementation of new or enhanced products. We may also experience technical or other difficulties in the integration of acquired technologies into our existing platform and applications. Inability to introduce or implement new or enhanced products in a timely manner could result in loss of market share if competitors are able to provide solutions to meet customer needs before we do, give rise to unanticipated expenses related to further development or modification of acquired technologies as a result of integration issues, and adversely affect future financial performance.

The market for our offerings is intensely and increasingly competitive, rapidly changing, and highly fragmented. We compete in the CRM sector, which includes marketing, sales, and service, BPM, Case Management, Decision Management, robotic automation, co-browsing, social engagement, and mobile application development platform software markets, as well as in markets for the vertical applications we provide (e.g. KYC for Financial Services, Underwriting for Insurance). The markets for our software and related implementation, consulting, and training services are intensely competitive, rapidly changing, and highly fragmented. We currently encounter significant competition from internal information systems departments of potential or existing clients that develop custom software and professional service organizations that develop custom software in conjunction with rendering consulting services. Competition for market share and pressure to reduce prices and make sales concessions are likely to increase. Many of our competitors, such as IBM, Oracle, and Salesforce, are large and have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages, or standards or to changes in client requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote, and distribute products and to provide related consulting and training services. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition. See “Business—Competition” in Item 1 of this Annual Report on Form 10-K.

The continued uncertainties in international economies may negatively impact our sales to, and the collection of receivables from, our clients. Our sales to, and our collection of receivables from, our clients may be impacted by adverse changes in global economic conditions. The United States and other key international economies have experienced cyclical downturns from time to time during which economic activity was been impacted by falling demand for goods and services, restricted credit, poor liquidity, reduced corporate profitability, volatility in credit, equity, and foreign exchange markets, bankruptcies, and economic uncertainty. These changes in global economic conditions could impact the ability and willingness of our clients to make investments in technology, which in turn may delay or reduce the number of purchases of our software and services. These factors could also impact the ability and willingness of these clients to pay their trade obligations and honor their contractual commitments under their noncancellable term licenses. These clients may also become subject to increasingly restrictive regulatory requirements, which could limit or delay their ability to proceed with new technology purchases and may result in longer sales cycles, increased price competition, and reductions in sales of our products and services. The financial uncertainties facing many of our clients and the industries in which they operate could negatively impact our business, operating results, and financial condition.

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We have historically sold to the financial services, healthcare, insurance, and communications markets, and rapid changes or consolidation in these markets could affect the level of demand for our products. We have historically derived a significant portion of our revenue from clients in the financial services, healthcare, insurance, and communications markets, and sales to these markets are important for our future growth. Competitive pressures, industry consolidation, decreasing operating margins, regulatory changes, and privacy concerns affect the financial condition of our clients and their willingness to buy. In addition, clients’ purchasing patterns in these industries for large technology projects are somewhat discretionary. The financial services and insurance markets continue to undergo intense domestic and international consolidation, and consolidation has increased in the healthcare and communications markets. Consolidation may interrupt normal buying behaviors and increase the volatility of our operating results. In recent years, several of our clients have been merged or consolidated, and we expect this to continue in the near future. Future mergers or consolidations may cause a decline in revenues and adversely affect our future financial performance. All of these factors affect the level of demand for our products from clients in these industries, and could adversely affect our business, operating results, and financial condition.

We rely on certain third-party relationships. We have a number of relationships with third parties that are significant to our sales, marketing and support activities, and to product development efforts, including Pega Cloud hosting facilities. We rely on software and hardware vendors, large system integrators, and technology consulting firms to provide marketing and sales opportunities for our direct sales force and to strengthen our products through the use of industry-standard tools and utilities. We also have relationships with third parties that distribute our products. There can be no assurance that these companies, most of which have significantly greater financial and marketing resources, will not develop or market products that compete with ours in the future or will not otherwise end or limit their relationships with us. Further, the use of third-party hosting facilities requires us to rely on data security as it is provided by such third parties, which despite our due diligence may be or become less than adequate, and on the functionality and availability of their services.

We face risks from operations and clients based outside of the U.S. Sales to clients based outside of the U.S. represented an average of 44% of our total revenue for the last three fiscal years. We market products and render consulting and training services to clients based outside of the U.S. including clients based in Canada, Europe, Latin America, Asia, and Australia. We have established offices in the Americas, Europe (including Russia and Turkey), Asia (including India), and Australia. We believe that growth will necessitate expanded international operations, requiring a diversion of managerial attention and increased costs. We anticipate hiring additional personnel to accommodate international growth, and we may also enter into agreements with local distributors, representatives, or resellers. If we are unable to do one or more of these things in a timely manner, our growth, if any, in our foreign operations may be restricted, and our business, operating results, and financial condition could be materially and adversely affected.

In addition, we may not be able to maintain or increase international market demand for our products. Additional risks inherent in our international business activities generally include:

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There can be no assurance that one or more of these factors will not have a material adverse effect on our foreign operations, and, consequently, on our business, operating results, and financial condition.

On June 23, 2016, the U.K. held a referendum in which U.K. voters approved an exit from the European Union (“the E.U.”), commonly referred to as “Brexit”. As a result of the referendum, it is expected that the British government will begin negotiating the future terms of the U.K. relationship with the E.U., including the terms of trade between the U.K. and the E.U. The announcement of Brexit caused significant volatility in global stock markets and currency exchange rate fluctuations that resulted in the strengthening of the U.S. dollar against foreign currencies in which we conduct business. The future effects of Brexit will depend on any agreements the U.K makes to retain access to E.U. markets either during a transitional period or more permanently. The measures could potentially disrupt the markets we serve and may cause our customers to closely monitor their costs and reduce their spending budget on our products and services. In addition, Brexit could lead to legal uncertainty and potentially divergent national laws and regulations as the U.K. determines which E.U. laws to replace or replicate. Given the lack of comparable precedent, it is unclear what financial, trade and legal implications the withdrawal of the U.K. from the E.U. would have and how such withdrawal would affect us. Adverse consequences such as deterioration in economic conditions, volatility in currency exchange rates, and prohibitive laws and regulations could have a negative impact on our business, operating results, and financial condition.

We are exposed to fluctuations in currency exchange rates that could negatively impact our financial results and cash flows. Because a significant portion of our business is conducted outside the U.S., we face exposure to adverse movements in foreign currency exchange rates. Our international sales are usually denominated in foreign currencies. The operating expenses of our foreign operations are also primarily denominated in foreign currencies, which partially offset our foreign currency exposure on our international sales. Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the U.S. dollar, the Euro, and the Australian dollar relative to the British Pound, and the Euro relative to the U.S. dollar. These exposures may change over time as business practices evolve, and they could have a material adverse impact on our financial results and cash flows. We use foreign currency forward contracts (“forward contracts”) to hedge our exposure to changes in foreign currency exchange rates associated with our foreign currency denominated cash, accounts receivable, and intercompany receivables and payables held by our U.S. parent company and Pegasystems Limited, its U.K. subsidiary. These forward contracts have terms not greater than six months and are intended to partially mitigate exposure to the foreign currency transaction gains and losses. We do not enter into any hedging contracts for trading or speculative purposes. Our realized gain or loss with respect to foreign currency fluctuations will generally depend on the size and type of cross-currency exposures that we enter into; the currency exchange rates associated with these exposures and changes in those rates; whether we have entered into forward contracts to offset these exposures; and other factors. All of these factors could materially impact our operating results, financial condition, and cash flows.

The announcement of Brexit adversely impacted global markets, including currencies, and resulted in a sharp decline in the value of the British pound, as compared to the U.S. dollar and other currencies. Volatility in exchange rates is expected to continue in the short term as the U.K. negotiates its exit from the E.U. A weaker British pound compared to the U.S. dollar during a reporting period causes our international revenue to be translated into fewer U.S. dollars which may adversely affect our results of operations.

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Factors relating to our internal operations and potential liabilities

We depend on certain key personnel, and must be able to attract and retain qualified personnel in the future. The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales, and marketing personnel, including our Chief Executive Officer who is also our founder and majority stockholder. The loss of key personnel could be disruptive to our operations and adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our success will depend in large part on the ability to hire and retain qualified personnel, and rapidly replace and ramp up new management. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell, and maintain our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected.

The acquisition of other businesses and technologies may present new risks. In the past, we have undertaken acquisitions and we continue to evaluate and consider other potential strategic transactions, including domestic and international acquisitions of businesses, technologies, services, products, and other assets. These acquisitions, if undertaken, may involve significant new risks and uncertainties, including distraction of management attention away from our current business operations, insufficient new revenue to offset expenses, inadequate return on capital, integration challenges, new regulatory and/or legal requirements, new third-party intellectual property infringement claims related to the acquired technology and/or services, dilution of shareholder value, cross border legal issues, and issues not discovered in our due diligence process. No assurance can be given that such acquisitions will be successful and will not adversely affect our profitability or operations.

We may not be able to achieve the key elements of our strategy and grow our business as anticipated. We currently intend to grow our business by pursuing strategic initiatives. Key elements of our strategy include continuing to grow our market share by developing and delivering robust applications for marketing, sales automation, customer service, and operations that can work together seamlessly with maximum differentiation and minimal customization, offering versatility in our Pega Platform and application deployment and licensing options to meet the specific needs of our clients, growing our network of partner alliances, and developing the talent and organizational structure capable of supporting both our revenue and earnings growth targets. We may not be able to achieve one or more of our key initiatives. Our success depends on our ability to appropriately manage our expenses as we grow our organization; successfully execute our marketing and sales strategies; successfully incorporate acquired technologies into our unified Pega Platform; and develop new products or product enhancements. If we are not able to execute on these actions, our business may not grow as we anticipated, and our operating results could be adversely affected.

We may experience significant errors or security flaws in our product and services, and could face privacy, product liability, and/or warranty claims as a result. Despite quality testing prior to their release, software products frequently contain errors or security flaws, especially when first introduced or when new versions are released. Errors in our software products could affect the ability of our products to work with other hardware or software products, or could delay the development or release of new products or new versions of products. Additionally, the detection and correction of any security flaws can be time consuming and costly. Errors or security flaws in our software could result in the inadvertent disclosure of confidential information or personal data relating to our clients, employees, or third parties. Software product errors and security flaws in our products or services could expose us to privacy, product liability, and/or warranty claims as well as harm our reputation, which could impact our future sales of products and services. Typically, we enter into license agreements that contain provisions intended to limit the nature and extent of our risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct client. Furthermore, some of our licenses with our clients are governed by non-U.S. law, and there is a risk that foreign law might give us less or different protection. Although we have not experienced any material

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product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management’s attention and our resources.

We face risks related to intellectual property claims or appropriation of our intellectual property rights. We rely primarily on a combination of copyright, trademark, and trade secrets laws, as well as intellectual property and confidentiality agreements to protect our proprietary rights. We also try to control access to and distribution of our technologies and other proprietary information. We have obtained patents in strategically important global markets relating to the architecture of our systems. We cannot assure that such patents will not be challenged, invalidated, or circumvented or that rights granted thereunder or the claims contained therein will provide us with competitive advantages. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain the use of information that we regard as proprietary. Although we generally enter into intellectual property and confidentiality agreements with our employees and strategic partners, despite our efforts our former employees may seek employment with our business partners, customers, or competitors, and there can be no assurance that the confidential nature of our proprietary information will be maintained. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the U.S. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology.

Other companies or individuals have obtained proprietary rights covering a variety of designs, processes, and systems. There can be no assurance that third parties, including clients, will not claim infringement by us with respect to current or future products. Although we attempt to limit the amount and type of our contractual liability for infringement of the proprietary rights of third parties, and also assert ownership of work product and intellectual property rights as appropriate, there are often exceptions, and limitations may not be applicable and enforceable in all cases. Even if limitations are found to be applicable and enforceable, our liability to our clients for these types of claims could be material given the size of certain of our transactions. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment and delivery delays, require us to enter into royalty or licensing agreements, or be precluded from making and selling the infringing products, if such proprietary rights are found to be valid. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results, and financial condition.

We are subject to increasingly complex and burdensome U.S. and foreign laws and regulations, and any failure to comply with these laws and regulations could subject us to, among other things, penalties and legal expenses that could harm our reputation or have a material adverse effect on our business, financial condition and results of operations. We are subject to extensive federal, state, and foreign laws and regulations, including but not limited to the U.S. Foreign Corrupt Practices Act, the U.K. Bribery Act, data privacy and security laws, and similar laws and regulations. The Foreign Corrupt Practices Act, the U.K. Bribery Act, and similar foreign anti-bribery laws generally prohibit companies and their intermediaries from making improper payments for the purpose of obtaining or retaining business. Similar laws and regulations exist in many other countries throughout the world in which we do or intend to do business. Data privacy laws and regulations in Europe, Australia, Latin America and elsewhere are undergoing rapid transformation towards increased restrictions. For example, in October 2015, the European Court of Justice invalidated the U.S.-EU Safe Harbor framework that had been in place since 2000, which allowed companies to meet certain European legal requirements for the transfer of personal data from the European Economic Area to the United States. In April 2016, the European Parliament adopted the General Data Protection Regulation (“GDPR”). The GDPR has a two-year phase-in period and extends the scope of European privacy laws to any entity which processes personal data about E.U. residents in connection with the offer of goods or services or the monitoring of behavior. Complying with the GDPR and other emerging and changing requirements may cause us to incur substantial costs or require us to change our business practices.

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We have developed and implemented a compliance program based on what we believe are current best practices, including the background checking of all of our current partners and of prospective clients and partners, but we cannot guarantee that we, our employees, our consultants, or our contractors are or will be in compliance with all federal, state, and foreign regulations, particularly as we expand our operations outside of the U.S. If we or our representatives fail to comply with any of these laws or regulations, a range of fines, penalties, and/or other sanctions could be imposed on us, which could have a material adverse effect on our business, financial condition, and results of operations. Even if we are determined not to have violated these laws, government investigations into these issues typically require the expenditure of significant resources and generate negative publicity, which could also have an adverse effect on our business, financial condition, and results of operations. In addition, regulation of data privacy and security laws is increasing worldwide, including various restrictions on cross-border access or transfer of data, including personal data of our employees, our clients, and customers of our clients. Compliance with such regulations may increase our costs and there is a risk of enforcement of such laws resulting in damage to our brand as well as financial penalties and potential loss of business, which could be significant.

We face risks related to outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic for Pega Cloud services demands more computing power. It requires that we maintain an Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of client data, power outages, or telecommunications infrastructure outages, by us or our third party service provider could diminish the quality of our user experience resulting in contractual liability, claims by clients and other third parties, damage to our reputation, loss of current and potential clients, and harm to our operating results and financial condition.

Security of our systems and of global client data is a growing challenge on many fronts. Cyber-attacks and security breaches may expose us to significant legal and financial liabilities. Our Pega Cloud services provide Pega Platform environments that are provisioned, monitored, and maintained for individual clients to create and deploy Pega-based applications using an Internet-based infrastructure. These services involve the storage and transmission of clients’ data and potential proprietary information. Security breaches could expose us and our clients to a risk of loss or misuse of this information. Any security breach could result in a loss of confidence in the security of our services, damage our reputation, disrupt our business, lead to legal liability, and negatively impact our future sales. High-profile security breaches at other companies have increased in recent years, and security industry experts and government officials have warned about the risks of hackers and cyber-attackers targeting information technology (“IT”) products and businesses. Threats to IT security can take a variety of forms. Individual hackers, groups of hackers, and sophisticated organizations including state-sponsored organizations or nation-states themselves, may take steps that pose threats to our clients and to our IT structure.

Our security measures, and those of our clients, may be breached as a result of third-party actions, or that of employees, consultants, or others, including intentional misconduct by computer hackers, system error, human error, technical flaws in our products, or otherwise. The techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not recognized until launched against a target. While we have invested in the protection of our data and systems and of our clients’ data to reduce these risks, there can be no assurance that our efforts will prevent breaches. We carry data breach insurance coverage to mitigate the financial impact of potential legal liability, though this may prove insufficient in the event of a breach.

Our Pega Cloud services involve the hosting of clients’ applications on the servers of a third-party technology provider. We also rely on third-party systems and technology including encryption, virtualized infrastructure, and support, and we employ a shared security model with our clients and our third-party technology providers. Because we do not control the development of Pega applications by our clients, the transmissions between our clients and our third-party technology providers, the processing of data on the servers at third-party technology providers, or the internal controls maintained by our clients and third-party technology providers that could prevent unauthorized access or provide appropriate data encryption, we cannot fully ensure the complete integrity or security of such

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transmissions processing, or controls. In addition, privacy, security, and data transmission concerns in some parts of the world may inhibit demand for our Pega Cloud services or lead to requirements to provide our products or services in configurations that may increase the cost of serving such markets.

In order to defend against security threats, we need to continuously engineer products and services with enhanced security and reliability features; improve the deployment of software updates to address security vulnerabilities; apply technologies which mitigate the risk of attacks; and maintain a digital security infrastructure that protects the integrity of our network, products, and services. The cost of these steps could negatively impact our operating margins.

Our implementation of significant modifications to our enterprise resource planning (“ERP”) system may adversely affect our business and results of operations or the effectiveness of internal control over financial reporting. During 2016, we implemented the billing and revenue recognition modules in our existing ERP system. The new revenue recognition module was implemented to facilitate the preparation of our financial statements under both the current revenue recognition guidance under Accounting Standards Codification 985-605, Software—Revenue Recognition and the new guidance under Accounting Standard Update No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”. See Note 2, “Significant Accounting Policies—New accounting pronouncements,” included in the Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K for further discussion of new guidance. Implementations of a project of this size and complexity involves risks inherent in the conversion to a new computer system, including loss of information and potential disruption of normal operations. The implementation was completed in the fourth quarter of 2016; however, post-implementation support activities are still ongoing. Our business and results of operations may be adversely affected if we experience operating problems with the new system that result in increased costs to correct post-implementation issues identified. Additionally, if the new system and the associated process changes do not give rise to the benefits that we expect, or if the new system does not operate as intended, it could adversely affect our financial reporting systems and processes, our ability to produce timely and accurate financial reports, and/or the effectiveness of internal control over financial reporting. We have assessed, and continue to monitor, our processes and procedures as a result of the implementation, as well as the impact on our internal controls over financial reporting. Where appropriate, we have made changes to these controls over financial reporting to address these system changes and to help ensure that we maintain effective internal controls over financial reporting as of December 31, 2016.

None.

Our principal administrative, sales, marketing, support, and research and development operations are located in Cambridge, Massachusetts in an approximately 185,000 square foot leased facility. Our lease expires in 2023, subject to our option to extend for two additional five-year periods. We also lease space for our other offices in the Americas, Europe, and the Asia Pacific under leases that expire at various dates through 2021. We periodically evaluate the adequacy of existing facilities and additional facilities in new cities, and we believe that additional or alternative space will be available as needed in the future on commercially reasonable terms.

See Note 12 “Commitments and Contingencies,” in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for more information about our lease commitments.

None.

Not applicable.

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PART II

Stock Split

On March 6, 2014, our Board of Directors approved a two-for-one stock split of our common stock, effected in the form of a common stock dividend (the “Stock Split”). On April 1, 2014, each stockholder of record at the close of business on March 20, 2014 (the “Record Date”) received as a dividend, one additional share of common stock, par value $0.01, for each share of common stock held on the Record Date. The per share amounts for all prior periods presented in this Annual Report on Form 10-K have been retroactively restated to reflect the Stock Split, except as otherwise noted.

Market Information

Our common stock is quoted on the NASDAQ Global Select Market (“NASDAQ”) under the symbol “PEGA.” The following table sets forth the range of high and low sales prices of our common stock on NASDAQ for each quarter in the years ended December 31:

Holders

As of February 10, 2017, we had approximately 23 stockholders of record and approximately 12,000 beneficial owners of our common stock.

Dividends

In July 2006, we began paying a quarterly cash dividend of $0.03 per share of common stock. This represents $0.015 per share of common stock giving effect to the Stock Split. On May 27, 2014, we announced an increase in our quarterly common stock cash dividend from $0.015 to $0.03 per share. Quarterly cash dividends are expected to continue at $0.03 per share, subject to change or elimination at any time by our Board of Directors.

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Issuer Purchases of Equity Securities

The following table sets forth information regarding our repurchases of our common stock during the fourth quarter of 2016.

On May 20, 2016, we announced that our Board of Directors extended the expiration date of the current stock repurchase program to June 30, 2017 and increased the amount of stock the Company is authorized to repurchase to $50 million between May 18, 2016 and June 30, 2017 (the “Current Program”). Under the Current Program, purchases may be made from time to time on the open market or in privately negotiated transactions. Shares may be repurchased in such amounts as market conditions warrant, subject to regulatory and other considerations. We have established a pre-arranged stock repurchase plan, intended to comply with the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 10b-18 under the Exchange Act (the “10b5-1 Plan”). All share repurchases under the Current Program during closed trading window periods will be made pursuant to the 10b5-1 Plan.

We net settle the majority of our employee stock option exercises and restricted stock unit (“RSU”) vestings, which results in the withholding of shares to cover the option exercise price and the minimum statutory withholding tax obligations that we are required to pay in cash to the applicable taxing authorities on behalf of our employees. We do not consider these transactions to be common stock repurchases.

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Stock Performance Graph and Cumulative Total Stockholder Return

The following performance graph represents a comparison of the cumulative total stockholder return (assuming the reinvestment of dividends) for a $100 investment on December 31, 2011 in our common stock, the Total Return Index for the NASDAQ Composite (“NASDAQ Composite”), a broad market index, and the Standard & Poors (“S&P”) North American Technology Sector -Software Index™ (“S&P NA Tech Software”), a published industry index. We paid dividends of $0.12 per share during 2016 and 2015, $0.09 per share during 2014, $0.045 per share during 2013, and $0.075 per share during 2012, respectively. The graph lines merely connect measurement dates and do not reflect fluctuations between those dates.

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The selected financial data presented below has been derived from our audited consolidated financial statements. This data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the consolidated financial statements, and accompanying notes.

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BUSINESS OVERVIEW

We develop, market, license, and support software applications for marketing, sales, service, and operations. In addition, we license our Pega Platform for clients that wish to build and extend their own applications. The Pega Platform assists our clients in building, deploying, and evolving enterprise applications, creating an environment in which business and IT can collaborate to manage back office operations, front office sales, marketing, and/or customer service needs. We also provide consulting services, maintenance, and training for our software. Our software applications and Pega Platform can be deployed on Pega-managed, partner-managed, or customer-managed cloud architectures.

Our clients include Global 3000 companies and government agencies that seek to manage complex enterprise systems and customer service issues with greater agility and cost-effectiveness. Our strategy is to sell a client a series of licenses, each focused on a specific purpose or area of operations, in support of longer term enterprise-wide digital transformation initiatives.

Our license revenue is primarily derived from sales of our applications and our Pega Platform. Our cloud revenue is derived from the licensing of our hosted Pega Platform and software application environments. Our consulting services revenue is primarily related to new license implementations. We offer training for our clients and partners at our regional training facilities and at third-party facilities, including client sites. Our online training through PegaAcademy provides an alternative way to learn our software in a virtual environment. We believe that this online training will continue to expand the number of trained experts at a faster pace.

Sales to clients based outside of the United States of America (“U.S.”) represented an average of 44% of our total revenue for the last three fiscal years. See Note 17, “Geographic Information and Major Clients,” included in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further detail on our geographic revenues.

At the end of June 2016, the United Kingdom (the “U.K.”) held a referendum in which U.K. voters approved an exit from the European Union (the “E.U.”), commonly referred to as “Brexit”. While Brexit has not had a meaningful impact on our business momentum, it has resulted in a sharp decline in the value of the British pound, slightly reducing revenue during 2016, but with no material impact on our results of operations. Prolonged weakening of the British pound relative to the U.S. dollar may adversely affect our revenue and results of operations in future periods.

We continue to expand our sales and marketing capacity to achieve broader market coverage, with sales and marketing costs representing 37%, 35%, and 35% of revenue during 2016, 2015, and 2014, respectively. We are investing heavily in research and development to expand and improve our software offerings, with research and development costs representing 19%, 19%, and 18% of revenue during 2016, 2015, and 2014.

In evaluating the financial condition and operating performance of our business, management focuses on the following key performance factors:

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Recurring revenue increased to 53% of total revenue in 2016 compared to 50% in 2015. Our business may continue to shift towards the recurring revenue streams of term and cloud licenses. As a result of this shift, gross profit, operating income, net income, and earnings per share may grow slower than historical trends due to more license revenue being recognized over longer periods.

Another key performance factor as we shift towards recurring revenue is license and cloud backlog. It is computed by adding deferred license and cloud revenue recorded on the balance sheet (See Note 11 “Deferred Revenue” in the Notes to Consolidated Financial Statements) and client license and cloud contractual commitments, which are not on our balance sheet because we have not yet invoiced our clients, nor have we recognized the associated revenues (See the table of future cash receipts in Liquidity and Capital Resources—Cash Provided by Operating Activities). License and cloud backlog may vary in any given period depending on the amount and timing of when the arrangements are executed, as well as the mix between perpetual, term, and cloud license arrangements, which may depend on our clients’ deployment preferences.

To grow our business, we intend to:

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Whether or not we are successful depends, in part, on our ability to:

We also regularly evaluate acquisitions or investment opportunities in complementary businesses, services and technologies, and intellectual property rights in an effort to expand and enhance our product offerings. On April 11, 2016, we acquired OpenSpan, Inc. (“OpenSpan”), a privately held software provider of robotic process automation and workforce analytics software for $48.8 million in cash, net of $1.8 million in cash acquired. Subsequent to the acquisition we unified the Pega Robotic Automation with our Pega Platform for Case and Business Process Management and our portfolio of CRM applications. We believe this will enable clients to intelligently optimize how work gets done across the enterprise and more effectively automate tasks, streamline processes, increase employee productivity, and ultimately deliver better customer experiences.

RESULTS OF OPERATIONS

Revenue

Software license revenue

The mix between perpetual and term license arrangements executed in a particular period varies based on client needs. A change in the mix may cause our revenues to vary materially from period to period. A higher proportion of term license arrangements executed would result in more license revenue being recognized over longer periods. Additionally, some of our perpetual license arrangements include extended payment terms or additional rights of use, which also result in the recognition of revenue over longer periods. The aggregate value of new license agreements executed also fluctuates quarter to quarter.

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Term license revenue as a percentage of total license revenue increased during 2016 compared to 2015. If this trend continues, it will result in slower license revenue growth as we continue to build license backlog.

2016 Compared to 2015

The decrease in perpetual license revenue was primarily due to the lower average value of perpetual license arrangements executed during 2016 compared to 2015 and the acceleration of the recognition of $4.6 million in revenue in the fourth quarter of 2015 from an existing license arrangement which was being recognized ratably. The aggregate value of revenue expected to be recognized and payments due in future periods under noncancellable perpetual licenses periods was $31.7 million as of December 31, 2016 compared to $33.5 million as of December 31, 2015. See the table of future cash receipts in Liquidity and Capital Resources—Cash Provided by Operating Activities.

The increase in term license revenue was primarily due to a term license arrangement greater than $10 million for which the license fee for the three year license term was paid and recognized in full in the first quarter of 2016 as well as the increase in term license arrangements executed during 2016 and 2015, reflecting the shift towards recurring revenue streams. The aggregate value of revenue expected to be recognized and payments due in future periods under noncancellable term licenses and our Pega Cloud arrangements grew to $434.3 million as of December 31, 2016 compared to $322.8 million as of December 31, 2015. See the table of future cash receipts in Liquidity and Capital Resources—Cash Provided by Operating Activities.

2015 Compared to 2014

The increase in perpetual license revenue was primarily due to revenue recognized from the higher volume and higher average value of arrangements executed in 2015 and the acceleration of the recognition of $4.6 million in revenue from an existing license arrangement which was being recognized ratably. The aggregate value of revenue expected to be recognized and payments due in future periods under noncancellable perpetual licenses was $33.5 million as of December 31, 2015 compared to $31.3 million as of December 31, 2014.

The increase in term license revenue was primarily due to prepayments of two arrangements executed in 2015. The aggregate value of revenue expected to be recognized and payments due in future periods under noncancellable term licenses and our Pega Cloud arrangements grew to $322.8 million as of December 31, 2015 compared to $270.1 million as of December 31, 2014. See the table of future cash receipts in Liquidity and Capital Resources—Cash Provided by Operating Activities.

Maintenance revenue

The increases in maintenance revenue were primarily due to the growth in the aggregate value of the installed base of our software and continued renewal rates in excess of 90%.

Services revenue

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2016 Compared to 2015

Consulting services revenue represents revenue primarily from new license implementations. Our consulting services revenue may fluctuate in future periods depending on the mix of new implementation projects we perform as compared to those performed by our enabled clients or led by our partners. The increase in consulting services revenue was due to higher realization rates and increased billable hours primarily related to two large projects in 2016, when compared to unusually low demand in Europe in the first half of 2015.

Cloud revenue represents revenue from our Pega Cloud offerings. The increase in cloud revenue was primarily due to growth of our cloud client base.

2015 Compared to 2014

The increase in consulting services revenue was due to the higher number of projects and billable hours in 2015 compared to 2014.

The increase in cloud revenue was primarily due to growth of our cloud client base.

Gross Profit

2016 Compared to 2015

The increase in total gross profit was primarily due to increases in maintenance and services revenue.

The increase in services gross profit percent was primarily due to higher realization rates in 2016 compared to 2015 and the recognition of revenue in 2016 related to several large projects which had been delayed from prior periods, for which the majority of the associated costs had already been recognized in 2015.

2015 Compared to 2014

The increase in total gross profit was primarily due to increases in software license and maintenance revenue.

The increase in services gross profit percent was primarily due to increased global professional services utilization rates in 2015 compared to 2014, partially offset by increased software license costs.

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Operating expenses

Amortization of intangibles

2016 Compared to 2015

The increases were primarily due to the amortization associated with the $24.3 million of intangible assets acquired from OpenSpan in April 2016.

2015 Compared to 2014

The decreases were due to the full amortization in 2014 of acquired technology and other intangibles from our 2010 acquisition of Chordiant and our 2013 acquisition of Antenna.

Selling and marketing

Selling and marketing expenses include compensation, benefits, and other headcount-related expenses associated with our selling and marketing personnel as well as advertising, promotions, trade shows, seminars, and other programs. Selling and marketing expenses also include the amortization of customer related intangibles.

The increases in headcount reflect our efforts to increase our sales capacity to target new accounts in existing industries as well as to expand coverage in new industries and geographies, and to increase the number of our sales opportunities.

2016 Compared to 2015

The increase was primarily due to a $29.4 million increase in compensation and benefit expenses associated with higher headcount and sales commissions, a $2 million increase in sales and marketing programs expenses primarily related to our digital advertising and brand awareness campaigns and our PegaWorld annual user conference, and a $1 million increase in amortization expense due to the customer-related intangible assets acquired from OpenSpan.

2015 Compared to 2014

The increase was primarily due to a $14 million increase in compensation and benefit expenses associated with higher headcount, an $11.4 million increase in sales and marketing programs expenses primarily related to our digital advertising and brand awareness campaigns, and a $10 million increase in sales commissions associated with the higher value of new license arrangements executed in 2015 compared to 2014.

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Research and development

Research and development expenses include compensation, benefits, contracted services, and other headcount-related expenses associated with the creation and development of our products as well as enhancements and engineering changes to existing products and integration of acquired technologies.

The increases in headcount primarily reflect the growth in our India research facility which usually lowers our average compensation expense per employee.

2016 Compared to 2015

The increase was primarily due to a $16.1 million increase in compensation and benefit expenses associated with higher headcount and a $1.5 million increase in expendable equipment and software license expenses.

2015 Compared to 2014

The increase was primarily due to an $11.9 million increase in compensation and benefit expenses associated with higher headcount, a $1.4 million increase in outsourced hosting expenses, a $1.4 million increase in expendable equipment and software license expenses, and an $0.8 million increase in contracted professional services.

General and administrative

General and administrative expenses include compensation, benefits, and other headcount-related expenses associated with finance, legal, corporate governance, and other administrative headcount. They also include accounting, legal, and other professional consulting and administrative fees.

The general and administrative headcount includes employees in human resources, information technology, and corporate services departments whose costs are allocated to our other functional departments.

2016 Compared to 2015

The increase was primarily due to a $4.9 million increase in compensation and benefits expenses associated with higher headcount of which $2.2 million was due to higher stock-based compensation expense primarily from the increased value of our annual periodic equity awards. The increase was also due to the fact that 2016 did not include a $1.8 million benefit from the settlement of our indemnification claims against the former Antenna, Inc. shareholders and a $1.6 million benefit from the settlement of certain indirect tax liabilities, which reduced our general and administrative expense in 2015.

2015 Compared to 2014

The decrease was primarily due to the recognition in the first quarter of 2015 of the $1.8 million benefit from the settlement of our indemnification claims against the former Antenna, Inc. shareholders and the

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$1.6 million benefit from the settlement of certain indirect tax liabilities discussed above, partially offset by a $2.2 million increase in compensation and benefit expenses associated with higher headcount.

Stock-based compensation

We recognize stock-based compensation expense associated with equity awards in our consolidated statements of operations based on the fair value of these awards at the date of grant using the accelerated recognition method, while treating each vesting tranche as if it were an individual grant.

The increases were primarily due to the increased value of our annual periodic equity awards granted in March 2015 and 2016. These awards generally have a five-year vesting schedule.

See Note 14 “Stock-Based Compensation” in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information on our stock-based awards.

Non-operating income and expenses, net

We use foreign currency forward contracts (“forward contracts”) to hedge our exposure to fluctuations in foreign currency exchange rates associated with our foreign currency denominated cash, accounts receivable, and intercompany receivables and payables held by our U.S. parent company in currencies other than the U.S. dollar and by our U.K. subsidiary in currencies other than the British pound.

These forward contracts are not designated as hedging instruments. As a result, we record the fair value of the outstanding contracts at the end of the reporting period in our consolidated balance sheet, with any fluctuations in the value of these contracts recognized in other expense, net.

The total change in the fair value of our foreign currency forward contracts recorded in other expense, net, during 2016, 2015, and 2014 was a loss of $5.6 million, $1 million, and $0.5 million respectively.

See Note 4 “Derivative Instruments” in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for discussion on our use of forward contracts.

Provision for income taxes

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The provision for income taxes represents current and future amounts owed for federal, state, and foreign taxes.

2016 Compared to 2015

The decrease in the effective income tax rate for 2016 compared to 2015 was primarily due to the impact of the adoption of ASU 2016-09, which decreased income tax expense by $6.7 million. The adoption of ASU 2016-09 significantly impacts both the timing and method of how the tax effects of share-based awards are recognized. ASU 2016-09 requires the income tax effects to be recognized in the provision for income taxes when the awards vest or are settled whereas previously such income tax benefits were recognized as part of additional paid-in capital and could not be recognized until they were realized through a reduction in income taxes payable. See Note 2 “Significant Accounting Policies” —New accounting pronouncements” included in the Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K for additional information related to this adoption.

As of December 31, 2016, we had approximately $22.7 million of total unrecognized tax benefits, which will decrease our effective tax rate if recognized. We expect that the changes in the unrecognized benefits within the next twelve months will be approximately $0.1 million, which relate to the expiration of the applicable statute of limitations and will reduce our effective tax rate if recognized.

2015 Compared to 2014

The increase in effective income tax rate for 2015 compared to 2014 was primarily due to a $2.3 million decrease in the benefit related to income generated in foreign jurisdictions that are subject to tax at a lower rate than the U.S. statutory rate.

As of December 31, 2015, we had approximately $24 million of total unrecognized tax benefits, which would decrease our effective tax rate if recognized.

LIQUIDITY AND CAPITAL RESOURCES

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The decreases in cash and cash equivalents during the years ended December 31, 2016 and 2015 were driven by the increases in trade accounts receivable, largely due to the timing of collections and the large amounts of new and annual license and maintenance billings, and the increases in cash used in financing activities, primarily for share repurchases. The increase in cash and cash equivalents during the year ended December 31, 2014 was driven by the increase in cash provided by operating activities. Cash provided by operating activities is our primary source of liquidity. We use this source to fund our capital expenditures and acquisitions, investments, dividend payments, and share repurchase program. We believe that our current cash, cash equivalents, and cash flow from operations will be sufficient to fund our operations and our share repurchase program for at least the next 12 months. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected cash requirements.

We evaluate acquisition opportunities from time to time, which if pursued, could require use of our funds. In October, 2013, we acquired Antenna, and $0.8 million was paid in the first quarter of 2014 representing the remaining merger consideration related to the final working capital adjustment. During 2014, we completed three acquisitions for $6.3 million in cash, inclusive of $2.1 million in cash acquired, and $1.1 million in additional cash consideration which was paid in 2015 to the selling shareholders of one of the three companies acquired in 2014. During 2015 and 2016, we also paid $0.5 million and $0.3 million, respectively, in additional cash consideration to the selling shareholders of another one of the three companies acquired in 2014, based on the achievement of certain performance milestones. The final cash payment of $0.3 million was made in January 2017 to the same selling shareholders based on the achievement of additional performance milestones through the end of 2016. In April 2016, we acquired OpenSpan for $48.8 million in cash, net of cash acquired. As of December 31, 2016, $7.4 million of the cash consideration remains in escrow for up to an 18-month period after the acquisition as security for the indemnification obligations of the selling shareholders.

As of December 31, 2016, approximately $51.8 million of our cash and cash equivalents was held in our foreign subsidiaries. If it becomes necessary to repatriate these funds, we may be required to pay U.S. tax, net of any applicable foreign tax credits, upon repatriation. We consider the earnings of our foreign subsidiaries to be permanently reinvested and, as a result, U.S. taxes on such earnings are not provided. It is impractical to estimate the amount of U.S. tax we could have to pay upon repatriation due to the complexity of the foreign tax credit calculations. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures. See “Risk Factors—If it became necessary to repatriate any of our foreign cash balances to the United States, we may be subject to increased income taxes, other restrictions, and limitations” in Item 1A of this Annual Report on Form 10-K.

Cash provided by operating activities

The primary driver during 2016 was net income of $27 million.

The primary drivers during 2015 were net income of $36.3 million and a $17.7 million increase in deferred revenue primarily resulting from the difference in timing of billings and revenue recognition.

The primary drivers during 2014 were net income of $33.3 million, a $13.4 million increase in accounts payable and accrued expenses primarily due to the timing of income tax payments, and an $11.2 million increase in deferred revenue primarily resulting from the difference in timing of billings and revenue recognition for annual maintenance.

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Future Cash Receipts from Committed License and Cloud Arrangements

As of December 31, 2016, none of the amounts shown in the table below had been billed and no revenue had been recognized. The timing of future cash receipts may not coincide with the timing of future revenue recognition.

Total contractual future cash receipts due from our existing license agreements was approximately $356.4 million as of December 31, 2015 and $301.4 million as of December 31, 2014.

Cash used in investing activities

During 2016, we acquired OpenSpan for $48.8 million, net of cash acquired, and invested $19.1 million primarily in internally developed software and leasehold improvements at our corporate headquarters and our office in Hyderabad, India, partially offset by proceeds received from the sales of marketable debt securities of $62.2 million.

During 2015, we purchased marketable debt securities for $75.7 million, partially offset by the proceeds received from sales, maturities and called marketable debt securities of $43.9 million. In 2015, we paid additional cash consideration of $1.1 million to the selling shareholders of one of the three companies acquired in 2014 and $0.5 million to the selling shareholders of another one of the three companies acquired in 2014 based on the achievement of certain performance milestones. We also invested $11 million primarily in leasehold improvements for the build-out of our office in Hyderabad, India and purchases of computer equipment for our U.S. and India offices.

During 2014, cash used in investing activities was primarily for purchases of marketable debt securities for $55.5 million, partially offset by the proceeds received from the maturities and called marketable debt securities of $33.2 million. We paid $3.9 million for acquisitions for 2014, net of cash acquired. We also invested $11.5 million primarily in leasehold improvements for the build-out of our new India offices and purchases of computer equipment for our U.S. and India offices.

Cash used in financing activities

Net cash used in financing activities during 2016, 2015, and 2014 was primarily for repurchases of our common stock and the payment of our quarterly dividend. Since 2004, our Board of Directors has approved annual stock repurchase programs that have authorized the repurchase of up to $195 million of our common stock. On May 20, 2016, we announced that our Board of Directors extended the expiration date of the current stock repurchase program to June 30, 2017 and authorized the Company to repurchase up to an additional

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$50 million of our stock between May 18, 2016 and June 30, 2017 (the “Current Program”). As of December 31, 2016, approximately $149.1 million had been repurchased, $39.4 million remained available for repurchase, and $6.4 million had expired. Purchases under these programs have been made on the open market.

Common stock repurchases

The following table is a summary of our repurchase activity under all of our stock repurchase programs:

In addition to the share repurchases made under our repurchase programs, we net settled the majority of our employee stock option exercises and RSU vestings, which resulted in the withholding of shares to cover the option exercise price and the minimum statutory tax withholding obligations.

During 2016, 2015, and 2014, option and RSU holders net settled a total of 2,277,000 shares; 1,821,000 shares; and 1,193,000 shares, respectively, of which only 1,092,000 shares; 932,000 shares; and 641,000 shares, respectively, were issued to the option and RSU holders. The balance of the shares were surrendered to us to pay for the exercise price with respect to stock options and the applicable taxes for both options and RSUs. During 2016, 2015, and 2014, instead of receiving cash from the equity holders, we withheld shares with a value of $16.2 million, $9.8 million, and $6.1 million, respectively, for withholding taxes, and $18.1 million, $11.9 million, and $6.4 million, respectively, for the exercise price.

Dividends

On May 27, 2014, we announced an increase in our quarterly cash dividend from $0.015 to $0.03 per share. We declared quarterly dividends totaling $0.12 per share, $0.12 per share, and $0.105 per share for the years ended December 31, 2016, 2015, and 2014, respectively. For the years ended December 31, 2016, 2015, and 2014, we paid cash dividends of $9.2 million, $9.2 million, and $6.9 million, respectively. It is our current intention to pay a quarterly cash dividend of $0.03 per share, however, the Board of Directors may terminate or modify this dividend program at any time without notice.

Contractual obligations

As of December 31, 2016, we had purchase obligations for customer support and marketing programs and payments under operating leases. Our lease arrangement for our office headquarters expires in 2023, subject to our option to extend for two additional five-year periods. We also lease space for our other offices under noncancellable operating leases that expire at various dates through 2021.

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CRITICAL ACCOUNTING ESTIMATES AND SIGNIFICANT JUDGMENTS

Management’s discussion and analysis of the financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. and the rules and regulations of the SEC for annual financial reporting. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information.

We believe that, of our significant accounting policies, which are described in Note 2, “Significant Accounting Policies,” in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, the following accounting policies are most important to the portrayal of our financial condition and require the most subjective judgment. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. If actual results differ significantly from management’s estimates and projections, there could be a material effect on our financial statements.

Revenue recognition

Our revenue is derived primarily from software licenses, maintenance fees related to our software licenses, and consulting services. Our license arrangements, whether involving a perpetual license or a term license, generally also contain multiple other elements, including consulting services, training, and software maintenance services. See Note 2, “Significant Accounting Policies—(a) Revenue recognition,” in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for our full revenue recognition accounting policy.

Software revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether VSOE of fair value exists for those elements. The amount of consideration allocated to undelivered elements is based on the VSOE of fair value for those elements and is recognized as those elements are delivered. Any remaining portion of the total arrangement fee is allocated to the software license—the first element delivered. Revenue is recognized for each element when all of the revenue recognition criteria have been met. Changes in the mix of the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue.

Goodwill and Intangible Assets Impairment

Our goodwill and intangible assets result from our business acquisitions. Goodwill and intangible assets with indefinite useful lives are not amortized, but are tested for impairment at least annually or as circumstances indicate their value may no longer be recoverable. We do not carry any intangible assets with indefinite useful lives other than goodwill. We perform our annual goodwill impairment as of November 30th of each fiscal year. To assess if goodwill is impaired, we first perform a qualitative assessment to determine whether further

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impairment testing is necessary. If, as a result of the qualitative assessment, we consider it more-likely-than-not that the fair value of our reporting unit is less than its carrying amount, we perform a quantitative impairment test in a two-step process. For the first step, we screen for impairment, and if any possible impairment exists, we undertake a second step of measuring such impairment by performing discounted cash flow analysis. This analysis is based on cash flow assumptions that are consistent with the plans and estimates being used to manage our business. In the first step, we review the carrying amount of our reporting unit compared to the “fair value” of the reporting unit. An excess carrying value over fair value would indicate that goodwill may be impaired. If we determined that goodwill may be impaired, then we would compare the “implied fair value” to the carrying value of the goodwill. We periodically re-evaluate our business and have determined that we have one operating segment and one reporting unit. If our assumptions change in the future, we may be required to record impairment charges to reduce the carrying value of our goodwill. Changes in the valuation of goodwill could materially impact our operating results and financial position. We evaluate our intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. In evaluating potential impairment of these assets, we specifically consider whether any indicators of impairment are present, including, but not limited to:

If indicators of impairment are present, we compare the estimated undiscounted cash flows that the specific asset is expected to generate to its carrying value. The key assumptions of the cash flow model involve significant subjectivity. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value.

As of December 31, 2016, we had $73.2 million of goodwill and $44.2 million of acquired intangible assets. If our estimates or the related assumptions change in the future, we may be required to record impairment charges to reduce the carrying value of these assets. Changes in the valuation of long-lived assets could materially impact our operating results and financial position. To date, there have been no impairments of goodwill or intangible assets.

Accounting for Income Taxes

Significant judgment is required in determining our provision for income taxes and income tax assets and liabilities, including evaluating uncertainties in the application of accounting principles and complex tax laws. Changes in tax laws or our interpretation of tax laws and the resolution of any tax audits could significantly impact our financial statements.

We regularly assess the need for a valuation allowance against our deferred tax assets. Future realization of our deferred tax assets ultimately depends on the existence of sufficient taxable income within the available carryback or carryforward periods. We record a valuation allowance to reduce our deferred tax assets to an amount we believe is more likely than not to be realized. Changes in our valuation allowance impact income tax expense in the period of adjustment. Our deferred tax valuation allowance requires significant judgment and uncertainties, including assumptions about future taxable income that are based on historical and projected information.

We assess our income tax positions and record tax benefits based upon management’s evaluation of the facts, circumstances, and information available at the reporting date. For those tax positions where it is more-likely-than-not that a tax benefit will be sustained, we record the largest amount of tax benefit with a greater than

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50 percent likelihood of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information. For those income tax positions where it is not more-likely-than-not that a tax benefit will be sustained, no tax benefit is recognized in the financial statements.

As a global company, we use significant judgment to calculate and provide for income taxes in each of the tax jurisdictions in which we operate. In the ordinary course of our business, there are transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a consequence of transfer pricing for transactions with our subsidiaries and nexus and tax credit estimates. In addition, the calculation of acquired tax attributes and the associated limitations are complex. We estimate our exposure to unfavorable outcomes related to these uncertainties and estimate the probability of such outcomes.

Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome will not be different from what is reflected in our historical income tax provisions, returns, and accruals. Such differences, or changes in estimates relating to potential differences, could have a material impact on our income tax provision and operating results in the period in which such a determination is made.

See Note 15 “Income Taxes” in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information.

NEW ACCOUNTING PRONOUNCEMENTS

New Accounting Pronouncements are detailed in Note 2, “Significant Accounting Policies,” in the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily related to fluctuations in foreign exchange rates and interest rates.

Foreign currency exposure

Our international sales are usually denominated in foreign currencies. However, the operating expenses of our foreign operations are also primarily denominated in foreign currencies, which partially offset our foreign currency exposure. Changes in exchange rates have recently and may continue to have a negative effect on our total revenues. A hypothetical 10% strengthening in the U.S. dollar against other currencies would result in an approximately 3% decrease in revenues for each of the years ended December 31, 2016 and 2015, respectively, but with no material impact on our results of operations. See “Risk Factors—We are exposed to fluctuations in currency exchange rates that could negatively impact our financial results and cash flows” in Item 1A of this Annual Report on Form 10-K.

We have experienced and expect to continue to experience fluctuations in our net income as a result of transaction gains or losses related to remeasuring monetary assets and liabilities that are denominated in currencies other than the functional currency of the entities in which they are recorded. We are primarily exposed to changes in foreign currency exchange rates associated with Australian dollar, Euro, and U.S. dollar denominated cash, accounts receivable, and intercompany receivables and payables held by our U.K. subsidiary, a British pound functional entity. We recognized a net foreign currency transaction gain (loss) of $2.2 million and $(4.2) million for the years ended December 31, 2016 and 2015, respectively. We have historically used forward contracts to manage our exposure to changes in foreign currency exchange rates. These forward contracts are not designated as hedging instruments, and changes in the fair value of these forward contracts are recognized in other expense, net, in the accompanying consolidated statements of operations. If the British pound exchange rate in comparison to the Australian dollar, Euro, and U.S. dollar at December 31, 2016 and 2015 uniformly strengthened by 10%, the impact to the amount of foreign currency transaction gain (loss) and loss from the change in the fair value of forward contracts we report would be immaterial.

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Interest rate exposure

As of December 31, 2016, we had $63.2 million of marketable debt securities, which consisted primarily of corporate and municipal bonds, with a weighted-average remaining maturity of 14 months. Due to the overall short-term remaining maturities of our marketable debt securities, our interest rate exposure is not significant. As of December 31, 2016, a 200 basis point increase in market interest rates would have reduced the fair value of our fixed rate marketable debt securities by approximately $1.4 million.

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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Pegasystems Inc.

Cambridge, Massachusetts

We have audited the accompanying consolidated balance sheets of Pegasystems Inc. and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. We also have audited the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Pegasystems Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

/S/ DELOITTE & TOUCHE LLP

Boston, Massachusetts

February 24, 2017

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PEGASYSTEMS INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)