NOTE 1—DESCRIPTION OF BUSINESS

APX Group Holdings, Inc. (“Holdings” or “Parent”), and its wholly-owned subsidiaries, (collectively the “Company”), is one of the largest residential security and home automation companies in North America. The Company is engaged in the sale, installation, servicing and monitoring of electronic home security and automation systems in the United States and Canada.

On November 16, 2012, APX Group, Inc. (“APX”), 2GIG Technologies, Inc. (“2GIG”), and their respective subsidiaries were acquired by an investor group comprised of certain investment funds affiliated with Blackstone Capital Partners VI L.P., and certain co-investors and management investors (collectively, the “Investors”). This stock acquisition was accomplished through certain mergers and related reorganization transactions (collectively, the “Merger”) pursuant to which each of APX and 2GIG, and their respective subsidiaries became indirect wholly-owned subsidiaries of 313 Acquisition LLC, an entity wholly-owned by the Investors.

As a result of the Merger, Vivint, Inc. and its wholly-owned subsidiaries and 2GIG and its wholly-owned subsidiaries collectively became wholly-owned by APX Group, Inc., which is wholly-owned by APX Group Holdings, Inc., which is wholly-owned by APX Parent Holdco, Inc., which is wholly owned by 313 Acquisition, LLC. APX Parent Holdco, Inc. and APX Group Holdings, Inc. have no operations and were formed for the purpose of facilitating the Merger.

NOTE 2—SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation—As a result of the Merger, the consolidated financial statements are presented on two bases of accounting and are not necessarily comparable: January 1, 2011 through November 16, 2012 (the “Predecessor Period” or “Predecessor” as context requires) and November 17, 2012 through December 31, 2013 (the “Successor Period” or “Successor” as context requires), which relate to the period preceding the Merger and the period succeeding the Merger, respectively. The audited consolidated financial statements for the Predecessor Period are presented for APX Group, Inc. and its wholly-owned subsidiaries, including variable interest entities. The audited consolidated financial statements for the Successor Period reflect the Merger presenting the financial position and results of operations of APX Group Holdings, Inc. and its wholly-owned subsidiaries. The financial position and results of operations of the Successor are not comparable to the financial position and results of operations of the Predecessor due to the Merger and the basis of presentation of purchase accounting as compared to historical cost in accordance with Accounting Standards Codification (“ASC”) 805 Business Combinations.

The consolidated financial statements for the Predecessor and Successor include the financial position and results of operations of the following entities:

 

Successor		Predecessor
APX Group Holdings, Inc.		—
APX Group, Inc.		APX Group, Inc.
Vivint, Inc.		Vivint, Inc.
Vivint Canada, Inc.		Vivint Canada, Inc.
ARM Security, Inc.		ARM Security, Inc.
AP AL, LLC		AP AL, LLC
Vivint Purchasing, LLC		Vivint Purchasing, LLC
Vivint Servicing, LLC		Vivint Servicing, LLC
2GIG Technologies, Inc. (1)		2GIG Technologies, Inc.
2GIG Technologies Canada, Inc. (1)		2GIG Technologies Canada, Inc.
—		V Solar Holdings, Inc.
—		Vivint Solar, Inc.
313 Aviation, LLC		—
Vivint Wireless, Inc. (2)		—
Smartrove, Inc. (3)		—
Vivint New Zealand, Ltd. (2)		—
Vivint Australia Pty Ltd. (2)		—
Vivint Louisiana, LLC. (2)		—
Vivint Funding Holdings, LLC. (2)		—

 

(1)	The audited consolidated financial statements for the year ended December 31, 2013 include the results of 2GIG up through April 1, 2013, which was the date the Company completed the 2GIG Sale to Nortek (See Note 4).

(2)	Formed during the year ended December 31, 2013.

(3)	Acquired on May 29, 2013.

The Successor and Predecessor Period include substantially the same operating entities except that Vivint Solar, Inc. and its subsidiaries (“Solar”) is not included in the Successor Period since Solar is separately owned and is no longer a consolidated variable interest entity.

Principles of Consolidation—The accompanying Successor consolidated financial statements include the accounts of APX Group Holdings, Inc. and its subsidiaries, including 2GIG as a wholly-owned subsidiary through April 1, 2013. The accompanying Predecessor consolidated financial statements include APX Group, Inc. and its subsidiaries, and 2GIG and Solar, which were variable interest entities (or “VIE’s”) prior to the Merger (See Note 7). All significant intercompany balances and transactions have been eliminated in consolidation.

The financial information presented in the accompanying consolidated financial statements reflects the financial position and operating results of Smart Grid as discontinued operations (See Note 6).

Changes in Presentation of Comparative Financial Statements—Certain reclassifications, such as the presentation of deferred tax assets and deferred tax liabilities (See Note 12), have been made to our prior period consolidated financial information in order to conform with the current year presentation. These changes did not have a significant impact on the consolidated financial statements.

 

Revenue Recognition—The Company recognizes revenue principally on four types of transactions: (i) monitoring, which includes revenues for monitoring of the Company’s subscriber contracts and certain subscriber contracts that have been sold, (ii) activation fees on the Company’s contracts, which are amortized over the expected life of the customer, (iii) service and other sales, which includes services provided on contracts, contract fulfillment revenue, sales of products that are not part of the basic equipment package and revenue from 2GIG, and (iv) contract sales.

Monitoring services for the Company’s subscriber contracts are billed in advance, generally monthly, pursuant to the terms of subscriber contracts and recognized ratably over the service period. Revenue from monitoring contracts that have been sold is recognized monthly as services are provided based on rates negotiated as part of the contract sales. Costs of providing ongoing monitoring services are expensed in the period incurred.

Activation fees are generally charged to a customer when a new account is opened. This revenue is deferred and recognized using a 150% declining balance method over 12 years and converts to a straight-line methodology when the resulting revenue recognition is greater than that from the accelerated method for the remaining estimated life.

Service and other sales revenue is recognized as services are provided or when title to the products and equipment sold transfers to the customer. Contract fulfillment revenue, included in service and other sales, is recognized when payment is received from customers who cancel their contract in-term. Revenue from sales of products that are not part of the basic equipment package is recognized upon delivery of products.

Through the date of the 2GIG Sale, service and other sales revenue included net recurring services revenue, which was based on back-end services, provided by Alarm.com, for all panels sold to distributors and direct-sell dealers and subsequently placed in service in end-user locations. The Company received a fixed monthly amount from Alarm.com for each system installed with non-Vivint customers that used the Alarm.com platform.

Revenue from the sale of subscriber contracts is recognized when ownership of the contracts has transferred to the purchaser. Any unamortized deferred revenue and costs related to contract sales are recognized at the time of the sale.

Subscriber Contract Costs— A portion of the direct costs of acquiring new subscribers, primarily sales commissions, equipment, and installation costs, are deferred and recognized over a pattern that reflects the estimated life of the subscriber relationships. For both the Successor Period and Predecessor Period, the Company amortizes these costs using a 150% declining balance method over 12 years and converts to a straight-line methodology when the resulting amortization charge is greater than that from the accelerated method for the remaining estimated life. The Company evaluates subscriber account attrition on a periodic basis, utilizing observed attrition rates for the Company’s subscriber contracts and industry information and, when necessary, makes adjustments to the estimated subscriber relationship period and amortization method.

In conjunction with the Merger and in accordance with purchase accounting, the total purchase price was allocated to the Company’s net tangible and identifiable intangible assets based on their estimated fair values as of November 16, 2012 (See Note 3). The Company recorded the value of Subscriber Contract Costs on the date of the Transactions at fair value and classified it as an intangible asset, which is amortized over 10 years in a pattern that is consistent with the amount of revenue expected to be generated from the related subscriber contracts.

Cash and Cash Equivalents—Cash and cash equivalents consists of highly liquid investments with remaining maturities when purchased of three months or less.

Restricted Cash and Cash Equivalents—Restricted cash and cash equivalents is restricted for a specific purpose and cannot be included in the general cash account. At December 31, 2013 and 2012, the restricted cash and cash equivalents was held by a third-party trustee. At December 31, 2013, the current portion of restricted cash and cash equivalents was $14,375,000. Restricted cash equivalents consists of highly liquid investments with remaining maturities when purchased of three months or less.

Accounts Receivable—Accounts receivable consists primarily of amounts due from customers for recurring monthly monitoring services. The accounts receivable are recorded at invoiced amounts and are non-interest bearing. The gross amount of accounts receivable has been reduced by an allowance for doubtful accounts of $1,901,000 and $2,301,000 at December 31, 2013 and 2012, respectively. The Company estimates this allowance based on historical collection rates, subscriber attrition rates, and contractual obligations underlying the sale of the subscriber contracts to third parties. When the Company determines that there are accounts receivable that are uncollectible, they are charged off against the allowance for doubtful accounts. As of December 31, 2013 and 2012, no accounts receivable were classified as held for sale. Provision for doubtful accounts is included in general and administrative expenses in the accompanying consolidated statements of operations.

The changes in the Company’s allowance for accounts receivable were as follows for the years ended (in thousands):

 

		Successor								Predecessor
						Period from				Period from
						November 17,				January 1,
		Year ended				through				through				Year ended
		December 31,				December 31,				November 16,				December 31,
		2013				2012				2012				2011
Beginning balance		$	2,301			$	3,649			$	1,903			$	1,484
Provision for doubtful accounts			10,360				1,307				8,204				7,026
Write-offs and adjustments			(10,760	)			(2,655	)			(6,458	)			(6,607	)
Balance at end of period		$	1,901			$	2,301			$	3,649			$	1,903

Inventories—Inventories, which comprise home automation and security system equipment and parts, are stated at the lower of cost or market with cost determined under the first-in, first-out (FIFO) method. The Company records an allowance for excess and obsolete inventory based on anticipated obsolescence, usage and historical write-offs. The allowance for excess and obsolete inventory was $3,167,000 and $1,484,000, as of December 31, 2013 and 2012, respectively.

Long-lived Assets and Intangibles—Property and equipment are stated at cost and depreciated on the straight-line method over the estimated useful lives of the assets or the lease term, whichever is shorter. Intangible assets with definite lives are amortized over the remaining estimated economic life of the underlying technology or relationships, which ranges from 2 to 10 years. Amortization expense associated with leased assets is included with depreciation expense. Routine repairs and maintenance are charged to expense as incurred. Intangible assets are amortized on the straight-line method over the estimated useful life of the asset or in a pattern in which the economic benefits of the intangible asset are consumed. The Company periodically assesses potential impairment of its long-lived assets and intangibles and performs an impairment review whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The Company has no intangible assets with indefinite useful lives.

 

Deferred Financing Costs—Costs incurred in connection with obtaining debt financing are deferred and amortized utilizing the straight-line method, which approximates the effective-interest method, over the life of the related financing. If such financing is paid off or replaced prior to maturity with debt instruments that have substantially different terms, the unamortized costs are charged to expense. In connection with refinancing the debt, in conjunction with the Transactions the Company wrote off $3,451,000 related to unamortized deferred financing costs associated with the Credit Agreement. Deferred financing costs included in the accompanying consolidated balance sheets at December 31, 2013 and 2012 were $59,375,000 and $57,322,000, net of accumulated amortization of $9,875,000 and $1,032,000, respectively. Amortization expense on deferred financing costs recognized and included in interest expense in the accompanying consolidated statements of operations, totaled $8,843,000 for the year ended December 31, 2013, $1,032,000 for the Successor Period ended December 31, 2012, $6,619,000 for the Predecessor Period ended November 16, 2012 and $7,709,000 for the year ended December 31, 2011.

Residual Income Plan—Prior to the Merger, the Company had a program that allowed sales representatives to elect to defer commission payments and for third-party sales channel partners to receive additional compensation based on the performance of the underlying contracts they created during the season. The Company calculated the present value of the expected future payments and recognized this amount in the period the commissions were earned. Subsequent accretion and adjustments to the estimated liability were recorded as interest and other expense, respectively. The Company monitored actual payments and customer attrition on a periodic basis and, when necessary, made adjustments to the liability. In connection with the Merger, the Company settled its obligation to the employee participants of this plan. The obligation related to commissions owed to third-party channel partners was not settled in connection with the Merger, and this program continued after the Merger. The amount included in accrued expenses and other current liabilities was $2,426,000 and $1,418,000 at December 31, 2013 and 2012, respectively, representing the present value of the estimated amounts owed to third-party sales channel partners.

Stock-Based Compensation—The Company measures compensation cost based on the grant-date fair value of the award and recognizes that cost over the requisite service period of the awards (See Note 13).

Advertising Expense—Advertising costs are expensed as incurred. Advertising costs were approximately $23,038,000 for the year ended December 31, 2013, $1,686,000 for the Successor Period ended December 31, 2012, $8,204,000 for the Predecessor Period ended November 16, 2012 and $8,505,000 for the year ended December 31, 2011.

Income Taxes—The Company accounts for income taxes based on the asset and liability method. Under the asset and liability method, deferred tax assets and deferred tax liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets when it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized.

The Company recognizes the effect of an uncertain income tax position on the income tax return at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. The Company’s policy for recording interest and penalties is to record such items as a component of the provision for income taxes.

Liability—Contracts Sold—During 2007 and 2008, the Company received approximately $118,136,000 in proceeds from the sale of certain subscriber contracts to a third-party. Concurrently, the Company entered into an agreement with the buyer to continue providing monitoring and support services for the contracts that were sold. Following the initial one-year warranty period from the date of the sales, the Company had no obligation under the terms of the sales agreement to make any additional payments to the seller. In August 2012, the Company agreed to repurchase the contracts upon a change of control, as defined. As a result of this continuing involvement on the part of the Company in the servicing of the contracts, accounting guidance precluded gain recognition at the time of the sales. Accordingly, the Company recorded a liability for the proceeds received at the time of the sales and amortized the liability using the effective interest method over twelve years, the expected life of the subscriber contracts. The Company recorded the monthly fees from these contracts as monitoring revenue in the statements of operations. In connection with the Merger, these contracts were re-acquired and, as a result, the related liability was satisfied.

Use of Estimates—The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates.

Concentrations of Credit Risk—Financial instruments that potentially subject the Company to concentration of credit risk consist principally of receivables and cash. At times during the year, the Company maintains cash balances in excess of insured limits. The Company is not dependent on any single customer or geographic location. The loss of a customer would not adversely impact the Company’s operating results or financial position.

Concentrations of Supply Risk—As of December 31, 2013, approximately 87% of the Company’s installed panels were 2GIG Go!Control panels. On April 1, 2013, the Company completed the 2GIG Sale. In connection with the 2GIG Sale, the Company entered into a five-year supply agreement with 2GIG, pursuant to which they will be the exclusive provider of the Company’s control panel requirements, subject to certain exceptions as provided in the supply agreement. The loss of 2GIG as a supplier could potentially impact the Company’s operating results or financial position.

Fair Value Measurement—Assets and liabilities subject to on-going fair value measurement are categorized and disclosed into one of three categories depending on observable or unobservable inputs employed in the measurement. These two types of inputs have created the following fair value hierarchy:

Level 1: Quoted prices in active markets that are accessible at the measurement date for assets and liabilities.

Level 2: Observable prices that are based on inputs not quoted in active markets, but corroborated by market data.

Level 3: Unobservable inputs are used when little or no market data is available.

This hierarchy requires the Company to minimize the use of unobservable inputs and to use observable market data, if available, when determining fair value. The Company recognizes transfers between levels of the hierarchy based on the fair values of the respective financial measurements at the end of the reporting period in which the transfer occurred. There were no transfers between levels of the fair value hierarchy during fiscal 2013 or 2012.

The carrying amounts of the Company’s accounts receivable, accounts payable and accrued and other liabilities approximate their fair values due to their short maturities.

Goodwill—The Company conducts a goodwill impairment analysis annually and as necessary if changes in facts and circumstances indicate that the fair value of the Company’s reporting units may be less than its carrying amount. When indicators of impairment do not exist and certain accounting criteria are met, the Company is able to evaluate goodwill impairment using a qualitative approach. When necessary, the Company’s quantitative goodwill impairment test consists of two steps. The first step requires that the Company compare the estimated fair value of its reporting units to the carrying value of the reporting unit’s net assets, including goodwill. If the fair value of the reporting unit is greater than the carrying value of its net assets, goodwill is not considered to be impaired and no further testing is required. If the fair value of the reporting unit is less than the carrying value of its net assets, the Company would be required to complete the second step of the test by analyzing the fair value of its goodwill. If the carrying value of the goodwill exceeds its fair value, an impairment charge is recorded (See Note 10).

Foreign Currency Translation and Other Comprehensive Income—The functional currencies of Vivint Canada, Inc. and Vivint New Zealand, Ltd. are the Canadian dollar and the New Zealand dollar, respectively. Accordingly, assets and liabilities are translated from their respective functional currencies into U.S. dollars at year-end rates and revenue and expenses are translated at the weighted-average exchange rates for the year. Adjustments resulting from this translation process are classified as other comprehensive income (loss) and shown as a separate component of equity.

 

Letters of Credit—At December 31, 2013 and 2012, respectively, the Company had $2,174,000 and $2,168,000 of unused letters of credit associated with workers compensation and a bond line for the Company’s corporate, sales and installation personnel.

New Accounting Pronouncement—In September 2011, the FASB issued authoritative guidance which amends the process of testing goodwill for impairment. The guidance permits an entity to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (defined as having a likelihood of more than fifty percent) that the fair value of a reporting unit is less than its carrying amount. If an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, performing the traditional two-step goodwill impairment test is unnecessary. If an entity concludes otherwise, it would be required to perform the first step of the two-step goodwill impairment test. If the carrying amount of the reporting unit exceeds its fair value, then the entity is required to perform the second step of the goodwill impairment test. However, an entity has the option to bypass the qualitative assessment in any period and proceed directly to step one of the impairment test. The guidance became effective for the Company in the fourth quarter of fiscal year 2013. The adoption of this guidance did not have a material impact on the Company’s financial position, results of operations or cash flows.

In July 2012, the FASB issued authoritative guidance which amends the process of testing indefinite-lived intangible assets for impairment. This guidance permits an entity to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (defined as having a likelihood of more than fifty percent) that the indefinite-lived intangible asset is impaired. If an entity determines it is not more likely than not that the indefinite-lived intangible asset is impaired, the entity will have an option not to calculate the fair value of an indefinite-lived asset annually. The guidance became effective for the Company in the fourth quarter of fiscal year 2013. The adoption of this guidance did not have a material impact on the Company’s financial position, results of operations or cash flows.

In February 2013, the FASB issued authoritative guidance which expands the disclosure requirements for amounts reclassified out of accumulated other comprehensive income (“AOCI”). The guidance requires an entity to provide information about the amounts reclassified out of AOCI by component and present, either on the face of the income statement or in the notes to financial statements, significant amounts reclassified out of AOCI by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts, an entity is required to cross-reference to other disclosures required under GAAP that provide additional detail about those amounts. This guidance does not change the current requirements for reporting net income or OCI in financial statements. The guidance is effective for the Company in the first quarter of fiscal year 2014. The adoption of this guidance is not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

In July 2013, the FASB issued authoritative guidance which amends the guidance related to the presentation of unrecognized tax benefits and allows for the reduction of a deferred tax asset for a net operating loss carryforward whenever the net operating loss carryforward or tax credit carryforward would be available to reduce the additional taxable income or tax due if the tax position is disallowed. This guidance is effective for annual and interim periods for fiscal years beginning after December 15, 2013, and early adoption is permitted. The adoption of this guidance is not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

NOTE 3—BUSINESS COMBINATION

As described in Note 1, the Merger was completed on November 16, 2012, and was financed by a combination of equity invested by affiliates of The Blackstone Group, certain co-investors, the Company’s management and certain employees and borrowings under senior credit facilities. The Company’s management and certain employees invested approximately $155,160,000 in the form of a rollover of their equity in APX and 2GIG and cash investments were used to repay all outstanding borrowings under the Predecessor’s secured credit facilities, pay Predecessor shareholders, purchase equity units of Acquisition LLC and pay transaction fees and expenses. As part of the Merger, as of December 31, 2013 and 2012, there was $28,428,000 held in escrow and presented as restricted cash in the accompanying financial statements for payments to employees that will be due in the next two years. At the time of the Transactions, approximately $54,300,000 was placed in escrow to cover potential adjustments to the total purchase consideration associated with general representations and warranties and adjustments to tangible net worth, in accordance with the terms of the Merger’s escrow agreement. This amount is included in the total purchase consideration discussed below. The remaining escrow balance, after all adjustments are made in accordance with the escrow agreement, are expected to be paid to the former Company shareholders no later than the second quarter of 2014. Because these amounts held in escrow are not controlled by the Company, they are not included in the accompanying consolidated balance sheets.

Purchase Consideration

The following table summarizes the purchase price consideration (in thousands):

 

Revolving line of credit		$	10,000
Issuance of bonds, net of issuance costs			1,246,646
Contributed equity			713,821
Less: Transaction costs			(31,540	)
Less: Net worth adjustment			(3,289	)
Total purchase consideration		$	1,935,638

Purchase Price Allocation

The purchase price of approximately $1,935,638,000 includes the purchase of all outstanding stock, settlement of the Predecessor’s debt, settlement of stock-based awards, payments to employees under long-term incentive arrangements, transaction fees and expenses and purchase of subscriber accounts held by third parties. Payments to employees consisted of payments to officers, employees and directors as change in control payments and special retention bonuses. On the date of the Transactions, the Company paid $28,428,000 or 50% of the amount due to employees under long-term incentive arrangements. The remaining 50% will be paid in two equal payments on the second and third anniversary dates of the Merger. In addition to the payments under these long-term incentive arrangements, the Company also incurred $48,586,000 of costs related to bonus and other payments to employees directly related to the Transactions. These employee expenses are included in total costs and expenses in the Predecessor Period Consolidated Statement of Operations.

The estimated fair values of the assets acquired and liabilities assumed are based on information obtained from various sources including, the Company’s management and historical experience. The fair value of the intangible assets was determined using the income and the cost approaches. Key assumptions used in the determination of fair value include projected cash flows, subscriber attrition rates and discount rates between 8% and 14%.

 

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed as of December 31, 2013 (in thousands):

 

Current assets acquired		$	73,239
Property, plant and equipment			29,293
Other assets			30,535
Intangible assets			1,062,300
Goodwill			880,302
Current liabilities assumed			(100,258	)
Deferred income tax liability			(33,996	)
Other liabilities			(5,777	)
Total purchase price allocation		$	1,935,638

Goodwill resulting from the Transactions is not deductible for income tax purposes.

Transaction Related Costs

The Company incurred costs associated with the Transactions of approximately $31,885,000 in the Successor Period from November 17, 2012 through December 31, 2012 and approximately $23,461,000 in the Predecessor Period from January 1, 2012 through November 16, 2012. These costs consist of accounting, investment banking, legal and professional fees and employee expenses directly associated with the Transactions and are included in the accompanying consolidated statements of operations.

Smartrove Acquisition

On May 29, 2013, a wholly-owned subsidiary of the Company, Vivint Wireless, Inc. (“Vivint Wireless”), completed a 100% stock acquisition of Smartrove. Pursuant to the terms of the stock purchase agreement, Vivint Wireless acquired the business for aggregate cash consideration of $4,275,000, of which $870,000 is held in escrow. This strategic acquisition was made to provide Vivint Wireless with full ownership of certain intellectual property used in its operations. The accompanying consolidated financial statements include the financial position and results of operations of Smartrove as a wholly-owned subsidiary from May 29, 2013. The pro forma impact of Smartrove on the Company’s financial position and results of operations for the year ended December 31, 2013 is immaterial.

The determination of the final purchase price is subject to potential adjustments, primarily related to the finalization of income taxes and the escrow amounts discussed above. The associated goodwill is not deductible for income tax purposes. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed as of December 31, 2013 (in thousands):

 

Net assets acquired from Smartrove—Cash		$	3
Deferred income tax liability			(1,533	)
Intangible assets (See Note 10)			4,040
Goodwill			1,765
Total fair value of the assets acquired and liabilities assumed		$	4,275

Transaction Related Costs

During the year ended December 31, 2013, the Company incurred costs associated with the Smartrove Acquisition, which were not material, consisting of accounting, investment banking, legal and professional fees and payments to employees directly associated with the acquisition. These costs are included in the accompanying consolidated statements of operations.

NOTE 4—DIVESTITURE OF SUBSIDIARY

On April 1, 2013, the Company completed the 2GIG Sale. Pursuant to the terms of the 2GIG Sale, Nortek, Inc. acquired all of the outstanding common stock of 2GIG for aggregate cash consideration of approximately $148,871,000, including cash, working capital and indebtedness adjustments as provided in the stock purchase agreement. In connection with the 2GIG Sale, the Company entered into a five-year supply agreement with 2GIG, pursuant to which they will be the exclusive provider of the Company’s control panel requirements, subject to certain exceptions as provided in the supply agreement. A portion of the net proceeds from the 2GIG Sale was used to repay $44,000,000 of outstanding borrowings under the Company’s revolving credit facility. The terms of the indenture governing the existing senior unsecured notes, the indenture governing the existing senior secured notes and the credit agreement governing the revolving credit facility, permit the Company, subject to certain conditions, to distribute all or a portion of the net proceeds from the 2GIG Sale to the Company’s stockholders. In May 2013, the Company distributed a dividend of $60,000,000 from such proceeds to stockholders. Subject to the applicable conditions, the Company may distribute the remaining proceeds in the future. The Company’s financial position and results of operations include 2GIG through March 31, 2013.

The following table summarizes the net gain recognized in connection with this divestiture (in thousands):

 

Adjusted net sale price		$	148,871
2GIG assets (including cash of $3,383), net of liabilities			(109,053	)
2.0 technology, net of amortization			16,903
Other			(9,855	)
Net gain on divestiture		$	46,866

NOTE 5—LONG-TERM DEBT

Successor

Notes

In connection with the Merger on November 16, 2012, APX issued $1,305,000,000 aggregate principal amount of notes, of which $925,000,000 aggregate principal amount of 6.375% senior secured notes due 2019 (the “outstanding 2019 notes”) mature on December 1, 2019 and are secured on a first-priority lien basis by substantially all of the tangible and intangible assets whether now owned or hereafter acquired by the Company, subject to permitted liens and exceptions, and $380,000,000 aggregate principal amount of 8.75% senior notes due 2020 (the “outstanding 2020 notes” and together with the outstanding 2019 notes, the “notes”), which mature on December 1, 2020.

During 2013, the Company completed two subsequent offerings of 8.75% Senior Notes due 2020 under the indenture dated November 16, 2012. On May 31, 2013, the Company issued $200,000,000 of 2020 notes at a price of 101.75% and on December 13, 2013, the Company issued an additional $250,000,000 of 2020 notes at a price of 101.50%.

 

Interest on the notes accrues at the rate of 6.375% per annum for the outstanding 2019 notes and 8.75% per annum for the outstanding 2020 notes. Interest on the notes is payable semiannually in arrears on each June 1 and December 1, commencing June 1, 2013. The Company may redeem each series of the notes, in whole or part, at any time at a redemption price equal to the principal amount of the notes to be redeemed, plus a make-whole premium and any accrued and unpaid interest at the redemption date. In addition, APX may redeem the notes at the prices and on the terms specified in the applicable indenture.

In connection with each issuance of the notes, the Company entered into an Exchange and Registration Rights Agreement (each a “Registration Rights Agreement”) with the initial purchasers of the notes, dated November 16, 2012, May 8, 2013 and December 13, 2013, respectively.

In connection with the issuance of the initial notes on November 16, 2012 and the subsequent offering on May 31, 2013, in accordance with the Registration Rights Agreement, the Company filed a registration statement Form S-4 with the Securities and Exchange Commission with respect to an exchange offer to exchange the Notes of each series for an issue of Notes (except the Exchange Notes do not contain transfer restrictions). The exchange offer was completed on October 29, 2013.

In connection with the issuance of the subsequent offering on December 13, 2013, under the applicable Registration Rights Agreement, the Company filed a registration statement Form S-4 with the Securities and Exchange Commission with respect to an exchange offer to exchange the Notes of each series for an issue of Notes (except the Exchange Notes do not contain transfer restrictions). The exchange offer was completed on March 7, 2014.

Revolving Credit Facility

In connection with the Merger, APX, the Company and the other guarantors entered into a revolving credit facility in the aggregate principal amount of $200,000,000. Borrowings bear interest based on the London Interbank Offered Rate (“LIBOR”) or, at the Company’s option, an alternative base rate, plus spread, based upon the Company’s consolidated first lien leverage ratio at the end of each fiscal quarter and a commitment fee of 0.50% on unused portions of the revolving credit facility. The borrowings are due November 16, 2017, which may be repaid at any time without penalty.

The Company’s debt at December 31, 2013 had maturity dates of 2019 and beyond and consisted of the following (in thousands):

 

		Outstanding				Unamortized				Net Carrying
		Principal				Premium				Amount
Revolving credit facility		$	—			$	—			$	—
6.375% Senior Secured Notes due 2019			925,000				—				925,000
8.75% Senior Notes due 2020			830,000				7,049				837,049
Total Notes payable		$	1,755,000			$	7,049			$	1,762,049

The Company’s debt at December 31, 2012 consisted of the following (in thousands):

 

		Outstanding				Unamortized				Net Carrying
		Principal				Premium				Amount
Revolving credit facility		$	28,000			$	—			$	28,000
6.375% Senior Secured Notes due 2019			925,000				—				925,000
8.75% Senior Notes due 2020			380,000				—				380,000
Total Notes payable		$	1,333,000			$	—			$	1,333,000

NOTE 6—DISCONTINUED OPERATIONS

During the first quarter of 2012, the Company abandoned Smart Grid, a component of its energy management business. The circumstances leading up to the abandonment included a shift in the strategic direction for Smart Grid within the energy management framework. All operating activity ceased during the second quarter of 2012. No income taxes were recorded on discontinued operations because the tax effect was immaterial and the tax benefit of the loss was offset by a valuation allowance.

The following table presents discontinued operations of the disposed business component (in thousands):

 

		Predecessor
		Period from January 1, through November 16, 2012				Year ended December 31, 2011
Revenue, net		$	91			$	336
Operating loss			(329	)			(1,938	)
Interest expense			(1	)			—
Impairment of acquired intangible asset			—				(1,315	)
Total discontinued operations		$	(239	)		$	(2,917	)

NOTE 7—VARIABLE INTEREST ENTITIES

Accounting rules require the primary beneficiary of a variable interest entity (“VIE”) to include the financial position and results of operations of the VIE in its condensed consolidated financial statements. The Predecessor consolidated financial statements include APX Group, Inc. and its subsidiaries, and 2GIG and Solar, which were VIE’s prior to the Merger in the Predecessor Period. In connection with the Merger, 2GIG became a wholly-owned subsidiary and their financial position and results of operations were consolidated by the Company in the Successor Period through the date of the 2GIG Sale. Also in connection with the Merger, the Investors purchased Solar for $75,000,000 and, while Solar remains a VIE of the Company, the Investors became the primary beneficiary and, as a result, the Solar financial position and results of operations are not consolidated by the Company in the Successor Period.

 

2GIG

2GIG is engaged in the manufacture, wholesale distribution, and monitoring of electronic home security and automation systems primarily in the United States and Canada. 2GIG supplies the majority of the equipment used by the Company in its security systems installations. Sales of this equipment to other legal entities owned or consolidated by the Company represented approximately 71% of 2GIG’s total sales during 2013 through April 1, 2013, the date of the 2GIG Sale. The Company determined that 2GIG was a VIE, prior to the Merger, and the Company was the primary beneficiary because Vivint, Inc. was 2GIG’s largest customer, 2GIG was dependent on Vivint, Inc. for ongoing financial support and because the Company, through its related parties, had the ability to control the operations of 2GIG. Accordingly, as indicated above, the financial position and results of operations are consolidated by the Company for the Predecessor Period. Non-controlling interests in the consolidated financial statements include the portion of equity and results of operations related to 2GIG.

Solar

Solar, formed in April 2011, installs solar panels on the roofs of customer’s homes and enters into purchase agreements for the customers to purchase the electricity generated by the panels. Solar also takes advantage of local government and federal incentive programs that offer assistance in generating green power. During the Predecessor Period, the Company determined that Solar was a VIE and the Company was the primary beneficiary because Solar was dependent on Vivint, Inc. for ongoing financial support and because the Company had the ability to control the operations of Solar through its related parties. Accordingly, as indicated above, the financial position and results of operations are consolidated by the Company for the Predecessor Period and not for the Successor Period. The assets of Solar are restricted in that they are only available to settle the obligations of Solar and not of the Company and similarly, the creditors of Solar have no recourse to the general assets of the Company.

On June 1, 2011, Vivint, Inc. and Solar entered into an Administrative Services Agreement (“Service Agreement”) and a Trademark License Agreement (“Trademark Agreement”). The Service Agreement provided Solar with certain administrative, managerial and account management services to be performed by Vivint. In exchange for the services and licenses under these agreements, Solar agreed to pay Vivint a combined fee of $0.05 per kilowatt hour of electricity generated by the solar equipment each month for each customer account. In June 2013, the Company and Solar entered into a Turnkey Full-Service Sublease Agreement (“Sublease Agreement”) and terminated the Service Agreement. The Sublease Agreement specifies the terms under which the Company subleases corporate office space, and provides certain other administrative services, to Solar. The Trademark Agreement was also amended in conjunction with the execution of the Sublease Agreement. During the year ended December 31, 2013, the Company charged $2,883,000 of general and administrative expenses to Solar in connection with the Sublease Agreement. As of December 31, 2013, the balance of $3,070,000 due from Solar in connection with the Sublease Agreement and other expenses paid on Solar’s behalf is included in prepaid expenses and other current assets in the accompanying consolidated balance sheets.

In June 2011, the Company entered into a Revolving Credit Note (“Loan”) with Solar. This Loan was due in May 2013, had a principal balance of $5,000,000 and accrued interest at a rate per annum equal to 13%. In connection with the Merger, the loan was satisfied and there was no balance outstanding as of December 31, 2013 or 2012.

 

On December 27, 2012, the Company executed a new Subordinated Note and Loan Agreement with Solar. The terms of the agreement state that Solar may borrow up to $20,000,000, bearing interest on the outstanding balance at an annual rate of 7.5% based on a 365 day year, which interest is due and payable semi-annually on June 1 and December 1 of each year commencing on June 1, 2013. The balance outstanding on December 31, 2013, representing principal of $20,000,000 and payment-in-kind interest of $1,323,000, is included in long-term investments and other assets in the accompanying consolidated balance sheets. In addition, accrued interest of $138,000 is included in prepaid expenses and other current assets in the accompanying consolidated balance sheets. The balance outstanding on December 31, 2012 was $15,000,000. These variable interests represent the Company’s maximum exposure to loss from direct involvement with Solar.

NOTE 8—BALANCE SHEET COMPONENTS

The following table presents balance sheet component balances as of December 31, 2013 and December 31, 2012 (in thousands):

 

		December 31,
		2013				2012
Subscriber contract costs
Subscriber contract costs		$	310,666			$	12,934
Accumulated amortization			(22,350	)			(181	)
Subscriber contract costs, net		$	288,316			$	12,753
Long-term investments and other assets
Notes receivable, net of allowance (See Notes 7 and 15)		$	21,323			$	15,341
Security deposit receivable			6,261				6,236
Other			92				128
Total long-term investments and other assets, net		$	27,676			$	21,705
Accrued payroll and commissions
Accrued payroll and commissions		$	15,475			$	7,396
Accrued commissions			30,532				13,050
Total accrued payroll and commissions		$	46,007			$	20,446

NOTE 9—PROPERTY AND EQUIPMENT

Property and equipment consisted of the following (in thousands):

 

		December 31,								Estimated
		2013				2012				Useful Lives
Vehicles		$	13,851			$	10,038			3 - 5 years
Computer equipment and software			6,742				4,797			3 - 5 years
Leasehold improvements			13,345				7,599			2 - 15 years
Office furniture, fixtures and equipment			4,793				1,924			7 years
Warehouse equipment			1,802				3,066			7 years
Buildings			702				702			39 years
Construction in process			3,119				3,245
			44,354				31,371
Accumulated depreciation and amortization			(8,536	)			(1,165	)
Net property and equipment		$	35,818			$	30,206

Property and equipment includes approximately $13,728,000 and $9,795,000 of assets under capital lease obligations, net of accumulated amortization of $2,650,000 and $319,000 at December 31, 2013 and 2012, respectively. Depreciation and amortization expense on all property and equipment was $9,062,000 for the year ended December 31, 2013, $1,165,000 for the Successor Period ended December 31, 2012, $7,378,000 for the Predecessor Period ended November 16, 2012 and $5,820,000 for the year ended December 31, 2011. Amortization expense relates to assets under capital leases as included in depreciation and amortization expense.

NOTE 10—GOODWILL AND INTANGIBLE ASSETS

Goodwill

The changes in the carrying amount of goodwill for the years ended December 31, 2013 and 2012, by operating segment, were as follows (in thousands):

 

		Vivint				2GIG				Consolidated
Balance as of January 1, 2012		$	—			$	—			$	—
Goodwill resulting from the Merger			832,579				43,792				876,371
Effect of foreign currency translation			271				—				271
Balance as of December 31, 2012			832,850				43,792				876,642
Goodwill resulting from Smartrove acquisition			1,765				—				1,765
Goodwill resulting from net worth adjustments			2,079				—				2,079
Goodwill resulting from income tax adjustments			1,852				—				1,852
Effect of foreign currency translation			(2,228	)			—				(2,228	)
Divestiture of 2GIG			—				(43,792	)			(43,792	)
Balance as of December 31, 2013		$	836,318			$	—			$	836,318

In accordance with authoritative guidance for accounting for goodwill and other intangible assets, the Company performs an impairment test on its goodwill annually, as of October 1, or more often when events occur or circumstances change that would, more likely than not, reduce the fair value of a reporting unit below its carrying value. When indicators of impairment do not exist and certain accounting criteria are met, the Company is able to evaluate goodwill impairment using a qualitative approach. As of December 31, 2013, no indicators of impairment existed.

Intangible assets, net

The following table presents intangible asset balances as of December 31, 2013 and 2012 (in thousands):

 

		December 31,								Estimated
		2013				2012				Useful Lives
Customer contracts		$	984,403			$	990,777			10 years
2GIG 2.0 technology			17,000				17,000			8 years
CMS and other technology			6,114				2,300			5 years
Smartrove technology			4,040				—			3 years
Other technology			650				—			2 years
2GIG customer relationships			—				45,000			10 years
2GIG 1.0 technology			—				8,000			6 years
			1,012,207				1,063,077
Accumulated amortization			(171,493	)			(10,058	)
Net ending balance		$	840,714			$	1,053,019

The 2GIG customer relationships and 2GIG 1.0 technology intangible assets were disposed of in connection with the 2GIG Sale (See Note 4). The 2GIG 2.0 technology was retained by the Company. In addition, as of December 31, 2013, the Company had unamortized capitalized software development costs of $3,672,000 related to the 2GIG 2.0 technology. During the year ended December 31, 2013, the Company recognized $141,000 of amortization expense related to the capitalized software development costs. There were no capitalized software development costs for the Successor Period ended December 31, 2012, the Predecessor Period ended November 16, 2012 or for the year ended December 31, 2011.

In connection with the Smartrove acquisition, the Company also purchased certain intellectual property for cash consideration of $650,000, of which $130,000 is held in escrow for the indemnification of claims or disputes that may arise. The escrow is scheduled to be released on May 30, 2014, less any amount of unresolved claims.

Amortization expense related to intangible assets was $164,230,000 for the year ended December 31, 2013, $10,058,000 for the Successor Period ended December 31, 2012, $325,000 for the Predecessor Period ended November 16, 2012 and $1,751,000 for the year ended December 31, 2011.

Estimated future amortization expense of intangible assets is as follows (in thousands):

 

2014		$	150,352
2015			133,900
2016			115,781
2017			99,704
2018			87,627
Thereafter			253,350
Total estimated amortization expense		$	840,714

NOTE 11—FAIR VALUE MEASUREMENTS

Fair value is based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements, accounting guidance establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels. These levels, in order of highest priority to lowest priority, are described below:

Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities.

Level 2: Observable prices that are based on inputs not quoted on active markets, but corroborated by market data.

Level 3: Unobservable inputs are used when little or no market data is available.

Cash equivalents and restricted cash equivalents are classified as Level 1 as they have readily available market prices in an active market. The following summarizes the financial instruments of the Company at fair value based on the valuation approach applied to each class of security as of December 31, 2013 and 2012 (in thousands):

 

		Fair Value Measurement at Reporting Date Using
		Balance at December 31, 2013				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Cash equivalents:
Money market funds		$	10,002			$	10,002			$	—			$	—
Restricted cash equivalents:
Money market funds			14,214				14,214				—				—
Restricted cash equivalents, net of current portion:
Money market funds			14,214				14,214				—				—
Total assets		$	38,430			$	38,430			$	—			$	—

 

		Fair Value Measurement at Reporting Date Using
		Balance at December 31, 2012				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets:
Restricted cash equivalents, net of current portion:
Money market funds		$	28,428			$	28,428			$	—			$	—
Total assets		$	28,428			$	28,428			$	—			$	—

The carrying amounts of the Company’s accounts receivable, accounts payable and accrued and other liabilities approximate their fair values due to their short maturities.

The fair market value of the Company’s Senior Secured Notes was approximately $941,188,000 as of December 31, 2013 and $917,980,000 as of December 31, 2012. The carrying value of the Company’s Senior Secured Notes was $925,000,000 as of December 31, 2013 and December 31, 2012. The Company’s Senior Notes had a fair market value of approximately $844,525,000 as of December 31, 2013 and $374,478,000 as of December 31, 2012 and a carrying amount of $830,000,000 as of December 31, 2013 and $380,000,000 as of December 31, 2012. The fair value of the Senior Secured Notes and the Senior Notes was considered a Level 2 measurement as the value was determined using observable market inputs, such as current interest rates as well as prices observable from less active markets.

In connection with the Transactions, the fair value of intangible assets was considered a Level 3 measurement and was determined using the income and cost approach and input obtained from various sources, including the Company’s management and historical experience. Key assumptions used in the determination of fair value include projected cash flows, subscriber attrition rates and discount rates between 8% and 14%.

In connection with the Smartrove acquisition, the fair value of intangible assets was considered a Level 3 measurement and was determined using the cost and relief from royalty approach. Key assumptions used in the determination of the fair value include estimated replacement costs, hypothetical royalty rates and a discount rate of 25%.

NOTE 12—INCOME TAXES

APX Group files a consolidated federal income tax return with its wholly-owned subsidiaries.

For tax purposes, the Transaction was treated as a stock acquisition. As a result, assets and liabilities were not adjusted to fair value for tax purposes. Goodwill resulting from the transaction is not deductible for tax purposes. For tax purposes, acquisition costs are divided into three categories; deductible costs, amortizable costs, and capitalized costs. Acquisition costs are allocated among the categories based on the nature and timing of the incurred cost. Deductible costs are deducted in the period incurred. Amortizable costs are capitalized and amortized over a period of 15 years. Capitalized costs are capitalized to the cost of the stock and are not amortized.

 

Income tax (benefit) provision consisted of the following (in thousands):

 

		Successor								Predecessor
						Period from				Period from
						November 17,				January 1,
		Year ended				through				through				Year ended
		December 31,				December 31,				November 16,				December 31,
		2013				2012				2012				2011
Current income tax:
Federal		$	(579	)		$	—			$	2,635			$	86
State			(1,351	)			56				837				633
Foreign			(145	)			28				276				—
Total			(2,075	)			84				3,748				719
Deferred income tax:
Federal			8,614				(9,489	)			—				—
State			(1,938	)			(1,788	)			—				—
Foreign			(1,009	)			290				1,175				(4,458	)
Total			5,667				(10,987	)			1,175				(4,458	)
Provision (benefit) for income taxes		$	3,592			$	(10,903	)		$	4,923			$	(3,739	)

 

		Successor								Predecessor
						Period from				Period from
						November 17,				January 1,
		Year ended				through				through				Year ended
		December 31,				December 31,				November 16,				December 31,
		2013				2012				2012				2011
Computed expected tax expense		$	(41,113	)		$	(13,941	)		$	(50,970	)		$	(22,489	)
State income taxes, net of federal tax effect			(2,171	)			(1,143	)			555				434
Foreign income taxes			136				(69	)			610				831
Permanent differences			1,215				534				4,820				193
Non-deductible acquisition costs			—				3,716				2,896				—
Intercompany elimination			—				—				2,843				—
Change in valuation allowance			45,525				—				44,169				17,292
Provision (benefit) for income taxes		$	3,592			$	(10,903	)		$	4,923			$	(3,739	)

 

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities were as follows (in thousands):

 

		December 31,
		2013				2012
Gross deferred tax assets:
Net operating loss carry forwards		$	430,327			$	339,831
Accrued expenses and allowances			35,435				25,236
Inventory reserves			2,398				528
Alternative minimum tax credit and research and development credit			—				101
Deferred subscriber income			835				15
Valuation allowance			(48,685	)			—
			420,310				365,711
Gross deferred tax liabilities:
Deferred subscriber contract costs			(394,448	)			(354,142	)
Purchased intangibles			(29,128	)			(28,744	)
Property and equipment			(4,261	)			(1,823	)
Prepaid expenses			(1,687	)			(107	)
			(429,524	)			(384,816	)
Net deferred tax liability		$	(9,214	)		$	(19,105	)

The Company had net operating loss carryforwards as follows (in thousands):

 

		December 31,
		2013				2012
Net operating loss carry forwards:
United States		$	1,021,238			$	845,095
State			967,155				789,687
Canada			35,689				32,369
New Zealand			1,388				—

United States (“U.S.”) and state net operating loss carryforwards will begin to expire in 2026, if not used. Canadian net operating loss carryforwards will begin to expire in 2029. Included in both the U.S. and state net operating loss carryforwards was approximately $11,483,000 at both December 31, 2013 and 2012 of net operating loss carryforwards for which a benefit will be recorded in Additional Paid in Capital when realized. The Company had no U.S. alternative minimum tax credits at December 31, 2013, and U.S. alternative minimum tax credits of $71,000 at December 31, 2012, for which life is unlimited. The Company had no U.S. research and development credits at December 31, 2013, and U.S. research and development credits of approximately $30,000 at December 31, 2012, which begin to expire in 2030. Realization of the Company’s net operating loss carryforwards and tax credits is dependent on generating sufficient taxable income prior to their expiration. The Company has determined that there is an IRC Section 382 limitation with respect to the carryforward items.

The Company has considered and weighed the available evidence, both positive and negative, to determine whether it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized.

Based on available information, management does not believe it is more likely than not that its deferred tax assets will be utilized. Accordingly, the Company has established a valuation allowance to the extent of and equal to the net deferred tax assets. The Company recorded a valuation allowance for U.S. deferred tax assets of $48,685,000 at December 31, 2013. The Company had no valuation allowance for U.S. deferred tax assets at December 31, 2012. In addition to the change in valuation allowance from operations, the valuation allowance changes include impact of acquisition and disposition related items.

As of December 31, 2013, the Company’s income tax returns for the years ended December 31, 2007 through December 31, 2013, remain subject to examination by the Internal Revenue Service and state authorities.