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PEGA Pegasystems

Filed: 28 Oct 20, 4:08pm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________
FORM 10-Q
_____________________________________
Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2020
OR
Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-11859 
____________________________

PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter) 
____________________________
Massachusetts04-2787865
(State or other jurisdiction of incorporation or organization)(IRS Employer Identification No.)
One Rogers Street, Cambridge, MA 02142-1209
(Address of principal executive offices, including zip code)
(617) 374-9600
(Registrant’s telephone number, including area code)
____________________________
Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading symbol(s)Name of each exchange on which registered
Common Stock, $.01 par value per sharePEGANASDAQ Global Select Market
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes x No ¨            
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filerxAccelerated filerNon-accelerated filerSmaller reporting companyEmerging growth company
If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No
There were 80,697,696 shares of the Registrant’s common stock, $0.01 par value per share, outstanding on October 19, 2020.



PEGASYSTEMS INC.

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

Page
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Unaudited Condensed Consolidated Balance Sheets as of September 30, 2020 and December 31, 2019
Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2020 and 2019
Unaudited Condensed Consolidated Statements of Comprehensive (Loss) for the three and nine months ended September 30, 2020 and 2019
Unaudited Condensed Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2020 and 2019
Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2020 and 2019
Notes to Unaudited Condensed Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II - OTHER INFORMATION
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits
Signature
 
2

PART I - FINANCIAL INFORMATION
ITEM 1.     FINANCIAL STATEMENTS
PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)

September 30, 2020December 31, 2019
Assets
Current assets:
Cash and cash equivalents$281,218 $68,363 
Marketable securities186,810 
Total cash, cash equivalents, and marketable securities468,028 68,363 
Accounts receivable137,953 199,720 
Unbilled receivables208,823 180,219 
Other current assets89,406 57,308 
Total current assets904,210 505,610 
Unbilled receivables108,456 121,736 
Goodwill78,864 79,039 
Other long-term assets395,797 278,427 
Total assets$1,487,327 $984,812 
Liabilities and stockholders�� equity
Current liabilities:
Accounts payable$20,443 $17,475 
Accrued expenses43,447 48,001 
Accrued compensation and related expenses90,836 104,126 
Deferred revenue181,680 190,080 
Other current liabilities19,916 18,273 
Total current liabilities356,322 377,955 
Convertible senior notes, net513,794 
Operating lease liabilities62,544 52,610 
Other long-term liabilities25,345 15,237 
Total liabilities958,005 445,802 
Stockholders’ equity:
Preferred stock, 1,000 shares authorized; NaN issued
Common stock, 200,000 shares authorized; 80,697 and 79,599 shares issued and outstanding at
September 30, 2020 and December 31, 2019, respectively
807 796 
Additional paid-in capital201,882 140,523 
Retained earnings338,300 410,919 
Accumulated other comprehensive (loss)(11,667)(13,228)
Total stockholders’ equity529,322 539,010 
Total liabilities and stockholders’ equity$1,487,327 $984,812 

See notes to unaudited condensed consolidated financial statements.
3


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)

Three Months Ended
September 30,
Nine Months Ended
September 30,
2020201920202019
Revenue
Software license$39,784 $58,005 $187,023 $165,543 
Maintenance74,670 70,371 220,587 207,406 
Pega Cloud54,776 35,153 147,080 94,610 
Consulting56,721 53,174 164,227 167,282 
Total revenue225,951 216,703 718,917 634,841 
Cost of revenue
Software license691 676 2,354 2,982 
Maintenance5,478 6,688 16,645 19,315 
Pega Cloud19,717 17,824 56,238 47,769 
Consulting51,913 55,710 158,781 162,349 
Total cost of revenue77,799 80,898 234,018 232,415 
Gross profit148,152 135,805 484,899 402,426 
Operating expenses
Selling and marketing132,053 115,237 395,684 341,064 
Research and development60,024 52,492 177,620 152,802 
General and administrative17,907 14,843 49,192 41,693 
Total operating expenses209,984 182,572 622,496 535,559 
(Loss) from operations(61,832)(46,767)(137,597)(133,133)
Foreign currency transaction gain (loss)4,236 (1,970)2,545 (3,577)
Interest income243 598 1,092 1,865 
Interest expense(5,956)(42)(13,791)(42)
Gain on capped call transactions18,989 19,816 
Other income, net323 1,374 378 
(Loss) before (benefit from) income taxes(44,320)(47,858)(126,561)(134,509)
(Benefit from) income taxes(25,053)(17,520)(61,182)(43,158)
Net (loss)$(19,267)$(30,338)$(65,379)$(91,351)
(Loss) per share
Basic$(0.24)$(0.38)$(0.82)$(1.16)
Diluted$(0.24)$(0.38)$(0.82)$(1.16)
Weighted-average number of common shares outstanding
Basic80,537 79,200 80,191 78,928 
Diluted80,537 79,200 80,191 78,928 

See notes to unaudited condensed consolidated financial statements.
4


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS)
(in thousands)

Three Months Ended
September 30,
Nine Months Ended
September 30,
2020201920202019
Net (loss)$(19,267)$(30,338)$(65,379)$(91,351)
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on available-for-sale securities(166)(216)(66)396 
Foreign currency translation adjustments113 (2,201)1,627 (983)
Total other comprehensive (loss) income, net of tax$(53)$(2,417)$1,561 $(587)
Comprehensive (loss)$(19,320)$(32,755)$(63,818)$(91,938)

See notes to unaudited condensed consolidated financial statements.
5



PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except per share amounts)
Common StockAdditional
Paid-In Capital
Retained Earnings
Accumulated Other Comprehensive (Loss)
Total
Stockholders’ Equity
Number
of Shares
Amount
December 31, 201878,526 $785 $123,205 $510,863 $(13,322)$621,531 
Repurchase of common stock(144)(1)(7,586)— — (7,587)
Issuance of common stock for share-based compensation plans514 (14,843)— — (14,838)
Stock-based compensation— — 18,406 — — 18,406 
Cash dividends declared ($0.03 per share)— — — (2,367)— (2,367)
Other comprehensive income— — — — 2,001 2,001 
Net (loss)— — — (28,717)— (28,717)
March 31, 201978,896 $789 $119,182 $479,779 $(11,321)$588,429 
Repurchase of common stock(88)(1)(6,301)— — (6,302)
Issuance of common stock for share-based compensation plans320 (11,217)— — (11,214)
Issuance of common stock under the employee stock purchase plan16 — 1,103 — — 1,103 
Stock-based compensation— — 20,113 — — 20,113 
Cash dividends declared ($0.03 per share)— — — (2,375)— (2,375)
Other comprehensive (loss)— — — — (171)(171)
Net (loss)— — — (32,296)— (32,296)
June 30, 201979,144 $791 $122,880 $445,108 $(11,492)$557,287 
Repurchase of common stock(88)(1)(6,396)— — (6,397)
Issuance of common stock for share-based compensation plans268 (8,804)— — (8,801)
Stock-based compensation— — 21,879 — — 21,879 
Cash dividends declared ($0.03 per share)— — — (2,381)— (2,381)
Other comprehensive (loss)— — — — (2,417)(2,417)
Net (loss)— — — (30,338)— (30,338)
September 30, 201979,324 $793 $129,559 $412,389 $(13,909)$528,832 
See notes to unaudited condensed consolidated financial statements.
6


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except per share amounts)
Common StockAdditional
Paid-In Capital
Retained Earnings
Accumulated Other Comprehensive (Loss)
Total
Stockholders’ Equity
Number
of Shares
Amount
December 31, 201979,599 $796 $140,523 $410,919 $(13,228)$539,010 
Equity component of convertible senior notes, net— — 61,604 — — 61,604 
Repurchase of common stock(87)(1)(5,999)— — (6,000)
Issuance of common stock for share-based compensation plans564 (23,017)— — (23,011)
Stock-based compensation— — 23,199 — — 23,199 
Cash dividends declared ($0.03 per share)— — — (2,405)— (2,405)
Other comprehensive (loss)— — — — (414)(414)
Net (loss)— — — (25,372)— (25,372)
March 31, 202080,076 $801 $196,310 $383,142 $(13,642)$566,611 
Repurchase of common stock(23)(2,199)— — (2,199)
Issuance of common stock for share-based compensation plans349 (14,085)— — (14,082)
Issuance of common stock under the employee stock purchase plan18 — 1,403 — — 1,403 
Stock-based compensation— — 25,674 — — 25,674 
Cash dividends declared ($0.03 per share)— — — (2,413)— (2,413)
Other comprehensive income— — — — 2,028 2,028 
Net (loss)— — — (20,740)— (20,740)
June 30, 202080,420 $804 $207,103 $359,989 $(11,614)$556,282 
Repurchase of common stock(94)(1)(10,628)— — (10,629)
Issuance of common stock for share-based compensation plans371 (22,524)— — (22,520)
Stock-based compensation— — 27,931 — — 27,931 
Cash dividends declared ($0.03 per share)— — — (2,422)— (2,422)
Other comprehensive (loss)— — — — (53)(53)
Net (loss)— — — (19,267)— (19,267)
September 30, 202080,697 $807 $201,882 $338,300 $(11,667)$529,322 

See notes to unaudited condensed consolidated financial statements.
7


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

Nine Months Ended
September 30,
20202019
Operating activities
Net (loss)$(65,379)$(91,351)
Adjustments to reconcile net (loss) to cash (used in) operating activities
Stock-based compensation76,755 60,242 
(Gain) on capped call transactions(19,816)
Deferred income taxes(43,476)(40,531)
Amortization of deferred commissions24,922 22,372 
Lease expense11,997 10,454 
Amortization of debt discount and issuance costs10,405 
Amortization of intangible assets and depreciation15,677 16,998 
Amortization of investments252 798 
Foreign currency transaction (gain) loss(2,545)3,577 
Other non-cash(1,374)(363)
Change in operating assets and liabilities, net(33,675)4,342 
Cash (used in) operating activities(26,257)(13,462)
Investing activities
Purchases of investments(190,319)(11,182)
Proceeds from maturities and called investments13,066 
Sales of investments1,424 68,937 
Payments for acquisitions, net of cash acquired(10,934)
Investment in property and equipment(21,806)(6,439)
Cash (used in) provided by investing activities(210,701)53,448 
Financing activities
Proceeds from issuance of convertible senior notes600,000 
Purchase of capped calls related to convertible senior notes(51,900)
Payment of debt issuance costs(14,527)
Dividend payments to shareholders(7,206)(7,105)
Common stock repurchases(76,737)(54,836)
Cash provided by (used in) financing activities449,630 (61,941)
Effect of exchange rate changes on cash and cash equivalents183 (363)
Net increase (decrease) in cash and cash equivalents212,855 (22,318)
Cash and cash equivalents, beginning of period68,363 114,422 
Cash and cash equivalents, end of period$281,218 $92,104 

See notes to unaudited condensed consolidated financial statements.
8

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION
Pegasystems Inc. (together with its subsidiaries, “the Company”) has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all the information required by accounting principles generally accepted in the United States of America (“U.S.”) for complete financial statements and should be read in conjunction with the Company’s audited financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2019.
In the opinion of management, the Company has prepared the accompanying unaudited condensed consolidated financial statements on the same basis as its audited financial statements, and these financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of the interim periods presented.
All intercompany transactions and balances have been eliminated in consolidation. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year 2020.
2. NEW ACCOUNTING PRONOUNCEMENTS
Convertible debt
In August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (ASU 2020-06), which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts in an entity’s own equity. The standard eliminates the liability and equity separation model for convertible instruments with a cash conversion feature. As a result, after adoption, entities will no longer separately present in equity an embedded conversion feature for such debt. Additionally, the embedded conversion feature will no longer be amortized into income as interest expense over the instrument’s life. Instead, entities will account for a convertible debt instrument wholly as debt unless (1) a convertible instrument contains features that require bifurcation as a derivative under ASC Topic 815, Derivatives and Hedging, or (2) a convertible debt instrument was issued at a substantial premium. Additionally, the standard requires applying the if-converted method to calculate convertible instruments’ impact on diluted earnings per share (“EPS”). The standard is effective for fiscal years beginning after December 15, 2021, with early adoption permitted for fiscal years beginning after December 15, 2020. It can be adopted on either a full retrospective or modified retrospective basis. The Company is currently evaluating the effect this ASU will have on its consolidated financial statements and related disclosures. The Company expects to early adopt the new standard on January 1, 2021.
Financial instruments
In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which requires measurement and recognition of expected credit losses for financial assets measured at amortized cost, including accounts receivable, upon initial recognition of that financial asset using a forward-looking expected loss model, rather than an incurred loss model. Credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses when the fair value is below the asset’s amortized cost, removing the concept of “other-than-temporary” impairments. The Company adopted this standard effective January 1, 2020. The adoption of this standard did not have a material effect on the Company’s financial position or results of operations.
3. MARKETABLE SECURITIES

September 30, 2020
(in thousands)Amortized CostUnrealized GainsUnrealized LossesFair Value
Government debt$50,987 $$(11)$50,976 
Corporate debt136,045 (212)135,834 
$187,032 $$(223)$186,810 
As of September 30, 2020, maturities of marketable securities ranged from October 2020 to September 2023, with a weighted-average remaining maturity of approximately 1.3 years.
As of December 31, 2019, the Company did not hold any marketable securities.
9

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



4. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE
Receivables
(in thousands)September 30, 2020December 31, 2019
Accounts receivable$137,953 $199,720 
Unbilled receivables208,823 180,219 
Long-term unbilled receivables108,456 121,736 
$455,232 $501,675 
Unbilled receivables are client committed amounts for which revenue recognition precedes billing, and billing is solely subject to the passage of time.
Unbilled receivables are expected to be billed in the future as follows:
(Dollars in thousands)September 30, 2020
1 year or less$208,823 66 %
1-2 years91,325 29 %
2-5 years17,131 %
$317,279 100 %
Unbilled receivables based upon contract effective date:
(Dollars in thousands)September 30, 2020
2020$105,380 33 %
201999,875 32 %
201839,281 12 %
201737,824 12 %
2016 and prior34,919 11 %
$317,279 100 %
Major clients
Clients accounting for 10% or more of the Company’s receivables:
September 30, 2020December 31, 2019
Client A11 %*
* Client accounted for less than 10% of total receivables.
Contract assets and deferred revenue
(in thousands)September 30, 2020December 31, 2019
Contract assets (1)
$8,104 $5,558 
Long-term contract assets (2)
5,579 5,420 
13,683 10,978 
Deferred revenue181,680 190,080 
Long-term deferred revenue (3)
6,673 5,407 
$188,353 $195,487 
(1) Included in other current assets. (2) Included in other long-term assets. (3) Included in other long-term liabilities.
Contract assets are client committed amounts for which revenue recognized exceeds the amount billed to the client and the right to payment is subject to conditions other than the passage of time, such as the completion of a related performance obligation. Deferred revenue consists of billings and payments received in advance of revenue recognition. Contract assets and deferred revenue are netted at the contract level for each reporting period.
The change in deferred revenue in the nine months ended September 30, 2020 was primarily due to new billings in advance of revenue recognition, and $170.5 million of revenue recognized during the period that was included in deferred revenue at December 31, 2019.
5. DEFERRED COMMISSIONS
(in thousands)September 30, 2020December 31, 2019
Deferred commissions (1)
$87,992 $85,314 
(1) Included in other long-term assets.
10

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



Three Months Ended
September 30,
Nine Months Ended
September 30,
(in thousands)2020201920202019
Amortization of deferred commissions (1)
$8,861 $8,193 $24,922 $22,372 
(1) Included in selling and marketing expense.
6. DEBT
Convertible senior notes and capped calls
Convertible senior notes
In February 2020, the Company issued Convertible Senior Notes (the "Notes") with an aggregate principal amount of $600 million, due March 1, 2025, in a private placement. The proceeds from the Notes were used or are anticipated to be used for the Capped Call Transactions (described below), working capital, and other general corporate purposes. There are no required principal payments prior to the maturity of the Notes. The Notes accrue interest at an annual rate of 0.75%, payable semi-annually in arrears on March 1 and September 1, beginning on September 1, 2020.
Proceeds from the Notes and Capped Call Transactions:
(in thousands)Amount
Principal$600,000 
Less: issuance costs(14,527)
Less: Capped Call Transactions(51,900)
$533,573 
Conversion rights
The conversion rate is 7.4045 shares of common stock per $1,000 principal amount of the Notes, representing an initial conversion price of approximately $135.05 per share of common stock. The Company will settle conversions by paying or delivering, as applicable, cash, shares of its common stock, or a combination of cash and shares of its common stock, at the Company’s election, based on the applicable conversion rate. The conversion rate will be adjusted upon the occurrence of certain events, including spin-offs, tender offers, exchange offers, and certain stockholder distributions.
Beginning on September 1, 2024, noteholders may convert their Notes at any time at their election. Before September 1, 2024, noteholders may convert their Notes in the following circumstances:
During any calendar quarter commencing after the calendar quarter ending on June 30, 2020 (and only during such calendar quarter), if the last reported sale price per share of the Company’s common stock exceeds one hundred and thirty percent (130%) of the conversion price for each of at least twenty (20) trading days (whether or not consecutive) during the thirty (30) consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter.
���During the 5 consecutive business days immediately after any 5 consecutive trading day period (the “Measurement Period”), if the trading price per $1,000 principal amount of Notes for each trading day of the Measurement Period was less than 98% of the product of the last reported sale price per share of common stock on such trading day and the conversion rate on such trading day.
Upon the occurrence of certain corporate events or distributions, or if the Company calls all or any Notes for redemption, then the noteholder of any Note may convert such Note at any time before the close of business on the business day immediately before the related redemption date (or if the Company fails to pay the redemption price due on such redemption date in full, at any time until the Company pays such redemption price in full).
As of September 30, 2020, no Notes were eligible for conversion at the noteholders’ election.
Repurchase rights
On or after March 1, 2023 and on or before the 40th scheduled trading day immediately before the maturity date, the Company may redeem for cash all or part of the Notes, at a repurchase price equal to 100% of the principal amount, plus accrued and unpaid interest, if the last reported sale price of the Company’s common stock exceeded 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which the Company provides a redemption notice.
If certain corporate events that constitute a “Fundamental Change” (as described below) occur at any time, each noteholder will have the right, at such noteholder’s option, to require the Company to repurchase for cash all of such noteholder’s Notes, or any portion of the principal thereof that is equal to $1,000 or an integral multiple of $1,000, at a repurchase price equal to 100% of the principal amount thereof, plus accrued and unpaid interest. A fundamental change relates to events such as mergers, changes in control of the Company, liquidation/dissolution of the Company, or the delisting of the Company’s common stock.
11

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



Impact of the Notes
In accounting for the transaction, the Notes have been separated into liability and equity components.
The initial carrying amount of the liability component was calculated by measuring a similar debt instrument’s fair value that does not have an associated conversion feature. The excess of the Notes’ principal amount over the initial carrying amount of the liability component, the debt discount, is amortized as interest expense over the Notes’ contractual term.
The equity component was recorded as an increase to additional paid-in capital and is not remeasured as long as it continues to meet the conditions for equity classification.
The Company incurred issuance costs of $14.5 million related to the Notes, allocated between the Notes’ liability and equity components proportionate to the initial carrying amount of the liability and equity components.
Issuance costs attributable to the liability component are recorded as an offset to the Notes’ principal balance. They are amortized as interest expense using the effective interest method over the contractual term of the Notes.
Issuance costs attributable to the equity component are recorded as an offset to the equity component in additional paid-in capital and are not amortized.
Net carrying amount of the liability component:
(in thousands)September 30, 2020
Principal$600,000 
Unamortized debt discount(75,061)
Unamortized issuance costs(11,145)
$513,794 
Net carrying amount of the equity component, included in additional paid-in capital:
(in thousands)September 30, 2020
Conversion options (1)
$61,604 
(1) Net of issuance costs and taxes.
Interest expense related to the Notes:
Three Months Ended
September 30,
Nine Months Ended
September 30,
(in thousands)2020201920202019
Contractual interest expense (0.75% coupon)$1,125 $$2,700 $
Amortization of debt discount (1)
3,807 9,060 
Amortization of issuance costs (1)
565 1,345 
$5,497 $$13,105 $
(1) Amortized based upon an effective interest rate of 4.31%.
Future payments of principal and contractual interest:
September 30, 2020
(in thousands)PrincipalInterestTotal
2020$$$
20214,500 4,500 
20224,500 4,500 
20234,500 4,500 
20244,500 4,500 
2025600,000 1,488 601,488 
$600,000 $19,488 $619,488 
Capped call transactions
In February 2020, the Company entered into privately negotiated capped call transactions (“Capped Call Transactions”) with certain financial institutions. The Capped Call Transactions cover approximately 4.4 million shares (representing the number of shares for which the Notes are initially convertible) of the Company’s common stock. They are generally expected to reduce potential dilution to the common stock upon any conversion of Notes and/or offset any potential cash payments the Company is required to make in excess of the principal amount of converted Notes, as the case may be, with such reduction and/or offset subject to a cap. The cap price of the Capped Call Transactions is $196.44, subject to adjustment upon the occurrence of specified extraordinary events affecting the Company, including merger events and tender offers.
12

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



The Capped Call Transactions are accounted for as derivative instruments. The Capped Call Transactions do not qualify for the Company’s own equity scope exception in ASC 815 since, in some cases of early settlement, the settlement value of the Capped Call Transactions, calculated in accordance with the governing documents, may not represent a fair value measurement. The Capped Call Transactions are classified as “other long term assets” and remeasured to fair value at the end of each reporting period, resulting in a non-operating gain or loss.
Change in value of Capped Call Transactions:
(in thousands)Nine Months Ended
September 30, 2020
Value at issuance$51,900 
Fair value adjustment19,816 
Balance as of September 30,$71,716 
Credit facility
In November 2019, and as amended in February 2020, July 2020, and October 2020, the Company entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association (“PNC”). The Company may use borrowings to finance working capital needs and for general corporate purposes. Subject to specific conditions, the Credit Facility allows the Company to increase the aggregate commitment to $200 million. The commitments expire on November 4, 2024, and any outstanding loans will be payable on such date. The Credit Facility, as amended, contains customary covenants, including, but not limited to, those relating to additional indebtedness, liens, asset divestitures, and affiliate transactions.
The Company is also required to comply with financial covenants, including:
Beginning with the fiscal quarter ended on September 30, 2020 and ending with the fiscal quarter ended December 31, 2021 at least $200 million in cash and investments held by Pegasystems Inc.
Beginning with the quarter ended on March 31, 2022 a maximum net consolidated leverage ratio of 3.5 to 1.0 (with a step-up in the event of certain acquisitions) and a minimum consolidated interest coverage ratio of 3.5 to 1.0.
As of September 30, 2020 and December 31, 2019, we had 0 outstanding borrowings under the Credit Facility.
7. FAIR VALUE MEASUREMENTS
Assets and liabilities measured at fair value on a recurring basis
The Company records its cash equivalents, Capped Call Transactions, and venture investments at fair value on a recurring basis. Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants based on assumptions that market participants would use in pricing an asset or liability.
As a basis for classifying the fair value measurements, a three-tier fair value hierarchy, which classifies the fair value measurements based on the inputs used in measuring fair value, was established as follows:
Level 1 - observable inputs such as quoted prices in active markets for identical assets or liabilities;
Level 2 - significant other inputs that are observable either directly or indirectly; and
Level 3 - significant unobservable inputs on which there is little or no market data, which require the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and minimize unobservable inputs when determining fair value.
The fair value of the Capped Call Transactions at the end of each reporting period is determined using a Black-Scholes option-pricing model. The valuation models use various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield, as applicable. The Company applies judgment in its determination of expected volatility. The Company considers both historical and implied volatility levels of the underlying equity security and, to a lesser extent, historical peer group volatility levels. The Company’s venture investments are recorded at fair value based on valuation methods using the observable transaction price and other unobservable inputs, including the volatility, rights, and obligations of the securities the Company holds.
The Company’s assets and liabilities measured at fair value on a recurring basis:
September 30, 2020December 31, 2019
(in thousands)Level 1Level 2Level 3TotalLevel 1Level 2Level 3Total
Cash equivalents (1)
$212,917 $$$212,917 $$$$
Marketable securities$$186,810 $$186,810 $$$$
Capped Call Transactions (2) (3)
$$71,716 $$71,716 $$$$
Venture investments (2) (4)
$$$7,927 $7,927 $$$4,871 $4,871 
(1) Investments in money market funds. (2) Included in other long-term assets. (3) See "6. Debt" for additional information. (4) Investments in privately-held companies.
13

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



Change in venture investments:
(in thousands)Nine Months Ended
September 30, 2020
December 31, 2019$4,871 
New investments3,006 
Sales of investments(1,424)
Fair value adjustment1,474 
September 30, 2020$7,927 

The carrying value of certain other financial instruments, including receivables and accounts payable, approximates fair value due to the relatively short maturity of these items.
Fair value of the Notes
The fair value of the Company’s Notes was recorded at $515.9 million upon issuance, which reflected the principal amount of the Notes less the fair value of the conversion feature. The fair value of the debt component was determined based on a discounted cash flow model. The discount rate used reflected both the time value of money and credit risk inherent in the Notes. The carrying value of the Notes will be accreted, over the remaining term to maturity, to their principal value of $600 million.
The Notes’ fair value (inclusive of the conversion feature, which is embedded in the Notes) was $680 million as of September 30, 2020. The fair value was determined based on the Notes’ quoted price in an over-the-counter market on the last trading day of the reporting period and classified within Level 2 in the fair value hierarchy. See "6. Debt" for additional information.
8. REVENUE
Geographic revenue
Three Months Ended
September 30,
Nine Months Ended
September 30,
(Dollars in thousands)2020201920202019
U.S.$120,971 53 %$123,447 57 %$436,199 61 %$347,120 55 %
Other Americas10,737 %11,748 %35,009 %49,450 %
United Kingdom (“U.K.”)25,150 11 %23,034 11 %68,246 %64,269 10 %
Europe (excluding U.K.), Middle East, and Africa39,656 18 %34,761 16 %106,472 15 %102,342 16 %
Asia-Pacific29,437 13 %23,713 11 %72,991 10 %71,660 11 %
$225,951 100 %$216,703 100 %$718,917 100 %$634,841 100 %
Revenue streams
Three Months Ended
September 30,
Nine Months Ended
September 30,
(in thousands)2020201920202019
Perpetual license$3,852 $9,016 $16,568 $43,286 
Term license35,932 48,989 170,455 122,257 
Revenue recognized at a point in time39,784 58,005 187,023 165,543 
Maintenance74,670 70,371 220,587 207,406 
Pega Cloud54,776 35,153 147,080 94,610 
Consulting56,721 53,174 164,227 167,282 
Revenue recognized over time186,167 158,698 531,894 469,298 
$225,951 $216,703 $718,917 $634,841 

14

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



(in thousands)Three Months Ended
September 30,
Nine Months Ended
September 30,
2020201920202019
Pega Cloud$54,776 $35,153 $147,080 $94,610 
Maintenance74,670 70,371 220,587 207,406 
Term license35,932 48,989 170,455 122,257 
Subscription (1)
165,378 154,513 538,122 424,273 
Perpetual license3,852 9,016 16,568 43,286 
Consulting56,721 53,174 164,227 167,282 
$225,951 $216,703 $718,917 $634,841 
(1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license).
Remaining performance obligations ("Backlog")
Expected future revenue on existing contracts:
September 30, 2020
(Dollars in thousands)Perpetual licenseTerm licenseMaintenancePega CloudConsultingTotal
1 year or less$8,708 $50,788 $170,643 $211,661 $14,977 $456,777 54 %
1-2 years1,700 5,341 40,631 157,500 2,042 207,214 25 %
2-3 years7,052 18,277 93,283 770 119,382 14 %
Greater than 3 years9,597 44,363 653 54,617 %
$10,408 $63,185 $239,148 $506,807 $18,442 $837,990 100 %

September 30, 2019
(Dollars in thousands)Perpetual licenseTerm licenseMaintenancePega CloudConsultingTotal
1 year or less$7,689 $25,948 $158,220 $133,785 $13,145 $338,787 56 %
1-2 years853 3,798 18,590 105,081 863 129,185 21 %
2-3 years1,306 591 8,323 72,915 841 83,976 14 %
Greater than 3 years85 4,959 51,591 56,635 %
$9,848 $30,422 $190,092 $363,372 $14,849 $608,583 100 %

9. STOCK-BASED COMPENSATION
Expense
Three Months Ended
September 30,
Nine Months Ended
September 30,
(in thousands)2020201920202019
Cost of revenue$5,100 $4,787 $15,636 $14,216 
Selling and marketing12,658 8,317 33,968 24,055 
Research and development5,765 4,858 17,066 13,990 
General and administrative4,402 3,884 10,085 7,981 
$27,925 $21,846 $76,755 $60,242 
Income tax benefit$(5,604)$(4,430)$(15,293)$(12,226)
As of September 30, 2020, the Company had $115.0 million of unrecognized stock-based compensation expense, net of estimated forfeitures, which is expected to be recognized over a weighted-average period of 2.2 years.
Grants
The Company granted the following stock-based compensation awards:
Nine Months Ended
September 30, 2020
(in thousands)SharesTotal Fair Value
RSUs1,026 $92,456 
Non-qualified stock options1,886 $44,505 
Common stock$701 

15

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



10. INCOME TAXES
Effective income tax rate

Three Months Ended
September 30,
Nine Months Ended
September 30,
(Dollars in thousands)2020201920202019
(Benefit from) income taxes$(25,053)$(17,520)$(61,182)$(43,158)
Effective income tax rate48 %32 %
During the nine months ended September 30, 2020, the Company’s effective income tax rate benefit increased primarily due to the excess tax benefits from stock-based compensation and a carryback claim benefit as a result of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”).
11. (LOSS) PER SHARE
Basic (loss) per share is calculated using the weighted-average number of common shares outstanding during the period. Diluted (loss) per share is calculated using the weighted-average number of common shares outstanding during the period, plus the dilutive effect of outstanding stock options, RSUs, and the conversion spread of the Company’s convertible senior notes.
Calculation of the basic and diluted earnings per share:
Three Months Ended
September 30,
Nine Months Ended
September 30,
(in thousands, except per share amounts)2020201920202019
Net (loss)$(19,267)$(30,338)$(65,379)$(91,351)
Weighted-average common shares outstanding80,537 79,200 80,191 78,928 
(Loss) per share, basic$(0.24)$(0.38)$(0.82)$(1.16)
Net (loss)$(19,267)$(30,338)$(65,379)$(91,351)
Weighted-average common shares outstanding, assuming dilution (1) (2)
80,537 79,200 80,191 78,928 
(Loss) per share, diluted$(0.24)$(0.38)$(0.82)$(1.16)
Outstanding anti-dilutive stock options and RSUs (3)
6,622 5,953 6,166 5,923 
(1) The Company expects to settle the principal amount of the Notes in cash. As a result, only the amount by which the conversion value exceeds the aggregated principal amount of the Notes is included in the diluted earnings per share computation under the treasury stock method. The conversion spread has a dilutive impact on diluted net income per share when the average market price of the Company’s common stock for a given period exceeds the initial conversion price of $135.05 per share for the Notes. In connection with the Notes’ issuance, the Company entered into Capped Call Transactions, which were not included in calculating the number of diluted shares outstanding, as their effect would have been anti-dilutive.
(2) In periods of loss, all dilutive securities are excluded as their inclusion would be anti-dilutive.
(3) Certain outstanding stock options and RSUs were excluded from the computation of diluted earnings per share because they were anti-dilutive in the period presented. These awards may be dilutive in the future.

16


ITEM 2.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains or incorporates forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
Words such as expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely, and usually, or variations of such words and other similar expressions identify forward-looking statements, which are based on current expectations and assumptions.
These forward-looking statements deal with future events, and are subject to various risks and uncertainties that are difficult to predict, including, but not limited to, statements about our future financial performance and business plans, the adequacy of our liquidity and capital resources, the continued payment of quarterly dividends, the timing of revenue recognition, management of our transition to a more subscription-based business model, variation in demand for our products and services, including among clients in the public sector, the impact of actual or threatened public health emergencies, such as the Coronavirus (COVID-19), reliance on third-party service providers, compliance with our debt obligations and debt covenants, the potential impact of our convertible senior notes and related Capped Call Transactions, reliance on key personnel, the continued uncertainties in the global economy, foreign currency exchange rates, the potential legal and financial liabilities and reputation damage due to cyber-attacks, security breaches and security flaws, our ability to protect our intellectual property rights and costs associated with defending such rights, maintenance of our client retention rate, and management of our growth. These risks and others that may cause actual results to differ materially from those expressed in such forward-looking statements are described further in Part I of our Annual Report on Form 10-K for the year ended December 31, 2019, and other filings we make with the U.S. Securities and Exchange Commission (“SEC”).
Except as required by applicable law, we do not undertake and expressly disclaim any obligation to publicly update or revise these forward-looking statements whether as the result of new information, future events, or otherwise.
BUSINESS OVERVIEW
We develop, market, license, host, and support enterprise software applications that help organizations transform how they engage with their customers and process work across their enterprise. We also license our low-code Pega Platform™ for rapid application development to clients that wish to build and extend their business applications. Our cloud-architected portfolio of customer engagement and digital process automation applications leverages artificial intelligence (“AI”), case management, and robotic automation technology, built on our unified low-code Pega Platform, empowering businesses to quickly design, extend, and scale their enterprise applications to meet strategic business needs.
Our target clients are Global 3000 organizations and government agencies that require applications to differentiate themselves in the markets they serve. Our applications achieve and facilitate differentiation 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.
Cloud Transition
We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud (“Cloud Transition”). Until we substantially complete our Cloud Transition, which we expect to occur in early 2023, we expect to continue to experience lower revenue growth and lower operating cash flow growth or negative cash flow. The actual mix of perpetual license, term license, and Pega Cloud in a given period can fluctuate based on client preferences.
Additional information on the transition’s impact can be found below and in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2019.
COVID-19
As of September 30, 2020, COVID-19 has not had a material impact on our results of operations or financial condition.
The ultimate impact of COVID-19 on our operational and financial performance will depend on future developments, including the duration and spread of the outbreak, impact on our clients and our sales cycles, and impact on our partners, vendors, or employees, all of which are uncertain and unpredictable. Our shift towards subscription-based revenue streams, the industry mix of our clients, our product mix, the fact that many of our clients are well-known and of large size, and the critical nature of our products to our clients may reduce or delay the impact of COVID-19 on our business. However, it is not possible to estimate the ultimate impact that COVID-19 will have on our business. See “Coronavirus (“COVID-19”)” under Item 1A. Risk Factors for additional information.
17


Performance metrics
We utilize several performance metrics to analyze and assess our overall performance, make operating decisions, and forecast and plan for future periods, including:
Annual contract value (“ACV”) | Increased 21% since September 30, 2019
ACV represents the annualized value of our active contracts as of the measurement date. The contract's total value is divided by its duration in years to calculate ACV for term license and Pega Cloud contracts. Maintenance revenue for the quarter then ended is multiplied by four to calculate ACV for maintenance. Client Cloud ACV is composed of maintenance ACV and ACV from term license contracts. We believe the presentation of ACV on a constant currency basis enhances the understanding of our results, as it provides visibility into the impact of changes in foreign currency exchange rates, which are outside of our control. All periods shown reflect foreign currency exchange rates as of September 30, 2020.
Remaining performance obligations (“Backlog”) | Increased 38% since September 30, 2019
Backlog represents contracted revenue that has not yet been recognized and includes deferred revenue and non-cancellable amounts expected to be invoiced and recognized as revenue in future periods.
Year to date Pega Cloud revenue | Increased 55% since September 30, 2019
Pega Cloud revenue is revenue as reported under U.S. GAAP for cloud contracts.
pega-20200930_g1.jpg
18


pega-20200930_g2.jpgpega-20200930_g3.jpg
CRITICAL ACCOUNTING POLICIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) and the rules and regulations of the SEC for interim financial reporting. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions, and expectations of what could occur in the future given the available information.
For more information regarding our critical accounting policies, we encourage you to read the discussion in the following locations in our Annual Report on Form 10-K for the year ended December 31, 2019:
“Critical Accounting Estimates and Significant Judgments” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”; and
Note 2. “Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data.”
There have been no significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019 other than those listed below.
Capped Call Transactions
In February 2020, we entered into privately negotiated capped call transactions (“Capped Call Transactions”) with certain financial institutions. The Capped Call Transactions cover approximately 4.4 million shares (representing the number of shares for which the Notes are initially convertible) of our common stock and are generally expected to reduce potential dilution of our common stock upon any conversion of the Notes. The fair value of the Capped Call Transactions at the end of each reporting period is determined using a Black-Scholes option-pricing model. The valuation models use various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield, as applicable. Management applies judgment in its determination of expected volatility. We consider both historical and implied volatility levels of the underlying equity security and, to a lesser extent, historical peer group volatility levels.
The Capped Call Transactions are classified as “other long-term assets” and remeasured to fair value at the end of each reporting period, resulting in a non-operating gain or loss.
See "6. Debt" and “7. Fair Value Measurements” in Item 1 of this Quarterly Report for additional information.
19


RESULTS OF OPERATIONS
Revenue
Our Pega Cloud revenue is derived from our hosted Pega Platform and software applications. Our license revenue is derived from sales of our applications and the Pega Platform.
Cloud Transition
We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud. As revenue from Pega Cloud arrangements is generally recognized over the contract term while revenue from perpetual and term licenses is generally recognized when the license rights become effective, the shift has and is expected to continue to result in slower revenue growth during the transition.
(Dollars in thousands)Three Months Ended
September 30,
ChangeNine Months Ended
September 30,
Change
2020201920202019
Pega Cloud$54,776 24 %$35,153 16 %$19,623 56 %$147,080 20 %$94,610 15 %$52,470 55 %
Maintenance74,670 33 %70,371 32 %4,299 %220,587 31 %207,406 33 %13,181 %
Term license35,932 16 %48,989 23 %(13,057)(27)%170,455 24 %122,257 19 %48,198 39 %
Subscription (1)
$165,378 73 %$154,513 71 %10,865 %$538,122 75 %$424,273 67 %113,849 27 %
Perpetual license3,852 %9,016 %(5,164)(57)%16,568 %43,286 %(26,718)(62)%
Consulting56,721 25 %53,174 25 %3,547 %164,227 23 %167,282 26 %(3,055)(2)%
$225,951 100 %$216,703 100 %$9,248 %$718,917 100 %$634,841 100 %$84,076 13 %
(1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license).
The changes in total revenue in the three and nine months ended September 30, 2020 generally reflect our Cloud Transition. Other factors impacting our revenue included:
Term license revenue was higher in the three months ended September 30, 2019 primarily due to a greater number of large deals than in the three months ended September 30, 2020.
An increasing portion of our term license contracts include multi-year committed maintenance periods instead of annually renewable maintenance. Under such arrangements, a greater portion of the total contract value is recorded as maintenance revenue, which is recognized over the contract term, rather than as term revenue, as the license rights become effective which is usually shortly after contract execution. In the three and nine months ended September 30, 2020 multi-year committed maintenance contributed $2.9 million and $7.7 million to maintenance revenue growth. In the nine months ended September 30, 2020 multi-year committed maintenance reduced term revenue growth by $10.2 million.
Maintenance renewal rates remained over 90% in the nine months ended September 30, 2020.
The decrease in consulting revenue in the nine months ended September 30, 2020 was primarily due to lower billable travel expenses as a result of COVID-19. The increase in consulting revenue in the three months ended September 30, 2020 was primarily due to increased billable hours which more than offset the impact of reduced billable travel expenses due to COVID-19.
Gross profit
Three Months Ended
September 30,
ChangeNine Months Ended
September 30,
Change
(Dollars in thousands)2020201920202019
Software license$39,093 98 %$57,329 99 %$(18,236)(32)%$184,669 99 %$162,561 98 %$22,108 14 %
Maintenance69,192 93 %63,683 90 %5,509 %203,942 92 %188,091 91 %15,851 %
Pega Cloud35,059 64 %17,329 49 %17,730 102 %90,842 62 %46,841 50 %44,001 94 %
Consulting4,808 %(2,536)(5)%7,344 *5,446 %4,933 %513 10 %
$148,152 66 %$135,805 63 %$12,347 %$484,899 67 %$402,426 63 %$82,473 20 %
* not meaningful
The changes in gross profit in the three and nine months ended September 30, 2020 were primarily due to our Cloud Transition, revenue growth, and cost efficiency gains as Pega Cloud grows and scales.
The increase in consulting gross profit in the three months ended September 30, 2020 was primarily due to an increase in consultant utilization. Consultant utilization is impacted by several factors, including the scope and timing of new implementation projects and our level of involvement in implementation projects compared to our consulting partners and enabled clients. To support our long-term strategy, we intend to grow and increasingly leverage our partners and enabled clients for future implementation projects, which may reduce the future growth rate.
20


Operating expenses
(Dollars in thousands)Three Months Ended
September 30,
ChangeNine Months Ended
September 30,
Change
2020201920202019
% of Revenue% of Revenue% of Revenue% of Revenue
Selling and marketing$132,053 58 %$115,237 53 %$16,816 15 %$395,684 55 %$341,064 54 %$54,620 16 %
Research and development$60,024 27 %$52,492 24 %$7,532 14 %$177,620 25 %$152,802 24 %$24,818 16 %
General and administrative$17,907 %$14,843 %$3,064 21 %$49,192 %$41,693 %$7,499 18 %
The increases in selling and marketing in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $24.4 million and $76.0 million, attributable to increases in headcount and equity compensation. The increases in headcount reflect our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts. These increases were partially offset by decreases in travel and entertainment of $8.5 million and $17.4 million as a result of COVID-19.
The increases in research and development in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $7.8 million and $23.6 million, attributable to increases in headcount and equity compensation.
The increases in general and administrative in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $0.8 million and $3.0 million, attributed to increases in headcount and equity compensation, and increases in professional services fees of $1.5 million and $4.2 million.
Other income (expense), net
(Dollars in thousands)Three Months Ended
September 30,
ChangeNine Months Ended
September 30,
Change
2020201920202019
Foreign currency transaction gain (loss)$4,236 $(1,970)$6,206 *$2,545 $(3,577)$6,122 *
Interest income243 598 (355)(59)%1,092 1,865 (773)(41)%
Interest expense(5,956)(42)(5,914)(14,081)%(13,791)(42)(13,749)(32,736)%
Gain on capped call transactions18,989 — 18,989 *19,816 — 19,816 *
Other income, net— 323 (323)(100)%1,374 378 996 263 %

$17,512 $(1,091)$18,603 *$11,036 $(1,376)$12,412 *
* not meaningful
The changes in foreign currency transaction gain (loss) in the three and nine months ended September 30, 2020 were primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency-denominated cash, accounts receivable, and intercompany receivables and payables held by our United Kingdom (“U.K.”) subsidiary.
The decreases in interest income in the three and nine months ended September 30, 2020 were due to the decreases in market interest rates.
The increases in interest expense in the three and nine months ended September 30, 2020 were due to our issuance of $600 million in aggregate principal amount of the Notes on February 24, 2020. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
Interest expense related to the Notes:
Three Months Ended
September 30,
ChangeNine Months Ended
September 30,
Change
(in thousands)2020201920202019
Contractual interest expense (0.75% coupon)$1,125 $— $1,125 $2,700 $— $2,700 
Amortization of debt discount3,807 — 3,807 9,060 — 9,060 
Amortization of issuance costs565 — 565 1,345 — 1,345 
$5,497 $— $5,497 $13,105 $— $13,105 
The increases in the gain on capped call transactions in the three and nine months ended September 30, 2020 were due to fair value adjustments on the Capped Call Transactions entered into in connection with our issuance of the Notes. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
The increase in other income, net in the nine months ended September 30, 2020 was due to a gain from our venture investments portfolio.
21


(Benefit from) income taxes
Three Months Ended
September 30,
Nine Months Ended
September 30,
(Dollars in thousands)2020201920202019
(Benefit from) income taxes$(25,053)$(17,520)$(61,182)$(43,158)
Effective income tax rate48 %32 %
The inclusion of excess tax benefits from stock-based compensation in the provision for income taxes has increased the variability of the effective tax rates in recent periods. This fluctuation may continue in future periods, depending on our future stock price in relation to the fair value of awards, the timing of the vestings of RSU awards, the exercise behavior of our stock option holders, and the total value of future grants of stock-based compensation awards.
During the nine months ended September 30, 2020, our effective income tax rate benefit increased primarily due to the excess tax benefits from stock-based compensation and a carryback claim benefit as a result of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”).
LIQUIDITY AND CAPITAL RESOURCES
Nine Months Ended
September 30,
 (in thousands)20202019
Cash provided by (used in):
Operating activities$(26,257)$(13,462)
Investing activities(210,701)53,448 
Financing activities449,630 (61,941)
Effect of exchange rates on cash and cash equivalents183 (363)
Net increase (decrease) in cash and cash equivalents$212,855 $(22,318)

(in thousands)September 30, 2020December 31, 2019
Held by U.S. entities$415,358 $23,437 
Held by foreign entities52,670 44,926 
Total cash, cash equivalents, and marketable securities$468,028 $68,363 
We believe that our current cash, cash flow from operations, and borrowing capacity will be sufficient to fund our operations and quarterly cash dividends for at least the next 12 months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results, and the investments required to respond to the possible increased demand for our services. If we require additional capital resources to grow our business, we may seek to finance our operations from available funds or additional external financing.
If it became necessary to repatriate foreign funds, we may be required to pay U.S. and foreign taxes upon repatriation. Due to the complexity of income tax laws and regulations, and the Tax Reform Act’s effects, it is impracticable to estimate the amount of taxes we would have to pay.
Cash (used in) operating activities
We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud. As cash from Pega Cloud and term arrangements is generally collected over the contract term while cash from perpetual licenses is generally collected when the license rights become effective, the shift has and is expected to continue to impact our cash collections. As client preferences continue to shift in favor of Pega Cloud arrangements, we could continue to experience slower operating cash flow growth, or negative cash flow, in the near term.
In the nine months ended September 30, 2020, COVID-19 did not have a material impact on our cash flows from operations. See “Coronavirus (“COVID-19”)” under Item 1A. Risk Factors for additional information.
The change in cash (used in) operating activities in the nine months ended September 30, 2020 was primarily due to our Cloud Transition and increased costs as we accelerated investments in our Pega Cloud offering and selling and marketing activities to support future growth.

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Cash (used in) provided by investing activities
The change in cash (used in) provided by investing activities in the nine months ended September 30, 2020 was primarily driven by purchases of financial instruments and investments in property and equipment at several of our office locations.
Cash provided by (used in) financing activities
Convertible senior notes
In February 2020, we issued $600 million in aggregate principal amount of our convertible senior notes (“Notes”) due March 1, 2025, which provided proceeds as follows:
(in thousands)Amount
Principal$600,000 
Less: issuance costs(14,527)
Less: Capped Call Transactions(51,900)
$533,573 
A portion of the proceeds of the Notes was used to fund the Capped Call Transactions with the remainder to be used for working capital and other general corporate purposes. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
Credit facility
In November 2019, and as amended in February 2020, July 2020, and October 2020, we entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association (“PNC”). As of September 30, 2020, we had no outstanding borrowings under the Credit Facility. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
Stock repurchase program (1)
Changes in the remaining stock repurchase authority:
(in thousands)Nine Months Ended
September 30, 2020
December 31, 2019$45,484 
Authorizations (2)
20,516 
Repurchases(18,828)
September 30, 2020$47,172 
(1) Purchases under this program have been made on the open market. (2) On June 15, 2020, we announced that our Board of Directors extended the current stock repurchase program’s expiration date to June 30, 2021 and increased the remaining stock repurchase authority to $60 million.
Common stock repurchases
Nine Months Ended
September 30,
20202019
(in thousands)SharesAmountSharesAmount
Tax withholdings for net settlement of equity awards599 $59,613 514 $34,871 
Stock repurchase program204 18,828 321 20,286 
803 $78,441 835 $55,157 

During the nine months ended September 30, 2020 and 2019, instead of receiving cash from the equity holders, we withheld shares with a value of $49.5 million and $31.6 million, respectively, for the exercise price of options. These amounts have been excluded from the table above.
Dividends
Nine Months Ended
September 30,
(in thousands)20202019
Dividend payments to shareholders$7,206 $7,105 
We currently intend to pay a quarterly cash dividend of $0.03 per share. However, the Board of Directors may terminate or modify the dividend program at any time without prior notice.
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Contractual obligations
As of September 30, 2020, our contractual obligations were:
Payments due by period
(in thousands)202020212022-20232024-20252026 and thereafterOtherTotal
Purchase obligations (1)
$21,627 $56,689 $61,117 $173 $— $— $139,606 
Investment commitments (2)
300 500 — — — — 800 
Liability for uncertain tax positions (3)
— — — — — 5,441 5,441 
Operating lease obligations5,490 22,887 43,888 13,187 9,959 — 95,411 
$27,417 $80,076 $105,005 $13,360 $9,959 $5,441 $241,258 
(1) Represents the fixed or minimum amounts due under purchase obligations for hosting services and sales and marketing programs.
(2) Represents the maximum funding that would be expected under existing venture investment agreements. Our investment agreements generally allow us to withhold unpaid committed funds at our discretion.
(3) We are unable to reasonably estimate the timing of the cash outflow due to uncertainties in the timing of the effective settlement of tax positions.
ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates.
Foreign currency exposure
Translation risk
Our foreign operations’ operating expenses are primarily denominated in foreign currencies. However, our international sales are also primarily denominated in foreign currencies, which partially offsets our foreign currency exposure.
A hypothetical 10% strengthening in the U.S. dollar against other currencies would result in the following impact:
Nine Months Ended
September 30,
20202019
(Decrease) increase in revenue(4)%(4)%
(Decrease) increase in net (loss)(13)%(6)%
Remeasurement risk
We experience fluctuations in transaction gains or losses from remeasurement of monetary assets and liabilities 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 the Australian dollar, Euro, and U.S. dollar-denominated cash and cash equivalents, accounts receivable, unbilled receivables, and intercompany receivables and payables held by our U.K. subsidiary, a British pound functional entity.
A hypothetical 10% strengthening in the British pound exchange rate in comparison to the Australian dollar, Euro, and U.S. dollar would result in the following impact:
Nine Months Ended
September 30,
(in thousands)20202019
Foreign currency gain (loss)$(6,326)$1,099 

ITEM 4.     CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures
Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)) as of September 30, 2020. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2020.
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(b) Changes in internal control over financial reporting
There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended September 30, 2020 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
COVID-19
In response to COVID-19, we have undertaken measures to protect our employees, partners, and clients, including encouraging employees to work remotely. These changes have compelled us to modify some of our control procedures. However, those changes have so far not been material.
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PART II - OTHER INFORMATION
ITEM 1A.     RISK FACTORS
We encourage you to carefully consider the risk factors identified below and in Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the Securities and Exchange Commission on February 12, 2020. These risk factors could materially affect our business, financial condition, and future results, and they could cause our actual business and financial results to differ materially from those contained in forward-looking statements made in this Quarterly Report on Form 10-Q or elsewhere by management.
Coronavirus (“COVID-19”)
Epidemic diseases, such as the recent global COVID-19 outbreak, could harm our business and results of operations.
The recent outbreak of a novel coronavirus disease (“COVID-19”), which has been declared by the World Health Organization to be a pandemic, has spread across the globe and is impacting worldwide economic activity. A pandemic, including COVID-19, or other public health epidemics pose the risk that our employees, partners, and clients may be prevented from conducting business activities at full capacity for an indefinite period, including due to the spread of the disease within these groups or due to the shutdowns that are requested or mandated by governmental authorities. Moreover, these conditions can affect the rate of IT spending and may adversely affect our clients’ willingness to purchase our solutions, delay prospective clients’ purchasing decisions, reduce the value or duration of their contracts, request concessions including extended payment terms or better pricing, or affect attrition rates, all of which could adversely affect our future sales and operating results. The global spread of COVID-19 has created significant volatility, uncertainty, and economic disruption.
We have undertaken measures to protect our employees, partners, and clients, including by adopting a virtual-only meeting format for our annual PegaWorld conference and encouraging employees to work remotely. There can be no assurance that these measures will be sufficient, however, or that we can implement them without adversely affecting our business operations.
We continue to monitor the situation, and adjust our policies as more information and public health guidance become available. Precautionary measures that have been adopted, or may be adopted in the future, could negatively affect our client success efforts, sales, and marketing efforts, delay and lengthen our sales cycles, or create operational or other challenges, any of which could harm our business and results of operations. In addition, COVID-19 may disrupt our clients’, vendors’, and partners’ operations for an indefinite period, including as a result of travel restrictions and/or business shutdowns, all of which could negatively impact our business and results of operations, including cash flows.
At this time, it is not possible to estimate the ultimate impact that COVID-19 could have on our business, as the impact will depend on future developments, which are highly uncertain and cannot be predicted. Furthermore, due to our shift to a renewable model, the effect of COVID-19 may not be fully reflected in our results of operations until future periods. The extent to which COVID-19 impacts our business, operations, and financial results will depend on numerous evolving factors that we may not be able to predict accurately, including:
the duration and scope of the pandemic;
governmental, business, and individual actions taken in response to the pandemic and the impact of those actions on global economic activity;
the actions taken in response to economic disruption;
the impact of business disruptions and reductions in our clients’ business and the resulting impact on their demand for our services and solutions; and
our ability to provide our services and solutions, including as a result of our employees or our clients’ employees working remotely and/or closures of offices and facilities.
Risks related to our Convertible Senior Notes
We have a significant amount of debt that may decrease our business flexibility, access to capital, and/or increase our borrowing costs, and we may still incur additional debt in the future, which may adversely affect our operations and financial results.
As of September 30, 2020, we had $600 million aggregate principal amount of indebtedness under our Convertible Senior Notes due 2025 (the “Notes”).
Our indebtedness may:
limit our ability to borrow additional funds for working capital, capital expenditures, acquisitions, or other business purposes;
limit our ability to use our cash flow or obtain additional financing for future working capital, capital expenditures, acquisitions, or other general business purposes;
require us to use a substantial portion of our cash flow from operations to make debt service payments;
limit our flexibility to plan for, or react to, changes in our business and industry;
place us at a competitive disadvantage compared to our less leveraged competitors;
dilute the interests of our existing stockholders as a result of issuing shares of our common stock upon the conversion of the Notes; and
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increase our vulnerability to the impact of adverse economic and industry conditions.
Our ability to pay our debt when due or refinance our indebtedness, including the Notes, depends on our future performance, which is subject to economic, financial, competitive, and other factors beyond our control. Our business may not generate cash flow from operations in the future sufficient to service our debt and make necessary investments in our business. Our ability to refinance our indebtedness will depend on the capital markets and our financial condition at such time. We may not be able to engage in any of these activities or engage in these activities on desirable terms, which could result in a default on our debt obligations which could, in turn, result in that and our other indebtedness becoming immediately payable in full. In addition, we may incur additional debt to meet future financing needs. If we incur additional indebtedness, the risks related to our business and our ability to service or repay our indebtedness will increase.
The conditional conversion feature of the Notes, if triggered, may adversely affect our financial condition and operating results.
Under certain circumstances, the noteholders may convert their Notes at their option prior to the scheduled maturities. Upon conversion of the Notes, unless we elect to deliver solely shares of our common stock to settle such conversion, we will be obligated to make cash payments. In addition, holders of our Notes will have the right to require us to repurchase their Notes upon the occurrence of a fundamental change (as defined in the indenture, dated as of February 24, 2020, between U.S. Bank National Association, as trustee (the “Trustee”) and us (the “Indenture”)), at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest, if any, to, but not including, the fundamental change repurchase date. Although it is our intention and we currently expect to settle the conversion value of the Notes in cash up to the principal amount and any excess in shares, there is a risk that we may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of Notes surrendered therefor or Notes being converted. In addition, our ability to make payments may be limited by law, by regulatory authority, or by agreements governing our future indebtedness. Our failure to repurchase Notes when the Indenture requires the repurchase or to pay any cash payable on future conversions of the Notes as required by the Indenture would constitute a default under the Indenture. A default under the Indenture or the fundamental change itself could also lead to a default under agreements governing our future indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the Notes or make cash payments upon conversions thereof. In addition, even if holders of Notes do not elect to convert their Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.
The accounting method for convertible debt securities that may be settled in cash, such as the Notes, could have a material impact on our reported financial results.
Under Accounting Standards Codification 470-20, Debt with Conversion and Other Options (ASC 470-20), an entity must separately account for the liability and equity components of the convertible debt instruments (such as the Notes) that may be settled entirely or partially in cash upon conversion in a manner that reflects the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for the Notes is that the equity component is required to be included in the additional paid-in capital section of stockholders’ equity on our consolidated balance sheet at the issuance date and the value of the equity component is treated as debt discount for purposes of accounting for the debt component of the Notes. As a result, we will be required to record non-cash interest expense through the amortization of the excess of the face amount over the carrying amount of the expected life of the Notes. We will report larger net losses (or lower net income) in our financial results because ASC 470-20 requires interest to include both the amortization of the debt discount and the instrument’s cash coupon interest rate, which could adversely affect our reported or future financial results, the trading price of our common stock, and the trading price of the Notes.
In addition, under certain circumstances, convertible debt instruments (such as the Notes) that may be settled entirely or partially in cash may be accounted for utilizing the treasury stock method, the effect of which is that the shares issuable upon conversion of such Notes are not included in the calculation of diluted earnings per share except to the extent that the conversion value of such Notes exceeds their principal amount. Under the treasury stock method, the number of common stock shares that would be necessary to settle such excess, if we elected to settle such excess in shares, is included in the denominator to calculate diluted earnings per share. We cannot be sure that the accounting standards will continue to permit the treasury stock method. If we are unable or otherwise elect not to use the treasury stock method in accounting for the shares issuable upon conversion of the Notes, our diluted earnings per share could be adversely affected.
The Capped Call Transactions may affect the value of the Notes and our common stock.
In connection with the Notes’ issuance, we entered into Capped Call Transactions with certain financial institutions (“option counterparties”). The Capped Call Transactions are generally expected to reduce the potential dilution to our common stock upon any conversion of the Notes and/or offset any cash payments we are required to make in excess of the principal amount of converted Notes, as the case may be, with such reduction and/or offset subject to a cap. From time to time, the option counterparties that are parties to the Capped Call Transactions or their respective affiliates may modify their hedge positions by entering into or unwinding various derivative transactions with respect to our common stock and/or purchasing or selling our common stock or other securities of ours in secondary market transactions prior to the maturity of the Notes. This activity could cause a decrease in the market price of our common stock.
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We are subject to counterparty risk with respect to the Capped Call Transactions.
The option counterparties are financial institutions, and we are subject to the risk that one or more of the option counterparties may default or otherwise fail to perform, or may exercise certain rights to terminate, their obligations under the Capped Call Transactions. Our exposure to the credit risk of the option counterparties is not secured by any collateral. Recent global economic conditions have resulted in the actual or perceived failure or financial difficulties of many financial institutions. If an option counterparty becomes subject to insolvency proceedings, we will become an unsecured creditor in those proceedings with a claim equal to our exposure at the time under such transaction. Our exposure depends on many factors, but our exposure will generally increase if the market price or the volatility of our common stock increases. In addition, upon default or other failures to perform, or termination of obligations, by an option counterparty, we may suffer more dilution than we currently anticipate with respect to our common stock. We can provide no assurances as to the financial stability or viability of the option counterparties.
Provisions in the Notes’ Indenture may deter or prevent a business combination that may be favorable to our stockholders.
If a fundamental change occurs prior to the Notes’ maturity date, holders of the Notes will have the right, at their option, to require us to repurchase all or a portion of their Notes. In addition, if a “make-whole fundamental change” (as defined in the Indenture) occurs prior to the maturity date, we will in some cases be required to increase the conversion rate of the Notes for a holder that elects to convert its Notes in connection with such make-whole fundamental change.
Furthermore, the Indenture will prohibit us from engaging in certain mergers or acquisitions unless, among other things, the surviving entity assumes our obligations under the Notes. These and other provisions in the Indenture could deter or prevent a third party from acquiring us even when the acquisition may be favorable to our stockholders.
Conversion of the Notes may dilute the ownership interest of existing stockholders.
The conversion of some or all of the Notes will dilute the ownership interests of existing stockholders to the extent we deliver shares of our common stock upon conversion of any of the Notes. Any sales in the public market of the common stock issuable upon such conversion could adversely affect our common stock’s prevailing market prices. In addition, the existence of the Notes may encourage short selling by market participants because the conversion of the Notes could be used to satisfy short positions, or anticipated conversion of the Notes into shares of our common stock could depress the price of our common stock.
ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Issuer purchases of equity securities
Common stock repurchased in the three months ended September 30, 2020 was:
(in thousands, except per share amounts)
Total Number of Shares Purchased (1) (2)
Average 
Price Paid
per Share (1) (2)
Total Number of Shares Purchased as Part of Publicly Announced Share Repurchase Program (2)
Approximate Dollar Value of Shares That May Yet Be Purchased at Period End Under Publicly Announced Share Repurchase Programs (2)
July 1, 2020 - July 31, 2020135$109.36 42$53,470 
August 1, 2020 - August 31, 2020162$120.08 26$50,321 
September 1, 2020 - September 30, 2020138$124.88 26$47,172 
435$118.29 94
(1) Shares withheld to cover the option exercise price and tax withholding obligations under the net settlement provisions of our stock compensation awards have been included in these amounts.
(2) On June 15, 2020, we announced that our Board of Directors extended the current stock repurchase program’s expiration date to June 30, 2021 and increased the remaining stock repurchase authority to $60 million. See "Liquidity and Capital Resources" in Item 2 of this Quarterly Report for additional information.
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ITEM 6.     EXHIBITS
Exhibit No.Description
3.1
3.2
31.1+
31.2+
32++
10.1+
10.2+
10.3+
101.INSInline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
101.SCHInline XBRL Taxonomy Extension Schema Document.
101.CALInline XBRL Taxonomy Calculation Linkbase Document.
101.DEFInline XBRL Taxonomy Extension Definition Linkbase Document.
101.LABInline XBRL Taxonomy Label Linkbase Document.
101.PREInline XBRL Taxonomy Presentation Linkbase Document.
104Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)
+ Filed herewith.
++ Indicates that the exhibit is being furnished with this report and is not filed as a part of it.
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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
Pegasystems Inc.
Dated:October 28, 2020By:/s/ KENNETH STILLWELL
Kenneth Stillwell
Chief Financial Officer and Chief Administrative Officer
(Principal Financial Officer)

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