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MSP Datto Holding

Filed: 10 Nov 21, 4:24pm

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, 2021
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                 to                 
Commission File Number 001-39637 
DATTO HOLDING CORP.
(Exact name of registrant as specified in its charter)
Delaware 81-3345706
(State or other jurisdiction of incorporation) (IRS Employer Identification No.)
101 Merritt 7
Norwalk,CT06851
(Address of principal executive offices)(Zip Code)
888-995-1431
(Registrant’s telephone number, including area code)
Not Applicable
(Former name or former address, if changed since last report.)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Trading
Symbol(s)
 Name of each exchange
on which registered
Common Stock, $0.001 par value MSP The New York Stock Exchange
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒  No  ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    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 filer    Accelerated filer  
Non-accelerated filer    Smaller reporting company  
   Emerging 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 by Rule 12b-2 of the Exchange Act).    Yes ☐    No  ☒
At October 31, 2021, there were approximately 163,073,476 shares of the Registrant’s Common Stock outstanding (excluding treasury shares of 362,126).



TABLE OF CONTENTS
 
OTHER AVAILABLE INFORMATION
Please note that in addition to filing our periodic and current reports, we may announce material business and financial information to our investors using filings we make with the Securities and Exchange Commission (“SEC”), webcasts, press releases, conference calls, and our investor relations website which can be found at www.investors.datto.com. The SEC maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. We use these media, including our website, to communicate with our stockholders and the public about our company. It is possible that the information that we make available through these media may be deemed to be material information. We therefore encourage investors and others interested in our company to review all such media.
The information contained on the website referenced in this Quarterly Report on Form 10-Q is not incorporated by reference into this filing, and the website address is provided only as a reference.

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PART I – FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS
DATTO HOLDING CORP.
INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 

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DATTO HOLDING CORP.
Condensed Consolidated Balance Sheets
(in thousands, except share amounts)
(unaudited)
September 30,
2021
December 31,
2020
ASSETS
Current assets
Cash and cash equivalents$205,862 $168,877 
Restricted cash1,309 1,536 
Accounts receivable, net9,400 13,946 
Inventory31,739 13,811 
Prepaid expenses and other current assets33,640 28,316 
Total current assets281,950 226,486 
Property and equipment, net100,420 91,876 
Operating lease assets30,290 — 
Goodwill1,144,496 1,120,954 
Intangible assets, net295,264 287,395 
Other assets82,486 66,560 
Total assets$1,934,906 $1,793,271 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable$12,549 $7,574 
Accrued expenses and other current liabilities47,538 39,461 
Deferred revenue21,634 23,763 
Total current liabilities81,721 70,798 
Deferred revenue, noncurrent3,108 3,322 
Deferred income taxes30,476 18,947 
Operating lease liabilities, noncurrent30,849 — 
Other long-term liabilities3,537 11,736 
Total liabilities149,691 104,803 
Commitments and contingencies (Note 8)00
STOCKHOLDERS’ EQUITY
Preferred stock, $0.001 par value; 50,000,000 authorized at September 30, 2021 and December 31, 2020; no shares issued or outstanding at September 30, 2021 or December 31, 2020— — 
Common stock, $0.001 par value; 500,000,000 shares authorized at September 30, 2021 and December 31, 2020; 163,212,109 and 161,420,016 shares issued and outstanding at September 30, 2021 and December 31, 2020, respectively (inclusive of treasury stock)163 161 
Additional paid-in capital1,807,533 1,755,387 
Treasury stock, at cost; 362,126 shares at September 30, 2021 and December 31, 2020(3,621)(3,621)
Accumulated deficit(19,539)(65,226)
Accumulated other comprehensive income679 1,767 
Total stockholders’ equity1,785,215 1,688,468 
Total liabilities and stockholders’ equity$1,934,906 $1,793,271 
The accompanying notes are an integral part of these condensed consolidated financial statements.
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DATTO HOLDING CORP.
Condensed Consolidated Statements of Operations
(in thousands, except share and per share amounts)
(unaudited)
 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
Revenue:
Subscription$146,764 $122,753 $424,097 $356,348 
Device10,242 6,964 27,652 21,098 
Professional services and other886 950 2,654 2,347 
Total revenue157,892 130,667 454,403 379,793 
Cost of revenue:
Subscription22,776 18,915 65,344 60,786 
Device12,930 10,089 33,552 26,464 
Professional services and other1,470 1,332 4,521 4,399 
Depreciation and amortization8,572 5,526 23,795 15,746 
Total cost of revenue45,748 35,862 127,212 107,395 
Gross profit112,144 94,805 327,191 272,398 
Operating expenses:
Sales and marketing35,173 24,709 99,234 83,828 
Research and development26,872 15,257 76,690 48,000 
General and administrative27,802 17,433 78,908 59,389 
Depreciation and amortization6,531 6,820 19,554 20,600 
Total operating expenses96,378 64,219 274,386 211,817 
Income from operations15,766 30,586 52,805 60,581 
Other expense:
Interest expense156 7,065 433 23,590 
Other expense (income), net338 (987)224 (1,402)
Total other expense494 6,078 657 22,188 
Income before income taxes15,272 24,508 52,148 38,393 
Provision for income taxes(1,787)(4,962)(6,461)(8,727)
Net income$13,485 $19,546 $45,687 $29,666 
Net income per share attributable to common stockholders:
Basic$0.08 $0.14 $0.28 $0.22 
Diluted$0.08 $0.14 $0.28 $0.22 
Weighted-average shares used in computing net income per share:
Basic162,424,260 135,553,097 161,657,479 135,496,696 
Diluted166,248,941 138,590,770 165,483,710 137,006,921 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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DATTO HOLDING CORP.
Condensed Consolidated Statements of Comprehensive Income
(in thousands)
(unaudited)
 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
Net income$13,485 $19,546 $45,687 $29,666 
Other comprehensive income (loss):
Currency translation adjustment(1,437)719 (1,088)(60)
Total comprehensive income$12,048 $20,265 $44,599 $29,606 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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DATTO HOLDING CORP.
Condensed Consolidated Statements of Changes in Stockholders’ Equity
(in thousands, except share amounts)
(unaudited)
 
 Common StockTreasury
Stock
Additional
Paid in
Capital
Accumulated
Deficit
Accumulated
Other
Comprehensive
Income (Loss)
Total
SharesAmount
Balance at January 1, 2021161,420,016 $161 $(3,621)$1,755,387 $(65,226)$1,767 $1,688,468 
Stock-based compensation— — — 11,511 — — 11,511 
Shares issued upon exercise of stock options and vesting of restricted stock units19,139 — — 117 — — 117 
Other comprehensive loss— — — — — (1,012)(1,012)
Net income— — — — 15,286 — 15,286 
Balance at March 31, 2021161,439,155 $161 $(3,621)$1,767,015 $(49,940)$755 $1,714,370 
Stock-based compensation— — — 12,241 — — 12,241 
Shares issued upon exercise of stock options and vesting of restricted stock units951,278 — 9,587 — — 9,588 
Other comprehensive income— — — — — 1,361 1,361 
Net income— — — — 16,916 — 16,916 
Balance at June 30, 2021162,390,433 $162 $(3,621)$1,788,843 $(33,024)$2,116 $1,754,476 
Stock-based compensation— — — 11,603 — — 11,603 
Shares issued upon exercise of stock options and vesting of restricted stock units821,676 — 7,087 — — 7,088 
Other comprehensive loss— — — — — (1,437)(1,437)
Net income— — — — 13,485 — 13,485 
Balance at September 30, 2021163,212,109 $163 $(3,621)$1,807,533 $(19,539)$679 $1,785,215 
 
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 Common StockTreasury
Stock
Additional
Paid in
Capital
Accumulated
Deficit
Accumulated
Other
Comprehensive
Income (Loss)
Total
SharesAmount
Balance at January 1, 2020135,655,428 $136 $(3,621)$1,083,082 $(87,724)$430 $992,303 
Stock-based compensation— — — 1,914 — — 1,914 
Exercise of common stock options255,438 — — 2,500 — — 2,500 
Other comprehensive loss— — — — — (700)(700)
Net income— — — — 1,353 — 1,353 
Balance at March 31, 2020135,910,866 $136 $(3,621)$1,087,496 $(86,371)$(270)$997,370 
Stock-based compensation— — — 1,858 — — 1,858 
Other comprehensive loss— — — — — (79)(79)
Net income— — — — 8,767 — 8,767 
Balance at June 30, 2020135,910,866 $136 $(3,621)$1,089,354 $(77,604)$(349)$1,007,916 
Net share settlement of stock-based payment awards4,661 — — (53)— — (53)
Stock-based compensation— — — 2,789 — — 2,789 
Other comprehensive income— — — — — 719 719 
Net income— — — — 19,546 — 19,546 
Balance at September 30, 2020135,915,527 $136 $(3,621)$1,092,090 $(58,058)$370 $1,030,917 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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DATTO HOLDING CORP.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
 Nine Months Ended September 30,
 20212020
OPERATING ACTIVITIES
Net income$45,687 $29,666 
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation23,368 19,615 
Amortization of acquired intangible assets19,981 16,731 
Amortization of debt issuance costs255 1,265 
Reserve for inventory obsolescence54 1,508 
Non-cash operating lease expense5,273 — 
Stock-based compensation35,355 6,561 
Provision for bad debt2,630 4,793 
Deferred income taxes4,727 7,556 
Unrealized foreign exchange(296)(647)
Changes in operating assets and liabilities:
Accounts receivable1,878 (766)
Inventory(18,043)(6,337)
Prepaid expenses and other current assets(5,490)2,099 
Other assets(16,719)(8,446)
Accounts payable, accrued expenses and other2,928 109 
Deferred revenue(2,479)348 
Net cash provided by operating activities99,109 74,055 
INVESTING ACTIVITIES
Purchase of property and equipment(32,170)(28,519)
Acquisition of business, net of cash acquired(45,486)(4,371)
Net cash used in investing activities(77,656)(32,890)
FINANCING ACTIVITIES
Proceeds from debt— 32,100 
Repayments of debt and capital leases(73)(4,468)
Capitalized transaction costs(684)(980)
Proceeds from stock option exercises16,839 2,500 
Net share settlement and settlement of stock-based payment awards— (53)
Net cash provided by financing activities16,082 29,099 
Effect of exchange rate changes on cash and cash equivalents(777)720 
Net increase in cash and cash equivalents36,758 70,984 
Cash and cash equivalents and restricted cash, beginning of year170,413 29,066 
Cash and cash equivalents and restricted cash, end of period$207,171 $100,050 
Reconciliation of cash and cash equivalents and restricted cash:
Cash and cash equivalents$205,862 $98,614 
Restricted cash$1,309 $1,436 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for income taxes$3,533 $151 
Cash paid for interest$— $22,317 
NON-CASH INVESTING AND FINANCING ACTIVITIES
Purchase of property and equipment included in accounts payable$251 $40 
Unpaid initial public offering costs in total current liabilities$— $2,620 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
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DATTO HOLDING CORP.

INDEX TO NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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DATTO HOLDING CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
1.Business

Description of Business
Datto Holding Corp. (“Datto Holding”) provides cloud-based software and security solutions purpose-built for delivery through the managed service provider (“MSP”) channel to small and medium businesses (“SMB”). Unless the context otherwise indicates or requires, references to “Datto”, “we,” “us,” “our” and “the Company” shall refer to Datto Holding and its wholly-owned subsidiaries as a combined entity.

The Company’s platform enables its MSP partners to serve the SMB information technology market and includes mission-critical cloud-based software and technologies that MSPs sell to SMBs, business management software to help MSPs scale their own businesses, and marketing tools, content, training and industry-leading events that cultivate an empowered and highly engaged MSP partner community. The Company typically has no contractual relationship with the SMBs and considers its MSP partners to be the customers. By selling through the MSP channel, the Company is able to cost-effectively scale the reach of the Company’s solutions and support the global requirements of SMBs without a direct-to-SMB sales and support model.

Initial Public Offering

On October 23, 2020, the Company completed an initial public offering (“IPO”) of its common stock. As part of the IPO, the Company issued and sold 22,000,000 shares of its common stock at a public offering price of $27.00 per share. The Company received proceeds of approximately $558.0 million from the IPO, after deducting the underwriting discount. In addition, on November 3, 2020, the underwriters exercised in full their option to purchase 3,300,000 additional shares of common stock at a price of $27.00 per share, resulting in proceeds of approximately $83.6 million, after deducting the underwriting discount.

The Company utilized the IPO proceeds to repay the outstanding principal balances of $590.2 million under the 2019 Credit Agreement, to pay $5.3 million of IPO offering costs, and to pay $1.2 million in debt issuance costs under the 2020 Credit Agreement. Upon entering the 2020 Credit Agreement in October 2020, the 2019 Credit Agreement was terminated.

As of September 30, 2021, funds controlled by Vista Equity Partners (“Vista”) owned approximately 69.9% of the Company’s outstanding common stock, excluding treasury shares. As a result, the Company is a “controlled company” under New York Stock Exchange (“NYSE”) corporate governance rules. Sales to and purchases from as well as balances due to or from Vista and its portfolio companies as of and for the three and nine months ended September 30, 2021 and 2020, respectively, were immaterial.

Emerging Growth Company Status

The Company is an emerging growth company (“EGC”), as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). Under the JOBS Act, EGCs can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act, until such time as those standards apply to private companies.

The Company has elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date that the Company (i) is no longer an EGC or (ii) affirmatively and irrevocably opts out of the extended transition period provided in the JOBS Act. As a result, the Company’s condensed consolidated financial statements may not be comparable to the financial statements of issuers who are required to comply with the effective dates for new or revised accounting standards based on public company effective dates.

On June 30, 2021, the last day of the Company’s second fiscal quarter in 2021, the market value of the Company’s common equity held by non-affiliates exceeded $700 million. Accordingly, the Company will no longer qualify as an EGC; rather, it will be deemed a large accelerated filer as of December 31, 2021. Accordingly, the Company will no longer have the ability to take advantage of the extended transition period to comply with new or revised accounting standards.
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2.Significant Accounting Policies

Unaudited Interim Financial Information

The unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and the requirements of the Securities and Exchange Commission (“SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by GAAP can be condensed or omitted. These financial statements have been prepared on the same basis as the Company’s annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, which are necessary for the fair statement of the Company’s financial information. These interim results are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2021 or for any other interim period or for any other future year. The accompanying unaudited condensed consolidated financial statements and related financial information should be read in conjunction with the audited consolidated financial statements and the related notes contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as filed with the SEC on March 11, 2021 (the “Annual Report”).

There continue to be many uncertainties regarding the ongoing coronavirus 2019 (“COVID-19”) pandemic, and the Company continues to monitor the impact of the pandemic on all aspects of its business, including how it has impacted and may continue to impact the Company’s operations and the operations of its MSP partners and their SMB customers in the future, including as a result of travel restrictions, business shutdowns, supply chain constraints, labor shortages and/or inflationary pressure. The governments of many of the countries in which the Company operates have eased the earlier measures to control the spread of COVID-19. However, it continues to be difficult at this time to estimate the impact that COVID-19 will continue to have on worldwide economic activity, the Company’s business, and the additional measures that may be taken by governments, businesses and other organizations in response to COVID-19 that could affect our business. The Company will continue to assess the evolving impact of the COVID-19 pandemic and will make adjustments to its operations as necessary.

Basis of Presentation and Principles of Consolidation

Datto Holding owns 100% of Merritt Holdco, Inc. (“Merritt Holdco”), which owns 100% of Datto, Inc., the Company’s primary operating company. Datto Holding has no operations or significant assets or liabilities other than its investment in Merritt Holdco. Accordingly, Datto Holding is dependent upon distributions from Merritt Holdco to fund any activity, including the payment of dividends. All obligations under Datto’s 2020 Credit Agreement, as defined in Note 9. Debt, are guaranteed by Merritt Holdco and certain direct and indirect subsidiaries of Datto, Inc. The condensed consolidated financial statements include the accounts of Datto Holding and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.

On an ongoing basis, the Company evaluates its estimates and assumptions, including those related to revenue recognition, contract balances, contract acquisition costs, allowances for doubtful accounts, reserves for inventory obsolescence, useful lives and recoverability of long-lived assets, the incremental borrowing rate for operating leases, determining the fair value of assets acquired and liabilities assumed in business combinations, income taxes, stock-based compensation and contingencies. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, including the uncertainty surrounding rapidly changing market and economic conditions from the COVID-19 pandemic. Actual results could materially differ from these estimates. With the exception of the adoption of the lease standard discussed below, there have been no material changes to the Company’s significant accounting policies.
Foreign Currency Translation

The Company’s reporting currency is the U.S. Dollar. The functional currency of the Company's foreign subsidiaries is generally the local currency. Assets and liabilities are translated into U.S. Dollars at the exchange rates at the balance sheet date, equity accounts are translated at historical exchange rates and revenue, expenses, gains and losses are
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translated using average exchange rates for the reporting period. Resulting foreign currency translation adjustments are recorded directly within accumulated other comprehensive income (loss), a separate component of stockholders’ equity.

Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in other (income) expense, net in the accompanying condensed consolidated statements of operations. Transaction gains and losses were a charge of $0.3 million for the nine months ended September 30, 2021 and income of $1.0 million for the nine months ended September 30, 2020.

Cash and Cash Equivalents and Restricted Cash

Cash is stated at fair value. As of September 30, 2021 and December 31, 2020, the U.S. Dollar value of cash and restricted cash denominated in foreign currencies was $30.3 million and $28.1 million, respectively, comprised of various currencies in which the Company operates, including Euros, Australian Dollars and British Pounds.
Cash equivalents consist of short-term, highly liquid investments with an original maturity of three months or earlier. The Company did not hold any cash equivalents as of September 30, 2021 or December 31, 2020.
Restricted cash primarily includes amounts held by banks as security related to lease arrangements for office space.

Accounts Receivable, Net

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. Accounts receivable are presented net of an estimated allowance for doubtful accounts. The Company maintains an allowance for doubtful accounts based upon an analysis of past credit history and the current financial condition of the Company's partners, as well as the consideration of expected trends based upon characteristics of the accounts receivable and general economic conditions. The Company also considers other specific operational factors which may impact the Company's ability to collect past due amounts, including the impact of COVID-19. Account balances are written off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.

The following table summarizes the activity of the allowance for doubtful accounts (in thousands):
 Amount
Balance as of December 31, 2020$5,485 
Provision for bad debt2,630 
Net reductions and other(2,495)
Balance as of September 30, 2021$5,620 
Unbilled accounts receivable are included in the accounts receivable balances and represent revenue earned, but the amount is not contractually billable as of the balance sheet date. The unbilled accounts receivable balance is principally invoiced within the following month. As of September 30, 2021 and December 31, 2020, unbilled accounts receivable was $1.7 million and $3.0 million, respectively.

Leases

The Company determines if an arrangement is or contains a lease at inception by assessing whether the arrangement contains an identified asset and whether the Company has the right to control the identified asset. Right-of-use (“ROU”) assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments in order to obtain the right to use the asset over the lease term. Lease liabilities are recognized at the lease commencement date based on the present value of future lease payments over the lease term. The Company elected to combine lease and non-lease components for its office and equipment leases. ROU assets are based on the measurement of the lease liability and also include any lease prepayments and any initial direct costs incurred, offset by tenant incentives received by the Company. For leases with an initial term of 12 months or less, the Company does not recognize a ROU asset and corresponding lease liability. Rent expense for the Company’s operating leases is recognized on a straight-line basis over the lease term.

Generally, the Company’s leases do not provide an implicit interest rate, and therefore the Company uses its incremental borrowing rate based on the estimated rate of interest for a collateralized borrowing over a similar term of the lease payments at the commencement date. The Company includes options to extend or terminate the lease in the determination of the ROU asset and corresponding lease liability when it is reasonably certain the Company will exercise the option.
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Recently Adopted Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), (“ASC 842”). ASC 842 amends a number of aspects of lease accounting under ASC Topic 840 — Leases (“ASC 840”), including requiring lessees to recognize almost all leases with a term greater than one year as an ROU asset and corresponding lease liability, measured at the present value of the lease payments. ASC 842 provides a number of optional practical expedients in transition. On January 1, 2021, the Company adopted ASC 842 using the modified retrospective approach, and elected the practical expedients to i) not reassess its prior conclusions about lease identification under the new standard, ii) not reassess lease classification, and iii) not reassess initial direct costs. The Company did not elect the practical expedient allowing the use-of-hindsight, which would require the Company to reassess the lease term of its leases based on all facts and circumstances through the effective date.

Upon adoption of ASC 842 the Company recognized operating lease assets of $35.8 million and operating lease liabilities of $46.3 million at January 1, 2021. Prior period amounts were not restated and are reported in accordance with ASC 840.

For a description of the Company’s leases, see Note 6. Leases.

Accounting Pronouncements Issued but Not Yet Adopted

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASC 326”). This standard changes the impairment model for most financial assets, including trade receivables and financial instruments and will require the Company to use a forward-looking expected loss method, which may result in earlier recognition of allowances for losses and require expected credit losses to be reflected as allowances rather than reductions in the amortized cost basis of financial assets. For public entities, the standard is currently effective. As the Company will cease to be an EGC as of December 31, 2021, the Company will adopt the standard on December 31, 2021, with the initial application of ASC 326 beginning on January 1, 2021. The Company is evaluating the impact this guidance will have on its consolidated financial statements.

In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASC 740”), which simplifies the accounting for income taxes by eliminating certain exceptions to the guidance in ASC 740 related i) to the approach for intraperiod tax allocation, ii) the methodology for calculating income taxes in an interim period and iii) the recognition of deferred tax liabilities for outside basis differences. The new guidance also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill and allocating consolidated income taxes to separate financial statements of entities not subject to income tax. The standard is currently effective for publicly traded companies. As the Company will cease to be an EGC as of December 31, 2021, the Company will adopt the standard on December 31, 2021, with the initial application of the standard beginning on January 1, 2021. Upon adoption, the Company must apply certain aspects of this standard retrospectively for all periods presented while other aspects are applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. The Company is currently evaluating the impact this guidance will have on the Company’s consolidated financial statements.

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3.Revenue Recognition
Disaggregation of Revenue

The following table disaggregates revenue by service and timing of recognition (in thousands):

 Three Months Ended September 30, 2021
 DeviceProfessional
Services
SubscriptionTotal
Timing of revenue recognition:
Recognized at a point in time$10,242 $— $— $10,242 
Recognized over time— 886 146,764 147,650 
Total$10,242 $886 $146,764 $157,892 
 
 Three Months Ended September 30, 2020
 DeviceProfessional
Services
SubscriptionTotal
Timing of revenue recognition:
Recognized at a point in time$6,964 $— $— $6,964 
Recognized over time— 950 122,753 123,703 
Total$6,964 $950 $122,753 $130,667 

 Nine Months Ended September 30, 2021
 DeviceProfessional
Services
SubscriptionTotal
Timing of revenue recognition:
Recognized at a point in time$27,652 $— $— $27,652 
Recognized over time— 2,654 424,097 426,751 
Total$27,652 $2,654 $424,097 $454,403 
 
 Nine Months Ended September 30, 2020
 DeviceProfessional
Services
SubscriptionTotal
Timing of revenue recognition:
Recognized at a point in time$21,098 $— $— $21,098 
Recognized over time— 2,347 356,348 358,695 
Total$21,098 $2,347 $356,348 $379,793 

The following table summarizes sales to customers by geography (in thousands):
 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
United States$110,273 $94,632 $317,892 $277,654 
International47,619 36,035 136,511 102,139 
Total$157,892 $130,667 $454,403 $379,793 

Revenue by geography is determined by the billing address for the customer.

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Contract Balances

Contract assets represent amounts for which the Company has recognized revenue, generally for device sales or contracts which contain free subscription periods pursuant to its revenue recognition policy, for contracts that have not yet been fully invoiced to customers where there is a remaining performance obligation. Contract assets relate to contractual arrangements which contain both a subscription and a device, a free subscription period or a professional service performance obligation. Amounts are recorded as a current asset or a non-current asset based on the amounts anticipated to be billed within one year of the balance sheet date. Current contract assets of $10.4 million and $7.7 million were included in prepaid expenses and other current assets as of September 30, 2021 and December 31, 2020, respectively. Non-current contract assets of $10.3 million and $7.9 million were included in other assets as of September 30, 2021 and December 31, 2020, respectively.

Contract liabilities consist of customer payments in advance of revenue being recognized. Amounts anticipated to be recognized within one year of the balance sheet date are recorded as deferred revenue, current and the remaining portion is recorded as deferred revenue, noncurrent on the condensed consolidated balance sheets. Deferred revenue as of September 30, 2021 and December 31, 2020, was $24.7 million (of which $3.1 million was classified as non-current) and $27.1 million (of which $3.3 million was classified as non-current), respectively.

The following table summarizes the activity of the Company's current and noncurrent deferred revenue balances for the nine months ended September 30, 2020 (in thousands):
 Amount
Balance at December 31, 2020$27,085 
Deferred revenue recognized(19,631)
Amounts deferred17,341 
Foreign currency translation and other(53)
Balance at September 30, 2021$24,742 

Contract Acquisition Costs

The Company capitalizes commission expenses paid to internal sales personnel for obtaining customer contracts, using a portfolio approach. Contract acquisition costs are included in other assets on the condensed consolidated balance sheets. Contract acquisition costs as of September 30, 2021 and December 31, 2020 were $59.1 million and $48.2 million, respectively.

Remaining Performance Obligations

Revenues expected to be recognized in the future related to performance obligations that are unsatisfied at September 30, 2021 were approximately $354.4 million, of which greater than 50% is anticipated to be recognized in the next twelve months, with substantially all revenue related to performance obligations to be recognized within thirty-six months. The amount excludes month-to-month contracts.

4.Inventory
Inventory, net of the reserves for obsolescence, consisted of the following (in thousands):
September 30,
2021
December 31,
2020
Components$22,578 $8,914 
Work in progress3,449 580 
Finished goods5,712 4,317 
Total inventory$31,739 $13,811 

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5.Property and Equipment, Net
Property and equipment, net, consisted of the following (in thousands):
Estimated
Useful Life
(in Years)
September 30,
2021
December 31,
2020
Servers3-5$117,637 $96,048 
Leasehold improvements(a)31,365 32,455 
Computer equipment3-514,284 14,977 
Internally developed software313,254 7,811 
Furniture and fixtures55,807 6,305 
Purchased software31,149 999 
Vehicles5134 103 
Total property and equipment183,630 158,698 
Less: accumulated depreciation and amortization(83,210)(66,822)
Total property and equipment, net$100,420 $91,876 
(a) The shorter of the remaining lease term or useful life.
The Company capitalized $5.4 million and $1.6 million of internally developed software costs during the nine months ended September 30, 2021 and 2020, respectively.

Depreciation expense included in cost of revenue and operating expenses was $5.9 million and $2.1 million, respectively, for the three months ended September 30, 2021, and $4.4 million and $2.4 million, respectively, for the three months ended September 30, 2020.
Depreciation expense included in cost of revenue and operating expenses was $17.1 million and $6.3 million, respectively, for the nine months ended September 30, 2021, and $12.2 million and $7.4 million, respectively, for the nine months ended September 30, 2020.

6.Leases

The Company enters into operating leases from time to time, primarily for office space and co-located data centers. The Company’s leases have remaining lease terms which vary, up to approximately 8 years. These leases require monthly lease payments that may be subject to annual increases throughout the lease term. Certain of these leases also include options at the election of the Company to renew or extend the leases. The periods associated with these options to renew or extend have not been included in the determination of the ROU assets or lease liabilities associated with these leases as the Company did not consider it reasonably certain it would exercise the renewal options.

For the three months ended September 30, 2021 and 2020, the Company recorded $2.4 million and $2.3 million, respectively, of operating lease costs in the condensed consolidated statements of operations. For the nine months ended September 30, 2021 and 2020, the Company recorded $7.1 million and $7.2 million, respectively, of operating lease costs in the condensed consolidated statements of operations. Variable lease costs, which are comprised primarily of the Company's proportionate share of operating expenses, property taxes, and insurance, were $0.6 million and $1.8 million, for the three and nine months ended September 30, 2021, respectively. Variable lease costs are not included in the measurement of the Company's ROU assets and lease liabilities.

Cash paid for amounts related to operating lease liabilities for the nine months ended September 30, 2021 was $7.9 million.

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The following represents the Company's future minimum payments under non-cancelable operating leases as of September 30, 2021 (in thousands):
 
Remaining 2021$2,608  
20229,756  
20239,852  
20248,944  
20255,375  
Thereafter6,725  
Total future undiscounted lease payments$43,260  
Less imputed interest3,470 
Total reported lease liability$39,790 

The weighted average remaining lease term and discount rate as of September 30, 2021 were 4.9 years and 3.3%, respectively. As of September 30, 2021, the Company recorded operating lease assets of $30.3 million, and lease liabilities of $9.0 million and $30.8 million in accrued expenses and other current liabilities and operating lease liabilities, noncurrent, respectively, within the condensed consolidated balance sheets.

7.Acquisitions
In March 2021, the Company acquired BitDam Ltd., an Israel-based cyber threat detection company (“BitDam”). The business combination was accounted for under the acquisition method of accounting. The consideration paid was allocated to the tangible and intangible assets acquired and liabilities assumed based on their fair values as of the acquisition date. As of September 30, 2021, the Company has performed a preliminary valuation of the assets acquired and liabilities assumed, including the fair value of acquired intangible assets. The preliminary valuation is subject to adjustment as the Company finalizes the allocation during the measurement period. The preliminary allocation of the purchase consideration is as follows (in thousands):
Acquisition of BitDam
Assets acquired
Other current and noncurrent assets$63  
Property and equipment49  
Finite lived intangible assets27,400  
Goodwill23,155  
Total assets acquired$50,667 
Other current and noncurrent liabilities879 
Deferred tax liabilities4,302 
Total liabilities assumed$5,181 
Purchase consideration, net of cash acquired$45,486  

The finite lived intangible assets consist of acquired developed technology with an estimated life of 5 years. The Company has recorded $1.4 million and $2.8 million of amortization expense within cost of revenue for the three and nine months ended September 30, 2021, respectively, related to this asset.
General and administrative expense within the condensed consolidated statements of operations includes $1.0 million of costs incurred in relation to the BitDam acquisition in the nine months ended September 30, 2021.
In July 2020, the Company acquired all of the outstanding equity of 2 affiliated Australian entities, Gluh Pty Ltd and Keystone Software Holdings Pty Ltd (together, “Gluh”). Gluh offers a real-time quoting platform that enables MSPs to simplify the procurement of IT products and services for their clients. The purchase consideration was approximately $4.4 million, reflecting the purchase price of $4.0 million and certain closing adjustments.

8.Commitments and Contingencies
Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection
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with loss contingencies are expensed as incurred. The Company believes there is no litigation or other liabilities for loss contingencies pending, individually or in the aggregate, that could have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

9.Debt
On October 23, 2020, Datto, Inc., as borrower (the “Borrower”), and certain of its direct and indirect wholly-owned subsidiaries of Datto (the “Guarantors,” and, together with the Borrower, the “Loan Parties”), entered into a new credit agreement with the lenders party thereto and Morgan Stanley Senior Funding, Inc., as administrative agent (the "2020 Credit Agreement"). The 2020 Credit Agreement is guaranteed by the “Guarantors” and is supported by a security interest in substantially all of the Loan Parties’ personal property and assets, subject to customary exceptions, as defined in the 2020 Credit Agreement.

The 2020 Credit Agreement provides for an initial $200.0 million in commitments for revolving credit loans, which may be increased or decreased under specific circumstances, with a $40.0 million letter of credit sublimit and a $100.0 million alternative currency sublimit. In addition, the 2020 Credit Agreement provides for the ability of the Borrower to request term loan facilities. Borrowings pursuant to the 2020 Credit Agreement may be used for working capital and other general corporate purposes, including for acquisitions permitted under the 2020 Credit Agreement, and are scheduled to mature on October 23, 2025. The 2020 Credit Agreement contains certain customary representations and warranties and affirmative and negative covenants. At September 30, 2021, the Company was in compliance with all applicable covenants.

The interest rates applicable to the revolving borrowings under the 2020 Credit Agreement, are, at the Borrower’s option, either (i) a base rate, equal to the greater of (a) the Prime Rate, (b) the Federal Funds Effective Rate plus 0.5% or (c) the Adjusted LIBO Rate for a one month Interest Period (each term as defined in the 2020 Credit Agreement) plus 1%, or (ii) the Adjusted LIBO Rate equal to the LIBO Rate for the applicable Interest Period, plus in the case of each of clauses (i) and (ii), the Applicable Rate (as defined in the 2020 Credit Agreement). The Applicable Rate (i) for base rate loans ranges from 0.25% to 1.0% per annum and (ii) for LIBO Rate loans ranges from 1.25% to 2.0% per annum, in each case, based on the Company's Senior Secured Net Leverage Ratio (as defined in the 2020 Credit Agreement). The 2020 Credit Agreement provides for a commitment fee ranging from 0.20% to 0.35% per annum of the average daily undrawn portion of the revolving commitments based on the Company's Senior Secured Net Leverage Ratio (as defined in the 2020 Credit Agreement).

As of September 30, 2021 and December 31, 2020, the 2020 Credit Agreement was undrawn, with the exception of $1.9 million of outstanding letters of credit.

The Company recorded amortization of the debt issuance costs and original issue discount of $0.1 million and $0.4 million as interest expense during the three months ended September 30, 2021 and 2020, respectively.

The Company recorded amortization of the debt issuance costs and original issue discount of $0.3 million and $1.3 million as interest expense during the nine months ended September 30, 2021 and 2020, respectively.

Until October 2020, the Company was party to the 2019 Credit Agreement, which provided for a $550.0 million term loan facility and a $50.0 million revolving credit facility. In connection with the IPO and entering into the 2020 Credit Agreement, the 2019 Credit Agreement was terminated.

10.Stock-Based Compensation

The Company has equity awards outstanding under various plans, as described further below.

Datto 2020 Omnibus Incentive Plan

In conjunction with the IPO, in October 2020, the Board adopted the Datto Holding Corp. Omnibus Incentive Plan (the “2020 Plan”) in order to align the interests of the participants with the interests of the Company's stockholders. The 2020 Plan provides for the grant of stock options, stock appreciation rights, restricted stock, restricted stock units (“RSUs”), bonus stock, dividend equivalents, other stock-based awards, substitute awards, annual incentive awards and performance awards to employees, consultants, and members of the Board. Authorized shares under the 2020 Plan automatically increase each January 1st by 5% of the outstanding number of shares of the Company's common stock on the immediately preceding December 31st, or such lesser number of shares as determined by the Board. See below for a reconciliation of
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shares of the Company’s common stock reserved for issuance under the 2020 Plan. Under the 2020 Plan, 4,068,399 RSUs and 80,000 stock options were outstanding as of September 30, 2021.

2017 Stock Option Plan

In December 2017, the Company adopted the 2017 Stock Option Plan (the “2017 Plan”), as amended, which provides for grants of stock options to employees, directors, officers, and consultants. As of September 30, 2021, 7,314,484 stock options were outstanding under the 2017 Plan. No additional awards may be issued under the 2017 Plan.

Other Equity Plans

The Company also has outstanding options which were issued under the Autotask Superior Holdings 2013 Stock Option Plan (the “Autotask Plan”). As of September 30, 2021, 265,095 fully-vested stock options were outstanding under the Autotask Plan. No additional awards may be issued under the Autotask Plan. In addition, the Company has 2 other plans, which were adopted in relation to grants to independent members of the Board, prior to the adoption of the 2020 Plan. As of September 30, 2021, 11,719 RSUs were outstanding and no additional awards may be issued under these plans.
 
Stock Options

The following table summarizes stock option activity related to all plans during the nine months ended September 30, 2021 (in thousands, except share and per share amounts):
Number of
Shares
Weighted
Average
Exercise
Price
Weighted
Average
Remaining
Contractual
Life (Years)
Aggregate
Intrinsic
Value
Options outstanding at December 31, 20209,555,082 $10.49 7.5$157,800 
Options granted80,000 $25.50 
Options exercised(1,704,829)$9.86 
Options forfeited & expired(270,674)$10.97 
Options outstanding at September 30, 20217,659,579 $10.76 7.3$100,738 
Options vested and exercisable at September 30, 20214,509,837 $10.14 7.0$62,067 

The aggregate intrinsic value of stock options exercised during the nine months ended September 30, 2021 and 2020 was $27.7 million and $1.3 million, respectively.

The weighted average fair value of options granted to purchase common stock during the nine months ended September 30, 2021 was $11.60.

As of September 30, 2021, unrecognized compensation expense related to outstanding stock options was $27.0 million, which is expected to be recognized over the remaining weighted average term of 1.8 years.

Restricted Stock Units

The following table summarizes RSU activity under all plans during the nine months ended September 30, 2021:
 Number of
Shares
Weighted
Average
Grant Date Fair Value
 
RSUs outstanding at December 31, 2020696,338$26.73  
RSUs granted3,560,809$25.83 
RSUs vested(91,854)$25.10 
RSUs forfeited(85,175)$26.17 
RSUs outstanding at September 30, 20214,080,118$25.99  

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As of September 30, 2021, unrecognized compensation expense related to outstanding RSUs was $95.1 million, which is expected to be recognized over the remaining weighted average term of 3.5 years.

Shares Available for Future Grants

The following table summarizes the shares available for future grants under the 2020 Plan:
 Shares
Available for
Future Grant
Balance at December 31, 202020,195,974 
Annual authorization increase8,071,001 
Options and RSUs granted(3,640,809)
Options and RSUs forfeited or expired86,346 
Balance at September 30, 202124,712,512 
Datto 2021 Employee Stock Purchase Plan

In May 2021, shareholders approved the Datto Holding Corp. 2021 Employee Stock Purchase Plan (“ESPP”). The ESPP contains a component intended to qualify as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code (the “423 Component”) and a component primarily related to purchases by international employees. The ESPP provides all eligible Datto employees the opportunity to contribute up to 15% of their base earnings and other eligible compensation to purchase shares of Datto common stock. A participant can purchase a maximum of 1,000 shares of Datto common stock per biannual offering period, although participants in the 423 Component cannot purchase shares that would accrue at a rate which exceeds $25,000 of fair market value of Datto common stock (determined based on the fair market value on the first day of each offering period) for each calendar year. The purchase price is equal to 85% of the fair market value of Datto common stock on the first or last day of the offering period, whichever is lower. There are 3,221,541 shares available for issuance under the ESPP, although none were outstanding at September 30, 2021. The pool of shares available for issuance under the ESPP is subject to an annual increase on the first day of each year beginning on January 1, 2022 and annually thereafter ending in 2031 equal to the lesser of (i) 1% of all classes of the Company’s shares outstanding on the last day of the immediately preceding calendar year and (ii) such smaller number of shares as may be determined by the Board; provided, however, no more than 16,000,000 shares may be issued in total under the 423 Component.
Approximately 0.2 million shares will be purchased at the end of the offering period in January 2022, based on the enrollment and stock price as of September 30, 2021. The Company has withheld $1.5 million on behalf of employees for these future purchases under the ESPP, which is included in accrued expenses and other current liabilities within the condensed consolidated balance sheets as of September 30, 2021.
The fair value of shares issued under the ESPP is estimated on the grant date using the Black-Scholes option pricing model. As of September 30, 2021, unrecognized compensation expense related to the ESPP was $0.7 million, which is expected to be recognized over the remaining weighted average term of 0.3 years.
Stock-Based Compensation Expense
Stock-based compensation expense for the three and nine months ended September 30, 2021 and 2020 was as follows (in thousands):
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
Cost of revenue—subscription$1,052 $77 $3,165 $118 
Cost of revenue—device43 — 150 — 
Cost of revenue—professional services and other(15)— 151 — 
Sales and marketing2,354 524 6,491 1,803 
Research and development5,325 494 17,257 1,115 
General and administrative2,844 1,694 8,141 3,525 
Total stock-based compensation expense$11,603 $2,789 $35,355 $6,561 
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The table reflects stock-based compensation expense based upon the functional role of the holder. Stock-based compensation expense for awards with only a time-based vesting condition was recorded in all periods presented. During the three and nine months ended September 30, 2020, the Company also had awards which contained both a time-based and a performance-based vesting condition, which was the closing of an IPO. Stock-based compensation for these awards commenced during the fourth quarter of 2020 as a result of the Company's IPO ("IPO Contingent Options"). In 2021 the Company also issued restricted stock units with performance-based vesting conditions in connection with the acquisition of BitDam, for which stock-based compensation expense is being recorded based on the expected achievement of the performance targets.

11.Income Taxes
The Company incurred a provision for income taxes of $1.8 million and $5.0 million for the three months ended September 30, 2021 and 2020, respectively. The effective tax rate for the three months ended September 30, 2021 was 11.7%, driven by the tax benefit related to employee stock option exercises. The Company incurred a provision for income taxes of $6.5 million and $8.7 million for the nine months ended September 30, 2021 and 2020, respectively. The effective tax rate for the nine months ended September 30, 2021 was 12.4%, reflecting the favorable impact of a change in tax law in the state of Connecticut resulting in the ability to utilize additional research and development credits generated in prior years, the tax benefit related to employee stock option exercises, and the favorable impact of an amendment to the Company's 2018 federal tax return resulting from clarification of certain tax guidance.

12.Net Income per Share
Basic net income per share attributable to common stockholders is calculated by dividing the net income attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted net income per share attributable to common stockholders is calculated by giving effect to all potential shares of common stock, including the Company's outstanding stock options, common stock related to unvested RSUs, and the estimated number of shares to be issued under the ESPP based upon the enrollment and stock price as of September 30, 2021, to the extent such potential shares are dilutive. For the purpose of computing diluted earnings per share, options with a performance-based vesting condition are considered contingently issuable, and such contingent shares are included in the denominator for computing diluted net income per share only once the performance condition is met, and only to the extent such options are dilutive. As described in Note 10. Stock-Based Compensation, the IPO Contingent Options contained a performance-vesting condition, and were only considered in computing diluted net income per share after the IPO in October of 2020. The calculation of basic and diluted income per share is as follows (in thousands, except share and per share amounts):
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
Numerator:
Net income attributable to common stockholders$13,485 $19,546 $45,687 $29,666 
Denominator:
Weighted-average shares used in computing net income per share attributable to common stockholders
Basic162,424,260 135,553,097 161,657,479 135,496,696 
Total dilutive effect of outstanding equity awards including the ESPP3,824,681 3,037,673 3,826,231 1,510,225 
Diluted166,248,941 138,590,770 165,483,710 137,006,921 
Net income per share attributable to common stockholders
Basic$0.08 $0.14 $0.28 $0.22 
Diluted$0.08 $0.14 $0.28 $0.22 

For the three and nine month periods ended September 30, 2021 there were 256,111 and 316,521, respectively, of weighted-average outstanding options to purchase shares excluded from the computation of diluted net income per share attributable to common stockholders for the period presented because including them would have been antidilutive. For the three and nine month periods ended September 30, 2020 there were 1,058,594 and 2,216,118,
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respectively, of weighted-average outstanding options to purchase shares excluded from the computation of diluted net income per share attributable to common stockholders for the period presented because including them would have been antidilutive.

13.Restructuring

In response to the COVID-19 pandemic, the Company undertook various measures during the second quarter of 2020 to mitigate the risk of potential reductions in revenue and delays or reductions in payments from the Company's customers. The measures included a focus on the Company's cost structure to match expenditures to its revised forecasts of revenue and cash generation activities at that time. As a result of these actions, the Company incurred approximately $3.8 million for restructuring activities in the second quarter of 2020, primarily related to severance for a reduction in workforce, including $0.6 million in cost of revenue and $3.2 million in operating expenses, all of which was paid as of December 31, 2020.
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Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements that are subject to risks and uncertainties. All statements other than statements of historical fact included in this Quarterly Report on Form 10-Q are forward-looking statements. Forward-looking statements give our current expectations and projections relating to our financial condition, results of operations, plans, objectives, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe,” “may,” “will,” “should,” “can have,” “likely” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance or other events. For example, all statements we make relating to our estimated and projected costs, expenditures, cash flows, growth rates and financial results or our plans and objectives for future operations, growth initiatives, or strategies are forward-looking statements. All forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those that we expected, including:
the impact on our operations and financial condition from the effects of the current COVID-19 pandemic;
our ability to effectively compete;
fluctuations in our operating results;
our ability to sustain cash flows and profitability;
our ability to attract new managed service provider (“MSP”) partners;
our ability to sell additional products and subscriptions to our MSP partners;
the recognition of revenue from our subscription offerings;
the strength of the small and medium businesses (“SMB”) information technology (“IT”) market;
our ability to manage the ongoing growth of our business;
the risks associated with our current and future international operations;
the impact of volatility in the global economy;
the ability of our MSP partners to sell our products;
possible data losses or breaches experienced by MSP partners or their SMB customers using our products or solutions;
the risks associated with defects or vulnerabilities in our or our third-parties’ software, solutions, infrastructure and hardware;

the impact of natural disasters, terrorism or other catastrophic events;
our ability to recruit, retain and develop key employees and management personnel;
the impact of changes in SMBs’ IT needs and our ability to adapt our offerings;
our ongoing ability to utilize the application programming interfaces of products such as Microsoft 365 and Google Workspace;
our ability to realize benefits from our investment in research and development activities;
the impact of any manufacturing and logistics delays or pricing fluctuations relating to our manufacturing partners;
our ability to effectively manage our supply chain and inventory;
our dependence on a limited number of manufacturers for certain components of our products;
our ability to provide high quality technical support and the extent to which our MSP partners are able to provide satisfactory technical support to their SMB customers;
the risks related to our use of open source software in certain of our products and subscription offerings; 
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our ability to meet our contractual commitments related to response time and service level, and the quality of professional services we provide;
the risks associated with indemnity provisions in some of our agreements;
the risks and uncertainties associated with our limited operating history;
the risks associated with past and future business acquisitions;
our ability to make expenditures in order to support additional growth;
the risk of negative publicity, legal liability or other expenditures which could result from the material stored on our servers;
the effects of interruptions or delays in services provided by our data centers or other third parties;
our reliance on technology and intellectual property licensed from other parties;
our ability to integrate our products with other operating systems, software applications, platforms and hardware;
the impact of claims by others that we infringe upon their proprietary technology or other rights;
the potential adverse impact of legal proceedings;
the risks associated with our indemnification obligations and the limitations of our director and officer liability insurance;
our ability to protect and enforce our intellectual property rights;
the ability of our MSP partners to access high-speed internet and the continued reliability of the internet infrastructure;
our ability to sustain market recognition of and loyalty to our brand;
our ability to maintain our corporate culture;
the impact of foreign currency exchange rate fluctuations;
the impact of fluctuations in interest rates;
our ability to remediate our existing material weakness in our internal control over financial reporting;
our ability to develop and maintain proper and effective internal control over financial reporting;
the impact of changes in financial accounting standards or practices;
the accuracy of the estimates and judgments relating to our critical account policies;
the impact of tax consequences related to our domestic and international operations;
the impact of changes in tax laws or regulations affecting us or our partners;
the impact of the Tax Cuts and Jobs Act of 2017;
our ability to comply with governmental export controls and economic sanctions laws in connection with our international operations;
our ability to comply with legal requirements, contractual obligations and industry standards relating to security, data protection and privacy;
our ability to comply with the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”);
our ability to comply with the foreign corrupt practices act (“FCPA”) and similar laws associated with our activities outside of the United States;
our ability to comply with the other government laws and regulations applicable to our business; and
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other factors disclosed in the section entitled “Risk Factors” in this Form 10-Q and our Annual Report on Form 10-K filed with the SEC on March 11, 2021.
We derive many of our forward-looking statements from our operating budgets and forecasts, which are based on many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and it is impossible for us to anticipate all factors that could affect our actual results. Important factors that could cause actual results to differ materially from our expectations, or cautionary statements, are disclosed under the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Quarterly Report on Form 10-Q and in the section entitled “Risk Factors” in this Form 10-Q and our Annual Report on Form 10-K filed with the SEC on March 11, 2021. All written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by these cautionary statements as well as other cautionary statements that are made from time to time in our other SEC filings and public communications. You should evaluate all forward-looking statements made in this Quarterly Report on Form 10-Q in the context of these risks and uncertainties.
We caution you that the risks and uncertainties referenced above that may cause actual results to differ materially from those that we expected may not contain all of the factors that are important to you. In addition, we cannot assure you that we will realize the results or developments we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our operations in the way we expect. The forward-looking statements included in this filing are made only as of the date hereof. We undertake no obligation to update or revise any forward-looking statement as a result of new information, future events or otherwise, except as otherwise required by law.
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ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and our 2020 Annual Report on Form 10-K filed with the SEC on March 11, 2021. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those expressed or implied by such forward-looking statements. Important factors that could cause or contribute to these differences include, but are not limited to, those identified in this Quarterly Report and in our Form 10-K, particularly those discussed in the sections entitled “Risk Factors” and “Forward-Looking Statements.”
Overview

Datto is the leading provider of cloud-based software and security solutions purpose-built for delivery through the managed service provider, or MSP, channel to small and medium businesses, or SMBs. We enable our over 18,200 MSP partners to manage and grow their businesses serving the SMB information technology, or SMB IT, market. Our platform combines mission-critical cloud-based software and security solutions that MSPs sell to SMBs, business management software to help MSPs scale their own businesses, and marketing tools, content, training and industry-leading events that cultivate an empowered and highly engaged MSP partner community.

MSPs represent the future of IT management for SMBs. Digital transformation is driving SMB adoption of modern software and technology, while regulatory and data protection requirements and proliferating security threats are increasing the complexity and risk of IT for SMBs. These trends have created an inflection point in SMB outsourcing to MSPs for IT management. MSPs are equipped with the IT resources and expertise SMBs lack, providing a single source to meet all of an SMB’s IT needs. MSPs are trusted to select, procure, implement and manage software and technology stacks that support their SMB customers’ business and security needs. The number of MSPs continues to grow, with approximately 125,000 MSPs providing this critical function to millions of SMBs worldwide.

We are committed to the success of MSPs. It is the foundation of our strategy and culture. We empower our MSP partner channel, creating enormous sales and support leverage for us to efficiently address the large, but fragmented, SMB IT market. Our MSP-centric platform enables our partners to generate recurring revenue through the sale of our solutions to SMBs and to scale and effectively manage their own businesses. Our relationships are directly with our MSP partners. We are the leading pure-play vendor serving the MSP market, and believe our MSP-centric approach is highly differentiating as it aligns our mutual incentives, creates a motivated and engaged sales channel and reinforces our position as an integral component of our MSP partners’ businesses.

Our cloud-based platform provides Unified Continuity, Networking and Business Management software solutions. Our Unified Continuity offerings ensure the ongoing availability and security of mission-critical IT systems for SMBs on-premise, in private clouds and in the public cloud. Datto’s business continuity and disaster recovery, or BCDR, software, enables rapid restoration of an SMB’s full IT environment. Datto’s SaaS Protection is a reliable, automated and secure backup and restoration product for data stored on cloud applications such as Microsoft 365 and Google Workspace. Datto Networking constitutes a suite of MSP-centric networking solutions sold through our MSP partners to easily deliver networking as a managed service. These solutions are simple for MSPs to deploy, configure and manage across their SMB customers through a single portal. Our Business Management software provides critical operational tools to MSPs for efficient workflow management and delivery of end-to-end managed services. Our platform also includes a host of business development tools, training and content to help MSPs address the challenges of marketing and selling to SMB customers.

We recently launched two new cloud-based solutions - Datto Continuity for Microsoft Azure, ("DCMA") and SaaS Defense. DCMA is a comprehensive Business Continuity and Disaster Recovery ("BCDR") solution that protects MSPs and their clients’ data in the public cloud in the event of malicious ransomware attacks, security breaches, and vendor outages. SaaS Defense is an advanced threat protection and spam-filtering solution that provides MSPs with patented technology to proactively detect and prevent malicious malware, phishing, and Business Email Compromise ("BEC") attacks that target Microsoft Exchange, OneDrive, SharePoint, and Teams. The product is based on Datto’s acquisition of Israel-based cyber threat detection company BitDam earlier this year.

Our Business Model

Our cloud-based solutions are purpose-built to address the needs of MSPs and to enable the end-to-end delivery of managed services to their SMB customers.
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We generate substantially all our revenue from the sale of subscriptions to our cloud-based software and security solutions and recognize revenue ratably over the subscription term. These contracts typically begin with a 1-year or 3-year term and auto-renew on a monthly or annual basis thereafter. For certain offerings, we enable our ongoing subscription services with an up-front sale of equipment or professional services, for which we recognize revenue at the time of delivery and performance. The majority of our partners pay on a monthly basis, regardless of term length, with some opting to make quarterly, annual or multi-year prepayments.

As of September 30, 2021, our annual run-rate revenue, or ARR, was $626.7 million, and our revenue for the three months ended September 30, 2021 was $157.9 million, of which approximately 93% was recurring subscription revenue. For the three months ended September 30, 2021, our net income was $13.5 million and our Adjusted EBITDA was $43.8 million. Our revenue for the nine months ended September 30, 2021 was $454.4 million, of which approximately 93% was recurring subscription revenue. For the nine months ended September 30, 2021, our net income was $45.7 million and our Adjusted EBITDA was $135.6 million.

As of September 30, 2020, our ARR was $522.8 million and our revenue for the three months ended September 30, 2020, was $130.7 million, of which approximately 94% was recurring subscription revenue. For the three months ended September 30, 2020, our net income was $19.5 million and our Adjusted EBITDA was $45.8 million. Our revenue for the nine months ended September 30, 2020, was $379.8 million, of which approximately 94% was recurring subscription revenue. For the nine months ended September 30, 2020, our net income was $29.7 million and our Adjusted EBITDA was $109.7 million.

Refer to our discussion of ARR in Key Performance Metrics and Adjusted EBITDA in Non-GAAP Financial Measures.

Impact of COVID-19

While we have not incurred significant disruptions from the COVID-19 pandemic, there is still uncertainty relating to the extent of the impact of the pandemic on our business because of numerous global factors, including but not limited to, the severity of the disease, the duration of the pandemic, the reoccurrence or emergence of variants of the virus, the effectiveness and speed of vaccinations, actions taken by government authorities, the impact on our customers and suppliers, supply chain constraints, labor shortages, inflationary pressure and other factors. Specifically, we may experience impacts from customers deferring purchasing and activation decisions, reducing expenses and requesting extended payment terms or relief from payments.
The effect of the COVID-19 pandemic will not be fully reflected in our results of operations and overall financial performance until future periods. In addition, our condensed consolidated financial statements reflect estimates and assumptions made by management that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates and assumptions reflected in our condensed consolidated financial statements include, but are not limited to, establishing allowances for doubtful accounts, assessing the recoverability of prepaid assets, including trade shows and other marketing events impacted by the pandemic, determining useful lives for finite-lived assets, assessing the recoverability of long-lived assets, determining the fair value of assets acquired and liabilities assumed in business combinations, accounting for income taxes and related valuation allowances against deferred tax assets, valuing stock-based awards, recognizing revenue and the estimate for sales returns and upgrades, determining the amortization period for capitalized commissions and assessing the accounting treatment for commitments and contingencies. Management evaluates these estimates and assumptions on an ongoing basis and makes estimates based on historical experience and various other considerations that are believed to be reasonable. Actual results may differ from those estimates, including as a result of the COVID-19 pandemic. We will continue to evaluate the nature and extent of the impact of the pandemic on our business and our consolidated results of operations and financial condition.

Key Performance Metrics

In addition to our financial information presented in accordance with generally accepted accounting principles in the United States, or GAAP, we review a number of operating and financial metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans and make operating and strategic decisions.

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MSP Partners

The number of MSP partners represents the number of MSPs with active subscriptions as of the end of a period. We use this number to assess our ability to attract and retain MSP partners and thereby grow our business. As of September 30, 2021, we had approximately 18,200 MSP partners, a net increase of approximately 1,200 since December 31, 2020. Net changes in the number of our MSP partners are a result of the total new partners added during a period, largely based on our sales and marketing efforts, and the churn or reduction of existing partners during the period, which can be affected by the broader economic environment and factors such as the effects of COVID-19 on our partners' SMB end customers. As a result of our land-and-expand model, our reported revenue growth is driven principally by additional revenue from existing MSP partners. We view new MSP partner additions as a leading indicator of the health of the business, but the additions do not immediately drive material revenue growth in our reported results of operations.

Annual Run-Rate Revenue

We define ARR as the annualized value of all subscription agreements as of the end of a period. We calculate ARR by multiplying the monthly run-rate revenue for the last month of a period by 12. Monthly run-rate revenue is calculated by aggregating monthly subscription values during the final month of the reporting period from both long-term and month-to-month subscriptions. ARR only includes the annualized value of subscription contracts and excludes any one-time revenue for devices or professional services. ARR mitigates fluctuations resulting from seasonality and contract term. ARR does not have any standardized meaning and is therefore unlikely to be comparable to similarly titled measures presented by other companies. ARR should be viewed independently of revenue and deferred revenue and is not intended to be combined with or to replace either of those items. ARR is not a forecast and the active contracts at the date used in calculating ARR may or may not be extended or renewed by our MSP partners.

The table below sets forth our ARR as of September 30, 2021 and 2020:

As of September 30, 2021As of September 30, 2020$ Change% Change
 (dollars in millions)
ARR$626.7 $522.8 $103.9 19.9 %

Components of Results of Operations

Revenue

We generate revenue primarily from fees received for subscriptions to our products and services, and also from the sale of BCDR and Networking devices and professional services associated with our Business Management offerings.

Subscription. We derive revenue primarily from cloud-based software and security solutions sold on a recurring subscription basis. Subscription revenue is recognized ratably over the subscription term after all revenue recognition criteria have been met. We generally invoice subscription agreements monthly over the subscription period. Subscription revenue for our Unified Continuity and Networking solutions grows as the end-customers, managed by our MSP partners, add new subscription products, upgrade the service tier of their existing subscription products or increase the usage of their subscription products. Revenue from our Business Management solutions increases with the addition of employees of our MSP partners who require seat licenses, the proliferation of end-user devices managed by those MSPs and the expansion of products used by those MSPs to manage their SMB customers’ IT infrastructures.
 
Device. Our device revenue is derived from the sale of devices in conjunction with subscription solutions. Device revenue includes the sale of BCDR and Networking devices which enable us to deliver our BCDR and Networking services to our MSP partners under a recurring subscription model. Revenue from devices in our Unified Continuity solution primarily consists of the sale of our proprietary data storage devices. Revenue from devices in our Networking solution primarily consists of the sale of wireless access points, switches and edge routers. We recognize revenue at a point in time when control of the device has transferred to the MSP. Revenue from devices does not contribute significantly to overall revenue related to our Unified Continuity solutions.

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Professional services and other. We derive revenue from professional services associated with our Business Management offerings. These implementation and consulting services include configuration, database merging and data migration. Our professional services are generally priced on a time and materials basis and invoiced monthly, with revenue recognized as the services are performed, and we frequently discount our services to drive adoption of our business management offerings. 

Cost of revenue

Subscription. Subscription cost of revenue consists of costs directly related to our subscription services, including personnel costs related to operating our Datto Cloud infrastructure and customer support operations, hosting and data center related costs, third-party software licenses and allocated facilities and overhead costs associated with delivering these services.

Device. Device cost of revenue consists of hardware, manufacturing, shipping and logistics, personnel costs and allocated facilities and overhead costs associated with the purchase, production and delivery of our devices. Our Unified Continuity products rely on a mix of off-the-shelf hardware and custom designed hardware. Our Networking devices generally consist of off-the-shelf hardware, although some of our devices feature a unique industrial design.

Professional services and other. Professional services and other cost of revenue consists primarily of personnel costs and allocated facilities and overhead costs associated with delivering implementation and consulting services. Our professional services implementations aim to ensure higher software utilization and positive customer satisfaction, in order to drive greater upsell opportunity and lower churn over time.

Depreciation and amortization. Depreciation and amortization cost of revenue consists of depreciation of our Datto Cloud infrastructure and amortization of our acquired technology intangible assets.
 
Gross profit and gross margin

Gross profit, or revenue less cost of revenue, has been, and will continue to be, affected by various factors, including revenue fluctuations, the mix of revenue, the timing and amount of investments to expand our Datto Cloud infrastructure and launch new solutions, and stock-based compensation expense.

Operating expenses

Our operating expenses consist of sales and marketing, research and development and general and administrative expenses as well as depreciation, amortization of internally developed software and amortization of acquired intangible assets. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, sales commissions, payroll taxes and stock-based compensation expense. Other significant components of operating expenses include events and travel, professional fees, facilities and overhead costs, third party software subscription costs, marketing and promotion costs, payment processing fees and bad debt expense.

Sales and marketing

Sales and marketing expenses consist primarily of personnel costs, costs for events and travel, costs of marketing and promotional activities, payment processing fees and allocated facilities and overhead costs. Sales and marketing expenses may fluctuate as a percentage of our revenue from period to period because of the timing and extent of marketing activities, trade shows, and events including DattoCon and DattoCon EMEA, as well as the timing of amortization of sales commissions and stock-based compensation expense.

Research and development

Research and development expenses consist primarily of personnel costs, third-party professional fees and allocated facilities and overhead costs. Research and development expense may fluctuate as a percentage of our revenue from period to period because of the timing and extent of our investments in research and development activities, as well as the timing of stock-based compensation expense.

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General and administrative

General and administrative expenses consist primarily of personnel costs across the corporate functions of executive, finance, human resources, information technology, internal operations and legal, as well as third-party professional fees, bad debt expense, travel and costs for facilities. Following the completion of our initial public offering ("IPO") we began incurring additional general and administrative expenses as a result of operating as a publicly listed company, including increased expenses for insurance, costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, investor relations and professional services expenses, and increased stock-based compensation expense.

Depreciation and amortization

Depreciation and amortization expenses in operating expenses consist of amortization of tradenames and partner relationship intangibles as well as depreciation of other property and equipment such as leasehold improvements, furniture and fixtures, and computer equipment as well as amortization of internally developed software.
Other expense

Interest expense

Interest expense consists of interest payments on outstanding borrowings under our credit facilities, as well as commitment fees under our credit facilities and the amortization of debt issuance costs. In conjunction with our IPO in October 2020, we repaid all amounts outstanding under our 2019 Credit Agreement. In October 2020, Datto, Inc. and certain direct and indirect wholly-owned subsidiaries of Datto, entered into a new credit agreement with the lenders party thereto and Morgan Stanley Senior Funding, Inc., as administrative agent (the “2020 Credit Agreement”), which provides a $200.0 million revolving credit facility. No amounts have been drawn under the 2020 Credit Agreement. See “Liquidity and Capital Resources—Credit Facilities” for additional details.

Other (income) expense

Other (income) expense primarily consists of the net exchange (gains) or losses on foreign currency transactions.
Benefit from (provision for) income taxes

Benefit from (provision for) income taxes consists primarily of income tax expense related to U.S. federal and state income taxes and income taxes in foreign jurisdictions in which we conduct business.

Stock-Based Compensation

Stock-based compensation expense is recorded based upon the functional role of the holder. Stock-based compensation expense for awards which contained only a time-based vesting condition was recorded in all periods presented. Stock-based compensation expense for awards which contained both a time-based and a performance-based vesting condition, which was the closing of an IPO, commenced during the fourth quarter of 2020 as a result of our IPO. Additionally, in 2021 the Company issued restricted stock units with performance-based vesting conditions in relation to the acquisition of BitDam, for which stock-based compensation expense was recorded based on the expected achievement of the performance targets.
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Condensed Consolidated Results of Operations
The following table sets forth our condensed consolidated statements of operations data for the periods indicated:
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
 (in thousands)
Revenue:
Subscription$146,764 $122,753 $424,097 $356,348 
Device10,242 6,964 27,652 21,098 
Professional services and other886 950 2,654 2,347 
Total revenue157,892 130,667 454,403 379,793 
Cost of revenue:
Subscription (1)
22,776 18,915 65,344 60,786 
Device (1)
12,930 10,089 33,552 26,464 
Professional services and other (1)
1,470 1,332 4,521 4,399 
Depreciation and amortization8,572 5,526 23,795 15,746 
Total cost of revenue45,748 35,862 127,212 107,395 
Gross profit112,144 94,805 327,191 272,398 
Operating expenses:
Sales and marketing (1)
35,173 24,709 99,234 83,828 
Research and development (1)
26,872 15,257 76,690 48,000 
General and administrative (1)
27,802 17,433 78,908 59,389 
Depreciation and amortization6,531 6,820 19,554 20,600 
Total operating expenses96,378 64,219 274,386 211,817 
Income from operations15,766 30,586 52,805 60,581 
Other expense: 
Interest expense156 7,065 433 23,590 
Other expense (income), net338 (987)224 (1,402)
Total other expense494 6,078 657 22,188 
Income before income taxes15,272 24,508 52,148 38,393 
Provision for income taxes(1,787)(4,962)(6,461)(8,727)
Net income$13,485 $19,546 $45,687 $29,666 

(1)Includes stock-based compensation expense as follows:
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
 (in thousands)
Cost of revenue—subscription$1,052 $77 $3,165 $118 
Cost of revenue—device43 — 150 — 
Cost of revenue—professional services and other(15)— 151 — 
Sales and marketing2,354 524 6,491 1,803 
Research and development5,325 494 17,257 1,115 
General and administrative2,844 1,694 8,141 3,525 
Total$11,603 $2,789 $35,355 $6,561 
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The following table sets forth our condensed consolidated statements of operations data expressed as a percentage of total revenue for the period indicated (percentages may not foot as a result of rounding):
 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
Revenue:
Subscription93.0 %94.0 %93.3 %93.8 %
Device6.4 %5.3 %6.1 %5.6 %
Professional services and other0.6 %0.7 %0.6 %0.6 %
Total revenue100.0 %100.0 %100.0 %100.0 %
Cost of revenue:
Subscription14.4 %14.5 %14.4 %16.0 %
Device8.2 %7.7 %7.4 %7.0 %
Professional services and other0.9 %1.0 %1.0 %1.2 %
Depreciation and amortization5.4 %4.2 %5.2 %4.1 %
Total cost of revenue29.0 %27.4 %28.0 %28.3 %
Gross profit71.0 %72.6 %72.0 %71.7 %
Operating expenses:
Sales and marketing22.3 %18.9 %21.8 %22.1 %
Research and development17.0 %11.7 %16.9 %12.6 %
General and administrative17.6 %13.3 %17.4 %15.6 %
Depreciation and amortization4.1 %5.2 %4.3 %5.4 %
Total operating expenses61.0 %49.1 %60.4 %55.8 %
Income from operations9.9 %23.4 %11.6 %16.0 %
Other expense: 
Interest expense0.1 %5.4 %0.1 %6.2 %
Other expense (income), net0.2 %(0.8)%— %(0.4)%
Total other expense0.3 %4.7 %0.1 %5.8 %
Income before income taxes9.7 %18.8 %11.5 %10.1 %
Provision for income taxes(1.1)%(3.8)%(1.4)%(2.3)%
Net income8.5 %15.0 %10.1 %7.8 %


Comparison of the Three and Nine Months Ended September 30, 2021 and 2020
Revenue
 Three Months Ended September 30,ChangeNine Months Ended September 30,Change
 20212020$%20212020$%
 (dollars in thousands)
Revenue:
Subscription$146,764 $122,753 $24,011 19.6 %$424,097 $356,348 $67,749 19.0 %
Device10,242 6,964 3,278 47.1 %27,652 21,098 6,554 31.1 %
Professional services and other886 950 (64)(6.7)%2,654 2,347 307 13.1 %
Total revenue$157,892 $130,667 $27,225 20.8 %$454,403 $379,793 $74,610 19.6 %

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Subscription

Subscription revenue increased $24.0 million, or 19.6%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, including a benefit from favorable foreign exchange rates of approximately 1.5%. The increase in subscription revenue was primarily driven by increased sales of our Unified Continuity cloud-based offerings, as well as increases in our Business Management offerings. Recurring subscription revenue accounted for 93.0% of total revenue for the three months ended September 30, 2021 compared to 94.0% for the three months ended September 30, 2020.

Subscription revenue increased $67.7 million, or 19.0%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, including a benefit from favorable foreign exchange rates of approximately 2.7%. The increase in subscription revenue was primarily driven by increased sales of our Unified Continuity cloud-based offerings, as well as increases in Business Management offerings. Recurring subscription revenue accounted for 93.3% of total revenue for the nine months ended September 30, 2021 compared to 93.8% for the nine months ended September 30, 2020.

Device

Device revenue increased $3.3 million, or 47.1%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020.

Device revenue increased $6.6 million, or 31.1%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020.

Professional services and other

Professional services and other revenue decreased $0.1 million for the three months ended September 30, 2021 compared to the three months ended September 30, 2020.

Professional services and other revenue increased $0.3 million for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020.
Cost of Revenue
 
 Three Months Ended September 30,ChangeNine Months Ended September 30,Change
 20212020$%20212020$%
 (dollars in thousands)
Cost of revenue:
Subscription$22,776 $18,915 $3,861 20.4 %$65,344 $60,786 $4,558 7.5 %
Device12,930 10,089 2,841 28.2 %33,552 26,464 7,088 26.8 %
Professional services and other1,470 1,332 138 10.4 %4,521 4,399 122 2.8 %
Depreciation and amortization8,572 5,526 3,046 55.1 %23,795 15,746 8,049 51.1 %
Total cost of revenue$45,748 $35,862 $9,886 27.6 %$127,212 $107,395 $19,817 18.5 %

Subscription

Subscription cost of revenue for the three months ended September 30, 2021 increased $3.9 million, or 20.4%, compared to the three months ended September 30, 2020. The increase was primarily driven by an increase in personnel costs to support the growth in revenue, including an increase in stock-based compensation expense of $1.0 million for the three months ended September 30, 2021, and higher service costs to support the growth of our Datto Cloud, including costs related to the launch of our new SaaS Defense solution.

Subscription cost of revenue for the nine months ended September 30, 2021 increased $4.6 million, or 7.5%, compared to the nine months ended September 30, 2020. The increase was primarily driven by an increase in stock-based compensation expense of $3.0 million and other increased personnel costs to support the growth in revenue for the nine months ended
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September 30, 2021. During the nine months ended September 30, 2020, we recorded $0.5 million of restructuring costs related to our reduction in workforce in subscription cost of revenue.

Device

Device cost of revenue increased $2.8 million, or 28.2%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, driven by the 47.1% increase in device revenue.

Device cost of revenue increased $7.1 million, or 26.8%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, driven by the 31.1% increase in device revenue, and the impact of stock-based compensation expense of $0.2 million for the nine months ended September 30, 2021.

Professional services and other

Professional services and other cost of revenue increased $0.1 million for the three months ended September 30, 2021 compared to the three months ended September 30, 2020.

Professional services and other cost of revenue increased $0.1 million for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. The nine months ended September 30, 2021 included stock-based compensation expense of $0.2 million. During the nine months ended September 30, 2020, we recorded $0.1 million of restructuring costs related to our reduction in workforce in professional services and other cost of revenue.

Depreciation and amortization

Depreciation and amortization expense in cost of revenue increased $3.0 million for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and increased $8.0 million for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. The increases were attributable to ongoing capital expenditures for our Datto Cloud infrastructure to support the growth in subscriptions and the increase in amortization of acquired intangible assets as a result of recent acquisitions.


Gross Profit and Gross Margin
 
 Three Months Ended September 30,ChangeNine Months Ended September 30,Change
 20212020$%20212020$%
 (dollars in thousands)
Gross profit:
Subscription$123,988 $103,838 $20,150 19.4 %$358,753 $295,562 $63,191 21.4 %
Device(2,688)(3,125)437 (14.0)%(5,900)(5,366)(534)10.0 %
Professional services and other(584)(382)(202)52.9 %(1,867)(2,052)185 (9.0)%
Depreciation and amortization(8,572)(5,526)(3,046)55.1 %(23,795)(15,746)(8,049)51.1 %
Total gross profit$112,144 $94,805 $17,339 18.3 %$327,191 $272,398 $54,793 20.1 %
Gross margin:
Subscription84.5 %84.6 %(11)bps84.6 %82.9 %165bps
Device(26.2)%(44.9)%1,863bps(21.3)%(25.4)%410bps
Professional services and other(65.9)%(40.2)%(2,570)bps(70.3)%(87.4)%1,708bps
Total gross margin71.0 %72.6 %(153)bps72.0 %71.7 %28bps

Gross profit increased $17.3 million, or 18.3%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, driven by the increase in subscription gross profit, partially offset by the increase in depreciation and amortization. Gross margin decreased by 153 basis points for the three months ended September 30, 2021 compared to the three months ended September 30, 2020 primarily because of increased amortization of acquired intangible assets resulting from recent acquisitions and higher depreciation expense resulting from our ongoing investment in our Datto
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Cloud infrastructure, as well as an increase in stock-based compensation expense of $1.0 million. Subscription gross margin declined slightly for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, as higher stock-based compensation expense of $1.0 million and higher costs related to the launch of our new SaaS Defense solution were partially offset by the continued realization of operating efficiencies in providing our other Unified Continuity solutions.

Gross profit increased $54.8 million, or 20.1%, and gross margin increased by 28 basis points for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, driven by the increase in subscription gross profit and gross margin. The increase was partially offset by higher depreciation and amortization expense, primarily as a result of our investment in our Datto Cloud infrastructure and the amortization of acquired intangible assets, and an increase in personnel costs, including an increase in stock-based compensation expense of $3.3 million. Subscription gross margin increased 165 basis points for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020 as a result of our revenue growth out pacing the increased costs to provide our Unified Continuity solutions, partially offset by an increase in personnel costs, including an increase in stock-based compensation expense of $3.0 million as well as higher costs related to the launch of our new SaaS Defense solution. During the nine months ended September 30, 2020, we recorded $0.6 million of restructuring costs related to our reduction in workforce, including $0.5 million in subscription cost of revenue and $0.1 million in professional services and other cost of revenue.

Operating Expenses

 Three Months Ended September 30,ChangeNine Months Ended September 30,Change
 20212020$%20212020$%
 (dollars in thousands)
Operating expenses:
Sales and marketing$35,173 $24,709 $10,464 42.3 %$99,234 $83,828 $15,406 18.4 %
Research and development26,872 15,257 11,615 76.1 %76,690 48,000 28,690 59.8 %
General and administrative27,802 17,433 10,369 59.5 %78,908 59,389 19,519 32.9 %
Depreciation and amortization6,531 6,820 (289)(4.2)%19,554 20,600 (1,046)(5.1)%
Total operating expenses$96,378 $64,219 $32,159 50.1 %$274,386 $211,817 $62,569 29.5 %

 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
As a percentage of total revenue:
Sales and marketing22.3 %18.9 %21.8 %22.1 %
Research and development17.0 %11.7 %16.9 %12.6 %
General and administrative17.6 %13.3 %17.4 %15.6 %

Sales and marketing

Sales and marketing expense increased $10.5 million, or 42.3% for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, reflecting increased personnel costs to support the growth in our business, including increased stock-based compensation expense of $1.8 million and higher commission expense. In addition, marketing and promotional costs increased during 2021 as compared to 2020, as we increased our marketing efforts in support of our launch of DCMA and SaaS Defense and our other Unified Continuity solutions, as well as the impact of curtailing certain programs in 2020 as a result of the COVID-19 pandemic. Sales and marketing expense included $2.4 million and $0.5 million of stock-based compensation expense for the three months ended September 30, 2021 and 2020, respectively.

Sales and marketing expense increased $15.4 million, or 18.4% for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, primarily driven by increased personnel costs to support the growth in our business, including increased stock-based compensation expense of $4.7 million and higher commission expense, partially offset by lower restructuring costs. Marketing and promotional costs also increased during 2021 as compared to 2020, as we
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increased our marketing efforts in support of our launch of DCMA and SaaS Defense and our other Unified Continuity solutions, as well as the impact of curtailing certain programs in 2020 as a result of the COVID-19 pandemic. The increases in sales and marketing expense were partially offset by lower travel and event costs resulting from the COVID-19 pandemic. Sales and marketing expense included $6.5 million and $1.8 million of stock-based compensation expense for the nine months ended September 30, 2021 and 2020, respectively. During the nine months ended September 30, 2020, we recorded $1.9 million of restructuring costs related to our reduction in workforce in sales and marketing expense.

Research and development

Research and development expense increased $11.6 million, or 76.1%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, primarily driven by increased personnel costs, including an increase in stock-based compensation expense of $4.8 million, and our continued investment in innovation and information security. Research and development expense included $5.3 million and $0.5 million of stock-based compensation expense for the three months ended September 30, 2021 and 2020, respectively.

Research and development expense increased $28.7 million, or 59.8%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, primarily driven by increased personnel costs, including an increase in stock-based compensation expense of $16.1 million, and our continued investment in innovation and information security. Research and development expense included $17.3 million and $1.1 million of stock-based compensation expense for the nine months ended September 30, 2021 and 2020, respectively. During the nine months ended September 30, 2020, we recorded $0.9 million of restructuring costs related to our reduction in workforce in research and development expense.

General and administrative

General and administrative expense increased $10.4 million, or 59.5%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, driven primarily by increased personnel costs, including an increase in stock-based compensation expense of $1.2 million, as well as increased expenses related to being a publicly listed company and transaction related and other expense. General and administrative expense included $2.8 million and $1.7 million of stock-based compensation expense for the three months ended September 30, 2021 and 2020, respectively, and $1.3 million and $0.1 million of transaction related and other expense for the three months ended September 30, 2021 and 2020, respectively.

General and administrative expense increased $19.5 million, or 32.9%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, driven primarily by increased personnel costs, including an increase in stock-based compensation expense of $4.6 million, increased expenses related to being a publicly listed company and transaction related and other expense. Partially offsetting these increases were a $2.2 million reduction in bad debt expense as a result of improved collections activity, and decreased travel and events costs resulting from the COVID-19 pandemic. General and administrative expense included $8.1 million and $3.5 million of stock-based compensation expense for the nine months ended September 30, 2021 and 2020, respectively, and $4.1 million and $2.3 million of transaction related and other expense for the nine months ended September 30, 2021 and 2020, respectively.

During the nine months ended September 30, 2020, we recorded $0.4 million of restructuring costs related to our reduction in workforce in general and administrative expense.

Depreciation and amortization

Depreciation and amortization expense related to operating expenses decreased $0.3 million, or 4.2%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020. Amortization of intangible assets was $4.4 million in both the three months ended September 30, 2021 and 2020, and depreciation expense was $2.1 million and $2.4 million for the three months ended September 30, 2021 and 2020, respectively.

Depreciation and amortization expense related to operating expenses decreased $1.0 million, or 5.1%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. Amortization of intangible assets was $13.3 million and $13.2 million for the nine months ended September 30, 2021 and 2020, respectively, and depreciation expense was $6.3 million and $7.4 million for the nine months ended September 30, 2021 and 2020, respectively.

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Other Expenses (Income), Net and Provision for Income Taxes

Interest expense

Interest expense decreased $6.9 million and $23.2 million, respectively, for the three and nine months ended September 30, 2021 compared to the three and nine months ended September 30, 2020 as a result of the repayment of all outstanding debt with the proceeds from our IPO in the fourth quarter of 2020. In conjunction with the IPO, we terminated our 2019 Credit Agreement and entered into the 2020 Credit Agreement. No amounts have been drawn under the 2020 Credit Agreement and we have no outstanding debt as of September 30, 2021.

Other expense (income), net

Other expense, net increased $1.3 million for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and $1.6 million for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020, primarily as a result of the impact of exchange rate fluctuations on transactions denominated in a foreign currency.

Provision for income taxes

We incurred a provision for income taxes of $1.8 million and $5.0 million for the three months ended September 30, 2021 and 2020, respectively. The effective tax rate for the three months ended September 30, 2021 was 11.7%, driven by the tax benefit related to employee stock option exercises. We incurred a provision for income taxes of $6.5 million and $8.7 million for the nine months ended September 30, 2021 and 2020, respectively. The effective tax rate for the nine months ended September 30, 2021 was 12.4%, reflecting the favorable impact of a change in tax law in the state of Connecticut resulting in the ability to utilize additional research and development credits generated in prior years, the tax benefit related to employee stock option exercises, and the favorable impact of an amendment to the 2018 federal tax return as a result of clarification of certain tax guidance.

Non-GAAP Financial Measures
In addition to our results determined in accordance with GAAP, we believe the non-GAAP measures of Non-GAAP Gross Profit, Non-GAAP Income from Operations, Non-GAAP Net Income and Adjusted EBITDA are useful in evaluating our operating performance. We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only and should not be considered a substitute for financial information presented in accordance with GAAP and may be different from similarly titled non-GAAP measures used by other companies. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures.
Non-GAAP Gross Profit
Non-GAAP Gross Profit is a supplemental measure of operating performance that is not prepared in accordance with GAAP and that does not represent, and should not be considered as, an alternative to gross profit as determined in accordance with GAAP. We define Non-GAAP Gross Profit as gross profit, adjusted for amortization of acquired intangible assets, stock-based compensation expense, and restructuring expense. We use Non-GAAP Gross Profit to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans. We believe Non-GAAP Gross Profit is a useful measure to us and to our investors to assist in evaluating our core operating performance because it provides consistency and direct comparability with our past financial performance and between fiscal periods, as the metric eliminates the variability of stock-based compensation expense and amortization of acquired technology intangible assets, which are non-cash expenses that may fluctuate for reasons unrelated to overall operating performance, as well as restructuring expense, which is infrequent in nature. While the amortization expense of acquired technology intangible assets is excluded from Non-GAAP Gross Profit, the revenue related to acquired technology intangible assets is reflected in Non-GAAP Gross Profit as these assets contribute to our revenue generation. Non-GAAP Gross Profit has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Non-GAAP Gross Profit should not be considered as a replacement for gross profit, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Our presentation of Non-GAAP Gross Profit should not be construed to imply that our future
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results will be unaffected by the types of items excluded from the calculation of Non-GAAP Gross Profit. Non-GAAP Gross Profit is not a presentation made in accordance with GAAP and the use of the term may vary from other companies.
A reconciliation of Non-GAAP Gross Profit to gross profit, the most directly comparable GAAP measure, is as follows: 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
 (in thousands)
Gross profit$112,144 $94,805 $327,191 $272,398 
Amortization of acquired intangible assets2,702 1,175 6,714 3,525 
Stock-based compensation expense1,080 77 3,466 118 
Restructuring expense(1)
— — — 601 
Non-GAAP Gross Profit$115,926 $96,057 $337,371 $276,642 
(1) Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19 pandemic. Approximately $0.6 million of restructuring expense was recorded within cost of revenue for the nine months ended September 30, 2020.

Non-GAAP Income from Operations
Non-GAAP Income from Operations is a supplemental measure of operating performance that is not prepared in accordance with GAAP and that does not represent, and should not be considered as, an alternative to income from operations
as determined in accordance with GAAP. We define Non-GAAP Income from Operations as income from operations, adjusted for amortization of acquired intangible assets, stock-based compensation expense, restructuring expense and transaction related and other expense. We use Non-GAAP Income from Operations to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans. We believe that Non-GAAP Income from Operations facilitates comparison of our operating performance on a consistent basis between periods, and when viewed in combination with our results prepared in accordance with GAAP, helps provide a broader picture of factors and trends affecting our results of operations. While the amortization expense of acquired technology, partner relationships and tradenames is excluded from Non-GAAP Income from Operations, the revenue related to acquired technology, partner relationships and tradenames is reflected in Non-GAAP Income from Operations as these assets contribute to our revenue generation. Non-GAAP Income from Operations has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Non-GAAP Income from Operations should not be considered as a replacement for operating income, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Our presentation of Non-GAAP Income from Operations should not be construed to imply that our future results will be unaffected by the types of items excluded from the calculation of Non-GAAP Income from Operations. Non-GAAP Income from Operations is not a presentation made in accordance with GAAP and the use of the term may vary from other companies.
A reconciliation of Non-GAAP Income from Operations to income from operations, the most directly comparable GAAP measure, is as follows:
 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
 (in thousands)
Income from operations$15,766 $30,586 $52,805 $60,581 
Amortization of acquired intangible assets7,124 5,577 19,981 16,731 
Stock-based compensation expense11,603 2,789 35,355 6,561 
Restructuring expense(1)
— (15)— 3,835 
Transaction related and other expense (2)
1,338 95 4,137 2,329 
Non-GAAP Income from Operations$35,831 $39,032 $112,278 $90,037 
 
(1)Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19
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pandemic. Approximately $3.2 million and $0.6 million of restructuring expense was recorded within operating expenses and cost of revenue, respectively, for the nine months ended September 30, 2020.
(2)Transaction related and other expense consists of acquisition related costs and litigation related charges or benefits for the three and nine months ended September 30, 2021 as well as costs incurred in the three and nine months ended September 30, 2020 to support our public company readiness, acquisition related costs, and costs related to a decision to discontinue development of a back-office system.
Non-GAAP Net Income
Non-GAAP Net Income is a supplemental measure of operating performance that is not prepared in accordance with GAAP and that does not represent, and should not be considered as, an alternative to net (loss) income as determined in accordance with GAAP. We define Non-GAAP Net Income as net income before income taxes, adjusted for loss on extinguishment of debt, amortization of acquired intangible assets, stock-based compensation expense, restructuring expense, and transaction related and other expense, as adjusted for a normalized non-GAAP tax rate. The Company utilizes a normalized non-GAAP tax rate to provide better consistency across the interim reporting periods within a given fiscal year by eliminating the effects of non-recurring and period-specific items, which can vary in size and frequency, and which are not necessarily indicative of the Company’s long-term operations. The normalized non-GAAP tax rate applied to each period presented was 25%. We use Non-GAAP Net Income to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans. We believe that Non-GAAP Net Income facilitates comparison of our operating performance on a consistent basis between periods, and when viewed in combination with our results prepared in accordance with GAAP, helps provide a broader picture of factors and trends affecting our results of operations. While the amortization expense of acquired technology, customer relationships and tradenames is excluded from Non-GAAP Net Income, the revenue related to acquired technology, customer relationships and tradenames is reflected in Non-GAAP Net Income as these assets contribute to our revenue generation. Non-GAAP Net Income has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Non-GAAP Net Income should not be considered as a replacement for net income, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Our presentation of Non-GAAP Net Income should not be construed to imply that our future results will be unaffected by the types of items excluded from the calculation of Non-GAAP Net Income. Non-GAAP Net Income is not a presentation made in accordance with GAAP and the use of the term may vary from other companies.
A reconciliation of Non-GAAP Net Income to net income, the most directly comparable GAAP measure, is as follows:
 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
 (in thousands)
Net income$13,485 $19,546 $45,687 $29,666 
Provision for income taxes1,787 4,962 6,461 8,727 
Income before income taxes15,272 24,508 52,148 38,393 
Amortization of acquired intangible assets7,124 5,577 19,981 16,731 
Stock-based compensation expense11,603 2,789 35,355 6,561 
Restructuring expense(1)
— (15)— 3,835 
Transaction related and other expense (2)
1,338 95 4,137 2,329 
Non-GAAP provision for income taxes (3)
(8,834)(8,239)(27,905)(16,963)
Non-GAAP Net Income$26,503 $24,715 $83,716 $50,886 
 
(1)Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19 pandemic. Approximately $3.2 million and $0.6 million of restructuring expense was recorded within operating expenses and cost of revenue, respectively, for the nine months ended September 30, 2020.
(2)Transaction related and other expense consists of acquisition related costs and litigation related charges or benefits for the three and nine months ended September 30, 2021 as well as costs incurred in the three and nine months ended September 30, 2020 to support our public company readiness, acquisition related costs, and costs related to a decision to discontinue development of a back-office system.
(3)The normalized non-GAAP tax rate applied to each period presented was 25%. The Company may adjust its non-GAAP tax rate as additional information becomes available or events occur which may materially affect this rate, including impacts from the rapidly evolving global tax environment, significant changes in our geographic mix, merger and acquisition activity, or changes in our business outlook.
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Adjusted EBITDA
Adjusted EBITDA is a supplemental measure of operating performance monitored by management that is not defined under GAAP and that does not represent, and should not be considered as an alternative to net income, as determined by GAAP. We define Adjusted EBITDA as net income adjusted for interest and other expense, net, loss on extinguishment of debt, depreciation and amortization expense, (provision for) benefit from income taxes, stock-based compensation expense, restructuring expense and transaction related and other expense. We use Adjusted EBITDA to understand and evaluate our core operating performance and trends and to develop short-term and long-term operating plans.
Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, you should consider Adjusted EBITDA alongside other financial performance measures, including net income and our other GAAP results. Our presentation of Adjusted EBITDA should not be construed to imply that our future results will be unaffected by the types of items excluded from the calculation of Adjusted EBITDA. Adjusted EBITDA is not a presentation made in accordance with GAAP and the use of the term may vary from others in our industry.
A reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP measure, is as follows: 
 Three Months Ended September 30,Nine Months Ended September 30,
 2021202020212020
 (in thousands)
Net income$13,485 $19,546 $45,687 $29,666 
Interest and other expense, net(1)
494 6,078 657 22,188 
Depreciation and amortization15,103 12,346 43,349 36,346 
Provision for income taxes1,787 4,962 6,461 8,727 
Stock-based compensation expense11,603 2,789 35,355 6,561 
Restructuring expense(2)
— (15)— 3,835 
Transaction related and other expense(3)
1,338 95 4,137 2,329 
Adjusted EBITDA$43,810 $45,801 $135,646 $109,652 
 
(1)Interest and other expense, net includes interest expense, net, foreign currency gains and losses and other expenses.
(2)Restructuring expense primarily relates to severance costs incurred in connection with a reduction in workforce undertaken in Q2 2020 to align our cost structure to expectations of potentially reduced revenue resulting from the COVID-19 pandemic. Approximately $3.2 million and $0.6 million of restructuring expense was recorded within operating expenses and cost of revenue, respectively, for the nine months ended September 30, 2020.
(3)Transaction related and other expense consists of acquisition related costs and litigation related charges or benefits for the three and nine months ended September 30, 2021 as well as costs incurred in the three and nine months ended September 30, 2020 to support our public company readiness, acquisition related costs, and costs related to a decision to discontinue development of a back-office system.


Liquidity and Capital Resources

General

As of September 30, 2021, our principal source of liquidity was cash and cash equivalents and restricted cash totaling $207.2 million, $30.3 million of which was denominated in foreign currencies. In addition, as of September 30, 2021, we had no debt outstanding and $198.1 million of capacity under our 2020 Revolving Credit Facility, as defined below. We believe our existing cash and cash equivalents, cash provided by our ongoing operations and borrowing capacity under our 2020 Revolving Credit Facility will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months.

 Historically, as we invested in our organization and infrastructure to meet increasing demand for our products and services and to drive our rapid growth, we have financed our operations primarily through cash provided by our ongoing operations, debt financing and more recently our IPO. During 2020, in response to the spread of COVID-19 and its impacts on the world economy, we undertook various measures to improve our liquidity position and match our cost structure to our revenue and cash generation activities, and we continue to benefit from these measures. In addition, the COVID-19 pandemic continues to cause a reduction of marketing, event and travel costs, such as costs for our annual sales kick-off, which was held virtually in the first quarter of 2021. In the future we will continue to invest in our organization and
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infrastructure and will resume hosting our world-class partner events in-person when it is safe to do so, as we grow and innovate along with our MSP partners.
Our future capital requirements will depend on several factors, including but not limited to, our subscription revenue growth rate and the need to invest in our Datto Cloud infrastructure to support such growth, the timing of cash receipts and payments, the timing and extent of spending to support research and development, the pace of expansion of sales and marketing activities, including in international markets, the level of investment in back-office infrastructure, the cost to operate as a publicly listed company and the amount of our outstanding indebtedness. In the future, we may also enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights.

We may be required to seek additional equity or debt financing to meet our future capital requirements. In the event additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital or generate cash flows necessary to fund the expansion of our operations and invest in new technologies, this could reduce our ability to compete successfully and harm our results of operations.

Credit Facilities

Our 2020 Credit Agreement provides for an initial $200.0 million in commitments for revolving credit loans, which may be increased or decreased under specific circumstances, with a $40.0 million letter of credit sublimit and a $100.0 million alternative currency sublimit (the “2020 Revolving Credit Facility”). In addition, the 2020 Credit Agreement provides for the ability to request incremental term loan facilities. Borrowings pursuant to the 2020 Credit Agreement may be used for working capital and other general corporate purposes, including for acquisitions permitted under the 2020 Credit Agreement. Borrowings under the 2020 Credit Agreement are scheduled to mature on October 23, 2025. The 2020 Credit Agreement contains certain customary representations and warranties, covenants and restrictions.

The 2020 Revolving Credit Facility was undrawn as of September 30, 2021, with the exception of $1.9 million of capacity which was being used to backstop outstanding letters of credit.

Cash Flows

The following table presents a summary of our condensed consolidated cash flows from operating, investing and financing activities for the periods indicated.
 
 Nine Months Ended September 30,
 20212020
 (in thousands)
Net cash provided by operating activities$99,109 $74,055 
Net cash used in investing activities(77,656)(32,890)
Net cash provided by financing activities16,082 29,099 

Operating Activities

For the nine months ended September 30, 2021, net cash provided by operating activities was $99.1 million, which resulted from net income of $45.7 million, adjusted for non-cash charges of $91.3 million and net cash outflow of $37.9 million
from changes in operating assets and liabilities. Non-cash charges primarily consisted of depreciation and amortization expense of $43.3 million, stock-based compensation expense of $35.4 million, non-cash operating lease expense of $5.3 million, deferred income tax expense of $4.7 million and provision for bad debt of $2.6 million. The net cash outflow from changes in operating assets and liabilities was primarily driven by an increase in inventory of $18.0 million, as we have increased purchases to guard against possible supply chain disruptions resulting from the COVID-19 pandemic, an increase in other assets of $16.7 million driven by deferred contract acquisition costs, an increase in prepaid expenses and other current assets of $5.5 million, partially offset by an increase in accounts payable, accrued expenses and other of $2.9 million primarily resulting from the timing of payments.

For the nine months ended September 30, 2020, net cash provided by operating activities was $74.1 million, which resulted from net income of $29.7 million, adjusted for non-cash charges of $57.4 million and net cash outflow of $13.0 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of depreciation and amortization expense
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of $36.3 million, deferred income taxes of $7.6 million, stock-based compensation expense of $6.6 million and provision for bad debt of $4.8 million. The net cash outflow from changes in operating assets and liabilities was primarily driven by an increase in other assets of $8.4 million driven by deferred contract acquisition costs and an increase in inventory of $6.3 million, as we have increased purchases to guard against possible supply chain disruptions resulting from the COVID-19 pandemic. We elected to defer payment of our obligation for social security tax for the remainder of 2020 as provided in the CARES Act, resulting in a reduction in cash outflows of $4.1 million during the nine months ended September 30, 2020.

Investing Activities

Cash used in investing activities was $77.7 million during the nine months ended September 30, 2021, including $45.5 million, net of cash acquired, for the acquisition of BitDam Ltd., and capital expenditures of $32.2 million, primarily related to our investment in servers for our Datto Cloud infrastructure to support our overall subscription growth as well as investments in the development of our cloud-based platforms to serve our partners. We also purchased computer equipment to support our increased workforce.

Cash used in investing activities was $32.9 million during the nine months ended September 30, 2020, including $28.5 million of capital expenditures, primarily related to our investment in servers for our Datto Cloud infrastructure to support our overall subscription growth. In addition, we incurred expenses for leasehold improvements and furniture and fixtures to expand and update certain offices and purchased computer equipment to support our increased workforce. In July 2020, we paid $4.4 million to acquire two affiliated Australian entities, Gluh Pty Ltd and Keystone Software Holdings Pty Ltd.

Financing Activities

Cash provided by financing activities was $16.1 million during the nine months ended September 30, 2021, reflecting the proceeds from stock option exercises of $16.8 million, partially offset by the payment of capitalized transaction costs related to our IPO of $0.7 million.

Cash provided by financing activities was $29.1 million during the nine months ended September 30, 2020, reflecting proceeds from our Revolving Credit Facility of $32.1 million and proceeds from stock option exercises of $2.5 million, partially offset by the scheduled amortization payments of our Term Loan Facility of $4.1 million and principal payments under various capital lease arrangements, as well as the payment of capitalized transaction costs related to our IPO of $1.0 million.

Contractual Obligations and Commitments

Our principal commitments consist of obligations under operating leases for office space, co-located data center contracts and credit facilities, to the extent we have outstanding debt. In “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” included in the 2020 Annual Report on Form 10-K filed with the SEC on March 11, 2021 we disclosed our total contractual obligations as of December 31, 2020. There have been no material changes to our contractual obligations since December 31, 2020.

Impact of Inflation

While inflation may impact our net revenues, costs of revenues and operating expenses, we believe the effects of inflation, if any, on our results of operations and financial condition have not been significant. However, there can be no assurance that our results of operations and financial condition will not be materially impacted by inflation in the future, including inflation as a result of the COVID-19 pandemic.

Indemnification Agreements

In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify MSP partners, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, services to be provided by us or from intellectual property infringement claims made by third parties. No indemnification claims have been made under such agreements and there are no potential indemnification claims that we are aware of that could have a material effect on our condensed consolidated financial statements. In connection with the IPO, we entered into indemnification agreements with our directors and certain officers and employees that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees.

Off-Balance Sheet Arrangements
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We did not have any material off-balance sheet arrangements as of September 30, 2021.

JOBS Act

We currently qualify as an “emerging growth company” ("EGC") pursuant to the provisions of the JOBS Act. For as long as we are an “emerging growth company,” we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies,” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, exemptions from the requirements of holding shareholder advisory “say-on-pay” votes on executive compensation and shareholder advisory votes on golden parachute compensation.

The JOBS Act also permits an emerging growth company like us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We have elected to “opt-in” to this extended transition period for complying with new or revised accounting standards and, therefore, we will not be subject to the same new or revised accounting standards as other public companies that comply with such new or revised accounting standards on a non-delayed basis.

On June 30, 2021, the last day of our second fiscal quarter in 2021, the market value of our common equity held by non-affiliates exceeded $700 million. Accordingly, we will be deemed a large accelerated filer as of December 31, 2021, and will no longer qualify as an EGC with the ability to take advantage of the extended transition period to comply with new or revised accounting standards.

Critical Accounting Policies

Our condensed consolidated financial statements and accompanying notes have been prepared in accordance with U.S. GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

We adopted the provisions of ASU 2016-02, Leases (Topic 842) as of January 1, 2021, which requires the recording of right of use assets and associated lease liabilities. See Note 2. Significant Accounting Policies and Note 6. Leases to our condensed consolidated financial statements included in Part 1, Item 1 of this Quarterly Report on Form 10-Q for further discussion. For additional information about our critical accounting policies and estimates, see the disclosures included in the Form 10-K as well as Note 1. Business and Note 2. Significant Accounting Policies to the condensed consolidated financial statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q.

Recent Accounting Pronouncements

For a description of our recently adopted accounting pronouncements and accounting pronouncements issued but not yet adopted, see Note 2. Significant Accounting Policies, to our condensed consolidated financial statements included in Part 1, Item 1 of this Quarterly Report on Form 10-Q.

ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our financial position because of adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of exposure to potential changes in inflation, foreign exchange rates or interest rates, to the extent we have outstanding debt. We do not hold financial instruments for trading purposes.

Foreign Currency Exchange Risk

The functional currencies of our foreign subsidiaries are the respective local currencies. Most of our revenues and operating expenses are denominated in the currencies of the countries in which our operations are located, which are primarily in the United States, United Kingdom and Europe, although we do have certain arrangements in which we invoice in a non-
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functional currency, based upon the location of the partner. Our condensed consolidated results of operations and cash flows are, therefore, subject to fluctuations resulting from changes in foreign currency exchange rates and may be adversely affected in the future because of changes in foreign exchange rates. In addition, we maintain cash balances in foreign currencies, which are also subject to foreign currency exchange risk. To date, we have not entered into any hedging arrangements or other derivative financial instruments with respect to foreign currency risk. During the nine months ended September 30, 2021, a hypothetical 10% change in foreign currency exchange rates applicable to our business would not have had a material impact on our condensed consolidated financial statements.

Interest Rate Risk
At September 30, 2021, we had no outstanding borrowings under the 2020 Credit Agreement. To the extent we incur borrowings, our primary interest rate risk is from changes in the Prime Rate, the Federal Funds Effective Rate or LIBO Rate (and the LIBOR Successor Rate)-based interest rates. Interest rate risk is sensitive to many factors, including U.S. monetary and tax policies, U.S. and international economic factors and other factors beyond our control.

ITEM 4.     CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act), that are designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported accurately and within the time periods specified in the SEC’s rules and forms.
Disclosure controls and procedures include, without limitation, controls and procedures designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, accurately and within a reasonable time period to allow for timely decisions regarding required disclosure.

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2021, the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of September 30, 2021 because of the material weakness in internal control over financial reporting discussed below.

Notwithstanding the material weakness in internal control over financial reporting described below, our management has concluded that our condensed consolidated financial statements included in this Quarterly Report on Form 10-Q are fairly stated in all material respects in accordance with accounting principles generally accepted in the United States of America.

Material Weakness
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.

As disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as filed with the SEC on March 11, 2021, we have identified a material weakness in our internal control over the financial statement close process related to deficiencies in information technology general controls and process level controls. These control deficiencies could result in a misstatement of our accounts or disclosures that could result in a material misstatement of our financial results that would not be prevented or detected, and accordingly, we determined that these control deficiencies constitute a material weakness.

Remediation Plan

We have developed a detailed plan for compliance with Section 404 of the Sarbanes-Oxley Act, including developing and maintaining appropriate information technology general controls and process level controls. While we have performed certain remediation activities to strengthen our controls, control weaknesses are not considered remediated until new internal controls have been operational for a period of time, are tested, and management concludes that these controls are operating effectively. We will continue to monitor the effectiveness of our remediation measures in connection with our future assessments of the
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effectiveness of internal control over financial reporting and disclosure controls and procedures, and we will make any changes to the design of our plan and take such other actions that we deem appropriate given the circumstances. We expect to complete the remediation process by the end of the fourth quarter of 2021.

Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the fiscal quarter ended September 30, 2021 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. We are continuing to take steps to remediate the material weakness in our internal control over financial reporting, as discussed above.

Inherent Limitation on the Effectiveness of Internal Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, and not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected.
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PART II. OTHER INFORMATION
ITEM 1.     LEGAL PROCEEDINGS
From time to time, we may become involved in various legal proceedings and claims arising in the ordinary course of business. We do not believe that we are a party to any legal proceeding that, if determined adversely to us, would individually or taken together have a material adverse effect on our business, operating results, financial condition, or cash flows.

ITEM 1A.     RISK FACTORS
There have been no material changes to the risk factors disclosed in the section entitled “Risk Factors” in the Annual Report on Form 10-K filed with the SEC on March 11, 2021 except as noted in the Quarterly Reports on Form 10-Q filed periodically with the SEC.

ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.

ITEM 3.     DEFAULTS UPON SENIOR SECURITIES.
None.

ITEM 4.     MINE SAFETY DISCLOSURES.
Not applicable.

ITEM 5.     OTHER INFORMATION.
None.

















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ITEM 6.     EXHIBITS. 
Exhibit No.    Description of Exhibit
31.1
31.2
32.1+
32.2+
101.INSXBRL Instance Document
101.SCHXBRL Taxonomy Extension Schema Document
101.CALXBRL Taxonomy Extension Calculation Linkbase Document
101.LABXBRL Taxonomy Extension Label Linkbase Document
101.PREXBRL Taxonomy Extension Presentation Linkbase Document
101.DEFXBRL Taxonomy Extension Definition Linkbase Document
104Cover Page Interactive Data File: the cover page XBRL tags are embedded within the Inline XBRL document and are contained within Exhibit 101.

*Indicates a management contract or compensatory plan or arrangement.
+
The certifications furnished in Exhibit 32.1 and Exhibit 32.2 hereto are deemed to accompany this Quarterly Report on Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that the registrant specifically incorporates it by reference.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized on November 10, 2021.
 
Datto Holding Corp.
By:  /s/ John Abbot
Name:  John Abbot
Title:  Chief Financial Officer
(Principal Financial Officer)

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