Butterfly Network Inc.

02/27/2026 | Press release | Distributed by Public on 02/27/2026 07:05

Annual Report for Fiscal Year Ending December 31, 2025 (Form 10-K)

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of the financial condition and results of operations should be read in conjunction with the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements reflecting our current expectations, estimates and assumptions concerning events and financial trends that may affect our future operating results or financial position. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in the sections entitled "Risk Factors" and "Cautionary Statement Regarding Forward-Looking Statements" appearing elsewhere in this Annual Report on Form 10-K.
Overview
We are an innovative digital health business transforming care through a unique combination of portable, semiconductor-based ultrasound technology, intuitive software, services, and educational offerings that can make medical imaging more accessible than ever before. Butterfly's solution enables the practical application of ultrasound information into the clinical workflow through affordable hardware that fits in a healthcare professional's pocket and is paired with cloud-connected software that is easily accessed through a mobile application.
Butterfly developed ultrasound devices that can perform whole-body imaging in a single handheld probe because they are powered by our proprietary semiconductor technology instead of piezoelectric crystals. Our Ultrasound-on-Chip™ makes ultrasound more accessible outside of large healthcare institutions, while our software is intended to make the product easy to use, fully integrated with the clinical workflow, and accessible on a user's smartphone, tablet, and almost any hospital computer system connected to the Internet. We aim to enable the delivery of imaging information anywhere at point-of-care to drive earlier detection throughout the body and remote management of health conditions. We market and sell the Butterfly system, which includes probes, related accessories, and software subscriptions, to healthcare systems, physicians, and healthcare providers through a direct sales force, distributors, and our eCommerce channel. We also license our
proprietary Ultrasound-on-Chip™ semiconductor platform for co-development of novel technologies in non-competitive markets through a program called Butterfly Embedded™.
Key Performance Measures
We review the key performance measures discussed below to evaluate the business and measure performance, identify trends, formulate plans, and make strategic decisions. Our key performance measures may fluctuate over time as the adoption of our devices increases, which may shift the revenue mix more toward software and other services.
Units fulfilled
We define units fulfilled as the number of devices whereby control is transferred to a customer. We do not adjust this measure for returns as our volume of returns has historically been low. We view units fulfilled as a key indicator of the growth of our business. We believe that this measure is useful to investors because it presents our core growth and performance of our business period over period.
Units fulfilled increased by 1,792, or 9.1%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. The increase was driven by higher probe sales volume in our US and veterinary sales channels.
Software and other services mix
We define software and other services mix as a percentage of our total revenue recognized in a reporting period that is based on software subscriptions and other related services, consisting primarily of our software as a service ("SaaS") offering. We view software and other services mix as a key indicator of the profitability of our business, and thus we believe that this measure is useful to investors.
Software and other services mix increased by 1.1 percentage points, to 35.0%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. This increase was primarily driven by increases in software subscription revenue from our Butterfly Embedded™ partnerships.
Description of Certain Components of Financial Data
Revenue
Revenue consists of revenue from the sale of products, such as medical devices, accessories, and semiconductor chips, and the sale of software and other services. Our software and related service offerings include SaaS subscriptions, product support and maintenance ("Support"), software development kits ("SDKs") which may be perpetual or term-based, and partnership support services. SaaS subscriptions include licenses for teams and individuals as well as enterprise-level subscriptions. For sales of products and perpetual SDKs, revenue is recognized at a point in time upon transfer of control to the customer. SaaS subscriptions, Support, and term-based SDKs are generally related to stand-ready obligations and are recognized ratably over time.
Over time, as adoption of our devices increases through further market penetration, as practitioners in the Butterfly network continue to use our devices, and as our Butterfly Embedded™ collaborations continue to grow and develop, we expect our annual revenue mix to shift more toward software and other services. The quarterly revenue mix may be impacted by the timing of device sales.
To date, we have invested in building out our commercial footprint, with the ultimate goal of growing adoption at large-scale healthcare systems and driving awareness of the usability of ultrasound. As we expand our healthcare system software offerings and develop relationships with larger healthcare systems, we continue to expect a higher proportion of our sales in healthcare systems compared to eCommerce.
Cost of revenue
Cost of product revenue consists of product costs including manufacturing costs, personnel costs and benefits, inbound freight, packaging, warranty replacement costs, royalty fees for licensed intellectual property, payment processing fees, and inventory obsolescence and write-offs. We expect our cost of product revenue to fluctuate over time due to the level of units fulfilled in any given period and fluctuate as a percentage of product revenue over time as our focus on operational efficiencies in our supply chain may be offset by increased prices of certain inventory components.
Cost of software and other services revenue consists of personnel costs, cloud hosting costs and payment processing fees. Because the costs and associated expenses to deliver our SaaS offerings are less than the costs and associated expenses of manufacturing and selling our devices, we anticipate an improvement in profitability and margin expansion over time as our revenue mix shifts increasingly towards software and other services. We plan to continue to invest additional resources
to expand and further develop our SaaS and other service offerings which will be reflected in cost of revenue as amortization expense.
Research and development
Research and development expenses primarily consist of personnel costs and benefits, professional services, facilities-related expenses and depreciation, fabrication services, and software costs. Most of our research and development expenses are related to developing new products and services that have not reached the point of commercialization and improving our products and services that have been commercialized. Fabrication services include certain third-party engineering costs, product testing, and test boards. Research and development expenses are expensed as incurred. We expect to continue to make substantial investments in our product and software development, clinical, and regulatory capabilities.
Sales and marketing
Sales and marketing expenses primarily consist of personnel costs and benefits, advertising, conferences and events, facilities-related expenses, and software costs. We expect to increase our investments in our commercial capabilities.
General and administrative
General and administrative expenses primarily consist of personnel costs and benefits, insurance, patent fees, software costs, facilities-related expenses, and outside services. Outside services consist of professional services, legal fees and other professional fees.
Other
Operating expenses classified as other are expenses which we do not consider representative of our ongoing operations. These other expenses primarily consist of employee severance and benefits costs related to reductions in force, business transformation initiatives, litigation costs, and legal settlements.
Results of Operations
We operate as a single reportable segment to reflect the way our chief operating decision maker reviews and assesses the performance of the business. The accounting policies are described in Note 2 "Summary of Significant Accounting Policies" in our consolidated financial statements included in this Annual Report on Form 10-K.
Year ended December 31,
2025 2024 2023
(in thousands)
Dollars
% of total revenue
Dollars
% of total revenue
Dollars
% of total revenue
Revenue:
Product $ 63,443 65.0 % $ 54,200 66.1 % $ 40,036 60.8 %
Software and other services 34,167 35.0 27,856 33.9 25,864 39.2
Total revenue 97,610 100.0 82,056 100.0 65,900 100.0
Cost of revenue:
Product 44,065 45.1 24,380 29.7 40,655 61.7
Software and other services 7,811 8.0 8,845 10.8 8,389 12.7
Total cost of revenue 51,876 53.1 33,225 40.5 49,044 74.4
Gross profit 45,734 46.9 48,831 59.5 16,856 25.6
Operating expenses:
Research and development 36,262 37.1 37,800 46.1 55,616 84.4
Sales and marketing 45,876 47.0 41,567 50.7 39,073 59.3
General and administrative 39,235 40.2 39,810 48.5 49,613 75.3
Other 10,776 11.0 4,065 5.0 18,164 27.6
Total operating expenses 132,149 135.4 123,242 150.2 162,466 246.5
Loss from operations (86,415) (88.5) (74,411) (90.7) (145,610) (221.0)
Interest income 5,911 6.1 5,020 6.1 7,450 11.3
Interest expense (1,490) (1.5) (1,261) (1.5) - -
Change in fair value of warrant liabilities 2,272 2.3 (1,859) (2.3) 4,544 6.9
Other income (expense), net 2,768 2.8 (13) 0.0 (2) 0.0
Loss before provision for income taxes (76,954) (78.8) (72,524) (88.4) (133,618) (202.8)
Provision (benefit) for income taxes 110 0.1 (32) 0.0 82 0.1
Net loss and comprehensive loss $ (77,064) (79.0) % $ (72,492) (88.3) % $ (133,700) (202.9) %
Comparison of the Years Ended December 31, 2025 and 2024
Revenue
Year ended December 31,
(in thousands) 2025 2024 Change % Change
Product $ 63,443 $ 54,200 $ 9,243 17.1 %
Software and other services 34,167 27,856 6,311 22.7
$ 97,610 $ 82,056 $ 15,554 19.0 %
Product revenue increased by $9.2 million, or 17.1%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. This increase was primarily driven by both our increased sales volume and the impact of the higher selling price of our iQ3 probe, which launched in the US during the first quarter of 2024 and internationally during the third quarter of 2024, and our iQ3 Vet probe, which launched in the US and some international markets during the fourth quarter of 2025. Our product revenue also benefited from deliveries of semiconductor chips to one of our Butterfly Embedded™ partners in the current year.
Software and other services revenue increased by $6.3 million, or 22.7%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. This increase was primarily driven by increases in licensing revenue from our Butterfly Embedded™ partnerships.
Cost of revenue
Year ended December 31,
(in thousands) 2025 2024 Change % Change
Product $ 44,065 $ 24,380 $ 19,685 80.7 %
Software and other services 7,811 8,845 (1,034) (11.7)
$ 51,876 $ 33,225 $ 18,651 56.1 %
Percentage of revenue 53.1 % 40.5 %
Cost of product revenue increased by $19.7 million, or 80.7%, for the year ended December 31, 2025 compared to the year ended December 31, 2024, primarily driven by a non-recurring $17.4 million charge during the year ended December 31, 2025 for excess and obsolete inventory due to technological advancements in the underlying components of our devices and changes in our product portfolio. Additionally, the increased volume of probe sales during the year ended December 31, 2025 compared to the year ended December 31, 2024 resulted in a $1.8 million increase in cost of product revenue.
Cost of software and other services revenue decreased by $1.0 million, or 11.7%, for the year ended December 31, 2025 compared to the year ended December 31, 2024, primarily driven by a $2.1 million decrease in amortization expense for software development investments that we made in prior years, partially offset by a $1.0 million increase in costs related to specialized development activities for our Butterfly Embedded™ partners.
Cost of revenue as a percentage of revenue increased from 40.5% to 53.1% for the year ended December 31, 2025 compared to the year ended December 31, 2024, primarily due to the $17.4 million excess and obsolete inventory charge, which is 17.8% as a percentage of total revenue for the year ended December 31, 2025.
Research and development
Year ended December 31,
(in thousands) 2025 2024 Change % Change
Research and development $ 36,262 $ 37,800 $ (1,538) (4.1) %
Percentage of revenue 37.1 % 46.1 %
Research and development expenses decreased by $1.5 million, or 4.1%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. This decrease was primarily driven by a reduction of $2.4 million in personnel and other employment-related costs, due in part to our increased utilization of personnel in lower-cost geographies, as well as a reduction of $0.4 million in product engineering costs as we approach the completion of development for our next-generation technology. These reductions were partially offset by an increase of $1.4 million in professional services costs for software development and regulatory compliance.
Sales and marketing
Year ended December 31,
(in thousands) 2025 2024 Change % Change
Sales and marketing $ 45,876 $ 41,567 $ 4,309 10.4 %
Percentage of revenue 47.0 % 50.7 %
Sales and marketing expenses increased by $4.3 million, or 10.4%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. This increase was primarily driven by $3.3 million of higher personnel and other employment-related costs and $0.2 million of higher professional services costs, both resulting from investments in our sales force and client experience function in order to support continued revenue growth. Additionally, as our units fulfilled increased, we had $0.3 million of higher shipping and logistics costs.
General and administrative
Year ended December 31,
(in thousands) 2025 2024 Change % Change
General and administrative $ 39,235 $ 39,810 $ (575) (1.4) %
Percentage of revenue 40.2 % 48.5 %
General and administrative expenses decreased by $0.6 million, or 1.4%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. This decrease was primarily driven by reductions of $0.6 million in insurance costs and $0.3 million in credit loss expense.
Other
Year ended December 31,
(in thousands) 2025 2024 Change % Change
Other $ 10,776 $ 4,065 $ 6,711 165.1 %
Percentage of revenue 11.0 % 5.0 %
Other increased by $6.7 million for the year ended December 31, 2025 compared to the year ended December 31, 2024. This increase was driven by $7.1 million of higher legal costs due to litigation, including the $3.0 million accrued loss contingency recognized in 2025, partially offset by $0.4 million of lower employment-related costs. These costs are not representative of our ongoing operations.
Comparison of the Years Ended December 31, 2024 and 2023
Revenue
Year ended December 31,
(in thousands) 2024 2023 Change % Change
Product $ 54,200 $ 40,036 $ 14,164 35.4 %
Software and other services 27,856 25,864 1,992 7.7
$ 82,056 $ 65,900 $ 16,156 24.5 %
Product revenue increased by $14.2 million, or 35.4%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. This increase was primarily driven by higher product revenue across nearly all sales channels, from both volume and the impact of our iQ3 probe's higher selling price. The increase in product revenue was negatively impacted by two large grant-based deployments to medical schools that occurred in the prior year and did not repeat in 2024. Excluding the prior-year large medical school deployments, product revenue increased 44.4% for the year ended December 31, 2024 compared to the year ended December 31, 2023.
Software and other services revenue increased by $2.0 million, or 7.7%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. This increase was primarily driven by higher enterprise software revenue and increased licensing revenue from our Butterfly Embedded™ partnerships, partially offset by lower renewals of individual subscriptions. Enterprise as a percentage of software revenue increased by approximately 5 percentage points year-over-year.
Cost of revenue
Year ended December 31,
(in thousands) 2024 2023 Change % Change
Product $ 24,380 $ 40,655 $ (16,275) (40.0) %
Software and other services 8,845 8,389 456 5.4
$ 33,225 $ 49,044 $ (15,819) (32.3) %
Percentage of revenue 40.5 % 74.4 %
Cost of product revenue decreased by $16.3 million, or 40.0%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. This decrease was primarily driven by the non-recurrence of a $21.1 million loss on excess inventory in 2023 related to inventory on-hand that was deemed excess. Excluding this loss, prior year cost of product revenue was $19.6 million, and cost of product revenue increased in 2024 due to higher probe sales volume in 2024 resulting in increased costs of $4.1 million. In addition, in 2024 we experienced higher warranty costs resulting from an increase in our standard warranty.
Cost of software and other services revenue increased by $0.5 million, or 5.4%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. This increase was primarily driven by higher software amortization expenses but was partially offset by lower cloud hosting costs.
Research and development
Year ended December 31,
(in thousands) 2024 2023 Change % Change
Research and development $ 37,800 $ 55,616 $ (17,816) (32.0) %
Percentage of revenue 46.1 % 84.4 %
Research and development expenses decreased by $17.8 million, or 32.0%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. This decrease was primarily driven by reductions of $11.9 million in personnel costs resulting from our business transformation initiative in 2024 to optimize our non-specialized technical functions as well as the reductions in force carried out in 2023. Additional reductions of $3.2 million in facilities and software costs and $1.9 million in product development costs are largely attributable to increased efficiencies resulting from optimization efforts.
Sales and marketing
Year ended December 31,
(in thousands) 2024 2023 Change % Change
Sales and marketing $ 41,567 $ 39,073 $ 2,494 6.4 %
Percentage of revenue 50.7 % 59.3 %
Sales and marketing expenses increased by $2.5 million, or 6.4%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. This increase was primarily driven by $1.8 million of higher personnel costs and $1.4 million of higher marketing and event expenses, resulting from investments in our sales force and marketing functions in order to support the growth associated with the launch of the iQ3 probe. These increased costs were partially offset by a $0.6 million reduction in facilities and software costs.
General and administrative
Year ended December 31,
(in thousands) 2024 2023 Change % Change
General and administrative $ 39,810 $ 49,613 $ (9,803) (19.8) %
Percentage of revenue 48.5 % 75.3 %
General and administrative expenses decreased by $9.8 million, or 19.8%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. This decrease was primarily driven by reductions of $6.2 million in personnel costs resulting from our reductions in force carried out in 2023, $2.7 million in professional service fees for legal and other administrative services, and $1.5 million in insurance costs.
Other
Year ended December 31,
(in thousands) 2024 2023 Change % Change
Other $ 4,065 $ 18,164 $ (14,099) (77.6) %
Percentage of revenue 5.0 % 27.6 %
Other decreased by $14.1 million for the year ended December 31, 2024 compared to the year ended December 31, 2023. This decrease was primarily driven by reductions of $7.4 million of employee severance and benefits costs related to our reductions in force carried out in 2023 and $6.8 million in legal costs due to litigation and other legal matters. These costs are not representative of our ongoing operations.
Liquidity and Capital Resources
Since our inception, our primary sources of liquidity are cash flows from operations and proceeds from stock issuances and the Business Combination. Our primary uses of liquidity are operating expenses, working capital requirements, and capital expenditures.
On January 31, 2025, we raised $81.0 million, net of underwriting costs and related expenses, through the issuance and sale in a public offering of 27.6 million shares of our Class A common stock. Excluding this public offering, during the year ended December 31, 2025, the Company utilized $19.3 million of cash and cash equivalents. As of December 31, 2025, our cash and cash equivalents balance was $150.5 million. Our future spending will depend on various factors, including our rate of revenue growth and the timing and extent of spending on strategic business initiatives. We expect that our existing cash and cash flows from operations will be sufficient to meet our liquidity, capital expenditure, and anticipated working capital requirements and fund our operations for at least the next 12 months.
As of December 31, 2025, we have restricted cash of $4.0 million to secure a letter of credit for one of our leases, which is expected to be maintained as a security deposit for the duration of the lease.
Our material cash requirements include contractual obligations with third parties for office leases, technology licensing agreements, inventory supply agreements, and outsourced services. Our fixed office lease payment obligations were $24.3 million as of December 31, 2025, with $3.7 million payable within the next 12 months. Our fixed technology license payment obligations were $10.5 million as of December 31, 2025, with $1.5 million payable within the next 12 months. Our fixed purchase obligations for inventory supply agreements, net of vendor advances, were $4.2 million as of December 31, 2025, all of which is payable within the next 12 months. Our fixed outsourced services payment obligations were $4.1 million as of December 31, 2025, with $1.4 million payable within the next 12 months.
As of December 31, 2025, we had no obligations, assets or liabilities, which would be considered off-balance sheet arrangements.
Cash Flows
The following table summarizes our sources and uses of cash for the years ended December 31, 2025, 2024 and 2023:
Year ended December 31,
(in thousands) 2025 2024 2023
Net cash used in operating activities $ (12,700) $ (41,707) $ (98,820)
Net cash provided by (used in) investing activities (3,348) (2,658) 70,414
Net cash provided by (used in) financing activities 77,762 (1,495) 228
Net increase (decrease) in cash, cash equivalents, and restricted cash $ 61,714 $ (45,860) $ (28,178)
Comparison of the period for the years ended December 31, 2025 and 2024
Net cash used in operating activities
Net cash used in operating activities represents the cash receipts and disbursements related to our activities other than investing and financing activities. We expect cash provided by historical financing activities will continue to be our primary source of funds to support operating needs and capital expenditures for the foreseeable future.
Net cash used in operating activities decreased by $29.0 million, or 69.5%, for the year ended December 31, 2025 compared to the year ended December 31, 2024. The decrease was comprised of improvements of $8.9 million in net loss adjusted for certain non-cash items and $20.1 million in net working capital cash usage. The improvement in net working capital cash usage was primarily driven by a $12.4 million improvement in cash provided by changes in deferred revenue, a $5.6 million improvement in cash provided by changes in our inventory and the related vendor advances, a $3.3 million improvement in cash provided by changes in accounts payable and accrued expenses, and a $1.8 million improvement in cash used for changes in accounts receivable. These improvements were partially offset by a $2.9 million increase in cash used for changes in prepaid expenses and other assets.
Net cash used in investing activities
Net cash used in investing activities increased by $0.7 million for the year ended December 31, 2025 compared to the year ended December 31, 2024, primarily due to increased purchases of fixed assets.
Net cash provided by (used in) financing activities
Net cash provided by (used in) financing activities increased by $79.3 million for the year ended December 31, 2025 compared to the year ended December 31, 2024. This increase was primarily comprised of $81.0 million provided by the net proceeds from the public share offering in January 2025.
Comparison of the period for the years ended December 31, 2024 and 2023
Net cash used in operating activities
Net cash used in operating activities represents the cash receipts and disbursements related to our activities other than investing and financing activities. We expect cash provided by historical financing activities will continue to be our primary source of funds to support operating needs and capital expenditures for the foreseeable future.
Net cash used in operating activities decreased by $57.1 million, or 57.8%, for the year ended December 31, 2024 compared to the year ended December 31, 2023. The decrease was comprised of improvements of $61.2 million in net loss and $15.3 million in net working capital cash usage. These improvements were partially offset by a decrease in noncash adjustments that resulted in $19.4 million less in add-backs to net loss, largely due to the $21.1 million write-down of inventories in 2023 that didn't recur in 2024. The decrease in net working capital cash usage was driven by reductions of $18.8 million in cash used for changes in our inventory and the related vendor advances and accrued purchase commitments and $8.4 million in cash used for changes in accounts payable and accrued expenses. These reductions were partially offset by an $8.3 million increase in cash used for changes in accounts receivable, a $1.8 million decrease in cash provided by changes in deferred revenue, and a $1.7 million decrease in cash provided by changes in prepaid expenses and other assets.
Net cash provided by (used in) investing activities
Net cash provided by (used in) investing activities decreased by $73.1 million for the year ended December 31, 2024 compared to the year ended December 31, 2023. The decrease was primarily due to the sale of our marketable securities in 2023.
Net cash provided by (used in) financing activities
Net cash provided by (used in) financing activities decreased by $1.7 million for the year ended December 31, 2024 compared to the year ended December 31, 2023. The decrease was primarily due to $2.0 million of payments made in
connection with financing activities in 2024 that did not occur in 2023, partially offset by $0.5 million of proceeds from our employee stock purchase plan that began in 2024.
Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The process of preparing financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expense during the period. We base our assumptions, judgments, and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. We evaluate our assumptions, judgments, and estimates on a regular basis. Historically, our assumptions, judgments, and estimates relative to our critical accounting policies have not differed materially from actual results.
While our significant accounting policies are described in more detail in Note 2 "Summary of Significant Accounting Policies" in our consolidated financial statements, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our financial statements.
Revenue recognition
We generate revenue from the sale of products and software and other services. Our contracts with customers often include multiple performance obligations. Generally, we have identified the following performance obligations can be promised in our contracts with customers:
•Hardware devices and accessories;
•Software subscriptions, including renewal subscriptions, which represent an obligation to provide the customer with ongoing access to our cloud-hosted software applications on a continuous basis throughout the subscription period;
•Out-licensing arrangements of our intellectual property for novel technologies in non-competitive markets and related research and development services;
•Implementation and integration services;
•Extended warranties; and
•SDKs, either perpetual or term-based.
Transaction price is allocated to all identified performance obligations based on relative standalone selling prices of the underlying goods or services. Each sale of a hardware device, accessory, or perpetual SDK is a performance obligation satisfied at a point in time when control of the good transfers from us to the customer or when we provide the SDK to the customer. Our software subscriptions and extended warranties are stand-ready obligations that are satisfied over time, and our term-based SDKs are performance obligations satisfied over time through our continued provision of access to the customer. We use the time-elapsed (i.e., straight-line) measure of progress to recognize revenue for these services. Out-licensing arrangements and the related research and development services are performance obligations that are satisfied over time using an input method as progress is made towards key project milestones. Our implementation and integration services are a performance obligation satisfied over time, and we use costs incurred as inputs into the measure of progress to recognize revenue for these services.
We account for the warranty as an assurance-type warranty. When product revenue is recognized, an estimate of future warranty costs is recognized as cost of product revenue and accrued expenses. Factors that affect the estimate of future warranty costs include historical and current product failure rates, service delivery costs incurred in correcting product failures, and warranty policies and business practices.
Our contracts with customers include variable consideration in the form of refunds and credits for product returns and price concessions. We estimate variable consideration based on the individual contract characteristics or may apply a portfolio approach depending on the circumstances.
Stock-based compensation
Our stock-based compensation program includes stock option grants and restricted stock unit ("RSU") grants to our employees, directors, and consultants as well as an employee stock purchase plan ("ESPP"). Stock options are granted at exercise prices not less than the fair market value ("FMV") of our common stock on the grant date. The ESPP sets purchase prices as 85% of the lower of (i) the FMV of the stock on the offering date, or (ii) the FMV of the stock on the purchase date.
The grant date fair values of stock option grants and ESPP options are estimated using a Black-Scholes option-pricing model. Key inputs and assumptions include the underlying stock price, the exercise price, the risk-free interest rate, the expected dividend yield, the expected term of the option, and the expected stock price volatility. Many of the assumptions require significant judgment, and changes in assumptions could have a significant impact in the determination of stock-based compensation expense.
The grant date fair values of time-based and performance-based RSU grants are calculated as the FMV of our common stock on the grant date. The grant date fair values of market-based RSU grants are estimated using a Monte Carlo simulation with similar risk-free interest rate, expected dividend yield, and expected stock price volatility assumptions as those used in estimating the grant date fair value of our stock option grants and ESPP options.
Stock-based compensation expense is generally recognized evenly over the requisite service periods of awards, which is typically three to four years for RSU and stock option grants and typically two years for ESPP options. Stock-based compensation expense for performance-based and market-based RSU grants is generally recognized using the accelerated attribution method. We do not apply a forfeiture rate assumption to our awards.
No related tax benefits of the stock-based compensation expense have been recognized, and no related tax benefits have been realized from the exercise of stock options due to our net operating loss carryforwards.
Inventory and inventory valuation
Inventories are stated at the lower of actual cost, determined using the average cost method, or net realizable value ("NRV"). We routinely evaluate quantities and value of our inventories in light of current market conditions and market trends, and record a write-down against the cost of inventories for NRV below cost. NRV is based upon an estimated average selling price reduced by the estimated costs of completion, disposal, and transportation. The determination of NRV involves numerous judgments including estimating selling prices, existing customer orders, and estimated costs of completion, disposal, and transportation. If actual market conditions differ from our estimates, future results of operations could be materially affected. We reduce the value of our inventory for estimated obsolescence or lack of marketability by the difference between the cost of the affected inventory and the estimated market value.
The valuation of inventory also requires us to estimate excess and obsolete inventory. We periodically review the age, condition and turnover of our inventory to determine whether any inventory has become obsolete or has declined in value, and we incur a charge to operations for known and anticipated inventory obsolescence. We also consider the rate at which new products will be accepted in the marketplace and how quickly customers will transition from older products to newer products, including whether older products can be re-manufactured into new products. The evaluation also takes into consideration new product development schedules, the effect that new products might have on the sale of existing products, product obsolescence, product merchantability, and other factors. Market conditions are subject to change, and, if actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required, which would have a negative impact on gross margin.
Losses expected to arise from firm, non-cancelable, and unhedged commitments for the future purchase of inventory items are recognized unless the losses are recoverable through firm sales contracts or other means. We consider a variety of factors and data points when determining the existence and scope of a loss on the minimum purchase commitment. The factors and data points include Company-specific forecasts which are reliant on our limited sales history, agreement-specific provisions, macroeconomic factors, and market and industry trends. Determining the loss is subjective and requires significant management judgment and estimates. Future events may differ from those assumed in our assessment, and therefore the loss may change in the future.
We capitalize manufacturing overhead expenditures as part of inventory costs. Capitalized costs primarily include management's best estimate and allocation of the direct labor, materials costs, and other overhead costs incurred related to
inventory acquired or produced but not sold during the respective period. Manufacturing overhead costs are capitalized to inventory and are recognized as cost of revenues in future periods based on our rate of inventory turnover.
Recently Adopted Accounting Pronouncements
A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 "Summary of Significant Accounting Policies - Recent Accounting Pronouncements Issued but Not Yet Adopted" to our consolidated financial statements contained in this Annual Report on Form 10-K.
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