Shutterfly, Inc.
Annual Report 2007

Plain-text annual report

2007 ANNUAL REPORTShutterfly, Inc.LETTER TO STOCKHOLDERSwww.shutterfly.comSincerely, Jeff Housenbold, CEODear Shutterfly Stockholder: We are pleased to report performance for 2007. Founded in 1999, Shutterfly leads the markets for social expression and personal publishing with a growing product and services assortment, and an increasing base of highly satisfied customers. Our premium-quality products enable customers to “tell their stories” in unique and memorable ways – through innovative, personalized greeting cards, photo books, designer social stationery, calendars and other photo-based merchandise. Our customer-friendly website and archive policies make it easy for people to upload, share and preserve their memories securely, while our expanding array of collaboration services enables customers to celebrate life events and connect with their social networks of family and friends. 2007: Rapid Growth and Significant Accomplishments2007 was a record year of strong execution, and rapid, profitable growth for Shutterfly. Net revenues and annual Adjusted EBITDA1 increased 51% and 52%, respectively, over 2006. We expanded our award-winning photo book line-up to include new occasion-based design templates (such as Wedding and Baby), new holiday themes (such as Valentine’s Day and Halloween) and we introduced new Sesame Street™ and Dora the Explorer™ books. We also added new holiday card form factors and styles, collage posters and collage calendars, and we enhanced our already broad selection of photo-related merchandise. 2007 revenues from personal products and services increased 69% over 2006, comprising 56% of total revenues. Product innovations will continue in 2008, with a premium line of designer social stationery for birth announcements, invitations, thank you cards and additional new products. We extended awareness of Shutterfly’s premium lifestyle brand as the place to “Tell Your Story,” a tagline introduced with an all-new advertising campaign featuring real customers using Shutterfly to stay connected to family and friends. Strong growth in new customers resulted from targeted marketing and a loyal base of existing customers who evangelize the Shutterfly brand. In 2007, 2.4 million customers transacted with Shutterfly, a 37% increase over 2006, with approximately 74% of revenues coming from existing customers. Their enthusiastic word-of-mouth referrals – along with strategic partnerships with leading retailers and complementary brands, unique advertising and results-driven marketing, and outstanding media coverage by leading consumer publications and television news programs – contributed to Shutterfly’s impressive 2007 results. 2008: Becoming a More Meaningful Part of Our Customers’ LivesWhile still early, we believe that the markets for social expression and personal publishing present an enormous opportunity for Shutterfly. We intend to expand awareness of this category, and to further delight our customers while connecting the Shutterfly brand more meaningfully to their lives. We believe we can achieve our goals by innovating with value-added products and services and a sustained commitment to our corporate objectives. We also intend to increase awareness and trial of Shutterfly by supporting our viral and enthusiastic customer base, and by continuing focused advertising and marketing programs that convey consistent, actionable and compelling messages. In 2008 our investments in innovation will focus on services that enhance our customers’ experience at Shutterfly. We continue to evolve our website to enhance customers’ ability to discover new ways of sharing and preserving their memories. Forexample, newly-launched Shutterfly Gallery showcases our customers’ amazing photo book creations, and inspires people to tell their stories using our photo books, while simplifying the product creation process and stimulating product sales through our “make one like this” feature. Another example is our 2008 acquisition of Nexo Systems, Inc., a simple but sophisticated technology platform for online sharing and collaboration among members of social networks – including school groups, church groups, sports teams and many others. Shutterfly will also continue to drive manufacturing innovations. In 2007, we opened a second production facility in Charlotte, NC and it is performing very well. We believe we continue to benefit from many cost, quality and delivery advantages by controlling our manufacturing processes and technology.Shutterfly is well-positioned for 2008 and beyond. Our target markets are large and expanding, and we have a lengthening track record of strong execution in revenue growth, customer acquisition and retention, and increasing profits. We continue to innovate with new products and services to bind our customers more closely to our premium brand, while we successfully expand overall market awareness, market share and competitive differentiation. In conclusion, I want to extend heartfelt thanks to our employees (and their families) for their enthusiastic commitment to our customers, their tireless energy and their exceptional results. I thank our customers for their passionate evangelism of Shutterfly. On behalf of the entire team at Shutterfly, I thank our stockholders for their continued support of our Company.1Adjusted EBITDA is a non-GAAP financial measure defined as earnings before interest, taxes, depreciation, amortization, cumulative change in accounting principle, stock-based compensation, and a one-time, non-cash charitable contribution of $923,000 in 2006. For complete definitions and reconciliations, please refer to Shutterfly’s SEC filings.2800 Bridge ParkwayRedwood City, CA 94065BBC eBP - File Name: 31983_WO4_F39180_Cvrs.pdf Apr 12, 2008 - Page: 1 of 22007 ANNUAL REPORTShutterfly, Inc.LETTER TO STOCKHOLDERSwww.shutterfly.comSincerely, Jeff Housenbold, CEODear Shutterfly Stockholder: We are pleased to report performance for 2007. Founded in 1999, Shutterfly leads the markets for social expression and personal publishing with a growing product and services assortment, and an increasing base of highly satisfied customers. Our premium-quality products enable customers to “tell their stories” in unique and memorable ways – through innovative, personalized greeting cards, photo books, designer social stationery, calendars and other photo-based merchandise. Our customer-friendly website and archive policies make it easy for people to upload, share and preserve their memories securely, while our expanding array of collaboration services enables customers to celebrate life events and connect with their social networks of family and friends. 2007: Rapid Growth and Significant Accomplishments2007 was a record year of strong execution, and rapid, profitable growth for Shutterfly. Net revenues and annual Adjusted EBITDA1 increased 51% and 52%, respectively, over 2006. We expanded our award-winning photo book line-up to include new occasion-based design templates (such as Wedding and Baby), new holiday themes (such as Valentine’s Day and Halloween) and we introduced new Sesame Street™ and Dora the Explorer™ books. We also added new holiday card form factors and styles, collage posters and collage calendars, and we enhanced our already broad selection of photo-related merchandise. 2007 revenues from personal products and services increased 69% over 2006, comprising 56% of total revenues. Product innovations will continue in 2008, with a premium line of designer social stationery for birth announcements, invitations, thank you cards and additional new products. We extended awareness of Shutterfly’s premium lifestyle brand as the place to “Tell Your Story,” a tagline introduced with an all-new advertising campaign featuring real customers using Shutterfly to stay connected to family and friends. Strong growth in new customers resulted from targeted marketing and a loyal base of existing customers who evangelize the Shutterfly brand. In 2007, 2.4 million customers transacted with Shutterfly, a 37% increase over 2006, with approximately 74% of revenues coming from existing customers. Their enthusiastic word-of-mouth referrals – along with strategic partnerships with leading retailers and complementary brands, unique advertising and results-driven marketing, and outstanding media coverage by leading consumer publications and television news programs – contributed to Shutterfly’s impressive 2007 results. 2008: Becoming a More Meaningful Part of Our Customers’ LivesWhile still early, we believe that the markets for social expression and personal publishing present an enormous opportunity for Shutterfly. We intend to expand awareness of this category, and to further delight our customers while connecting the Shutterfly brand more meaningfully to their lives. We believe we can achieve our goals by innovating with value-added products and services and a sustained commitment to our corporate objectives. We also intend to increase awareness and trial of Shutterfly by supporting our viral and enthusiastic customer base, and by continuing focused advertising and marketing programs that convey consistent, actionable and compelling messages. In 2008 our investments in innovation will focus on services that enhance our customers’ experience at Shutterfly. We continue to evolve our website to enhance customers’ ability to discover new ways of sharing and preserving their memories. Forexample, newly-launched Shutterfly Gallery showcases our customers’ amazing photo book creations, and inspires people to tell their stories using our photo books, while simplifying the product creation process and stimulating product sales through our “make one like this” feature. Another example is our 2008 acquisition of Nexo Systems, Inc., a simple but sophisticated technology platform for online sharing and collaboration among members of social networks – including school groups, church groups, sports teams and many others. Shutterfly will also continue to drive manufacturing innovations. In 2007, we opened a second production facility in Charlotte, NC and it is performing very well. We believe we continue to benefit from many cost, quality and delivery advantages by controlling our manufacturing processes and technology.Shutterfly is well-positioned for 2008 and beyond. Our target markets are large and expanding, and we have a lengthening track record of strong execution in revenue growth, customer acquisition and retention, and increasing profits. We continue to innovate with new products and services to bind our customers more closely to our premium brand, while we successfully expand overall market awareness, market share and competitive differentiation. In conclusion, I want to extend heartfelt thanks to our employees (and their families) for their enthusiastic commitment to our customers, their tireless energy and their exceptional results. I thank our customers for their passionate evangelism of Shutterfly. On behalf of the entire team at Shutterfly, I thank our stockholders for their continued support of our Company.1Adjusted EBITDA is a non-GAAP financial measure defined as earnings before interest, taxes, depreciation, amortization, cumulative change in accounting principle, stock-based compensation, and a one-time, non-cash charitable contribution of $923,000 in 2006. For complete definitions and reconciliations, please refer to Shutterfly’s SEC filings.2800 Bridge ParkwayRedwood City, CA 94065UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 Form 10-K (Mark One) ¥ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2007 n TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to or Commission file number: 001-33031 SHUTTERFLY, INC. (Exact Name of Registrant as Specified in Its Charter) Delaware (State or Other Jurisdiction of Incorporation or Organization) 2800 Bridge Parkway, Suite 101 Redwood City, California (Address of Principal Executive Offices) 94-3330068 (I.R.S. Employer Identification No.) 94065 (Zip Code) Registrant’s telephone number, including area code (650) 610-5200 Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Common Stock, $0.0001 Par Value Per Share Name of Each Exchange on Which Registered Nasdaq Global Market Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes n No ¥ No ¥ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes n 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 n Indicate by check mark if disclosure of delinquent filers pursuant to Rule 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes ¥ No n Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer n Accelerated filer ¥ Smaller reporting company n Non-accelerated filer n (Do not check if a smaller reporting company) Indicate by check mark whether No ¥ Act). Yes n the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange As of June 29, 2007, the last business day of our most recently completed second fiscal quarter, the aggregate market value of our Common Stock held by non-affiliates based on the closing price or our Common Stock on June 29, 2007 as reported on the NASDAQ Global Market was $523,696,054. Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. Class Common stock, $0.0001 par value per share Outstanding at February 29, 2008 25,001,631 shares DOCUMENTS INCORPORATED BY REFERENCE Portions of the documents listed below have been incorporated by reference into the indicated parts of this reports, as specified in the responses to the item numbers involved: Designated portions of the Proxy Statement relating to the 2008 Annual Meeting of the Stockholders to be held on May 22, 2008 (the “Proxy Statement”): Part II (Item 5) and Part III (Items 10, 11, 12, 13 and 14). Except with respect to information specifically incorporated by reference in the Form 10-K, the Proxy Statement is not deemed to be filed as part hereof. Shutterfly, Inc. Table of Contents PART I Page Number ITEM 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 1A. Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 1B. Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 2. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 3. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 4. PART II ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 6. ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk . . . . . . . . . . . . . . . . . . . . . . Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 8. Changes in and Disagreements with Accountants on Accounting and Financial ITEM 9. Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 9A. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 9B. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PART III ITEM 10. Directors, Executive Officers and Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . ITEM 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 13. Certain Relationships and Related Transactions, and Director Independence . . . . . . . . . . Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITEM 14. 1 14 29 29 29 30 30 32 34 47 48 78 78 78 79 79 79 79 79 ITEM 15. Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 PART IV PART I Except for historical financial information contained herein, the matters discussed in this Form 10-K may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and subject to the safe harbor created by the Securities Litigation Reform Act of 1995. Such statements include declarations regarding our intent, belief, or current expectations and those of our management. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks, uncertainties and other factors, some of which are beyond our control; actual results could differ materially from those indicated by such forward-looking statements. Important factors that could cause actual results to differ materially from those indicated by such forward-looking statements include, but are not limited to: (i) that the information is of a preliminary nature and may be subject to further adjustment; (ii) those risks and uncertainties identified under “Risk Factors;” and (iii) the other risks detailed from time-to-time in our reports and registration statements filed with the Securities and Exchange Commission, or SEC. Except as required by law, we undertake no obligation to revise or update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. ITEM 1. BUSINESS. Overview We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities. Today, our primary focus is on helping consumers manage their memories through the powerful medium of photos. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print and preserve their memories in a creative and thoughtful manner. Consumers use our products and services to stay connected to their friends and family, to organize their memories in a single location, to tell stories and to preserve their memories for themselves and their children. Our customers purchase physical products both for their own personal use and for giving thoughtful and personalized gifts such as photo books, calendars, greeting cards and other photo-based products and merchandise. We currently generate the majority of our revenues by producing and selling professionally-bound photo books, personalized calendars, greeting cards, other photo-based merchandise and high-quality prints (ranging in size from wallet-sized to jumbo-sized 20(cid:2)30 enlargements). We manufacture these items in our Hayward, California and Charlotte, North Carolina manufacturing facilities. By controlling the production process in our own manufacturing facilities, we are able to produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. Additionally, we sell a variety of photo-based merchandise that is currently manufactured for us by third parties, such as mugs, mouse pads, coasters, tote bags, desk organizers, puzzles, playing cards, multi-media DVDs, magnets and keepsake boxes, and ancillary products, such as frames, photo albums and scrapbooking accessories. Our high-quality products and services and the compelling online experience we create for our customers, together with our focus on continuous innovation, have earned us numerous third-party accolades and, more importantly, have allowed us to establish a premium brand. We believe that we realize the benefits of a premium brand through high customer loyalty, low customer acquisition costs and premium pricing. Our customers are a central part of our business model. They generate most of the content on our service by uploading their photos and storing their memories. In addition, they share their photos electronically with their friends and families, extending and endorsing our brand and creating a sense of community. Finally, by giving Shutterfly-branded products to colleagues, friends and loved ones throughout the year, customers reinforce the Shutterfly brand. Through these various activities, our customers create a viral network of new users and customers. In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and 1 website presentation to specific customer segments. Consequently, customers are presented with a highly personalized Shutterfly shopping experience, which helps foster a unique and deep relationship with our brand. Our corporation was formed in 1999 and we have experienced rapid growth since launching our service in December 1999. During fiscal year 2007, we fulfilled more than seven million orders, to more than two million customers, at an average order value of more than $26 per order. In June 2005, we completed the acquisition of Memory Matrix, Inc., a Nevada engineering firm dedicated to improving the consumer digital photography experience, in exchange for 109,302 shares of common stock. In June 2007, we acquired for $1.6 million, certain assets and liabilities of CustomAbility, LLC, a New Jersey publishing company that produces customized children’s books under the brand name Make It About Me. On January 4, 2008, for $10.0 million in cash, and stock consideration of approximately $4.0 million, we acquired Nexo Systems, a privately held on-line sharing and group services company based in Palo Alto, California. Vision and Mission Our vision is to make the world a better place by helping people share life’s joy. Our mission is to build an unrivaled service that enables deeper, more personal relationships between our customers and those who matter most in their lives. We believe that people have an intrinsic desire for social expression, as they wish to capture and share their experiences and pass them on to future generations. Since the beginning of humankind, people have shared detailed stories of their lives through visual expression. Today, with the evolution of digital cameras and technology, millions of people around the world are capturing their memories and communicating in deeper, more meaningful ways. We believe people will continue to take pictures of important moments in their lives across various occasions throughout the year, including vacations, weddings, birthdays, anniversaries, graduations, family reunions and holidays. Our products and services make sharing, printing and preserving those memories easy, convenient and fun, and allow for our customers to be more thoughtful and creative with their memories. As our customers share these joyous memories, either digitally through our sharing service or physically through giving personalized photo-based gifts, they are enhancing their personal relationships, creating more joy in the world and making the world a better place. Industry Overview Historically, preserving photos and creating original, thoughtful compilations of memories was a difficult, expensive, manual, time-consuming and often inconvenient process for consumers. As a result of these constraints, the desire for easy, convenient, versatile, affordable and trusted online photo services has emerged. Until the widespread adoption of the Internet and digital cameras, there were significant inefficiencies and quality limitations associated with capturing, developing, processing, storing, editing and sharing images. Photos had to be stored in physical form and were vulnerable to deterioration, destruction or loss. Most people chose the limited option of storing their 4(cid:2)6 prints in shoeboxes or simple photo albums because photography-related markets — including film processing, photo printing and scrapbooking — either did not exist or were not well- integrated. In particular, convenient options for photo production, storage and sharing were very limited; consumers had to settle for ordering duplicate 4(cid:2)6 prints from either mail-order or local processing labs with varied capabilities and often poor quality control. Furthermore, the “shoebox” approach created significant difficulties for consumers in organizing their photos and limited their ability to be thoughtful and creative with their memories. The photo-related industries had not found a way to capitalize on the public’s need to preserve memories across generations in a secure, convenient, creative and engaging manner. Internet and digital photo-based technology enables consumers to create an archive of memories that extends beyond photos to include highly personalized, more engaging products and services that can be protected and 2 preserved for future generations. We believe that the key forces driving the expansion of the market for these products and services are: (cid:129) Proliferation of digital cameras and penetration of high-speed connectivity. The growing use of digital cameras, largely driven by price decreases, has increased the demand for online photo-printing services. High-bandwidth, high-speed Internet access has spurred the integration of the Internet into daily life and provides consumers with improved performance and speed for sharing information, especially large files sizes such as digital images. Industry sources estimate that in 2007, U.S. digital camera unit sales reached approximately 25 million units. Industry sources also estimate that 70% of all U.S. households will have broadband by 2012, with nearly 36 million new broadband subscribers emerging over the next five years. According to Industry Resources, 61.7% or approximately 71.4 million U.S. households have both a digital camera(s) and Internet access. (cid:129) Increasing convenience and quality of online photo services. Online photo services provide multiple advantages over at-home printing. Although at-home photo printing is instantaneous, it requires an investment in a printer, photo paper and ink, resulting in a much higher cost per print and is time consuming. The quality rendered from at-home printers is usually inferior compared to commercially produced prints. In addition, at-home printers are less capable of producing products that require binding and / or finishing, such as photo books, calendars and folded greeting cards. In contrast, online photo services conveniently provide a wide variety of customized, high-quality photo- based products delivered directly to consumers’ doorsteps. (cid:129) Growing consumer desire to find easy, convenient ways to generate personalized content. Consumers are interested in creating highly customized and personalized photo-based products and merchandise to preserve their precious memories, express their creativity and make gift giving more personal and thoughtful. Improvements in software and photo editing tools have enabled consumers to modify their photos quickly and easily using a personal computer. Consumers are now able to create digital compilations of memories that were previously only possible through a physical and more time- consuming process. (cid:129) Participation in online communities. Consumers have become increasingly comfortable with using the Internet as a forum for sharing and publishing information in open or permission-based networks. Many of the most popular online communities include user-generated, rich-media content such as photos and videos because of visual content’s inherent ability to communicate more powerfully than the written word. Addressable Markets Digital cameras, digital image processing and the Internet have dramatically changed the photo-related services market, and have created entirely new ways for consumers to capture, edit, enhance, organize, find, share, create, print and preserve images. In particular, the range and quality of printed photos, photo-based products, photo-based merchandise and ancillary products have expanded and improved significantly, while associated production costs and the time required to create this output have decreased dramatically. Consequently, companies like Shutterfly are now addressing a wide variety of consumer needs and multiple, large markets in ways not possible with earlier technology. We currently address several adjacent markets related to consumers’ desire to be thoughtful and creative with their memories. These include, but are not limited to: (cid:129) Greeting cards and stationery. According to the Greeting Card Association’s website, U.S. consumers purchase approximately 7 billion greeting cards each year, generating nearly $7.5 billion in retail sales. More than 90 percent of all U.S. households buy greeting cards, with the average household purchasing 30 individual cards per year. The Greeting Card Association also reports that nine out of ten Americans say they look forward to receiving personal letters and greeting cards because cards allow them to keep in touch with friends and family and make them feel they are important to someone else. (cid:129) Scrapbooks. According to a 2007 survey by Creating Keepsakes, the addressable markets for the US scrapbook industry was approximately $2.87 billion in 2007 up from $2.55 billion in 2004. Additionally, 3 approximately 82% of scrapbookers have at least a college degree and spend almost four hours a week assembling their memories into scrapbooks. (cid:129) Calendars. A 2002 guide published by the Calendar Marketing Association estimated that 500 million calendars are produced annually in the United States and that approximately 98% of American households have at least one calendar. (cid:129) Photo prints. Industry sources estimate that the number of digital images printed in the U.S. in 2006 reached 15 billion. Total U.S. digital revenue reached approximately $9 billion in 2007, growing to approximately $12 billion in 2011. (cid:129) Photo-based merchandise. Photo-based merchandise is a substantial market opportunity that includes any product that can be customized with the imprint of a digital image. Photo-based merchandise includes, but is not limited to, photo calendars, photo greeting cards and photo books. Industry sources estimate that U.S. revenue from photo-based merchandise reached approximately $560 million in 2007, growing to approximately $1.5 billion in 2012. We generally characterize our products as either “personalized products and services” or “prints”. Our personalized products and services revenues are derived from sales of greeting cards, calendars, photo books, and ancillary products such as scrapbooking accessories and other photo-based merchandise, and the related shipping revenue from these sales, while our print revenues are derived from sales of photo prints and the related shipping revenue. In 2007, 2006 and 2005, our personalized products and services revenues represented approximately 56%, 51% and 42% of our total net revenues, respectively, and our print revenues represented approximately 44%, 49% and 58% of our total net revenues, respectively. The addressable market for our products and services includes every person who enjoys the memories created by digital photographic devices such as cameras, camera cell phones or camcorders. Although photofinishing products and services are purchased by a broad consumer base, we believe that women, in particular, play a key role in many photo-based purchasing decisions. The U.S. Census Bureau reports that there were approximately 55 million women age 25-44 in 2006. We believe that securing the loyalty of this core consumer base represents a sizable market opportunity. Value for Our Customers Creating value for our customers is the basis for our success. Our tag line is “Tell Your Story,” and we offer customers easy, convenient and fun ways to tell their stories by: (cid:129) sharing and preserving memories for family, friends and themselves; (cid:129) organizing all of their photos in a safe and easily accessible location; (cid:129) maintaining emotional connections with friends and family, despite being time-constrained, through thoughtful and personal photo-based communications and gifts; and (cid:129) achieving satisfaction and self-expression through creativity and telling stories via photos and personalized photo-based products and services. We provide the following benefits to our customers: Broad offering. We offer a wide variety of premium products to customers, including prints and photo- based products that include, but are not limited to, greeting cards, calendars, photo books, mugs, mouse pads, frames, photo albums and scrapbooking products and accessories. In addition, we provide a number of valuable tools and services, such as the ability to upload and edit photos online, share photos with friends and family and store an unlimited number of photos on our system at no cost. With many creative options from which to choose, we enable customers to become engaged in the Shutterfly experience and feel a sense of pride in their creations. Exceptional quality and service. We have built strong relationships with our customers who trust us to preserve and protect their memories in a central storage repository. We enable customers to enhance, share and 4 make projects with their photos at their convenience. Our focus on ease of use, image quality, secure photo storage, high-quality products and first-rate packaging has established Shutterfly as a premium brand. Our customers have come to expect the best quality and service from us. This trust is maintained by fast, consistent fulfillment times, responsive customer service and continuous innovation. Customer-focused approach. The entire Shutterfly customer experience reflects our customer-centered approach. Membership is free and offers customers the ability to upload, edit, store and share an unlimited number of photos. Membership is not required to view shared pictures, which can be viewed with a simple click. We conveniently mail orders to our customers’ homes or offices, or directly to a gift recipient. We also offer a year-round direct-mail greeting card service where customers upload their electronic address books to Shutterfly and we mail their cards and party invitations on their behalf. We take special care to focus on our customers’ requests for new features and functionality, products and services. The Shutterfly Solution We have developed a portfolio of products and services along with specialized manufacturing capabilities that allow us to offer consumers an easy, convenient and fun way to enjoy, share and preserve their memories. We satisfy traditional consumer needs — by introducing consumers to new forms of communication and creative expression through our website features and functionality, photo prints, and personalized photo-based products and services. We also provide photo printing, storing and sharing. We believe that many people are intimidated by the process of creating photo-based products or merchandise or fear that it will take too much work. We believe that we have removed much of the difficulty and intimidation of the process and have made it easy and enjoyable. In addition to these consumer benefits, we believe that our business model is supported by the following characteristics: Viral network effect. We benefit from a viral network in several ways. When our existing customers upload and share their personal memories through photos, they are providing compelling user-generated content that attracts their friends and family to our website, thus enlarging our network of users and potential customers. This implicit endorsement, coupled with user-friendly policies, such as not requiring share recipients to register to view pictures, reinforces our trusted brand and leads to lower customer acquisition costs. In addition, as our customers create and give thoughtful and unique physical gifts such as greeting cards, calendars and photo books, these products create numerous opportunities for potential customers to interact with our brand. Many of our customers also use our website to create community-oriented products such as a photo book celebrating a school play or a yearbook for their children’s soccer team, and they often proactively introduce and sell these items to larger groups of potential new customers. As our products and services delight our customers, they often become enthusiastic evangelists for Shutterfly and introduce our products and services to their friends and family through word-of-mouth referrals and endorsements. Attractive target demographics reflected in our loyal customer base. Our customers have described themselves as being interested in maintaining personal connections with friends and family, wanting to tell stories, wishing to preserve their memories for themselves and their children and wanting an offering that is intuitive and easy to use. As a result, we believe that they are looking for an easy and convenient way to be both thoughtful and creative with their memories. Our customers use our website to share, enhance and preserve memories from vacations, holidays and family events and to create gifts for events such as birthdays, weddings, anniversaries, Halloween, Hanukkah, Christmas, Valentine’s Day, Easter, Mother’s Day and Father’s Day. We believe that our customer loyalty is also aided by high switching costs. If a customer were to leave Shutterfly, he or she would have to spend significant time uploading and organizing photos on a new service. Premium pricing power. We believe that we are able to maintain premium pricing power for many of our products because of our market position and the loyal customer base we have created. We believe that our market position and loyal customer base exist because we have differentiated ourselves in the marketplace by delivering high-quality products, outstanding customer service, an intuitive and easy user experience and continuous innovation across our products and services. Deep understanding of our customers. Customer insights are an important source of new product and service innovation for us, and we continually strive to understand our customers’ needs in order to improve 5 customer satisfaction. We invest significant time and resources to understand and address the needs of our customers through market research, focus groups, customer surveys, usability testing, customer response to promotions and customer service interactions. We believe a coordinated focus on understanding the customer allows us take measures to increase customer loyalty, consumer awareness of Shutterfly, customer satisfaction and repeat purchases. Vertical integration and superior technology. We derived approximately 82% of our net revenues in 2007 from products we manufactured in our Hayward, California and Charlotte, North Carolina facilities. Our vertically integrated and highly technical manufacturing approach provides quality control, agility in rolling out new products and ability to secure capacity at critical peak demand periods. We believe that vertical integration provides us with quality, cost, flexibility and innovation advantages, including: (cid:129) greater consistency and quality of output; (cid:129) increased ability to control and optimize costs for raw materials and production; (cid:129) fully automated image processing and print scheduling; (cid:129) more flexibility to provide rapid, responsive order fulfillment and processing; (cid:129) assured high-quality capacity, even during peak demand such as the fourth quarter holiday season; (cid:129) additional insights into new and existing photo products and production processes; (cid:129) rapid prototyping, testing and refinement of new products and services; and (cid:129) the ability to address customer inquiries quickly. We have devoted more than eight years to developing our proprietary software, technology and production systems that we believe give us an advantage over our competitors. It is our intention to continue investing in and protecting our proprietary technology, platforms and processes that help us differentiate ourselves from the competition, innovate, and control costs. Our Growth Strategy Our goal is to grow our business, build a premium lifestyle brand and become the leading online provider of products and services dedicated to improving the sharing and preservation of personal memories through social expression and personal publishing. We believe the combination of our focus, our dedication to customers and the benefits we derive from our vertically integrated production facilities will allow us to profitably capture a significant share of our addressable markets. In addition to strong consumer trends supporting our business — such as the proliferation of digital cameras, higher broadband penetration and greater adoption of Internet related e-commerce and communication services — we believe our growth will be supported by the following initiatives: Expand customer base. We intend to expand our customer base and continue to promote the Shutterfly brand. We will leverage existing channels, which include word-of-mouth referrals from existing customers, print advertising, catalogs, online advertising, search engine marketing and complementary alliances with other companies such as Sony, David’s Bridal and Delta Airlines. We have also begun to expand our customer base through our offerings at Target stores, including in-store placements and ad circulars which complement our retail sales and “print-to-Target” offerings. Expand product and service offerings. We will continue to innovate in order to increase the breadth and depth of our products and services, including prints, photo-based merchandise and ancillary products. During 2007, we have launched numerous new products, including “designer” cards, children’s story books, per- sonalized jewelry, holiday ornaments, custom framing, square-format scrapbook pages, digital scrapbooking card, calendar and photo book templates, and licensed content themed photo books including Martha Stewart, Dora the Explorer, Go Diego Go, and the Sesame Street adventure book. Increase sales to existing customers. We intend to increase both average order value and repeat orders per customer by expanding our products and services, tailoring our offerings to encourage additional purchases for different holidays and life events and increasing our cross-selling and up-selling activities. 6 Leverage vertical integration. We will continue to invest in vertical integration by expanding our in- house production capabilities. We believe this will allow us to extend our objectives to provide the highest quality products and services at the lowest possible costs, to provide exceptional fulfillment and customer service, even at peak demand periods, and to continue to innovate rapidly with new products and services. Develop new lines of business. We intend to continue to leverage our existing systems and capabilities to develop additional adjacent product offerings. For example, in 2007 we formed the Shutterfly Scrapbook Advisory Team, a team of scrapbooking experts, to advise us in product and services developments targeted toward scrapbookers. During the year, we introduced new scrapbook page formats, enhanced the visibility of scrapbooking on the Shutterfly website, and launched a holiday blog for scrapbookers, to provide a forum for discussions around printing holiday scrapbook pages greeting cards using the Shutterfly service. In 2008, we announced a strategic relationship with CK Media Scrapbooking, the industry’s largest print publisher, and the introduction of two new designer scrapbooks. International expansion. We intend to develop additional business opportunities through international expansion, targeting consumers in key geographies where digital camera penetration is high and where Internet usage and e-commerce are widespread. Products and Services Using the Shutterfly service is easy, convenient and fun. Our website is designed to be simple, uncluttered and inviting, and we work continuously to enhance the customer experience of the website, while also improving ease of use. In 2007, Shutterfly announced many enhancements to our innovative personal publishing platform, which includes: (cid:129) an easy-to-use search capability for our customers to find products and services; (cid:129) new adventure books featuring Dora the Explorer and Sesame Street; (cid:129) designer cards from popular designers; (cid:129) additional photo gift products such as photo ornaments; (cid:129) dozens of collage formats on calendars and poster prints; and (cid:129) partnership with Target for pick up at Target retail stores. There are only five navigational “tabs,” which correspond to the primary activities offered by the website — Add Pictures, View & Enhance, Share Online, Order Prints and Shutterfly Store. If consumers decide to either upload pictures or purchase products, they register on the website and begin the following process: Upload. Customers can upload digital photos from their computer to our website one at a time, many at once through simple drag-and-drop or by using Shutterfly Studio, our photo organization software. There are no limits to photo file sizes and the upload processes are accelerated by multi-threading, which enables photos to be uploaded simultaneously, thereby reducing image upload times. Unlike some competitive services, we do not compress image files as part of the upload process, which we believe preserves quality and photo resolution. Organize and find. Customers initially upload their photos into user-defined albums. We offer multiple ways to further organize and find pictures. For example, customers can automatically sort photos within albums by upload date, photo titles or original filenames. Additionally, customers can quickly search for photos in a number of ways, including by text, date taken, upload date and images ordered on prints or specified products. Customers can also use our “favorites” function to tag their favorite photos with a star rating system on both the website and within Shutterfly Studio. View and enhance. Once photos have been uploaded to Shutterfly, customers can choose to view their photos in a variety of ways, including photo slideshows. To improve picture quality, customers also have access to our free online editing and image enhancement tools. In addition to cropping and red-eye removal, we offer a variety of creative options, such as saturating photos with additional color or changing color shots to 7 black-and-white or sepia. Customers are also able to choose from a wide variety of photo borders. We offer free customized back printing on photos and the option to add captions to many of our products. Customers can view and enhance their photos online or on their desktop via Shutterfly Studio, which easily integrates with our website. Shutterfly Studio provides advanced viewing and enhancing capabilities such as full screen slideshows, cropping, red-, blue- and green-eye removal, sharpening, auto adjustments and captioning. Create. We enable customers to create a variety of personalized products from their photos, including prints in wallet, 4(cid:2)6, 5(cid:2)7, 8(cid:2)10, 11(cid:2)14, 16(cid:2)20 and 20(cid:2)30 sizes, greeting cards, calendars, photo books and other photo-based products and merchandise. Our highly-interactive, design-it-yourself “creation paths” help even first-time customers make professional-looking, high-quality prints and products. Customers can easily design each product by following simple step-by-step instructions and using intuitive features, such as dragging and dropping an image into a template. Our technology then generates an image of the customer’s product on screen so that customers can make any desired design choices or changes and then view the final product to ensure satisfaction before purchase. Customers can also save in-process projects and return to them at a more convenient time to finish and purchase. Recent enhancements made possible from innovations in our personal publishing platform include: (cid:129) a significantly expanded product offering, with many form factors and design choices including person- alized photo covers with printing on the spine, 8x8 Story Books and 12x12 Memory Books; (cid:129) a wide variety of background designs including numerous pre-set style templates organized across popular categories such as Wedding, Travel, Birthday, Baby, Kids, Class Year Book, Recipe Book, Portfolio and Journal; (cid:129) dozens of collage formats on our greeting-cards and calendars; (cid:129) licensed content from Martha Stewart, Dora the Explorer, Go Diego Go, Sesame Street, Clifford the Big Red Dog, Thomas and Friends, and Angelina Ballerina; and (cid:129) digi-scrap capabilities which allow for customers to upload their digi-scrap designs onto photo book pages or covers. Share. We enable our customers to share images in several different ways. Customers can e-mail friends, family and colleagues a link to an individual album that can be viewed as a slideshow of images. In order to view those images, e-mail recipients simply click on the URL link in the e-mail and view images immediately without the need to register with Shutterfly. Recipients can then order prints or save them into their own album. Similarly, customers can share their photo books electronically by sending an e-mail to friends and family with a link to a photo book project, thereby improving the ease of photo book development and collaboration, and sharing of personalized content. Yet another way to share photos is by creating a Shutterfly Collection, which is linked to a personal web address that is powered by Shutterfly. This allows customers to store and share an unlimited number of photo albums. Customers can invite friends and family to view the photos, add additional photos and post comments to both albums and individual photos via the Guestbook feature. To ensure the privacy of Collections, we offer users optional password protection. Shutterfly customers can create up to two free Collections. We also sponsor seasonal and topical photo contests that promote sharing of photos by our customers. To save our customers time, we offer an easy way to copy names, e-mail addresses and mailing addresses from various software such as Outlook, Outlook Express, Entourage, Palm and Eudora into their Shutterfly address book. In 2008, we announced the acquisition of Nexo Systems and the launch of Shutterfly Gallery. We believe the acquisition of the Nexo platform will accelerate our innovations in online sharing and collaboration services, giving our viral customers more ways to connect with family and friends with the ability to create personalized, secure websites for sports teams, school activities, clubs and other tight-knit social networks. And with the launch of Shutterfly Gallery, we are expanding our community sharing platform, allowing customers to post their photo books, share their thoughts and perspectives on storytelling, ad photo books to their “favorites list, rate and comment on other photo books, and share interesting Gallery projects with friends and family with the “email a friend” feature. 8 Order and ship. We provide convenient ordering and flexible shipping options. To order a product after it is created, the customer adds it to his or her shopping cart and completes the billing and shipping information. Shipping addresses can be typed in or easily added directly from a customer’s Shutterfly address book. When a picture or product is being ordered, we flag photos of poor quality, usually due to low resolution, to alert customers of potential quality issues. This helps ensure that a customer does not order an out-of-focus or poor quality picture. Customers can ship single orders to multiple recipients. We also offer several different shipping options, such as next-day, two-day or regular service. Standard turn-around times from the time an order is placed to the time it is shipped are one business day for most print orders and two business days for other photo-based products manufactured by Shutterfly. For our photo-based merchandise manufactured on our behalf by third parties, turn-around times vary, but generally range from two to five days from the time we receive the order and transmit it to our manufacturer. We also offer premium services for addressing, stamping and mailing greeting cards directly to recipients. Archive. We provide customers with unlimited storage of their photos, Collections and projects at no cost to the customer. Customers can also order a copy of their photos on a DVD for an extra fee. Marketing, Advertising and Promotion We use a variety of integrated marketing programs, including advertising, direct marketing technologies, channels, methods and strategic alliances to attract and retain our customers. These methods include direct marketing over the Internet, e-mail marketing to prospects and existing customers, search engine marketing, and traditional direct marketing mailings such as postcards and seasonal catalogs. In addition, because many of our products are either shared via the Internet or given as gifts, the appearance of our brand on the products and packaging provides ongoing distribution as well as viral advertising. We place advertisements that target women and families on websites and in publications, contract for targeted e-mail marketing services and contract for advertising placement on leading search engines. We also maintain an affiliate program under which we pay program participants for referral sales generated from hyperlinks to our website from the affiliate’s website and in promotional materials. We maintain alliances with complementary companies. For example, we have co-marketing and promotion arrangements with companies such as Delta Airlines SkyMiles, David’s Bridal, and Proctor and Gamble. In addition, in 2007, we began a relationship with Target Corporation where we provided our customers the ability to order their 4x6 prints online and pick them up at select local Target store in as little as an hour. During the holiday season, we also offered an in-store a suite of prepaid products including photo books, adventure books, photo gifts, and gift cards. Customers may purchase these products at select Target stores and redeem them online at Shutterfly.com. In addition, from time to time we create co-branded versions of our website. In general, these arrangements involve payment of a commission to or revenue sharing with these companies for sales of our products and services generated through these websites. Technology and Production Systems We use a combination of proprietary and third-party technology, including the following: Customer relationship management, or CRM, system. Our integrated CRM system is composed of various sophisticated tools designed to convert first-time customers into repeat buyers. We seek to increase average order sizes by expanding customer awareness, providing targeted, segmented offers to customers and encouraging cross- and up-selling. The system uses a variety of data, including website usage patterns, order size, order frequency, products purchased, seasonality factors, image upload and share usage, as well as customer satisfaction information. This data is continually updated and refreshed in a data warehouse, from which different customer segments are identified and modified on a continuing basis for targeted marketing communications. By using this deep customer intelligence and ongoing analysis, we are able to offer customers a more personalized website experience and to target them with specific website promotions, discounts, specialized 9 e-mail and direct mail offers. Our promotion engine generates special offers that are account specific and applied automatically at checkout. This enables us to run multiple offers at any given time that are targeted to specific customer profiles. We are also able to dynamically assign visitors to test and control groups who are shown different versions of our service. This testing enables us to continuously optimize products, pricing, promotions and user interaction with our website. We are able to run multiple tests at once, which enables us to rapidly launch new products and services and enhances our financial results. Website system. Our website powers our service and e-commerce functionality. We have designed our user interface to be simple, uncluttered and inviting. There are only five navigational “tabs” that correspond to the primary activities offered by the website — Add Pictures, View & Enhance, Share Online, Order Prints and Shutterfly Store, which includes personalized product creation. We have designed our website system to be highly available, secure and cost-effective. We can scale to increasing numbers of customers by adding relatively inexpensive industry-standard computers and servers. We have a strong commitment to our privacy policy, and we utilize technologies such as firewalls, encryption technology for secure transmission of personal information between customers’ computers and our website system and intrusion detection systems to ensure compliance with that policy. Image archive. We store our customers’ images in our image archive. Once a customer uploads a photo to our website, it is copied to multiple redundant systems, including an off-site copy. We continue to expand our storage capacity to meet increasing customer demand. Our innovative storage architecture provides low storage costs, facilitates the safe, secure archiving of customers’ images and delivers the speed and perfor- mance required to enable customers to access, enhance and edit their images in real-time. When we store and archive a customer’s image, we do not alter or reduce resolution of the original image (for example, we do not reduce the data file size), which preserves the quality and integrity of the image. This approach also lets customers enhance the image using a duplicate, while giving them the ability to recall the original at any time. Render farm. Once a customer orders a photo or any photo-based product or photo-based merchandise, our render farm technology performs fully automated image processing on the image prior to production. The customer’s original uploaded image is retrieved from the image archive, and automatic algorithms enhance the color, contrast and sharpness of the image. The render farm also performs customer-requested edits such as crop, borders, customized back-printing and red-eye removal. To ensure that output is of consistent quality, we apply our proprietary ColorSure technology during this render stage. ColorSure creates an automated mapping of the image’s specific attributes to the printer’s specific print calibrations and attributes, at which time the rendered image is scheduled for production. For example, this allows a photo that is printed on a 4x6 print to look the same as a photo printed on an enlargement or in a photo book, even if they are ordered at separate times. Production system. We operate our own production facilities in Hayward, California, and Charlotte, North Carolina. Our automated production system controls our production processes, including order management and pick, pack and ship operations. Using complex algorithms, the production system analyzes tens of thousands of orders daily and automates the workflow into our high-volume silver halide photo- finishing machines and our state-of-the-art digital offset presses. Competition The market for digital photography products and services is large, evolving and intensely competitive, and we expect competition to increase in the future. We face intense competition from a wide range of companies, including the following: (cid:129) online digital photography services companies such as Kodak EasyShare Gallery (formerly known as Ofoto), Snapfish, which is a service of Hewlett-Packard, American Greetings’ Photoworks and Webshots brands, and others; 10 (cid:129) “Big Box” retailers such as Wal-Mart, Costco and others that are seeking to offer low cost digital photography products and services. These competitors provide in-store fulfillment and self-service kiosks for printing, which may, among other strategies, offer their customers heavily discounted in-store products and services that compete directly with our offerings; (cid:129) drug stores such as Walgreens, CVS and others that offer in-store pick-up from Internet orders; (cid:129) regional photography companies such as Wolf Camera and Ritz Camera that have established brands and customer bases in existing photography markets; (cid:129) Internet portals and search engines such as Yahoo!, AOL, and Google that offer broad-reaching digital photography and related products and services to their large user bases; (cid:129) home printing service providers such as Hewlett-Packard, Epson and Canon, that are seeking to expand their printer and ink businesses by gaining market share in the emerging digital photography marketplace; and (cid:129) photo-related software companies such as Adobe, Apple, Microsoft, Corel and others. We believe the primary competitive factors in attracting and retaining customers are: (cid:129) brand recognition and trust; (cid:129) quality of products and services; (cid:129) breadth of products and services; (cid:129) user affinity and loyalty; (cid:129) customer service; (cid:129) ease of use; (cid:129) convenience; and (cid:129) price. We believe that we compete favorably with respect to many of these factors, particularly customer trust and loyalty, quality and breadth of products and services, and customer service. None of our competitors offers a comparable value proposition, trusted brand or singular focus on customers. Many of our competitors promote their products on the basis of low prices or the convenience of same-day availability for digital photos printed in drugstores or other retail outlets. As a general matter, we currently plan to distinguish ourselves from such competitors principally on the basis of product quality and innovation, rather than price or same-day delivery. The level of competition in our industry has been consistently high since our inception in 1999, and is likely to increase as current competitors improve their offerings and as new participants enter the market or as industry consolidation further develops. These competitors have or could develop a variety of competitive advantages over us, including significantly longer operating histories; larger and broader customer bases; greater brand recognition; greater financial, research and development and distribution resources; and greater ability to acquire, invest in or partner with traditional and online competitors. Well-funded new entrants may choose to prioritize growing their market share and brand awareness instead of profitability. We may be unable to compete successfully against current and future competitors, and competitive pressures could harm our business and prospects. Intellectual Property Protecting our intellectual property rights is part of our strategy for continued growth and competitive differentiation. We seek to protect our proprietary rights through a combination of patent, copyright, trade secret and trademark law. We enter into confidentiality and proprietary rights agreements with our employees, consultants and business partners, and control access to and distribution of our proprietary information. In February 2008, we entered into a licensing arrangement with a third party for certain of our patented technology. Under the terms of the license, we expect to receive annual installment payments of the license fee beginning at the time of the contract 11 execution, and continuing through March 2010. We expect to enter into other similar arrangements with third parties who seek to use our patented technology or infringe on our patented technology. As of December 31, 2007, we had 21 issued patents, which expire at various dates between November 2019 and May 2025, and more than 30 patent applications pending in the United States. Our issued patents and patent applications relate generally to the user interface for our website, our computer network infrastructure and software, personalized photo-related products and automated workflow and digital printing. We intend to pursue corre- sponding patent coverage in additional countries to the extent we believe such coverage is appropriate and cost efficient. However, we cannot be certain that any of our pending or any future applications will be granted. In addition, third parties could bring invalidity, co-inventorship or similar claims with respect to any of our currently issued patents or any patents that may be issued to us in the future. We have in the past received claims, and in the future a third party may claim, that we have infringed its patent rights. This can result in litigation and/or require us to enter into a license agreement with a third party. For example, effective May 1, 2005, Shutterfly entered into a settlement and license agreement to resolve litigation with respect to alleged infringement of certain processes under U.S. patents relating to uploading, storing, sharing, accessing, downloading and/or requesting or obtaining digital images or prints of digital images or merchandise to which such images are applied. Under the terms of the agreement, Shutterfly paid $2.0 million for a license to certain patents, including a non-exclusive, fully-paid up, royalty-free, worldwide license to the patents underlying the litigation, and a mutual release of claims. Our primary brand is “Shutterfly.” We hold registrations for the Shutterfly service mark in our major markets of the United States and Canada, as well as in the European Community, Mexico, Japan, Australia and New Zealand. We also hold “Shutterfly.com” Internet domain registrations in the United States, Mexico, Australia and New Zealand, and a “Shutterfly and Design” trademark, “Shutterfly Express”, “Shutterfly Collections” and “Postcards by Shutterfly” service mark registrations in the United States. An additional application for the Shutterfly mark is pending in Brazil. We also hold a registration for the “VividPics” service mark in the United States and Mexico, and have pending applications for additional marks, including “Shutterfly Studio”, a “Shutterfly Studio and Design” trademark, “Your pictures and more”, “Marking it personal”, and “Memory Vault”. During 2007, we also acquired the trademark to our tagline, “Tell Your Story.” These brand registrations are a critical component of our marketing programs. If we lose the ability to use our Shutterfly mark in a particular country or our domain name, we could be forced to either incur significant additional expenses to market our products within that country or elect not to sell products in that country. In addition, regulations governing domain names and laws protecting trademarks and similar proprietary rights could change in ways that block or interfere with our ability to use our current brand and to acquire or maintain the domain names that utilize the name Shutterfly in all of the countries in which we currently or intend to conduct business. The legal environment of the Internet is evolving rapidly in the United States and elsewhere. The manner in which existing laws and regulations will be applied to the Internet in general, and how they will relate to our business in particular, is unclear in many cases. Accordingly, we often cannot be certain how existing laws will apply in the online context, including with respect to such topics as privacy, defamation, pricing, credit card fraud, advertising, taxation, sweepstakes, promotions, content regulation, quality of products and services and intellectual property ownership and infringement. In particular, laws relating to the liability of providers of online services for activities of their users are currently unsettled both within the United States and abroad. Numerous laws have been adopted at the national and state level in the United States that could have an impact on our business. These laws include the following: (cid:129) The CAN-SPAM Act of 2003 and similar laws adopted by a number of states. These laws are intended to regulate unsolicited commercial e-mails, create criminal penalties for unmarked sexually-oriented material and e-mails containing fraudulent headers and control other abusive online marketing practices. (cid:129) The Communications Decency Act, which gives statutory protection to online service providers who distribute third-party content. 12 (cid:129) The Digital Millennium Copyright Act, which is intended to reduce the liability of online service providers for listing or linking to third-party websites that include materials that infringe copyrights or other rights of others. (cid:129) The Children’s Online Privacy Protection Act and the Prosecutorial Remedies and Other Tools to End Exploitation of Children Today Act of 2003, which are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information from minors. In addition, the Protection of Children From Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circumstances. (cid:129) Statutes adopted in the State of California require online services to report certain breaches of the security of personal data, and to report to California consumers when their personal data might be disclosed to direct marketers. To resolve some of the remaining legal uncertainty, we expect new laws and regulations to be adopted over time that will be directly applicable to the Internet and to our activities. Any existing or new legislation applicable to Shutterfly could expose us to substantial liability, including significant expenses necessary to comply with such laws and regulations, and could dampen the growth in the use of the Internet in general. We post on our website our privacy policies and practices concerning the use and disclosure of user data. Any failure by us to comply with our posted privacy policies, Federal Trade Commission requirements or other privacy- related laws and regulations could result in proceedings by governmental or regulatory bodies that could potentially harm our business, results of operations and financial condition. In this regard, there are a large number of legislative proposals before the United States Congress and various state legislative bodies regarding privacy issues related to our business. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could harm our business through a decrease in user registrations and revenues. These decreases could be caused by, among other possible provisions, the required use of disclaimers or other require- ments before users can utilize our services. Due to the global nature of the Internet, it is possible that the governments of other states and foreign countries might attempt to regulate its transmissions or prosecute us for violations of their laws. We might unintentionally violate such laws, such laws may be modified and new laws may be enacted in the future. Any such developments could harm our business, operating results and financial condition. We may be subject to legal liability for our online services. The law relating to the liability of providers of these online services for activities of their users is currently unsettled both within the United States and abroad. Claims may be threatened against us for aiding and abetting, defamation, negligence, copyright or trademark infringement, or other theories based on the nature and content of information to which we provide links or that may be posted online. Employees As of December 31, 2007, we had 431 full time employees. Approximately 124 employees were engaged in engineering, 179 in photo lab operations, 57 in sales and marketing, 16 in customer service and 55 in general and administrative functions. During the peak holiday season, we obtain contract workers on a temporary basis from third-party outsourcing firms. For example, during our peak production day in the fourth quarter of 2007, we used approximately 1,000 temporary workers to assist in our production and fulfillment operations during high-demand periods. None of our employees is represented by a labor union or is covered by a collective bargaining agreement. We have never experienced any employment-related work stoppages and consider our employee relations to be good. Available Information Our Internet website is located at http://www.shutterfly.com. The information on our website is not a part of this annual report. We make available free of charge on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after we 13 electronically file such material with, or furnish it to, the Securities and Exchange Commission. Our SEC reports can be accessed through the investor relations section of our Internet website. The public may also read and copy any materials we file with the Securities and Exchange Commission at the Securities and Exchange Commission’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission also maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the Securities and Exchange Commission. The Securities and Exchange Commission’s Internet website is located at http://www.sec.gov. ITEM 1A. RISK FACTORS Our net revenues, operating results and cash requirements are affected by the seasonal nature of our business. Our business is highly seasonal, with a high proportion of our net revenues, net income and operating cash flows generated during the fourth quarter. For example, we generated approximately 52% of our net revenues for 2007 in the fourth quarter of 2007, and the net income that we generated during the fourth quarter of 2007 was necessary for us to achieve profitability on an annual basis for 2007. In addition, we incur significant additional expenses in the period leading up to the fourth quarter holiday season in anticipation of higher sales volume in that period, including expenses related to the hiring and training of temporary workers to meet our seasonal needs, additional inventory and equipment purchases and increased advertising. If we are unable to accurately forecast and respond to consumer demand for our products during the fourth quarter, our financial results, reputation and brand will suffer and the market price of our common stock would likely decline. In addition, we base our operating expense budgets on expected net revenue trends. A portion of our expenses, such as office, lab facility, and various equipment leases and various personnel costs, are largely fixed and are based on our expectations of our peak levels of operations. We may be unable to adjust spending quickly enough to offset any unexpected revenue shortfall. Accordingly, any shortfall in net revenues may cause significant variation in operating results in any quarter. Our limited operating history makes it difficult to assess the exact impact of the seasonal factors on our business or whether our business is susceptible to cyclical fluctuations in the U.S. economy. In addition, our historically rapid growth may have overshadowed whatever seasonal or cyclical factors might have influenced our business to date. Seasonal or cyclical variations in our business may become more pronounced over time and may harm our future operating results. We are also subject to macro-economic fluctuations in the U.S. economy. Recent macro-economic issues involving sub-prime mortgages and liquidity issues, as well as liquidity issues in the auction rate securities that we invest in, may negatively impact the economy and our growth. If these issues persist, or if the economy enters a prolonged period of decelerating growth, our results of operations may be harmed. If we are unable to meet our production requirements, our net revenues and results of operations would be harmed. We believe that we must significantly grow our current production capability to meet our projected net revenue targets. We expect to spend between $43 million and $47 million in capital expenditures in 2008, representing a range of between 17.5% and 18.5% of our expected fiscal year 2008 net revenues, and a portion of which we expect will be used to add manufacturing capacity. During, 2007, we opened a new manufacturing and production plant in Charlotte, North Carolina. Our inability to meet our production requirements could lead to customer dissatisfaction and damage to our reputation and brand, which would result in reduced net revenues. Moreover, if the costs of meeting production requirements, including capital expenditures, were to exceed our expectations, our results of operations would be harmed. In addition, we face significant production risks at peak holiday seasons, including the risks of obtaining sufficient qualified seasonal production personnel. A majority of our workforce during the fourth quarter of 2007 14 was seasonal, temporary personnel. We have had difficulties in the past finding a sufficient number of qualified seasonal employees, and our failure to obtain qualified seasonal production personnel both in our Hayward, CA and Charlotte, NC production plants could harm our operations. Our quarterly financial results may fluctuate, which may lead to volatility in our stock price. Our future revenues and operating results may vary significantly from quarter-to-quarter due to a number of factors, many of which are difficult for us to predict and control. Factors that could cause our quarterly operating results to fluctuate include: (cid:129) demand for our products and services, including seasonal demand; (cid:129) our pricing and marketing strategies and those of our competitors; (cid:129) our ability to attract visitors to our website and convert those visitors into customers; (cid:129) our ability to retain customers and encourage repeat purchases; (cid:129) our ability to sustain our profit margins, and our ability to diversify our product offerings and sell to consumers (cid:129) photo-based products such as photo books, calendars and cards; (cid:129) the costs of customer acquisition; (cid:129) our ability to manage our production and fulfillment operations; (cid:129) the costs of expanding or enhancing our technology or website; (cid:129) a significant increase in returns and credits, beyond our estimated allowances, for customers who are not satisfied with our products; (cid:129) declines or disruptions to the travel industry; (cid:129) variations in weather, particularly heavy rain and snow which tend to depress travel and picture taking; (cid:129) the timing of holidays; (cid:129) volatility in our stock price, which may lead to higher stock-based compensation expense; (cid:129) consumer preferences for digital photography services; and (cid:129) improvements to the quality, cost and convenience of desktop printing of digital pictures and products. Based on the factors cited above, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. It is possible that in one or more future quarters, our operating results may be below the expectations of public market analysts and investors. In that event, the trading price of our common stock may decline. We have incurred operating losses in the past and may not be able to sustain profitability in the future. We have periodically experienced operating losses since our inception in 1999. In particular, we make investments in our business that generally result in operating losses in each of the first three quarters of our fiscal year. This typically enables us to generate the majority of our net revenue during the fourth quarter and to achieve profitability for the full fiscal year. If we are unable to produce our products and provide our services at commercially reasonable costs, if revenues decline or if our expenses exceed our expectations, we may not be able to sustain or increase profitability on a quarterly or annual basis. 15 We have a limited public company operating history, which makes it difficult to evaluate our business and prospects for the future. We became a public company in September 2006, and we have only a limited public operating history on which investors can base an evaluation of our business and future prospects. We face many risks, uncertainties, expenses and difficulties. To address these risks and uncertainties, we must do the following: (cid:129) maintain and increase the size of our customer base; (cid:129) maintain and enhance our brand; (cid:129) maintain and grow our website and customer operations; (cid:129) enhance and expand our products and services; (cid:129) successfully execute our business and marketing strategy; (cid:129) continue to develop and upgrade our technology and information processing systems; (cid:129) continue to enhance our service to meet the needs of a changing market; (cid:129) provide superior customer service; (cid:129) respond to competitive developments; and (cid:129) attract, integrate, retain and motivate qualified personnel. We may be unable to accomplish one or more of these requirements, which could cause our business to suffer. Accomplishing one or more of these requirements might be very expensive, which could harm our financial results. If we are not able to reliably meet our data storage and management requirements, customer satisfaction and our reputation could be harmed. As a part of our current business model, we offer our customers free unlimited online storage and sharing of photographs and, as a result, must store and manage multiple petabytes of data. This results in immense system requirements and substantial ongoing technological challenges, both of which are expected to continue to increase over time. If we are not able to reliably meet these data storage and management requirements, we could have disruptions in services which could impair customer satisfaction and our reputation and lead to reduced net revenues and increased expenses. Moreover, if the cost of meeting these data storage and management requirements exceeds our expectations, our results of operations would be harmed. Our data storage system could suffer damage or interruption from human error, fire, flood, power loss, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, our primary storage facilities are located near a major fault line, increasing our susceptibility to the risk that an earthquake could significantly harm our data storage system. If we experience disruption to our redundant systems located at our data storage center, such disruption could result in the deletion or corruption of customer stored images. For example, in 2007, we experienced a loss of a small number of customer images due to an isolated server failure. Interruptions to our website, information technology systems, print production processes or customer ser- vice operations could damage our reputation and brand and substantially harm our business and results of operations. The satisfactory performance, reliability and availability of our website, information technology systems, printing production processes and customer service operations are critical to our reputation, and our ability to attract and retain customers and maintain adequate customer satisfaction. We currently conduct periodic site maintenance several times a quarter that sometimes requires us to take the website down. The scheduled down times are planned at non-peak hours, typically at midnight. Any interruptions that result in the unavailability of our website or reduced order fulfillment performance or customer service could result in negative publicity, damage our reputation and brand and cause our business and results of operations to suffer. This risk is heightened in the fourth quarter, as we 16 experience significantly increased traffic to our website during the holiday season. Any interruption that occurs during such time would have a disproportionately negative impact than if it occurred during a different quarter. We depend in part on third parties to implement and maintain certain aspects of our communications and printing systems. Therefore many of the causes of system interruptions or interruptions in the production process may be outside of our control. As a result, we may not be able to remedy such interruptions in a timely manner, or at all. Our business interruption insurance policies do not address all potential causes of business interruptions that we may experience, and any proceeds we may receive from these policies in the event of a business interruption may not fully compensate us for the revenues we may lose. We may have difficulty managing our growth and expanding our operations successfully. We have grown from 275 employees as of December 31, 2006 to 431 employees as of December 31, 2007. We have website operations, offices and customer support centers in Redwood City, California and Mesa, Arizona, and production facilities in Hayward, California and Charlotte, North Carolina. Our growth has placed, and will continue to place, a strain on our administrative and operational infrastructure. Our ability to manage our operations and growth will require us to continue to refine our operational, financial and management controls, human resource policies and reporting systems. If we are unable to manage future expansion, we may not be able to implement improvements to our controls, policies and systems in an efficient or timely manner and may discover deficiencies in existing systems and controls. Our ability to provide a high-quality customer experience could be compromised, which would damage our reputation and brand and substantially harm our business and results of operations. During 2008, we plan to implement a new enterprise resource planning system (“ERP”) as part of our strategy to provide scale in our operations. These projects are expensive, complex, and subject to delays. If we are not able to effectively manage the deployment of this new ERP system, our results of operations, or our ability to provide timely financial reporting information may be harmed. Competitive pricing pressures, particularly with respect to 4(cid:2)6 print pricing and shipping, may harm our business and results of operations. Demand for our products and services is sensitive to price. Many external factors, including our production and personnel costs and our competitors’ pricing and marketing strategies, can significantly impact our pricing strategies. If we fail to meet our customers’ price expectations, we could lose customers, which would harm our business and results of operations. Changes in our pricing strategies have had, and may continue to have, a significant impact on our net revenues and net income. From time to time, we have made changes to our pricing structure for 4x6 prints in order to remain competitive. In December, 2007, one of our competitors lowered their list prices on 4x6 prints from $0.12 to $0.09. To date, we have not made any additional changes to the price of our 4(cid:2)6 prints as a result of this price cut. However, a drop in our 4x6 prices, without a corresponding increase in volume, or decreases in volume as a result of competitive pressures would negatively impact our net revenues and could adversely affect our gross margins and overall profitability. We generate a significant portion of our net revenues from the fees we collect from shipping our products. For example, these fees represented approximately 19%, 20% and 19% of our net revenues in 2007, 2006 and 2005 respectively. We offer discounted or free shipping, with a minimum purchase requirement, during promotional periods to attract and retain customers. If free shipping offers extend beyond a limited number of occasions, are not based upon a minimum purchase requirement or become commonplace, our net revenues and results of operations would be negatively impacted. In addition, Shutterfly occasionally offers free or discounted products and services to attract and retain customers. In the future, if we increase these offers to respond to actions taken by our competitors, our results of operations may be harmed. 17 We face intense competition from a range of competitors and may be unsuccessful in competing against current and future competitors. The digital photography products and services industries are intensely competitive, and we expect competition to increase in the future as current competitors improve their offerings and as new participants enter the market or as industry consolidation further develops. Competition may result in pricing pressures, reduced profit margins or loss of market share, any of which could substantially harm our business and results of operations. We face intense competition from a wide range of companies, including the following: (cid:129) Online digital photography services companies such as Kodak EasyShare Gallery (formerly known as Ofoto), Snapfish, which is a service of Hewlett-Packard, American Greetings’ Photoworks and Webshots brands, and others; (cid:129) “Big Box” retailers such as Wal-Mart, Costco and others that are seeking to offer low cost digital photography products and services, such as in-store fulfillment and self-service kiosks for printing; these competitors may, among other strategies, offer their customers heavily discounted in-store products and services that compete directly with our offerings; (cid:129) Drug stores such as Walgreens, CVS and others that offer in-store pick-up from Internet orders; (cid:129) Regional photography companies such as Wolf Camera and Ritz Camera that have established brands and customer bases in existing photography markets; (cid:129) Internet portals and search engines such as Yahoo!, AOL, Google that offer broad-reaching digital photography and related products and services to their large user bases; (cid:129) Home printing service providers such as Hewlett-Packard, Epson and Canon, that are seeking to expand their printer and ink businesses by gaining market share in the emerging digital photography marketplace; and (cid:129) Photo-related software companies such as Adobe, Apple, Microsoft, Corel and others. Many of our competitors have significantly longer operating histories, larger and broader customer bases, greater brand and name recognition and greater financial, research and development and distribution resources, and operate in more geographic areas than we do. The numerous choices for digital photography services can cause confusion for consumers, and may cause them to select a competitor with greater name recognition. Some competitors are able to devote substantially more resources to website and systems development, or to investments or partnerships with traditional and online competitors. Competitors that are well-funded, particularly new entrants, may choose to prioritize growing their market share and brand awareness instead of profitability. Competitors and new entrants in the digital photography products and services industries may develop new products, technologies or capabilities that could render obsolete or less competitive many of the products, services and content that we offer. We may be unable to compete successfully against current and future competitors, and competitive pressures could harm our business and prospects. If we are unable to adequately control the costs associated with operating our business, our results of operations will suffer. The primary costs in operating our business are related to producing and shipping products, acquiring customers, compensating our personnel and acquiring equipment and technology and leasing facilities. If we are unable to keep these costs aligned with the level of revenues that we generate, our results of operations would be harmed. Controlling our business costs is challenging because many of the factors that impact these costs are beyond our control. For example, the costs to produce prints, such as the costs of photographic print paper, could increase due to a shortage of silver or an increase in worldwide energy prices. In addition, we may become subject to increased costs by the third-party shippers that deliver our products to our customers, and we may be unable to pass along any increases in shipping costs to our customers. The costs of online advertising and keyword search could also increase significantly due to increased competition, which would increase our customer acquisition costs. 18 We invest in securities that are subject to market risk and the recent issues in the financial markets could adversely affect the value of our assets. At December 31, 2007, we had $122.6 million in cash and cash equivalents and $3.0 million in short-term investments. Included in these amounts, are investments in money market funds, commercial paper, and U.S. gov- ernment agency securities, which are subject to general credit, liquidity, market and interest rate risks, and which may be exacerbated by the current financial market credit and liquidity issues. During the year ended December 31, 2007, we determined that any declines in the fair value of our investments were temporary. There may be further declines in the value of these investments, which we may determined to be other-than-temporary. These market risks associated with our investment portfolio may have a negative adverse effect on our results of operations, liquidity, and financial condition. At February 29, 2008, $52.3 million of our marketable securities portfolio was invested in AAA rated investments in auction-rate debt securities. Auction-rate securities are long-term variable rate bonds tied to short- term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates. Following such a failed auction, we would not be able to access our funds that are invested in the corresponding auction-rate securities until a future auction of these investments is successful or new buyers express interest in purchasing these securities in between reset dates. As a result of the current negative liquidity conditions in the global credit markets, in February 2008, auctions for $42.3 million of original par value of our auction-rate securities failed, rendering these securities temporarily illiquid through the normal auction process. At the time of our initial investment and through the date of this Report, all of our auction-rate securities remain AAA rated. The assets underlying each security are student loans and 95% of the principal amounts are guaranteed by the Federal Family Education Loan Program (FFELP). Since we cannot predict when future auctions related to $52.3 million of our auction-rate securities will be successful, it may become necessary to classify this amount as long-term marketable securities in our consolidated balance sheet in future periods. In addition, if the underlying issuers are unable to successfully clear future auctions or if their credit rating deteriorates and the deterioration is deemed to be other-than-temporary, we would be required to adjust the carrying value of the auction-rate securities through an impairment charge to earnings. Any of these events could materially affect our results of operations and our financial condition. To access these funds in future periods, it may be necessary to attempt to sell these securities at an amount below our original purchase value. However, based on our ability to access our cash and cash equivalents and our other liquid investments, totaling $53.7 million at February 29, 2008, and our expected operating cash flows, we believe that we currently have adequate working capital resources to fund our operations and we do not expect to be required to sell these securities at a loss. The loss of key personnel and an inability to attract and retain additional personnel could affect our abil- ity to successfully grow our business. We are highly dependent upon the continued service and performance of our senior management team and key technical, marketing and production personnel. In addition, a majority of our executive team has recently joined Shutterfly, and has tenure of less than one year. The loss of these key employees, each of whom is “at will” and may terminate his or her employment relationship with us at any time, may significantly delay or prevent the achievement of our business objectives. We believe that our future success will also depend in part on our continued ability to identify, hire, train and motivate qualified personnel. We face intense competition for qualified individuals from numerous technology, marketing, financial services, manufacturing and e-commerce companies. In addition, competition for qualified personnel is particularly intense in the San Francisco Bay Area, where our headquarters are located. We may be unable to attract and retain suitably qualified individuals who are capable of meeting our growing operational and 19 managerial requirements, or we may be required to pay increased compensation in order to do so. Our failure to attract and retain qualified personnel could impair our ability to implement our business plan. Our evergreen option pool is limited to the lesser of a) 4.62% of stock options issued and outstanding on the December 31 immediately prior to the date of increase or b) a lesser number as determined by the Board. In order to attract key personnel, during 2007, the Board authorized additional inducement stock option grants totaling 380,000 to supplement our option pool. In the future, attracting key personnel may require a level of option grants in excess of the amount available in our option pool. Accordingly the Board may authorize additional inducement grants which could further dilute existing shareholders. If we are unable to attract customers in a cost-effective manner, or if we were to become subject to e-mail blacklisting, traffic to our website would be reduced and our business and results of operations would be harmed. Our success depends on our ability to attract customers in a cost-effective manner. We rely on a variety of methods to bring visitors to our website and promote our products, including paying fees to third parties who drive new customers to our website, purchasing search results from online search engines, e-mail and direct mail. We pay providers of online services, search engines, directories and other website and e-commerce businesses to provide content, advertising banners and other links that direct customers to our website. We also use e-mail and direct mail to offer free products and services to attract customers, and we offer substantial pricing discounts to encourage repeat purchases. Our methods of attracting customers, including acquiring customer lists from third parties, can involve substantial costs, regardless of whether we acquire new customers. Even if we are successful in acquiring and retaining customers, the cost involved in these efforts impact our results of operations. Customer lists are typically recorded as intangible assets and may be subject to impairment charges if the fair value of that list exceeds its carrying value. These potential impairment charges could harm our results from operations. If we are unable to enhance or maintain the methods we use to reach consumers, if the costs of attracting customers using these methods significantly increase, or if we are unable to develop new cost-effective means to obtain customers, our ability to attract new customers would be harmed, traffic to our website would be reduced and our business and results of operations would be harmed. In addition, various private entities attempt to regulate the use of e-mail for commercial solicitation. These entities often advocate standards of conduct or practice that significantly exceed current legal requirements and classify certain e-mail solicitations that comply with current legal requirements as unsolicited bulk e-mails, or “spam.” In addition, we have noted unauthorized “spammers” utilize our domain name to solicit spam. Some of these entities maintain blacklists of companies and individuals, and the websites, Internet service providers and Internet protocol addresses associated with those entities or individuals that do not adhere to what the blacklisting entity believes are appropriate standards of conduct or practices for commercial e-mail solicitations. If a company’s Internet protocol addresses are listed by a blacklisting entity, e-mails sent from those addresses may be blocked if they are sent to any Internet domain or Internet address that subscribes to the blacklisting entity’s service or purchases its blacklist. From time to time we are blacklisted, sometimes without our knowledge, which could impair our ability to market our products and services, communicate with our customers and otherwise operate our business. We may not succeed in promoting, strengthening and continuing to establish the Shutterfly brand, which would prevent us from acquiring new customers and increasing revenues. A component of our business strategy is the continued promotion and strengthening of the Shutterfly brand. Due to the competitive nature of the digital photography products and services markets, if we are unable to successfully promote the Shutterfly brand, we may fail to substantially increase our net revenues. Customer awareness of, and the perceived value of, our brand will depend largely on the success of our marketing efforts and our ability to provide a consistent, high-quality customer experience. To promote our brand, we have incurred, and will continue to incur, substantial expense related to advertising and other marketing efforts. Our ability to provide a high-quality customer experience also depends, in large part, on external factors over which we may have little or no control, including the reliability and performance of our suppliers and third-party 20 Internet and communication infrastructure providers. For example, some of our products, such as select photo- based merchandise, are produced and shipped to customers by our third-party vendors, and we rely on these vendors to properly inspect and ship these products. In addition, we rely on third-party shippers, including the U.S. Postal Service and United Parcel Service, to deliver our products to customers. Strikes or other service interruptions affecting these shippers could impair our ability to deliver merchandise on a timely basis. Our products are also subject to damage during delivery and handling by our third-party shippers. Our failure to provide customers with high-quality products in a timely manner for any reason could substantially harm our reputation and our efforts to develop Shutterfly as a trusted brand. The failure of our brand promotion activities could adversely affect our ability to attract new customers and maintain customer relationships, which would substantially harm our business and results of operations. Purchasers of digital photography products and services may not choose to shop online, which would harm our net revenues and results of operations. The online market for digital photography products and services is less developed than the online market for other consumer products. If this market does not gain widespread acceptance, our business may suffer. Our success will depend in part on our ability to attract customers who have historically used traditional retail photography services or who have produced photographs and other products using self-service alternatives, such as printing at home. Furthermore, we may have to incur significantly higher and more sustained advertising and promotional expenditures or reduce the prices of our products and services in order to attract additional online consumers to our website and convert them into purchasing customers. Specific factors that could prevent prospective customers from purchasing from us include: (cid:129) the inability to physically handle and examine product samples; (cid:129) delivery time associated with Internet orders; (cid:129) concerns about the security of online transactions and the privacy of personal information; (cid:129) delayed shipments or shipments of incorrect or damaged products; and (cid:129) inconvenience associated with returning or exchanging purchased items. If purchasers of digital photography products and services do not choose to shop online, our net revenues and results of operations would be harmed. If affordable broadband access does not become widely available to consumers, our revenue growth will likely suffer. Because our business currently involves consumers uploading and downloading large data files, we are highly dependent upon the availability of affordable broadband access to consumers. Many areas of the country still do not have broadband access, and the cost of broadband access may be too expensive for many potential customers. To the extent that broadband access is not available or not adopted by consumers due to cost, our revenue growth would likely suffer. If the single facility where substantially all of our computer and communications hardware is located fails or if our production facilities fail, our business and results of operations would be harmed. Our ability to successfully receive and fulfill orders and to provide high-quality customer service depends in part on the efficient and uninterrupted operation of our computer and communications systems. Substantially all of the computer hardware necessary to operate our website is located at a single third-party hosting facility in Santa Clara, California, and our production facilities are located in Hayward, California and Charlotte, North Caro- lina. Our systems and operations could suffer damage or interruption from human error, fire, flood, power loss, insufficient power availability, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, Hayward is located on, and Santa Clara is located near, a major fault line, increasing our susceptibility to the risk that an earthquake could significantly harm the operations of these facilities. We maintain business interruption insurance, however, this insurance may be insufficient to compensate us for losses that may 21 occur, particularly from interruption due to an earthquake which is not covered under our current policy. We do not presently have redundant systems in multiple locations, although we are considering an additional data center in our new facility in Charlotte. In addition, the impact of any of these disasters on our business may be exacerbated by the fact that we are still in the process of developing our formal disaster recovery plan and we do not have a final plan in place. Capacity constraints and system failures could prevent access to our website, which could harm our repu- tation and negatively affect our net revenues. Our business requires that we have adequate capacity in our computer systems to cope with the high volume of visits to our website. As our operations grow in size and scope, we will need to improve and upgrade our computer systems and network infrastructure to ensure reliable access to our website, in order to offer customers enhanced and new products, services, capacity, features and functionality. The expansion of our systems and infrastructure may require us to commit substantial financial, operational and technical resources before the volume of our business increases, with no assurance that our net revenues will increase. Our ability to provide high-quality products and service depends on the efficient and uninterrupted operation of our computer and communications systems. If our systems cannot be expanded in a timely manner to cope with increased website traffic, we could experience disruptions in service, slower response times, lower customer satisfaction, and delays in the introduction of new products and services. Any of these problems could harm our reputation and cause our net revenues to decline. Our technology, infrastructure and processes may contain undetected errors or design faults that could result in decreased production, limited capacity or reduced demand. Our technology, infrastructure and processes may contain undetected errors or design faults. These errors or design faults may cause our website to fail and result in loss of, or delay in, market acceptance of our products and services. If we experience a delay in a website release that results in customer dissatisfaction during the period required to correct errors and design faults, we would lose revenue. In the future, we may encounter scalability limitations, in current or future technology releases, or delays in the commercial release of any future version of our technology, infrastructure and processes that could seriously harm our business. We currently depend on third party suppliers for our photographic print paper, printing machines and other supplies, which expose us to risks if these suppliers fail to perform under our agreements with them. We have historically relied on an exclusive supply relationship with Fuji Photo Film U.S.A. to supply all of our photographic paper for silver halide print production, such as 4(cid:2)6 prints. We have an agreement with Fuji that expires in April 2010, but if Fuji fails to perform in accordance with the terms of our agreement and if we are unable to secure a paper supply from a different source in a timely manner, we would likely fail to meet customer expectations, which could result in negative publicity, damage our reputation and brand and harm our business and results of operations. We purchase other photo-based supplies from third parties on a purchase order basis, and, as a result, these parties could increase their prices, reallocate supply to others, including our competitors, or choose to terminate their relationship with us. In addition, we purchase or rent the machines used to produce certain of our photo-based products from Hewlett-Packard, which is one of our primary competitors in the area of online digital photography services. This competition may influence their willingness to provide us with additional products or services. If we were required to switch vendors of machines for photo-based products, we may incur delays and incremental costs, which could harm our operating results. We currently outsource some of our production of photo-based products to third parties, which exposes us to risks if these parties fail to perform under our agreements with them. We currently outsource the production of some our photo-based products to third parties. If these parties fail to perform in accordance with the terms of our agreements and if we are unable to secure another outsource partner in a 22 timely manner, we would likely fail to meet customer expectations, which could result in negative publicity, damage our reputation and brand and harm our business and results of operations. If we are unable to develop, market and sell new products and services that address additional market opportunities, our results of operations may suffer. In addition, we may need to expand beyond our cur- rent customer demographic to grow our business. Although historically we have focused our business on consumer markets for silver halide prints, such as 4(cid:2)6 prints, and photo-based products, such as photo books and calendars, we intend to address, and demand may shift to, new products and services. In addition, we believe we may need to address additional markets and expand our customer demographic in order to further grow our business. We may not successfully expand our existing services or create new products and services, address new market segments or develop a significantly broader customer base. Any failure to address additional market opportunities could result in loss of market share, which would harm our business, financial condition and results of operations. We may undertake acquisitions to expand our business, which may pose risks to our business and dilute the ownership of our existing stockholders. A key component of our business strategy includes strengthening our competitive position and refining the customer experience on our website through internal development. However, from time to time, we may selectively pursue acquisitions of businesses, like our June 2007 acquisition of Make it About Me! (“MIAM”), our January 2008 acquisition of Nexo Systems (“Nexo”) and other technologies or services. Integrating any newly acquired businesses, technologies or services is likely to be expensive and time consuming. To finance any acquisition, it may be necessary for us to raise additional funds through public or private financings. Additional funds may not be available on terms that are favorable to us, and, in the case of equity financings, would result in dilution to our stockholders. Also, the value of our stock may be insufficient to attract acquisition candidates. If we do complete any acquisitions, we may be unable to operate the acquired businesses profitably or otherwise implement our strategy successfully. If we are unable to integrate MIAM, Nexo, or any other newly acquired entities, technologies or services effectively, our business and results of operations will suffer. The time and expense associated with finding suitable and compatible businesses, technologies or services could also disrupt our ongoing business and divert our management’s attention. Future acquisitions by us could also result in large and immediate write-offs or assumptions of debt and contingent liabilities, any of which could substantially harm our business and results of operations. Our net revenues and results of operations are affected by the level of vacation and other travel by our customers, and any declines or disruptions in the travel industry could harm our business. Because vacation and other travel is one of the primary occasions in which our customers utilize their digital cameras, our net revenues and results of operations are affected by the level of vacation and other travel by our customers. Accordingly, downturns or weaknesses in the travel industry could harm our business. Travel expen- ditures are sensitive to business and personal discretionary spending levels and tend to decline during general economic downturns. Events or weakness in the travel industry that could negatively affect the travel industry include price escalation in the airline industry or other travel-related industries, airline or other travel related strikes, safety concerns, including terrorist activities, inclement weather and airline bankruptcies or liquidations. In addition, high gasoline prices may lead to reduced travel in the United States. Any decrease in vacation or travel could harm our net revenues and results of operations. Failure to adequately protect our intellectual property could substantially harm our business and results of operations. We rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect our intellectual property. These protective measures afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our website features and functionalities or to obtain and use information that we consider proprietary, such as the technology used to operate our website, our production operations and our trademarks. 23 As of December 31, 2007, we had 21 patents issued and more than 30 patent applications pending in the United States. We intend to pursue corresponding patent coverage in other countries to the extent we believe such coverage is appropriate and cost efficient. We cannot ensure that any of our pending applications will be granted. In addition, third parties have in the past and could in the future bring infringement, invalidity, co-inventorship or similar claims with respect to any of our currently issued patents or any patents that may be issued to us in the future. Any such claims, whether or not successful, could be extremely costly, could damage our reputation and brand and substantially harm our business and results of operations. Our primary brand is “Shutterfly.” We hold registrations for the Shutterfly service mark in our major markets of the United States and Canada, as well as in the European Community, Mexico, Japan, Australia and New Zealand. An additional application for the Shutterfly mark is pending in Brazil. Our competitors may adopt names similar to ours, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of marks that are similar to Shutterfly or one of our other marks. The Shutterfly brand is a critical component of our marketing programs. If we lose the ability to use the Shutterfly service mark in any particular market, we could be forced to either incur significant additional marketing expenses within that market, or elect not to sell products in that market. Any claims or customer confusion related to our marks could damage our reputation and brand and substantially harm our business and results of operations. If we become involved in intellectual property litigation or other proceedings related to a determination of rights, we could incur substantial costs, expenses or liability, lose our exclusive rights or be required to stop certain of our business activities. Third parties may sue us for infringing its intellectual property rights. In June 2007, we were sued by FotoMedia Technologies, LLC alleging patent infringement. In February 2008, we were also sued by Parallel Networks, also alleging patent infringement. Likewise, we may need to resort to litigation to enforce our intellectual property rights or to determine the scope and validity of third-party proprietary rights. The cost to us of any litigation or other proceeding relating to intellectual property rights, whether or not initiated by us and even if resolved in our favor, could be substantial, and the litigation would divert our management’s efforts from growing our business. Some of our competitors may be able to sustain the costs of complex intellectual property litigation more effectively than we can because they have substantially greater resources. Uncertainties resulting from the initiation and continuation of any litigation could limit our ability to continue our operations. Alternatively, we may be required to, or decide to, enter into a license with a third party. For example, in May 2005, we entered into a settlement and license agreement to resolve litigation brought by a third party with respect to our alleged infringement of its patents. Under the terms of the agreement, we agreed to pay the third party a total of $2.0 million, and we received a license to its patents. Any future license required under any other party’s patents may not be made available on commercially acceptable terms, if at all. In addition, such licenses are likely to be non-exclusive and, therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license and are unable to design around a patent, we may be unable to effectively conduct certain of our business activities, which could limit our ability to generate revenues and harm our results of operations and possibly prevent us from generating revenues sufficient to sustain our operations. The inability to acquire or maintain domain names for our website could substantially harm our business and results of operations. We currently are the registrant of the Internet domain name for our website, Shutterfly.com, as well as various related domain names. Domain names generally are regulated by Internet regulatory bodies and are controlled also by trademark and other related laws. The regulations governing domain names could change in ways that block or interfere with our ability to use relevant domains. Also, we might not be able to prevent third parties from registering or retaining domain names that interfere with our consumer communications, or infringe or otherwise decrease the value of our trademarks and other proprietary rights. Regulatory bodies also may establish additional generic or country-code top-level domains or modify the requirements for holding domain names. As a result, we might not be 24 able to acquire or maintain the domain names that utilize the name Shutterfly in all of the countries in which we currently or intend to conduct business. This could substantially harm our business and results of operations. We may be subject to past or future liabilities for collection of sales and use taxes, and the payment of corporate level taxes. Our policies concerning the collection of sales and use taxes and the payment of certain corporate level taxes has been based upon decisions of the U.S. Supreme Court that determine when a taxpayer is deemed to have nexus with a state sufficient to impose tax obligations under the Commerce Clause of the U.S. Constitution. Those Supreme Court decisions require that the taxpayer be physically present before a state can require the collection of sales and use taxes. States are currently attempting to expand the definition of what constitutes physical presence for sales and use taxes. At the same time, the standard governing the imposition of other taxes, for instance, corporate income taxes, is less established and a number of state courts have recently concluded that the Commerce Clause definition of nexus should be expanded to include either “physical” or “economic” presence (essentially marketing activities) which is a broader definition than is used for sales and use tax. In reliance upon the U.S. Supreme Court’s decisions, we have continued to collect sales and use taxes in California, Nevada, Pennsylvania, North Carolina, New York, New Jersey, and Arizona where we have employees and/or property. Starting in June 2007, we also began collecting sales and use taxes in other states where we have implemented joint sales efforts with Target Corporation. While we believe the U.S. Supreme Court decisions support our policies concerning the collection and payment of taxes, tax authorities could disagree with our interpretations. If sustained, those authorities might seek to impose past as well as future liability for taxes and/or penalties. Such impositions could also impose significant administrative burdens and decrease our future sales. Moreover, the U.S. Congress has been considering various initiatives that could limit or supersede the U.S. Supreme Court’s position regarding sales and use taxes. Our effective tax rate may be subject to fluctuation from federal and state audits, and disqualifying dispositions of stock options. We recently resolved an audit examination by the State of California for the 2003 tax year, with a favorable result. Future audits of other tax years or by other taxing authorities could also lead to fluctuations in our effective tax rate because the taxing authority may disagree with certain assumptions we have made regarding appropriate credits and deductions in filing our tax returns. Under current stock option tax regulations, we are entitled to a stock option compensation tax deduction when employees exercise and sell their incentive stock options within a two year period for a taxable gain. Our current effective tax rate estimate does not incorporate this deduction as the extent of the deduction, based on employee option disposition activity is not currently determinable. These disqualifying dispositions could lead to future fluctuations in our effective tax rate for any given quarter or year. Government regulation of the Internet and e-commerce is evolving, and unfavorable changes or failure by us to comply with these regulations could substantially harm our business and results of operations. We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet and e-commerce. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, restrictions on imports and exports, customs, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, the provision of online payment services, broadband residential Internet access and the characteristics and quality of products and services. It is not clear how existing laws governing issues such as property use and ownership, sales and other taxes, libel and personal privacy apply to the Internet and e-commerce as the vast majority of these laws were adopted prior to the advent of the Internet and do not contemplate or address the unique issues raised by the Internet or e-commerce. Those laws that do reference the Internet are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. For example, the Digital Millennium Copyright Act, or DMCA, is intended, in part, to limit the liability of eligible online service providers for including (or for listing or linking to third-party websites that include) materials that 25 infringe copyrights or other rights of others. Portions of the Communications Decency Act, or CDA, are intended to provide statutory protections to online service providers who distribute third-party content. We rely on the protections provided by both the DMCA and CDA in conducting our business. Any changes in these laws or judicial interpretations narrowing their protections will subject us to greater risk of liability and may increase our costs of compliance with these regulations or limit our ability to operate certain lines of business. The Children’s Online Protection Act and the Children’s Online Privacy Protection Act are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information from minors. In addition, the Protection of Children From Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circum- stances. The costs of compliance with these regulations may increase in the future as a result of changes in the regulations or the interpretation of them. Further, any failures on our part to comply with these regulations may subject us to significant liabilities. Those current and future laws and regulations or unfavorable resolution of these issues may substantially harm our business and results of operations. Legislation regarding copyright protection or content interdiction could impose complex and costly con- straints on our business model. Because of our focus on automation and high volumes, our operations do not involve, for the vast majority of our sales, any human-based review of content. Although our website’s terms of use specifically require customers to represent that they have the right and authority to reproduce the content they provide and that the content is in full compliance with all relevant laws and regulations, we do not have the ability to determine the accuracy of these representations on a case-by-case basis. There is a risk that a customer may supply an image or other content that is the property of another party used without permission, that infringes the copyright or trademark of another party, or that would be considered to be defamatory, pornographic, hateful, racist, scandalous, obscene or otherwise offensive, objectionable or illegal under the laws or court decisions of the jurisdiction where that customer lives. There is, therefore, a risk that customers may intentionally or inadvertently order and receive products from us that are in violation of the rights of another party or a law or regulation of a particular jurisdiction. If we should become legally obligated in the future to perform manual screening and review for all orders destined for a jurisdiction, we will encounter increased production costs or may cease accepting orders for shipment to that jurisdiction. That could substantially harm our business and results of operations. Our practice of offering free products and services could be subject to judicial or regulatory challenge. We regularly offer free products and free shipping as an inducement for customers to try our products. Although we believe that we conspicuously and clearly communicate all details and conditions of these offers — for example, that customers are required to pay shipping, handling and/or processing charges to take advantage of the free product offer — we may be subject to claims from individuals or governmental regulators that our free offers are misleading or do not comply with applicable legislation. These claims may be expensive to defend and could divert management’s time and attention. If we become subject to such claims in the future, or are required or elect to curtail or eliminate our use of free offers, our results of operations may be harmed. Any failure by us to protect the confidential information of our customers and networks against security breaches and the risks associated with credit card fraud could damage our reputation and brand and sub- stantially harm our business and results of operations. A significant prerequisite to online commerce and communications is the secure transmission of confidential information over public networks. Our failure to prevent security breaches could damage our reputation and brand and substantially harm our business and results of operations. For example, a majority of our sales are billed to our customers’ credit card accounts directly, orders are shipped to a customer’s address, and customers log on using their e-mail address. We rely on encryption and authentication technology licensed from third parties to effect the secure transmission of confidential information, including credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer transaction data. In addition, any party who is able to illicitly obtain a user’s password could access the user’s transaction data, personal information or stored images. Any compromise of 26 our security could damage our reputation and brand and expose us to a risk of loss or litigation and possible liability, which would substantially harm our business and results of operations. In addition, anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may need to devote significant resources to protect against security breaches or to address problems caused by breaches. In addition, under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. We do not currently carry insurance against this risk. To date, we have experienced minimal losses from credit card fraud, but we continue to face the risk of significant losses from this type of fraud. Our failure to adequately control fraudulent credit card transactions could damage our reputation and brand and substantially harm our business and results of operations. Changes in regulations or user concerns regarding privacy and protection of user data could harm our business. Federal, state and international laws and regulations may govern the collection, use, sharing and security of data that we receive from our customers. In addition, we have and post on our website our own privacy policies and practices concerning the collection, use and disclosure of customer data. Any failure, or perceived failure, by us to comply with our posted privacy policies or with any data-related consent orders, Federal Trade Commission requirements or other federal, state or international privacy-related laws and regulations could result in proceedings or actions against us by governmental entities or others, which could potentially harm our business. Further, failure or perceived failure to comply with our policies or applicable requirements related to the collection, use or security of personal information or other privacy-related matters could damage our reputation and result in a loss of customers. International expansion will require management attention and resources and may be unsuccessful, which could harm our future business development and existing domestic operations. To date, we have conducted limited international operations, but we intend to expand into international markets in order to grow our business. These expansion plans will require significant management attention and resources and may be unsuccessful. We have limited experience adapting our products to conform to local cultures, standards and policies. We may have to compete with local companies which understand the local market better than we do. In addition, to achieve satisfactory performance for consumers in international locations it may be necessary to locate physical facilities, such as production facilities, in the foreign market. We do not have experience establishing such facilities overseas. We may not be successful in expanding into any international markets or in generating revenues from foreign operations. In addition, different privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our business to be harmed. The success of our business depends on continued consumer adoption of digital photography Our growth is highly dependent upon the continued adoption by consumers of digital photography. The digital photography market is rapidly evolving, characterized by changing technologies, intense price competition, additional competitors, evolving industry standards, frequent new service announcements and changing consumer demands and behaviors. To the extent that consumer adoption of digital photography does not continue to grow as expected, our revenue growth would likely suffer. Moreover, we face significant risks that, if the market for digital photography evolves in ways that we are not able to address due to changing technologies or consumer behaviors, pricing pressures, or otherwise, our current products and services may become less attractive, which would likely result in the loss of customers, as well as lower net revenues and/or increased expenses. 27 Maintaining and improving our financial controls and the requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain qualified board members. As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002 and the rules and regulations of The NASDAQ Stock Market. The requirements of these rules and regulations will likely continue to increase our legal, accounting and financial compliance costs, make some activities more difficult, time-consuming or costly and may also place undue strain on our personnel, systems and resources. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and effective internal control over financial reporting. Significant resources and management oversight are required to design, document, test, implement and monitor internal control over relevant processes and to, remediate any deficiencies. As a result, management’s attention may be diverted from other business concerns, which could harm our business, financial condition and results of operations. These efforts also involve substantial accounting related costs. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on The NASDAQ Global Market. Under the Sarbanes-Oxley Act and the rules and regulations of The NASDAQ Stock Market, we are required to maintain a board of directors with a majority of independent directors. These rules and regulations may make it more difficult and more expensive for us to maintain directors’ and officers’ liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to maintain coverage. If we are unable to maintain adequate directors’ and officers’ insurance, our ability to recruit and retain qualified directors and officers, especially those directors who may be considered independent for purposes of NASDAQ rules, will be significantly curtailed. Our stock price may be volatile or may decline regardless of our operating performance. The market price of our common stock may fluctuate significantly in response to numerous factors, many of which are beyond our control, including: (cid:129) price and volume fluctuations in the overall stock market; (cid:129) changes in operating performance and stock market valuations of other technology companies generally, or those in our industry in particular; (cid:129) the financial projections we may provide to the public, any changes in these projections or our failure to meet these projections; (cid:129) changes in financial estimates by any securities analysts who follow our company, our failure to meet these estimates or failure of those analysts to initiate or maintain coverage of our stock; (cid:129) ratings downgrades by any securities analysts who follow our company; (cid:129) the public’s response to our press releases or other public announcements, including our filings with the SEC; (cid:129) announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures or capital commitments; (cid:129) introduction of technologies or product enhancements that reduce the need for our products; (cid:129) market conditions or trends in our industry or the macro-economy as a whole; (cid:129) impairment or loss in value of our investments in auction rate securities; (cid:129) the loss of key personnel; (cid:129) lawsuits threatened or filed against us; (cid:129) future sales of our common stock by our executive officers, directors and significant stockholders; and (cid:129) other events or factors, including those resulting from war, incidents of terrorism or responses to these events. 28 Some provisions in our restated certificate of incorporation and restated bylaws and Delaware law may deter third parties from acquiring us. Our restated certificate of incorporation and restated bylaws contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following: (cid:129) our board is classified into three classes of directors, each with staggered three-year terms; (cid:129) only our chairman, our chief executive officer, our president, or a majority of our board of directors is authorized to call a special meeting of stockholders; (cid:129) our stockholders may take action only at a meeting of stockholders and not by written consent; (cid:129) vacancies on our board of directors may be filled only by our board of directors and not by stockholders; (cid:129) our certificate of incorporation authorizes undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; and (cid:129) advance notice procedures apply for stockholders to nominate candidates for election as directors or to bring matters before an annual meeting of stockholders. These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors of their choosing and to cause us to take other corporate actions they desire. In addition, we are subject to Section 203 of the Delaware General Corporation Law, which, subject to some exceptions, prohibits “business combinations” between a Delaware corporation and an “interested stockholder,” which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of a Delaware corporation’s voting stock, for a three-year period following the date that the stockholder became an interested stockholder. Section 203 could have the effect of delaying, deferring or preventing a change in control that our stockholders might consider to be in their best interests. ITEM 1B. UNRESOLVED STAFF COMMENTS. Not applicable. ITEM 2. PROPERTIES. We maintain our corporate headquarters in Redwood City, California in a leased facility of approximately 60,420 square feet. The lease for this facility expires on May 31, 2010. We maintain our West-coast production and fulfillment operations in Hayward, California in leased facilities totaling approximately 71,708 square feet. Leases for these facilities expire between September 30, 2009 and July 31, 2010. We have an option to extend these leases for five years and a first right of refusal to lease any immediately adjacent contiguous space. We maintain our East-coast production and fulfillment operations in Charlotte, North Carolina in leased facilities totaling approximately 102,400 square feet. The lease for the facility commenced on the May 31, 2007, and continues through 2014. We have an option to extend the lease for three additional periods of either three or five years in length, and first rights of refusal to lease space in certain adjacent buildings. We have certain temporary office space in Mesa, Arizona in leased facilities totaling approximately 1,000 square feet. The lease for the facility commenced on September 26, 2007 and expires on September 30, 2008. We believe that our existing facilities are adequate to meet our needs through the first half of 2008, although we expect to require additional corporate facilities to handle future growth. We believe that suitable additional space will be available in the future on commercially reasonably terms as needed. ITEM 3. LEGAL PROCEEDINGS. On August 29, 2006, our former Chief Financial Officer, Virender Ahluwalia, sued us in San Mateo County Superior Court alleging causes of action for reformation of contract, breach of contract and breach of fiduciary duty. The plaintiff claimed that he was entitled to exercise stock options for an additional 15,535 shares of our common 29 stock because his vesting schedule should have been deemed to have started one year earlier than the date stated in our corporate records. In addition, the plaintiff claimed that the we initially did not advise him that withholding taxes were due at the time of exercise of his nonqualified stock options to purchase 292,674 shares of common stock in 2005, but that we later modified that tax advice, extended his option exercise date, and required that he make provision for the applicable withholding taxes at the time of exercise of such options. The plaintiff claimed he was damaged by having to immediately sell a portion of those shares upon his exercise in order to raise the funds necessary to pay applicable withholding taxes. He also claimed that the calculation of the fair market value of the shares for the purpose of calculating his tax liability was improper. The plaintiff was seeking compensatory and punitive damages. The case was stayed and sent to binding arbitration, and following a hearing on the legal issues and an evidentiary hearing, the Arbitrator issued a Final Award on November 16, 2007 finding us not liable and dismissed all claims brought by Mr. Ahluwalia. On or about June 18, 2007, Fotomedia Technologies, LLC filed suit in the United States District Court for the Eastern District of Texas against us and several other defendants alleging patent infringement. The Fotomedia Complaint sought unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction. In lieu of answering the Fotomedia Complaint, we moved to dismiss it under Rule 12 of the Federal Rules of Civil Procedure, by joining in a motion to the same effect filed by co-defendant Photobucket.com, Inc. While the motion was pending and not yet decided, on or about November 6, 2007, Fotomedia filed an Amended Complaint. The Amended Complaint likewise alleges infringement of the same patents and seeks unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction. However, the amended complaint dropped the allegations of willful infringement against us in connection with one of the patents-at-issue. Defendants moved to dismiss the Amended Complaint as well. The motion at this time is fully briefed but has not yet been ruled upon. As such, we have not yet been required to file an answer or other responsive pleading. On January 8, 2008, the court held a status conference and set May 28, 2009, as the date for the claims construction hearing, and set November 2, 2009 as the date for trial. Subsequently, the parties agreed upon and submitted orders that establish a case schedule, which the court entered on February 29, 2008. On or about February 5, 2008, Parallel Networks, LLC filed a lawsuit in the Eastern District of Texas against the Company and other companies alleging patent infringement. The Parallel Networks Complaint seeks damages of an unspecified amount, attorneys’ fees, and an injunction against all parties. We have not yet answered or otherwise responded to the complaint. In addition, in the ordinary course of our business, we are subject to periodic lawsuits, investigations and claims. Although we cannot predict with certainty the ultimate resolution of lawsuits, investigations and claims asserted against us, we do not believe that any other currently pending legal proceeding to which we are a party is likely to harm our business, results of operations, cash flows or financial condition. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES. Shutterfly’s common stock has been traded on the NASDAQ Global Market under the symbol “SFLY” since September 29, 2006. As of February 29, 2008, there were approximately 154 stockholders of record, excluding stockholders whose shares were held in nominee or street name by brokers. We have not paid any cash dividends and do not currently have plans to do so in the foreseeable future. The following table sets forth the high and low sales price per share for Shutterfly’s common stock for the periods indicated: High Low Year Ended December 31, 2006 Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16.73 Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16.29 $15.01 $12.05 30 Year Ended December 31, 2007 First Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18.53 Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22.92 Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32.46 Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $36.40 $13.38 $15.92 $21.80 $25.59 High Low We have never paid cash dividends on our capital stock. It is our present policy to retain earnings to finance the growth and development of our business and, therefore, we do not anticipate paying any cash dividends in the foreseeable future. Purchases of Equity Securities of the Issuer and Affiliated Purchasers Neither we nor any affiliated purchaser repurchased any of our equity securities in the fourth quarter of fiscal year 2007. Use of Proceeds The S-1 relating to our initial public offering was declared effective by the SEC on September 28, 2006 (Registration Statement File No. 333-135426), and the offering commenced the same day. J.P. Morgan Securities Inc. acted as the sole book-running manager for the offering and Piper Jaffray & Co. and Jefferies & Company, Inc. acted as co-managers of the offering. The securities registered were 5,800,000 shares of common stock, plus 870,000 additional shares to cover the underwriters’ over-allotment option. The underwriters’ over-allotment option expired on October 28, 2006, and was not exercised by the underwriters. The aggregate public offering price of the offering amount registered, including shares to cover the underwriters’ over-allotment option, was $100,050,000. We sold 5,800,000 shares of our common stock for an aggregate offering price of $87,000,000, and the offering has terminated. Expenses incurred in connection with the issuance and distribution of the securities registered were as follows: (cid:129) Underwriting discounts and commissions — $6,090,000 (cid:129) Other expenses — $2,442,000 (cid:129) Total expenses — $8,533,000 None of such payments were direct or indirect payments to any of our directors or officers or their associates or to persons owning ten percent or more of our common stock or direct or indirect payments to others. The net offering proceeds to us after deducting underwriters’ discounts and the total expenses described above was approximately $78.5 million. Through December 31, 2007, we have used approximately half of these proceeds to purchase capital equipment, acquire a business, and for general operating purposes. We expect to continue to use the remainder of the net proceeds for general corporate purposes, including working capital, operating expenses, and capital expenditures. In addition, we may also use a portion of the net proceeds for the acquisition of, or investment in, companies, technologies, products or assets that complement our business. Our management retains broad discretion in the allocation and use of the net proceeds of our initial public offering, and investors must rely on the judgment of our management regarding the application of the net proceeds. Pending specific utilization of the net proceeds as described above, we have invested the net proceeds of the offering in short-term, interest-bearing obligations, investment grade instruments, certificates of deposit or direct or guaranteed obligations of the United States. The investment objective with respect to net proceeds is capital preservation and liquidity so that such funds are readily available to fund our operations. 31 ITEM 6. SELECTED FINANCIAL DATA. The consolidated statements of income data for the years ended December 31, 2007, 2006 and 2005 and the consolidated balance sheet data as of December 31, 2007 and 2006 have been derived from our audited consolidated financial statements included elsewhere in this annual report. The consolidated statements of income data for the years ended December 31, 2004 and 2003 and the consolidated balance sheet data as of December 31, 2005, 2004 and 2003 have been derived from our audited consolidated financial statements not included in this annual report. The following selected consolidated financial data should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and consolidated financial statements and related notes to those statements included elsewhere in this annual report. 2007 Year Ended December 31, 2006 2005 2004 2003 Consolidated Income Statement Data: Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $186,727 84,111 Cost of net revenues(1) . . . . . . . . . . . . . . . . . . . . . . . . . $123,353 55,491 $83,902 36,941 $54,499 $31,395 14,310 24,878 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,616 67,862 46,961 29,621 17,085 (In thousands, except per share amounts) Operating expenses: Technology and development(1) . . . . . . . . . . . . . . . . . Sales and marketing(1) . . . . . . . . . . . . . . . . . . . . . . . General and administrative(1) . . . . . . . . . . . . . . . . . . Total operating expense . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (expense) net . . . . . . . . . . . . . . . . . . . . . . Income before income taxes and cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . . . (Provision) / benefit for income taxes(2) . . . . . . . . . . . . Net income before cumulative effect of change in 28,635 33,363 29,557 91,555 11,061 (179) 5,515 19,087 21,940 19,216 13,152 15,252 13,657 7,433 7,705 10,126 4,970 3,991 5,629 60,243 42,061 25,264 14,590 7,619 (266) 2,387 4,900 (367) (103) 4,357 (471) 81 2,495 (392) 9 16,397 (6,302) 9,740 (3,942) 4,430 24,060 3,967 (258) 2,112 (68) accounting principle(2) . . . . . . . . . . . . . . . . . . . . . . . 10,095 5,798 28,490 3,709 2,044 Cumulative effect of change in accounting principle . . . . Net income(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,095 $ — — 442 5,798 $28,932 — — $ 3,709 $ 2,044 Net income per share: Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.42 $ 0.38 $ 0.67 $ 0.56 $ 1.45 $ — $ — 1.02 $ — $ — Weighted Average Shares Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,295 26,273 8,622 10,331 3,255 4,609 2,231 2,231 1,574 1,574 (1) Includes stock-based compensation as follows: 2007 Cost of net revenues. . . . . . . . . . . . . . . . . . . . . . . . $ Technology and development . . . . . . . . . . . . . . . . . Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . General and administration . . . . . . . . . . . . . . . . . . . 189 880 877 2,055 $ Year Ended December 31, 2006 2005 2004 $ (In thousands) 28 826 239 2,217 96 736 521 947 $ $ 21 263 117 1,790 $ 4,001 $ 2,300 $ 3,310 $ 2,191 $ 32 2003 3 32 11 124 170 (2) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates — Income Taxes” for a discussion of the uncertainty related to our deferred tax asset. 2007 2006 December 31, 2005 (In thousands) 2004 2003 Consolidated Balance Sheet Data: Cash, cash equivalents, and short term investments . . . . . . . . . . . . . . . . . . . . . . . Property and equipment, net . . . . . . . . . . . . Working capital . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . Capital lease obligations, less current portion . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock warrant liability . . . . . . . . . . Redeemable convertible preferred stock . . . . Total stockholders’ equity (deficit) . . . . . . . . $125,584 48,416 104,025 208,770 $119,051 30,919 102,165 180,160 $ 39,153 $ 13,781 11,723 690 29,865 20,761 22,687 89,552 $ 10,670 5,140 2,002 17,754 107 — — 170,566 3,646 1,742 — 1,535 — 89,652 (27,262) 151,326 2,709 — 69,822 (59,568) 1,314 — 69,668 (65,333) 33 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS This document, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our expectations regarding the seasonality of our business, the decline in average selling prices for prints, our capital expenditures for 2008 and the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months and our ability to grow our personalized products and services as a percentage of our total revenues, as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “project,” “believe,” “anticipate,” “plan,” “expect,” “esti- mate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, the seasonality of our business, whether we are able to expand our customer base and increase our product and service offering, competition in our marketplace and the other risks set forth below under “Risk Factors” in Part I, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results. Overview We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities. Today, our primary focus is on helping consumers manage their memories through the powerful medium of photos. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print and preserve their memories in a creative and thoughtful manner. Consumers use our products and services to stay connected to their friends and family, to organize their memories in a single location, to tell stories and to preserve their memories for themselves and their children. Our customers purchase physical products both for their own personal use and for giving thoughtful and personalized gifts such as photo books, calendars, greeting cards and other photo-based products and merchandise. We currently generate the majority of our net revenues by producing and selling professionally-bound photo books, personalized calendars, greeting cards, other photo-based merchandise and high-quality prints (ranging in size from wallet to jumbo-sized 20x30 enlargements). We manufacture substantially all of these items in our Hayward, California and Charlotte, North Carolina manufacturing facilities. By controlling the production process in our own manufacturing facilities, we are able to produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. Addi- tionally, we sell a variety of photo-based merchandise that is currently manufactured for us by third parties, such as mugs, mouse pads, coasters, tote bags, desk organizers, puzzles, playing cards, multi-media DVDs, magnets and keepsake boxes, and ancillary products, such as frames, photo albums and scrapbooking accessories. Our high-quality products and services and the compelling online experience we create for our customers, together with our focus on continuous innovation, have earned us numerous third-party accolades and, more importantly, have allowed us to establish a premium brand. We believe that we realize the benefits of a premium brand through high customer loyalty, low customer acquisition costs and premium pricing. Our customers are a central part of our business model. They generate most of the content on our service by uploading their photos and storing their memories. In addition, they share their photos electronically with their friends and families, extending and endorsing our brand and creating a sense of community. Finally, by giving 34 Shutterfly-branded products to colleagues, friends and loved ones throughout the year, customers reinforce the Shutterfly brand. Through these various activities, our customers create a viral network of new users and customers. In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and website presentation to specific customer segments. Consequently, customers are presented with a highly personalized Shutterfly shopping experience, which helps foster a unique and deep relationship with our brand. Our corporation was formed in 1999 and we have experienced rapid growth since launching our service in December 1999. During fiscal year 2007, we fulfilled more than seven million orders, to more than two million customers, at an average order value of more than $26 per order. In June 2005, we completed the acquisition of Memory Matrix, Inc., a Nevada engineering firm dedicated to improving the consumer digital photography experience, in exchange for 109,302 shares of common stock. In June 2007, we acquired for $1.6 million, certain assets and liabilities of CustomAbility, LLC, a New Jersey publishing company that produces customized children’s books under the brand name Make It About Me. On January 4, 2008, for $10.0 million in cash and stock consideration of approximately $4.0 million, we acquired Nexo Systems, a privately held on-line sharing and group services company based in Palo Alto, California. Basis of Presentation Net Revenues. We generate revenues primarily from the printing and shipping of photo-based products, such as photo books, cards and calendars, photo prints, photo-based merchandise, such as mugs, mouse pads and magnets, and ancillary products such as frames, photo albums and scrapbooking accessories. Revenues are recorded net of estimated returns, promotions redeemed by customers and other discounts. Customers place orders via our website and pay primarily using credit cards. Our personalized products and services revenues are derived from the sale of photo-based products, photo- based merchandise and ancillary products and services, and the related shipping revenues. Referral fees are also included in personalized products and services revenue. We believe our products and services are differentiated from other traditional photo processors by our high quality production and numerous form factors and templates, which are key to attracting and retaining customers. Our print revenues are derived from sales of our photo processing of digital images, including sales of 4x6 prints, and the related shipping revenues. From time to time, we have made changes to our pricing structure for 4x6 prints in order to remain competitive. In December, 2007, one of our competitors lowered their list prices on 4x6 prints from $0.12 to $0.09. To date, we have not made any additional changes to the price of our 4x6 prints as a result of this price cut. However, a drop in our 4x6 prices, without a corresponding increase in volume, or decreases in volume as a result of competitive pressures would negatively impact our net revenues and could adversely affect our gross margins and overall profitability. To offset these periodic price declines and continue to generate net income, we have continued to invest in large scale manufacturing technology to enable us to reduce the cost of manufacturing prints. We have also continued to recruit highly qualified personnel with specialized skills in print manufacturing. We believe that these strategies have allowed us, and will continue to allow us, to compete successfully with other companies in our industry. In addition, we continue to focus on diversifying our business towards the large and growing market for personalized products and services. Our business is subject to seasonal fluctuations. In particular, we generate a substantial portion of our revenues during the holiday season in the calendar fourth quarter. We also typically experience increases in net revenues during other shopping-related seasonal events, such as Easter, Mother’s Day, Father’s Day, and Halloween. We generally experience lower net revenues during the first, second and third calendar quarters and, as is typical in the retail industry, have incurred and may continue to incur losses in these quarters. Due to the relatively short lead time required to fulfill product orders, usually one to three business days, order backlog is not material to our business. 35 To further understand net revenue trends, we monitor several key metrics including: Total Customers. We closely monitor total customers as a key indicator of demand. Total customers include the number of transacting customers in a given period. We seek to expand our customer base by empowering our existing customers with sharing and collaboration services (such as Shutterfly Gallery, the Nexo platform, and Shutterfly Collections), and by conducting integrated marketing and advertising programs. Total customers have increased on an annual basis for each year since inception, and we anticipate that this trend will continue. Average Order Value. Average order value is net revenues for a given period divided by the total number of customer orders recorded during that same period. We seek to increase average order value as a means of increasing net revenues. Average order value has increased on an annual basis for each year since 2000, and we anticipate that this trend will continue in the future. Total Number of Orders. We closely monitor total number of orders as a leading indicator of net revenue trends. We recognize the net revenues associated with an order when the products have been shipped and all other revenue recognition criteria have been met. Orders are typically processed and shipped within two business days after a customer places an order. Total number of orders has increased on an annual basis for each year since 2000, and we anticipate that this trend will continue in the future. Personalized Products and Services Revenues as Percentage of Net Revenues. We continue to innovate and improve our personalized products and services and expect the net revenues from these products and services to increase as percentage of net revenues as we continue to diversify our product offerings. Personalized products and services as a percentage of total net revenue increased from 51% in 2006 to 56% in 2007. In addition, as a percentage of total net revenues, revenues from 4x6 prints have been declining; from 37% in 2005, to 28% in 2006, and to 22% in 2007. We believe the analysis of these metrics and others provides us with important information on our overall net revenue trends and operating results. Fluctuations in these metrics are not unusual and no single factor is determinative of our net revenues and operating results. Cost of Net Revenues. Cost of net revenues consist primarily of direct materials (the majority of which consists of paper, ink, and photo book covers), payroll and related expenses for direct labor, shipping charges, packaging supplies, distribution and fulfillment activities, rent for production facilities, depreciation of production equipment, and third-party costs for photo-based merchandise. Cost of net revenues also includes payroll and related expenses for personnel engaged in customer service. In addition, cost of revenues includes any third-party software or patents licensed, as well as the amortization of acquired developed technology and capitalized website development costs. Operating Expenses. Operating expenses consist of technology and development, sales and marketing, and general and administrative expenses. We anticipate that each of the following categories of operating expenses will increase in absolute dollar amounts, but remain relatively consistent as a percentage of net revenues. Technology and development expense consists primarily of personnel and related costs for employees and contractors engaged in the development and ongoing maintenance of our website, infrastructure and software. These expenses include depreciation of the computer and network hardware used to run our website and store the customer data, as well as amortization of purchased software. Technology and development expense also includes colocation and bandwidth costs. Sales and marketing expense consists of costs incurred for marketing programs and personnel and related expenses for our customer acquisition, product marketing, business development and public relations activities. Our marketing efforts consist of various online and offline media programs, such as e-mail and direct mail promotions, the purchase of keyword search terms and various strategic alliances. We depend on these efforts to attract customers to our service. General and administrative expense includes general corporate costs, including rent for our corporate offices, insurance, depreciation on information technology equipment and legal and accounting fees. In addition, general and administrative expense includes personnel expenses of employees involved in executive, finance, accounting, 36 human resources, information technology and legal roles. Third-party payment processor and credit card fees are also included in general and administrative expense and have historically fluctuated based on revenues during the period. Interest Expense. and other borrowings. Interest expense consists of interest costs recognized under our capital lease obligations Other Income (Expense), Net. Other income (expense), net consists primarily of the interest income on our cash and investment accounts and the net income (expense) related to changes in the fair value of convertible preferred stock warrants. Subsequent to the completion of our initial public offering on October 4, 2006, all of our warrants to purchase shares of preferred stock converted into warrants to purchase shares of common stock. Accordingly, the liability for the convertible preferred stock warrants was reclassified as common stock and additional paid-in capital and the warrants are no longer subject to re-measurement. Income Taxes. Historically, we have only been subject to taxation in the United States because we have sold almost all of our products to customers in the United States. If we continue to sell our products primarily to customers located within the United States, we anticipate that our long-term future effective tax rate will range between 38% and 45%. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations will be affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, management’s judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We believe that the accounting policies discussed below are the most critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Revenue Recognition. We generate revenues primarily from the printing and shipping of prints and other photo-based products, and referral fees. We generally recognize revenues from product sales upon shipment when persuasive evidence of an arrangement exists (typically through the use of a credit card or receipt of a check), the selling price is fixed or determinable and collection of resulting receivables is reasonably assured. Revenues from amounts billed to customers, including prepaid orders, are deferred until shipment of fulfilled orders. We provide our customers with a 100% satisfaction guarantee whereby products can be returned within a 30-day period for a reprint or refund. We maintain an allowance for estimated future returns based on historical data. During the year ended December 31, 2007, returns totaled less than 1% of net revenues and have been within management’s expectations. We periodically provide incentive offers to our customers in exchange for setting up an account and to encourage purchases. Such offers include free products and percentage discounts on current purchases. Discounts, when accepted by customers, are treated as a reduction to the purchase price of the related transaction and are included in net revenues. Production costs related to free products are included in costs of revenues upon redemption. Shipping charged to customers is recognized as revenue at the time of shipment. Revenue from referral fees for click-throughs is recognized in the period that the click-through impression is delivered. Inventories. Our inventories consist primarily of paper, photo book covers and packaging supplies and are stated at the lower of cost on a first-in, first-out basis or net realizable value. The value of inventories is reduced by an estimate for excess and obsolete inventories. The estimate for excess and obsolete inventories is based upon 37 management’s review of utilization of inventories in light of projected sales, current market conditions and market trends. Software and Website Development Costs. We capitalize eligible costs associated with software developed or obtained for internal use in accordance with the AICPA Statement of Position No. 98-1 and EITF Issue No. 00-2. Accordingly, payroll and payroll-related costs incurred in the development phase are capitalized and amortized over the product’s estimated useful life, which is generally three years. Costs associated with minor enhancements and maintenance for our website are expensed as incurred. Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized by applying the statutory tax rates in effect in the years in which the differences between the financial reporting and tax filing bases of existing assets and liabilities are expected to reverse. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance against our deferred tax assets. We believe that all net deferred tax assets shown on our balance sheet are more likely than not to be realized in the future and no valuation allowance is necessary. In the event that actual results differ from those estimates or we adjust those estimates in future periods, we may need to record a valuation allowance, which will impact deferred tax assets and the results of operations in the period the change in made. Stock-based Compensation Expense. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment,” using the prospective transition method, which requires us to apply the provisions of SFAS No. 123R only to new awards granted, and to awards modified, repurchased or cancelled, after the effective date. Under this transition method, stock-based compensation expense recognized beginning January 1, 2006 is based on the following: (a) the grant-date fair value of stock option awards granted or modified after January 1, 2006; and (b) the balance of deferred stock-based compensation related to stock option awards granted prior to January 1, 2006, which was calculated using the intrinsic value method as previously permitted under APB Opinion No. 25. Under SFAS No 123R, we estimate the fair value of stock options granted using the Black-Scholes valuation model. This model requires us to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will retain vested stock options before exercising them, the estimated volatility of our common stock price and the number of options that will be forfeited prior to vesting. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of stock-based compensation and consequently, the related amount recognized in our consolidated statements of operations. 38 Results of Operations The following table presents the components of our income statement as a percent of net revenues: Year Ended December 31, 2007 2005 2006 Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100% 100% 100% 44% 45% 45% Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55% 55% 56% Operating expenses: Technology and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15% 18% 16% 6% 0% 2% 15% 18% 16% 6% 0% 2% 16% 18% 16% 6% 0% 0% Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefit (provision) for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8% 6% 8% (3)% (3)% 29% Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5% 5% 35% Comparison of the Years Ended December 31, 2007 and 2006 Year Ended December 31, 2007 2006 $ Change % Change (In thousands) Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of net revenues . . . . . . . . . . . . . . . . . . . . . . . . Percentage of net revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross profit $186,727 $ 84,111 $123,353 $ 55,491 45% 45% $102,616 $ 67,862 $63,374 $28,620 — $34,754 51% 52% — 51% Net revenues increased $63.4 million, or 51%, from 2006 to 2007. Revenue growth was attributable to the increases in both print and personalized products and services revenues. Personalized products and services (“PPS”) revenues increased $42.9 million, or 69%, to $105.3 million from 2006 to 2007. This change was the result of increased revenue across our entire PPS product base, and most significantly through increased sales of photo books, calendars, folded greeting cards, and referral fees. PPS made up 56% of revenues in 2007, up from 51% in 2006. Print revenues increased $20.5 million, or 34%, to $81.4 million from 2006 to 2007. This increase was primarily the result of increased revenues from 4x6, large format and photocard print sizes. As a percentage of total net revenue, 4x6 print revenues declined in 2007, decreasing from 28% in 2006 to 22% in 2007. Net revenue increases were also the result of year-over-year increases in all of our key metrics: customers, orders, and average order value, as noted below: Year Ended December 31, 2007 2006 Change % Change (In thousands, except AOV amounts) Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average order value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,357 7,062 $26.44 1,725 5,105 $24.16 632 1,957 $ 2.28 37% 38% 9% Cost of net revenues increased $28.6 million, or 52%, from 2006 to 2007. As a percentage of net revenues, cost of net revenues remained flat, at 45%, from 2006 to 2007. Overall, this increase was primarily the result of the increased volume of shipped products, and incremental costs associated with launching our second manufacturing facility in Charlotte, North Carolina. These costs were offset by savings in labor and shipping costs, reflecting 39 efficiencies in both the reduced cost of labor between the North Carolina and California manufacturing facilities and closer shipping routes to our east coast customers. 2007 Year Ended December 31, $ Change 2006 (In thousands) % Change Technology and development . . . . . . . . . . . . . . . . . . . . . Percentage of net revenues . . . . . . . . . . . . . . . . . . . . . Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of net revenues . . . . . . . . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . . . . . . . . . . . Percentage of net revenues . . . . . . . . . . . . . . . . . . . . . $28,635 $19,087 15% 15% $33,363 $21,940 18% 18% $29,557 $19,216 16% 16% $ 9,548 — $11,423 — $10,341 — 50% — 52% — 54% — Our technology and development expense increased $9.5 million, or 50%, from 2006 to 2007. As a percentage of net revenues, technology and development expense remained flat at 15% from 2006 to 2007. The overall increase in technology and development expense was attributable to increased personnel and related costs for employees and teams, which totaled consultants involved with website development and website infrastructure support $3.2 million, as well as increased third-party hosting expenses which increased by $0.8 million. In 2007, we capitalized $3.1 million in eligible costs associated with software developed or obtained for internal use, up from $1.3 million in 2006. We also continued to invest in our website infrastructure hardware to support our continued revenue growth, which resulted in increased depreciation expense of $3.7 million. Stock-based compensation expense was $0.9 million in 2007, compared to $0.7 million in 2006. Our sales and marketing expense increased $11.4 million, or 52%, from 2006 to 2007. Also as a percentage of net revenues, total sales and marketing expense remained flat at 18% from 2006 to 2007. For 2007, personnel and related costs for employees and consultants increased by $2.5 million, and our expenditures incurred on customer acquisition and promotion costs increased by $8.2 million. In addition, stock-based compensation expense was $0.9 million in 2007, compared to $0.5 million in 2006. Our general and administrative expense increased $10.3 million, or 54%, from 2006 to 2007, and remained flat as a percentage of net revenues at 16% in that same period. Personnel and related costs increased by $3.3 million in 2007 reflecting increased hiring in 2007 and an increase in stock-based compensation to $2.1 million, in 2007, compared to $0.9 million in 2006. Accounting and legal fees increased by $1.2 million in 2007, and consulting expenses increased by $2.2 million. Of that combined increase of $3.4 million, approximately $2.2 million was associated with our efforts to comply with the Sarbanes-Oxley Act of 2002. Additionally, rent and related facilities charges increased by $0.8 million for 2007 reflecting our additional square footage in Redwood City. Payment processing fees paid to third parties increased by $1.5 million during 2007 due to increased order volumes. In 2006, we made a non-recourse, non-refundable contribution of 65,000 shares of common stock to Silicon Valley Community Foundation, a California non-profit public benefit corporation, in order to establish the Shutterfly Foundation as a corporate-advised charitable fund within the Community Foundation, and recognized $0.9 million of charitable contribution expense for 2006. We had no charitable contribution expense in 2007. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (179) Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,515 2007 Change Year Ended December 31, 2006 (In thousands) $ (266) $2,387 $ 87 $3,128 Interest expense decreased by $0.1 million for 2007, due primarily to a decrease in interest expense on capitalized lease obligations. Other income (expense), net, increased by $3.1 million for 2007, due to larger invested cash balances for the full year 2007, versus 2006. In 2006, other income (expense), net also included $0.1 million of income related to changes in the fair value of our redeemable convertible preferred stock warrants. Upon the completion of our initial public offering on October 4, 2006, all of our warrants to purchase shares of preferred stock converted into warrants 40 to purchase shares of common stock and accordingly, no additional amounts for the change in fair value for the warrants will be recorded. Year Ended December 31, 2007 2006 (In thousands) Income tax provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(6,302) Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38% $(3,942) 40% The provision for income taxes was $6.3 million for 2007, compared to a provision of $3.9 million for 2006. Our effective tax rate was 38% in 2007, down from 40% in 2006. This decrease in our effective tax rate is primarily the result of a favorable resolution of a state tax audit by California, as well as the changes that were made to our ongoing research and development tax credits reserves. Other factors, such as the volume of disqualifying dispositions also contributed to the reduction in our tax rate, year-over-year. As of December 31, 2007, we had approximately $31 million of federal and $32 million of state net operating loss carryforwards available to reduce future taxable income. These net operating loss carryforwards begin to expire in 2020 and 2011 for federal and state tax purposes, respectively. Year Ended December 31, 2007 $ Change 2006 (In thousands) % Change Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of net revenues . . . . . . . . . . . . . . . . . . . . . . . $16,397 $10,095 $9,740 $5,798 5% 5% $6,657 $4,297 — 68% 74% — Net income increased by $4.3 million, or 74%, for 2007 as compared to 2006. As a percentage of net revenue, net income was flat at 5% in both FY06 and FY07. Overall, our net income growth in absolute dollars is attributable to our revenue growth year-over-year; with all other income statement items increasing in-proportion to net revenue increases. Comparison of the Years Ended December 31, 2006 and 2005 Year Ended December 31, 2006 $ Change 2005 (In thousands) % Change Net revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $123,353 Cost of net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 55,491 $83,902 $36,941 Percentage of net revenues . . . . . . . . . . . . . . . . . . . . Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45% 44% 67,862 46,961 $39,451 $18,550 — 20,901 47% 50% — 45% Net revenues increased $39.5 million, or 47%, from 2005 to 2006. Net revenue growth was attributable to the increases in both print and PPS revenues. PPS revenues increased $27.2 million, or 77%, to $62.4 million from 2005 to 2006 primarily due to increased sales of photo books, calendars, folded greeting cards and photo-based merchandise, which caused PPS revenues to increase to 51% of revenues in 2006 from 42% in 2005. Print revenues increased $12.2 million, or 25%, to $60.9 million from 2005 to 2006 primarily due to increased sales volumes of 4x6 prints, but negatively affected by a decrease in 4x6 print average selling prices due to competitive pricing pressures. We reduced the list price of our 4x6 prints by 34% from $0.29 to $0.19 in the fourth quarter of 2005. As a percentage of total revenue, 4x6 print revenue declined in 2006, decreasing from 37% in 2005 to 28% in 2006. Net 41 revenue increases were also the result of year-over-year increases in all of our key metrics including, customers, orders, and average order value, as noted below: Year Ended December 31, 2006 2005 $ Change % Change (In thousands, except AOV amounts) Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average order value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,725 5,105 $24.16 1,219 3,650 $22.99 506 1,455 $ 1.17 42% 40% 5% Cost of net revenues increased $18.6 million, or 50%, from 2005 to 2006. The cost of net revenues increase was driven by the increased volume of shipped products. Cost of net revenues as a percentage of net revenues increased by 1% from 2005 to 2006. The increase was the result of the 34% decline in the list 4x6 print prices, partially offset by the favorable impact of lower paper prices we negotiated in September 2005, lower shipping costs we negotiated in September 2006, and the reorganization of our workflows to achieve greater efficiencies which occurred during the third and fourth quarters of 2005. Year Ended December 31, 2006 2005 $ Change % Change (In thousands) Technology and development . . . . . . . . . . . . . . . . . . . $19,087 $13,152 Percentage of net revenues . . . . . . . . . . . . . . . . . . . 15% 16% Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . $21,940 $15,252 Percentage of net revenues . . . . . . . . . . . . . . . . . . . 18% 18% General and administrative . . . . . . . . . . . . . . . . . . . . . $19,216 $13,657 Percentage of net revenues . . . . . . . . . . . . . . . . . . . 16% 16% $5,935 — $6,688 — $5,559 — 45% — 44% — 41% — Our technology and development expense increased $5.9 million, or 45%, from 2005 to 2006. As a percentage of net revenues, technology and development expense decreased 1% from 2005 to 2006. The absolute dollar increase was attributable to increased personnel and related costs for employees and consultants involved with website development and website infrastructure support teams, which increased by $3.1 million, as well as increased third-party hosting expenses which increased by $0.6 million. In 2006, we capitalized $1.3 million in eligible costs associated with software developed or obtained for internal use, a slight decrease from the $1.7 million in 2005. We also continued to invest in our website infrastructure hardware to support our continued revenue growth, which resulted in increased depreciation expense of $1.8 million. Stock-based compensation expense was $0.7 million in 2006, compared to $0.8 million in 2005. Our sales and marketing expense increased $6.7 million, or 44%, from 2005 to 2006, and remained flat as a percentage of net revenues year-over-year. For 2006, personnel and related costs for employees and consultants increased by $1.9 million, and our expenditures incurred on customer acquisition and promotion costs increased by $4.6 million. In addition, stock-based compensation expense was $0.5 million in 2006, compared to $0.2 million in 2005. Our general and administrative expense increased $5.6 million, or 41%, from 2005 to 2006, and also remained flat as a percentage of revenue year over year. Personnel and related costs increased by $1.6 million in 2006. While legal fees decreased by $0.8 million in 2006, accounting fees increased by $0.8 million. Consulting expenses increased by $0.8 million, while rent and related facilities charges increased by $1.0 million for 2006. Payment processing fees paid to third parties increased by $1.2 million during 2006 due to increased order volumes. In September 2006, we made a non-recourse, non-refundable contribution of 65,000 shares of common stock to Silicon Valley Community Foundation, a California non profit public benefit corporation, in order to establish the Shutterfly Foundation as a corporate-advised charitable fund within the Community Foundation, and recognized $0.9 million of charitable contribution expense for 2006. We intend to work with Silicon Valley Community Foundation to develop a charitable program dedicated to enhancing communities in the San Francisco Bay Area and around the world. We had no charitable contribution expense in 2005 and we do not expect to make further 42 donations to the Silicon Valley Community Foundation for the foreseeable future. Stock-based compensation was $0.9 million, in 2006, compared to $2.2 million in 2005. Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (expense), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change Year Ended December 31, 2005 2006 (In thousands) $(367) $(103) $ (266) $2,387 $ 101 $2,490 Interest expense decreased by $0.1 million, or 28%, for 2006, due primarily to a decrease in interest expense on capitalized lease obligations. Other income (expense), net, totaled $2.4 million for 2006, an increase over the prior year other expense amount of $0.1 million. This income is due to larger invested cash balances from our initial public offering and higher interest rates. For 2006, other income (expense), net also included $0.1 million of income related to changes in the fair value of our redeemable convertible preferred stock warrants. Upon the completion of our initial public offering on October 4, 2006, all of our warrants to purchase shares of preferred stock converted into warrants to purchase shares of common stock and accordingly, no additional amounts for the change in fair value for the warrants will be recorded. Year Ended December 31 2006 2005 (In thousands) Income tax benefit (provision) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(3,942) 40% $24,060 494% The provision for income taxes was $3.9 million for 2006, compared to a benefit of $24.1 million for 2005, due to changes in our effective tax rate as a result of releasing our valuation allowance in the fourth quarter of 2005. Year Ended December 31, 2006 2005 $ Change % Change (In thousands) Income before income taxes and cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of net revenue . . . . . . . . . . . . . . . . . . . . $9,740 $5,798 $ 4,430 $28,932 5% 35% $ 5,310 $(23,134) — 120% (80)% — Net income decreased by $23.1 million, or 80%, for 2006 as compared to 2005. Included in 2005 net income was a $24.1 million non-cash tax benefit due to releasing our net deferred tax valuation allowance in the fourth quarter of 2005. Net income for 2005 also increased by $0.4 million for a cumulative effect of a change in accounting principle related to the adoption of FSP 150-5 in July 2005. We believe that income before income taxes and cumulative effect of change in accounting principle is relevant and useful information to assist investors in comparing our performance between 2006 and 2005. Income before income taxes and cumulative effect of change in accounting principle increased by $5.3 million, or 120%, from $4.4 million in 2005 to $9.7 million in 2006. 43 Liquidity and Capital Resources 2007 Year Ended December 31, 2006 (In thousands) 2005 Consolidated Statement of Cash Flows Data: Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 34,993 2,858 Acquisition of business and intangibles, net of cash acquired . . . . 17,796 Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . 42,219 Cash flows from operating activities . . . . . . . . . . . . . . . . . . . . . . (40,823) Cash flows from investing activities . . . . . . . . . . . . . . . . . . . . . . 2,135 Cash flows from financing activities . . . . . . . . . . . . . . . . . . . . . . $ 20,681 — 10,747 23,485 (20,681) 77,094 $ 10,858 (239) 6,522 18,606 (10,613) 17,379 Historically we have financed our operations and capital expenditures through operations, private sales of preferred stock, our initial public offering, lease financing and the use of bank and related-party loans. As a result of our initial public offering in September 2006, we raised approximately $80.9 million of proceeds, net of underwriters’ discount, which we received on October 4, 2006. At December 31, 2007 we had $125.6 million of cash, cash equivalents, and short term investments. Cash equivalents are compromised of money market funds and commercial paper. Short term investments is comprised of US government agency securities. At February 29, 2008, $52.3 million of our marketable securities portfolio was invested in AAA rated investments in auction-rate debt securities. Auction-rate securities are long-term variable rate bonds tied to short- term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates. Following such a failed auction, we would not be able to access our funds that are invested in the corresponding auction-rate securities until a future auction of these investments is successful or new buyers express interest in purchasing these securities in between reset dates. As a result of the current negative liquidity conditions in the global credit markets, in February 2008, auctions for $42.3 million of original par value of our auction-rate securities failed, rendering these securities temporarily illiquid through the normal auction process. At the time of our initial investment and through the date of this Report, all of our auction-rate securities remain AAA rated. The assets underlying each security are student loans and 95% of the principal amounts are guaranteed by the Federal Family Education Loan Program (FFELP). Since we cannot predict when future auctions related to $52.3 million of our auction-rate securities will be successful, it may become necessary to classify this amount as long-term marketable securities in our consolidated balance sheet in future periods. In addition, if the underlying issuers are unable to successfully clear future auctions or if their credit rating deteriorates and the deterioration is deemed to be other-than-temporary, we would be required to adjust the carrying value of the auction-rate securities through an impairment charge to earnings. Any of these events could materially affect our results of operations and our financial condition. To access these funds in future periods, it may be necessary to attempt to sell these securities at an amount below our original purchase value. However, based on our ability to access our cash and cash equivalents and our other liquid investments, totaling $53.7 million at February 29, 2008, and our expected operating cash flows, we believe that we currently have adequate working capital resources to fund our operations for at least the next 12 months. The adequacy of these resources to meeting our liquidity needs beyond the next 12 months will depend on our growth, operating results, the capital expenditures required to meet possible increased demand for our products, and the resolution of the auction rate securities auction failures. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to sell additional equity or enter into working capital financing arrangements. The sale of additional equity could 44 result in additional dilution to our stockholders. Financing arrangements may not be available to us, or may not be in amounts or on terms acceptable to us. Our industry is competitive and has endured periods of intense price competition. Because we plan to finance our operations and capital expenses largely through our operations, and because our results of operations are sensitive to the level of competition we face, increased competition could adversely affect our liquidity and capital resources. Increased competition could do so both by reducing our net revenues and net income, as a result of reduced sales, reduced prices and increased promotional activities, among other factors, as well as by requiring us to spend cash on advertising and marketing in an effort to maintain or increase market share in the face of such competition. In addition, we intend to increase many of our expenses, including some capital expenses, in advance of anticipated higher future revenues. However, such increased expenses, while intended to support anticipated increases in future revenues, must be funded from current capital resources or from borrowings or equity financings. As a result, our ability to grow our business relying largely on funds from our operations is sensitive to competitive pressures and other risks relating to our liquidity or capital resources. We anticipate capital expenditures of between $43 million to $47 million for 2008. These expenditures will be used to purchase machinery and equipment to support the growth in our business and to increase our production capacity and help enable us to respond more quickly and efficiently to customer demand. This range of capital expenditures, while significant, is not outside the ordinary course of our business or materially different from how we have expanded our business in the past. We believe that such capital expenditures will have a positive effect on our results of operations if demand increases in line with increases in our production capacity. However, these capital expenditures will have a negative effect on our results of operations if demand does not increase as we expect, and will have a negative effect on our results of operations in the short term if demand does not increase simultaneously, as we expect, with the capital expenditures spent to support increased demand. Operating Activities. For 2007, net cash provided by operating activities was $42.2 million, primarily due to our net income of $10.1 million and the net change in operating assets and liabilities of $4.2 million, adjusted for non-cash items including $17.8 million of depreciation and amortization expense, $5.9 million of provision for deferred income taxes, and $4.0 million of stock-based compensation. For 2006, net cash provided by operating activities was $23.5 million, primarily due to our net income of $5.8 million and the net change in operating assets and liabilities of $0.7 million, adjusted for non-cash items including $10.7 million of depreciation and amortization expense, $3.2 million of provision for income taxes, $2.3 million of stock-based compensation and $0.9 million for charitable contribution expense related to our September 2006 donation of 65,000 shares to Silicon Valley Community Foundation. We do not expect to make additional donations to Silicon Valley Community Foundation in the foreseeable future. In 2005, net cash provided from operating activities of $18.6 million resulted from net income of $28.9 million that was adjusted for $6.2 million of depreciation and amortization, $23.8 million of income tax benefit and $3.3 million of non-cash amortization of stock-based compensation. In addition, net cash from operating activities increased due to a $4.1 million increase in accounts payable and accrued liabilities due to seasonally high balances at December 31, 2005 related to increased purchasing for the fourth quarter holiday season. Accounts payable and accrued liability balances were higher as of December 31, 2005 compared to as of December 31, 2004 due to higher sales in the 2005 fourth quarter holiday season. Investing Activities. For 2007, net cash used in investing activities included $35.0 million for capital expenditures for computer and network hardware for our website infrastructure and information technology systems, capital expenditures for production equipment for our manufacturing and production operations at our California and North Carolina facilities, and capitalized website development costs related to projects that were placed into service. Additional cash of $3.0 million and $2.9 million was used for purchases of short-term investments and acquisition of “Make-it-About-Me,” respectively. For 2006, cash used in investing activities was $20.7 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology computer hardware, capital expendi- tures for production equipment for our manufacturing and production operations at our Hayward, California facilities, and capitalized website development costs related to projects that were placed into service. 45 For 2005, net cash used in investing activities was $10.6 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology computer hardware, capital expenditures for production equipment for our manufacturing and production operations at our Hayward, California facilities, and capitalized website development costs related to projects that were placed into service. Financing Activities. Our financing activities for 2007 provided cash of $2.1 million, primarily from $5.0 million of proceeds from issuance of common stock, offset by $2.8 million of capitalized lease obligations. Our financing activities for 2006 provided cash of $77.1 million, primarily from $78.5 million of IPO proceeds, net of underwriters’ fees and offering costs, offset by $1.4 million of capitalized lease obligations. For 2005, we generated cash of $17.4 million, primarily the result of receiving net proceeds of $19.8 million from the sale of our Series F preferred stock in November 2005. This increase in cash was offset by $2.4 million in principal payments on capital lease obligations. Contractual Obligations We lease office space in Redwood City, California and production facilities in Hayward, California under various non-cancelable operating leases that expire between 2009 and 2010. In 2006, we entered into a non- cancelable operating lease for our new production facility in Charlotte, North Carolina. The lease commenced in May, 2007, and will expire in 2014. We also lease website infrastructure computer and network hardware, production equipment, information technology equipment and software under various capital leases that expire through the year 2011. We also have a co-location agreement with a third-party hosting facility that expires in 2009. As a result of our growth strategies, we believe that our liquidity and capital resources requirements will grow in absolute dollars but will be generally consistent with historical periods on an annual basis as a percentage of net revenues. We anticipate leasing additional office space, production facilities and hosting facilities in future periods, consistent with our historical business model. The following are contractual commitments at December 31, 2007, associated with lease obligations and other arrangements: Total Less Than 1 Year 1-3 Years (In thousands) 3-5 Years More Than 5 Years Contractual Obligations Capital lease obligations . . . . . . . . . . . . . Operating lease obligations . . . . . . . . . . . Purchase obligations(1) . . . . . . . . . . . . . . $ 975 9,391 2,821 $ 864 2,548 2,620 Total contractual obligations . . . . . . . . . . $13,187 $6,032 $ 111 4,766 201 $5,078 $ — 2,077 — $2,077 $ — — — $ — (1) Purchase obligations include commitments under non-cancelable marketing agreements, license agreements, and third-party 1 hosting services. Other than the obligations, liabilities and commitments described above, we have no significant unconditional purchase obligations or similar instruments. We are not a guarantor of any other entities’ debt or other financial obligations. Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not have any undisclosed borrowings or debt, and we have not entered into any synthetic leases. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. In December, 2007, we had signed a definitive agreement to acquire Nexo Systems (“Nexo”) for total cash proceeds of $10.0 million and stock consideration of approximately $4.0 million. This transaction closed on 46 January 4, 2008 and that amount was paid on that date. As part of our June 2007 acquisition of Make It About Me! (“MIAM”), we agreed to make additional earnout payments if certain milestones are achieved over the next 12 months. As of December 31, 2007, the total potential earnout payment is $0.4 million. Recent Accounting Pronouncements In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. In February 2008, the FASB issued a staff position that delays the effective date of SFAS 157 for all nonfinancial assets and liabilities except for those recognized or disclosed at least annually. Except for the delay for nonfinancial assets and liabilities, SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within such years. The Company does not expect the adoption of FAS 157 will have a material effect on its financial position and results of operations. In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”) which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. FAS 159 was effective for the Company on January 1, 2008. The Company does not expect the adoption of FAS 159 will have a material effect on its financial position and results of operations. In December 2007, the FASB issued FAS No. 141R, “Business Combinations” (“FAS 141R”) which replaces FAS No. 141 and establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. FAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption of FAS 141R is prohibited. The Company is currently evaluating the impact, if any, of adopting FAS 141R on its financial position and results of operations. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“FAS 160”) which amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. In addition to the amendments to ARB 51, this Statement amends FASB Statement No. 128, Earnings per Share; so that earnings-per-share data will continue to be calculated the same way those data were calculated before this Statement was issued. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently evaluating the impact, if any, of adopting FAS 160 on its financial position and results of operations. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Interest Rate and Credit Risk. We have exposure to interest rate risk that relates primarily to our investment portfolio. All of our current investments are classified as cash equivalents and short-term investments and carried at cost, which approximates market value. We do not currently use or plan to use derivative financial instruments in our investment portfolio. The risk associated with fluctuating interest rates is limited to our investment portfolio and we do not believe that a 10% change in interest rates will have a significant impact on our interest income, operating results or liquidity. As of December 31, 2007, our cash and cash equivalents were maintained by financial institutions in the United States and our deposits may be in excess of insured limits. We believe that the financial institutions that hold our investments are financially sound and, accordingly, minimal credit risk exists with respect to these investments. Inflation. We do not believe that inflation has had a material effect on our current business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations. 47 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. SHUTTERFLY, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Consolidated Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Consolidated Statements of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficit) . . 52 Consolidated Statements of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Schedule II — Valuation and Qualifying Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 48 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders Shutterfly, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of redeemable convertible preferred stock and stockholders’ equity (deficit), and of cash flows present fairly, in all material respects, the financial position of Shutterfly, Inc. and its subsidiaries (the “Company”) at December 31, 2007 and December 31, 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our audits (which was an integrated audit in 2007). We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertainty in income taxes in 2007 and the manner in which it accounts for share-based compensation in 2006. In addition, as discussed in Note 3 to the consolidated financial statements, the Company changed the manner in which it accounts for freestanding warrants for redeemable convertible preferred stock in 2005. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. San Jose, California March 6, 2008 /s/ PricewaterhouseCoopers LLP 49 SHUTTERFLY, INC. CONSOLIDATED BALANCE SHEETS December 31, 2007 2006 (In thousands, except per share amounts) Current assets: ASSETS Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,582 3,002 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,480 Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,788 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,677 Deferred tax asset, current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,510 Prepaid expenses and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill and intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax asset, net of current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,039 48,416 3,859 13,294 2,162 $119,051 — 2,164 2,493 2,129 2,760 128,597 30,919 1,396 18,754 494 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $208,770 $180,160 Current liabilities: LIABILITIES AND STOCKHOLDERS’ EQUITY Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current portion of capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital lease obligations, less current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,783 18,724 8,699 808 37,014 1,083 107 38,204 $ 9,385 8,808 6,278 1,961 26,432 660 1,742 28,834 Commitments and contingencies (Note 6) Stockholders’ equity: Undesignated preferred stock, $0.0001 par value; 5,000 shares authorized at December 31, 2007 and 2006, respectively; no shares issued and outstanding . . . . . . — — Common stock, $0.0001 par value; 100,000 shares authorized; 24,805 and 23,705 shares issued and outstanding at December 31, 2007 and December 31, 2006, respectively. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred stock-based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 190,849 (12) (28) (20,245) 2 181,890 (35) (191) (30,340) Total stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170,566 151,326 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $208,770 $180,160 The accompanying notes are an integral part of these consolidated financial statements. 50 SHUTTERFLY, INC. CONSOLIDATED STATEMENTS OF INCOME December 31, Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $186,727 84,111 Cost of net revenues(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 2006 2007 (In thousands, except per share amounts) $123,353 55,491 $83,902 36,941 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,616 67,862 46,961 Operating expenses(1): . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Technology and development Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (expense), net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes and cumulative effect of change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Provision) benefit for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,635 33,363 29,557 91,555 11,061 (179) 5,515 16,397 (6,302) Net income before cumulative effect of change in accounting principle . . . 10,095 Cumulative effect of change in accounting principle, net of tax benefit. . . . — 19,087 21,940 19,216 60,243 7,619 (266) 2,387 9,740 (3,942) 5,798 — 13,152 15,252 13,657 42,061 4,900 (367) (103) 4,430 24,060 28,490 442 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,095 $ 5,798 $28,932 Net income per share — basic and diluted: Before cumulative effect of change in accounting principle . . . . . . . . . . $ Cumulative effect of change in accounting principle, net of tax benefit . . Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.42 — 0.42 Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.38 $ $ $ 0.67 — 0.67 0.56 Weighted average shares: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,295 8,622 Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,273 10,331 (1) Stock-based compensation is allocated as follows (Notes 2 and 7): Cost of net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Technology and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 880 877 2,055 $ 96 736 521 947 $ $ $ $ 1.31 0.14 1.45 1.02 3,255 4,609 28 826 239 2,217 The accompanying notes are an integral part of these consolidated financial statements. 51 CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT) SHUTTERFLY, INC. Redeemable Convertible Preferred Stock Shares Amount Common Stock Shares Amount Additional Paid-In Capital Deferred Stock-Based Compensation Accumulated Deficit Accumulated Other Comprehensive Loss Total Stockholders’ Equity (Deficit) (In thousands) 12,448 $ 69,822 2,827 $— $ 7,505 $(2,003) $(65,070) $ — $ (59,568) — — 750 — 1,354 19,830 — — 205 — — — — — — — — — — — — — — — — — — 1,100 — 65 — — 109 — — — 39 — — — — — 352 656 671 — — — (671) 500 2,261 365 (2,261) — — — — 1,710 — — (1,514) — — — — — — — — — — — — — — — — — — — — — — — — — — — — 28,932 — — — — — — — — — — — — — — 205 — 1,100 352 656 — 500 — 365 1,710 (1,514) 28,932 28,932 Balances, December 31, 2004 . . . . . Issuance of common stock upon exercise of options, net of repurchases . . . . . . . . . . . . . . . . Issuance of Series F preferred stock, net of issuance cost of $131 . . . . . Stock-based compensation expense in connection with option modifications . . . . . . . . . . . . . . Shares issued in connection with a settlement agreement with a former employee . . . . . . . . . . . . Vested shares issued upon acquisition . . . . . . . . . . . . . . . . Restricted shares issued upon acquisition . . . . . . . . . . . . . . . . Vesting of restricted shares . . . . . . . Deferred stock-based compensation, net of cancellations . . . . . . . . . . . Tax benefit of stock options. . . . . . . Amortization of deferred stock-based compensation, net of cancellations . . . . . . . . . . . . . . . Reclassification of preferred stock warrants to liability . . . . . . . . . . . Comprehensive income: Net income . . . . . . . . . . . . . . . . . Total comprehensive income . . . . . . Balances, December 31, 2005 . . . . . 13,802 $ 89,652 3,790 $— $ 10,501 $(1,625) $(36,138) $ — $ (27,262) 52 CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT) — (Continued) SHUTTERFLY, INC. Balances, December 31, 2005 . . . . . Issuance of common stock upon exercise of options, net of repurchases . . . . . . . . . . . . . . . . Issuance of common stock upon effective date of initial public offering (“IPO”), net of underwriting fees of $6,090 and other expenses of $2,442 . . . . . . . Issuance of Series A preferred stock upon net exercise of warrants . . . . Transfer of preferred stock warrant liability related to Series A preferred stock . . . . . . . . . . . . . Automatic conversion of preferred stock to common stock upon effective date of IPO. . . . . . . . . . Transfer of preferred stock warrant liability upon conversion of preferred stock warrants into common stock warrants . . . . . . . . Reversal of unearned stock based compensation upon modification of options. . . . . . . . . . . . . . . . . . . Vesting of restricted shares . . . . . . . Cancellation of common stock options and restricted shares . . . . . Amortization of deferred stock-based compensation, net of cancellations . . . . . . . . . . . . . . . Employees stock-based compensation expense recognized under SFAS No. 123R, net of estimated forfeiture . . . . . . . . . . . . . . . . . Donation of common stock to a charitable foundation . . . . . . . . . Change in unrealized loss in investments, net of tax . . . . . . . . Net income . . . . . . . . . . . . . . . . . Total comprehensive income . . . . . . Balances, December 31, 2006 . . . . . Redeemable Convertible Preferred Stock Shares Amount Common Stock Shares Amount Additional Paid-In Capital Deferred Stock-Based Compensation Accumulated Deficit Accumulated Other Comprehensive Loss Total Stockholders’ Equity (Deficit) (In thousands) 13,802 $ 89,652 3,790 $— $ 10,501 $(1,625) $(36,138) $ — $ (27,262) — — 127 — 101 — — — 101 — 61 — — 5,800 1 78,467 143 — — (143) — — — 871 (13,863) (89,795) 13,863 1 89,794 — — — — — — — 510 — — — — — — 60 — (526) — — — (249) 526 94 249 — — — — 565 — — — — — — — 1,641 65 — 923 — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — 5,798 — (35) — — 78,468 (143) 871 89,795 510 — 94 — 565 1,641 923 (35) 5,798 5,763 — 23,705 $ 2 $181,890 $ (191) $(30,340) $(35) $151,326 53 CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT) — (Continued) SHUTTERFLY, INC. Redeemable Convertible Preferred Stock Shares Amount Common Stock Shares Amount Additional Paid-In Capital Deferred Stock-Based Compensation Accumulated Deficit Accumulated Other Comprehensive Loss Total Stockholders’ Equity (Deficit) Balances, December 31, 2006 . . . . . Issuance of common stock upon net exercise of warrants . . . . . . . . . . Issuance of common stock upon exercise of options, net of repurchases . . . . . . . . . . . . . . . . Cancellation of common stock options and restricted shares . . . . . Amortization of deferred stock-based compensation, net of cancellations . . . . . . . . . . . . . . . Employees stock-based compensation expense recognized under SFAS No. 123R, net of estimated forfeiture . . . . . . . . . . . . . . . . . Tax benefit of stock options. . . . . . . Change in unrealized loss in investments, net of tax . . . . . . . . Net income . . . . . . . . . . . . . . . . . Total comprehensive income . . . . . . Balances, December 31, 2007 . . . . . — — — — — — — — — — — — 23,705 $ 2 $181,890 $ (191) $(30,340) $(35) $151,326 (In thousands) — 27 — — — 1,073 — 4,983 — — — — — (162) 162 — — — — 1 — — — — — — — — — — — — — — — 4,111 27 — — — — — — — — — — — — — — — 10,095 — — — — — — — 23 — — — 4,983 — 1 4,111 27 23 10,095 10,118 — 24,805 $ 2 $190,849 $ (28) $(20,245) $(12) $170,566 The accompanying notes are an integral part of these consolidated financial statements. 54 SHUTTERFLY, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, 2007 2006 (In thousands) 2005 Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,095 Adjustments to reconcile net income to net cash provided by operating activities $ 5,798 $ 28,932 Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of deferred stock-based compensation, net of cancellations . . . . . . . . . . . . . . . . . . Charitable contribution expense for shares issued to charitable foundation . . . . . . . . . . . . . . . . . Change in carrying value of preferred stock warrant liability . . . . . . . . . . . . . . . . . . . . . . . . . . Loss/(gain) on disposal of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in operating assets and liabilities, net of effects of acquisition Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,384 412 4,001 — — 262 5,880 (2,316) (2,290) (1,750) (1,668) (602) 10,390 2,421 10,525 222 2,300 923 (152) (29) 3,199 (1,215) (1,419) (1,171) (121) 5,514 (2,603) 1,714 6,246 276 3,310 — 21 207 (23,833) (547) (253) (398) (40) (434) 4,550 569 Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,219 23,485 18,606 Cash flows from investing activities: Purchases of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of business and intangible assets, net of cash acquired . . . . . . . . . . . . . . . . . . . . . . . . Purchases of short term investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (34,993) (2,858) (3,000) 28 (20,681) — — — (10,858) 239 — 6 Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,823) (20,681) (10,613) Cash flows from financing activities: Principal payments of capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from IPO shares issued, net of issuance costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from term loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayment of term loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal payment of note payable obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from issuance of redeemable convertible preferred stock, net of issuance costs . . . . . . . . . . Proceeds from issuance of common stock upon exercise of stock options . . . . . . . . . . . . . . . . . . . Repurchases of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,840) — — — — — 4,975 — 2,135 Net increase in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,531 119,051 (1,446) 78,468 — — — — 83 (11) 77,094 79,898 39,153 (2,379) — 2,571 (2,571) (192) 19,830 134 (14) 17,379 25,372 13,781 Cash and cash equivalents, end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,582 $119,051 $ 39,153 Supplemental disclosures of cash flow information Cash paid during the period for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Cash paid during the period for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplemental schedule of non-cash investing and financing activities Additions to property and equipment acquired under capital lease obligations and notes payable . . . . Net non-cash assets acquired upon acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vested shares issued upon acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Restricted shares issued upon acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassification of preferred stock warrants to liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred stock-based compensation, net of cancellations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred stock-based compensation in connection with option modifications . . . . . . . . . . . . . . . . . Tax benefit of stock options recorded in additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . Conversion of preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion of preferred stock warrant liability into APIC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock warrants exercised on net basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 198 812 $ 205 — 410 70 — — — — — — — 27 — — — — — — — — — — — 89,795 1,381 143 3,516 551 656 724 1,514 1,225 1,100 365 — — — The accompanying notes are an integral part of these consolidated financial statements. 55 SHUTTERFLY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 — Description of Business Shutterfly, Inc., (the “Company”) was incorporated in the state of Delaware in 1999 and began its services in December 1999. The Company is an Internet-based social expression and personal publishing service that enables customers to share, print and preserve their memories by leveraging a technology-based platform and manufac- turing processes. The Company provides customers a full range of products and services to organize and archive digital images; share pictures; order prints and create an assortment of personalized items such as cards, calendars and photo books. The Company is headquartered in Redwood City, California. On September 29, 2006, the Company completed its initial public offering (“IPO”) in which the Company sold 5,800,000 shares at a price to the public of $15.00 per share. As a result of the IPO, a total of $87.0 million in gross proceeds was raised, with net proceeds to the Company of $78.5 million after deducting underwriting fees and commissions of $6.1 million and other offering costs of $2.4 million. Upon the closing of the IPO, all shares of the Company’s outstanding redeemable convertible preferred stock automatically converted into an aggregate of 13,862,773 common shares. Note 2 — Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiary. The wholly owned subsidiary was dissolved in 2006 and was merged into the Company. All intercompany transactions and balances have been eliminated. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 as well as the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include intangible assets valuation and useful lives, excess and obsolete inventories, deferred tax valuation allowance, legal contingencies, and the valuation of equity instruments among others. Actual results could differ from these estimates. Cash, Cash Equivalents and Short Term Investments The Company considers all highly liquid investments purchased with original maturities (at the date of purchase) of three months or less to be cash equivalents. Management determines the appropriate classification of cash equivalents at the time of purchase and reevaluates such designations at each balance sheet date. Cash equivalents consist principally of money market funds and commercial paper. Short term investments consist entirely of U.S. government agency securities. At December 31, 2007, all investments are classified as “available-for-sale.” In accordance with Statement of Financial Accounting Standards No 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”) available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax reported in a separate component of accumulated other comprehensive income (loss) in shareholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are reported in other income (expense), net. The cost of securities sold is based on the specific identification method. Interest on securities classified as available-for-sale is included as a component of other income (expense), net. The contractual maturities for all of the Company’s available for sale securities are less than one year. See Note 11 for a discussion of the Company’s investment in auction rate securities subsequent to Decem- ber 31, 2007. 56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. Fair Value of Financial Instruments The carrying amount of certain of the Company’s financial instruments, including accounts receivable and accounts payable, are carried at cost, which approximates their fair value because of their short-term maturities. Based on borrowing rates available to the Company for loans with similar terms, the carrying value of capital lease obligations, approximates fair value. Concentration of Credit Risk Financial instruments that potentially subject the Company to credit risk consist principally of cash, cash equivalents, short term investments, and accounts receivable. Most of the Company’s cash and cash equivalents as of December 31, 2007, were deposited with financial institutions in the United States and Company policy restricts the amount of credit exposure to any one issuer and to any one type of investment. Deposits held with financial institutions may exceed federally insured limits. The Company’s accounts receivable are derived primarily from sales to customers located in the United States who make payments through credit cards, sales of our products in retail stores, and click-through referral fees. Credit card receivables settle relatively quickly and the Company maintains allowances for potential credit losses based on historical experience. To date, such losses have not been material and have been within management’s expectations. Excluding amounts due from credit cards, as of December 31, 2007, two customers accounted for 43% and 11% of the Company’s net accounts receivable. And as of December 31, 2006, one customer accounted for 14% of the Company’s net accounts receivable. Inventories Inventories are stated at the lower of cost on a first-in, first-out basis or net realizable value. The value of inventories is reduced by estimates for excess and obsolete inventories. The estimate for excess and obsolete inventories is based upon management’s review of utilization of inventories in light of projected sales, current market conditions and market trends. Inventories are primarily raw materials and consist principally of paper, photo book covers and packaging supplies. Property and Equipment Property and equipment, including equipment under capital leases, are stated at historical cost, less accu- mulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated lives of the assets, generally three to five years. Amortization of equipment acquired under capital lease obligations is computed using the straight-line method over the shorter of the remaining lease term or the estimated useful life of the related assets, generally three to four years. Leasehold improvements are amortized over their estimated useful lives, or the lease term if shorter, generally three to seven years. Upon retirement or sale, the cost and related accumulated depreciation are removed from the balance sheet and the resulting gain or loss is reflected in operating expenses. Major additions and improvements are capitalized, while replacements, mainte- nance and repairs that do not extend the life of the asset are charged to expense as incurred. Website Development Costs The Company capitalizes eligible costs associated with software developed or obtained for internal use in accordance with AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, and EITF 00-02, Accounting for Web Site Development Costs. Accordingly, the Company expenses all costs that relate to the planning and post implementation phases. Costs incurred in the development phase are capitalized and amortized over the product’s estimated useful life, generally three years. Costs associated with minor enhancements and maintenance for the Company’s website are expensed as incurred. 57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. Long-Lived Assets The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”). Recov- erability is measured by comparison of the carrying amount to the future net cash flows which the assets are expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future cash flows arising from the asset using a discount rate determined by management to be commensurate with the risk inherent to the Company’s current business model. Goodwill and Intangible Assets The Company accounts for intangible assets and goodwill in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”). Goodwill and intangible assets with indefinite lives are not amortized but are tested for impairment on an annual basis or whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Intangible assets with finite useful lives are amortized using the straight-line method over their useful lives and are reviewed for impairment in accordance with SFAS No. 144. Intangible assets from acquisitions are amortized on a straight-line basis over the estimated useful lives which range from one to five years. Preferred Stock Warrants Warrants and other similar instruments related to shares that are redeemable are accounted for in accordance with Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS No. 150”). Under SFAS No. 150, warrants that were related to the Company’s redeemable convertible preferred stock were recorded as liabilities on the consolidated balance sheet. The warrants were subject to re-measurement at each balance sheet date and any change in fair value was recognized as a component of other income (expense), net. Subsequent to the Company’s IPO and the associated conversion of the Company’s outstanding redeemable convertible preferred stock to common stock, the warrants to exercise the redeemable convertible preferred stock converted into common stock warrants; accordingly, the liability related to the redeemable convertible preferred stock warrants was transferred to common stock and additional paid-in-capital and the common stock warrants are no longer subject to re-measurement. Revenue Recognition The Company generally recognizes revenue from product sales, net of applicable sales tax upon shipment when persuasive evidence of an arrangement exists, the selling price is fixed or determinable and collection of resulting receivables is reasonably assured. Revenues from amounts billed to customers, including prepaid orders, are deferred until shipment of fulfilled orders or until the prepaid period expires. Shipping charged to customers is recognized as revenue at the time of shipment. The Company provides its customers with a 100% satisfaction guarantee whereby products can be returned within a 30-day period for a reprint or refund. The Company maintains an allowance for estimated future returns based on historical data. The provision for estimated returns is included in deferred revenue. The Company periodically provides incentive offers to its customers in exchange for setting up an account and to encourage purchases. Such offers include free products and percentage discounts on current purchases. Discounts, when accepted by customers, are treated as a reduction to the purchase price of the related transaction and are presented in net revenues. Production costs related to free products are included in cost of revenues upon redemption. 58 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. Revenue from referral fees for click-throughs is recognized in the period that the click-through impression is delivered. Advertising Costs Advertising costs are expensed as incurred, except for direct mail advertising which is expensed when the advertising first takes place. Total direct mail costs capitalized as of December 31, 2007 and December 31, 2006 was $355,000 and $0. Total advertising costs are included in selling and marketing expenses and totaled approximately $10,800,000, $5,710,000 and $4,878,000 during the years ended December 31, 2007, 2006 and 2005, respectively. Stock-Based Compensation Prior to January 1, 2006, the Company accounted for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and related interpretations, and followed the disclosure provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price. Employee stock-based compensation determined under APB No. 25 is recognized based on guidance provided in Financial Accounting Standards Board Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (“FIN 28”), which provides for accelerated expensing over the option vesting period. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123, Emerging Issues Task Force Abstract No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”), and FIN 28. Effective January 1, 2006, the Company adopted the fair value provisions of Statement of Financial Accounting Standards No. 123R, Share-Based Payment (“SFAS No. 123R”), which supersedes its previous accounting under APB 25. SFAS No. 123R requires the recognition of compensation expense, using a fair-value based method, for costs related to all share-based payments including stock options. SFAS No. 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The Company adopted SFAS No. 123R using the prospective transition method, which requires that for nonpublic entities that used the minimum value method for either pro forma or financial statement recognition purposes, SFAS No. 123R shall be applied to option grants after the required effective date. For options granted prior to the SFAS No. 123R effective date, which the requisite service period has not been performed as of January 1, 2006, the Company will continue to recognize compensation expense on the remaining unvested awards under the intrinsic-value method of APB 25. In addition, the Company will continue amortizing those awards valued prior to January 1, 2006 utilizing an accelerated amortization schedule while all option grants valued after January 1, 2006 will be expensed on a straight-line basis over the requisite period. In November 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123R-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. The Company has elected to adopt the prospective transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS No. 123R. Income Taxes The Company accounts for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities and net operating loss and credit carryforwards using enacted tax rates in effect for the year in which the 59 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. The Company accounts for uncertain tax positions in accordance with FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”), an interpretation of FASB Statement No. 109 (“SFAS 109”). The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. The Company is required to make subjective assumptions and judgments regarding its income tax exposures. Interpretations and guidance surrounding income tax laws and regulations change over time. As such, changes in the Company’s subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and statements of operations. The Company’s policy is to recognize interest and /or penalties related to all tax positions in income tax expense. To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made. No interest and penalties were accrued as of the date of adoption of FIN 48 or at December 31, 2007. Net Income Per Share Basic net income per share attributed to common shares is computed by dividing the net income attributable to common shares for the period by the weighted average number of common shares outstanding during the period as reduced by the weighted average unvested common shares subject to repurchase by the Company. Net income available to common stockholders is calculated using the two class method as the net income less preferred stock dividends for the period and amounts allocated to preferred stock to reflect the rights of the preferred stock to receive dividends in preference to common stock. Diluted net income per share attributed to common shares is computed by dividing the net income attributable to common shares for the period by the weighted average number of common and potential common shares outstanding during the period, if the effect of each class of potential common shares is dilutive. Potential common shares include restricted common stock, common stock subject to repurchase rights, and incremental shares of common stock issuable upon the exercise of stock options and warrants and upon conversion of preferred stock. 60 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. 2007 Year Ended December 31, 2006 2005 In thousands, except per share amounts Historical net income per share: Numerator Net income before cumulative effect of change in accounting principle. . . . . Cumulative effect of change in accounting principle. . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income allocable to preferred stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . $10,095 — 10,095 — $ 5,798 — $ 28,490 442 5,798 28,932 — (24,212) Net income allocable to common stockholders . . . . . . . . . . . . . . . . . . . . . $10,095 $ 5,798 $ 4,720 Denominator Weighted-average common shares outstanding . . . . . . . . . . . . . . . . . . . . . . . Less: Weighted-average unvested common shares subject to repurchase . . . . 24,309 (14) Denominator for basic net income per share . . . . . . . . . . . . . . . . . . . . . . . 24,295 Dilutive effect of stock options and shares subject to repurchase . . . . . . . . . . Dilutive effect of outstanding preferred stock warrants . . . . . . . . . . . . . . . . . 1,978 — 8,729 (107) 8,622 1,709 — Denominator for diluted net income per share . . . . . . . . . . . . . . . . . . . . . 26,273 10,331 Net income per share — basic and diluted Before cumulative effect of change in accounting principle . . . . . . . . . . . . . Cumulative effect of change in accounting principle. . . . . . . . . . . . . . . . . . . $ 0.42 — $ 0.67 — Net income per share — basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.42 $ 0.67 Net income per share — diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.38 $ 0.56 3,619 (364) 3,255 1,307 47 4,609 $ $ $ 1.31 0.14 1.45 1.02 The following weighted-average outstanding options and convertible preferred stock were excluded from the computation of diluted net income per common share for the periods presented because including them would have had an anti-dilutive effect: Year Ended December 31, 2005 2006 2007 In thousands Options to purchase common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,367 Convertible preferred stock (as converted basis) . . . . . . . . . . . . . . . . . . . . — 10,509 385 153 12,633 Comprehensive Income (Loss) FASB Statement No. 130, Reporting Comprehensive Income, establishes standards for reporting and dis- playing comprehensive income and comprehensive loss and its components in the consolidated financial state- ments. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Comprehensive income (loss) is composed of net income (loss) and unrealized gains and losses on marketable securities, which are disclosed in the accompanying consolidated statements of redeemable convertible preferred stock and shareholders’ equity (deficit). 61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. The components of accumulated other comprehensive income (loss) were as follows (in thousands): Year Ended December 31, 2006 2005 2007 Unrealized income (loss) in investments, net of tax of $13 and $19. . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 23 10,095 $ (35) 5,798 $ — 28,932 Total comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,118 $5,763 $28,932 Segment Reporting The Company operates in one industry segment — digital photofinishing services. The Company operates in one geographic area, being the United States of America. FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is its Chief Executive Officer. The Company’s Chief Executive Officer reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance. The Company has one business activity and there are no segment managers who are held accountable for operations, operating results and plans for products or components below the consolidated unit level. Accordingly, the Company reports as a single operating segment. Recent Accounting Pronouncements In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. In February 2008, the FASB issued a staff position that delays the effective date of SFAS 157 for all nonfinancial assets and liabilities except for those recognized or disclosed at least annually. Except for the delay for nonfinancial assets and liabilities, SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within such years. The Company does not expect the adoption of FAS 157 will have a material effect on its financial position and results of operations. In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”) which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. FAS 159 was effective for the Company on January 1, 2008. The Company does not expect the adoption of FAS 159 will have a material effect on its financial position and results of operations. In December 2007, the FASB issued FAS No. 141R, “Business Combinations” (“FAS 141R”) which replaces FAS No. 141 and establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. FAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption of FAS 141R is prohibited. The Company is currently evaluating the impact, if any, of adopting FAS 141R on its financial position and results of operations. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“FAS 160”) which amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling 62 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. In addition to the amendments to ARB 51, this Statement amends FASB Statement No. 128, Earnings per Share; so that earnings-per-share data will continue to be calculated the same way those data were calculated before this Statement was issued. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently evaluating the impact, if any, of adopting FAS 160 on its financial position and results of operations. Note 3 — Change in Accounting Policy On June 29, 2005, the FASB issued Staff Position 150-5, Issuer’s Accounting under FASB Statement No. 150 (“SFAS 150”) for Freestanding Warrants and Other Similar Instruments on Shares That Are Redeemable (“FSP 150-5”). Under FSP 150-5, the freestanding warrants that were related to the Company’s redeemable convertible preferred stock were classified as liabilities and were recorded at fair value. The Company previously accounted for freestanding warrants for the purchase of redeemable convertible preferred stock under EITF Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”). The Company adopted FSP 150-5 and accounted for the cumulative effect of the change in accounting principle as of July 1, 2005. For the year ended December 31, 2005, the impact of the change in accounting principle was to increase net income by $442,000, or $0.14 per share. There was $464,000 of additional expense recorded in other income (expense), net to reflect the increase in fair value between July 1, 2005 and December 31, 2005. In the year ended December 31, 2006, the Company recorded $153,000 of additional income reflected as other income (expense), net to reflect the decrease in fair value of the warrants. There were no amounts recorded in 2007. Note 4 — Balance Sheet Components Cash, Cash Equivalents, and Short Term Investments The components of the Company’s cash, cash equivalents, and short term investments, including the unrealized gains (losses) associated with each are as follows: Book Value Cash . . . . . . . . . . . . . . . . . . . . . . $ 15,955 Cash Equivalents Money Market Funds . . . . . . . . Commercial Paper . . . . . . . . . . Total Cash Equivalents . . . . . . . . . US Government Agency Securities . . . . . . . . . . . . . . . . . Total Cash, Cash Equivalents, and 22,363 84,284 106,647 3,000 December 31, 2007 Gross Unrealized Gains/(Losses) In thousands $ — — (20) (20) 2 Fair Value Book Value $ 15,955 $ 9,154 22,363 84,264 17,829 92,123 106,627 109,952 3,002 — December 31, 2006 Gross Unrealized Gains/(Losses) In thousands $ — — (54) (54) — Fair Value $ 9,154 17,829 92,068 109,897 — Short Term Investments . . . . . . $125,602 $(18) $125,584 $119,106 $(54) $119,051 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. The contractual maturities for all of the Company’s available for sale securities are less than one year (See subsequent event Note 11.) Property and Equipment December 31, 2007 2006 In thousands Computer and other equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 66,663 12,745 Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,952 Leasehold improvements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,282 Furniture and fixtures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 41,880 8,791 4,903 1,348 Less: Accumulated depreciation and amortization . . . . . . . . . . . . . . . . . . . . . 89,642 (41,226) 56,922 (26,003) Net property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,416 $ 30,919 Property and equipment includes $5,121,000 and $6,502,000 of equipment and software under capital leases at December 31, 2007 and 2006, respectively. Accumulated depreciation of assets under capital leases totaled $3,798,000 and $3,820,000 at December 31, 2007 and 2006, respectively. Depreciation and amortization expense for the years ended December 31, 2007, 2006 and 2005 was $17,384,000, $10,525,000 and $6,246,000, respectively. The Company has capitalized website development costs incurred in the application development phase and unamortized cost is included in property and equipment and totaled approximately $3,619,000 and $2,582,000 at December 31, 2007 and 2006, respectively. These amounts included $111,000 and $0 of stock based compensation expense. Amortization of capitalized costs totaled approximately $1,467,000, $993,000, and $404,000 for the years ended December 31, 2007, 2006 and 2005, respectively. Intangible Assets Intangible assets are composed of the following at December 31: Weighted Average Useful Life Purchased technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . 12 Years Customer relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . Licenses and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . Acquired workforce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . 3 Years 3 Years 1 Year December 31, 2007 2006 In thousands $3,350 (905) $2,030 (634) 2,445 990 (110) 880 186 (31) 155 279 (279) 1,396 — — — — — — 279 (279) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,480 $1,396 64 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. Purchased technology is amortized over a period ranging from 5 to 16 years. Licenses and other is amortized over a period ranging from three to five years. In August 2007, the Company entered into an agreement with a competitor to acquire the customer list of that competitor without restriction of use. The acquisition amount totaled $990,000 and was paid in September 2007. The Company recorded this payment as an intangible asset, and is being amortized ratably over its estimated life through August 2010. The Company recorded amortization expense of $110,000 in 2007. Intangible asset amortization expense for the years ended December 31, 2007, 2006 and 2005 was $412,000, $222,000 and $276,000 respectively. Amortization of existing intangible assets is estimated to be as follows (in thousands): Year Ending: 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 783 783 643 395 251 625 $3,480 Accrued Liabilities December 31, 2007 2006 In thousands Accrued marketing expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued income and sales taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued consultant expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued production facility expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,101 3,053 1,414 3,682 1,516 3,283 1,675 $1,822 1,201 483 1,235 884 1,784 1,399 $18,724 $8,808 Note 5 — Acquisitions Make It About Me On June 14, 2007, the Company acquired CustomAbility, LLC, a publishing company that produces customized children’s books under the brand name Make It About Me (“MIAM”). This acquisition augmented the Company’s personal publishing platform. The transaction was accounted for as a purchase business combination. The total purchase price of $1,632,000 consisted of $1,600,000 in cash consideration and approximately $32,000 in transaction fees. The initial purchase price was allocated to the assets and liabilities acquired based on their fair value, with the majority of the cost being allocated to purchased technology of $1,320,000 and licensed content of $150,000. The identifiable intangible assets have useful lives not exceeding five years, and a weighted average life of 4.8 years. No amount was allocated to in-process research and development and $179,000 was 65 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. initially allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired and for tax purposes, will be amortized over 15 years. In addition to the initial cash consideration, the sellers of MIAM can earn additional consideration totaling $200,000 and $400,000 if certain contingencies are met. If these contingencies are met, these earn-out payments will be recorded as additional goodwill. The first contingency was met as of November 2007, increasing goodwill by $200,000. This amount was subsequently paid in January 2008. Prior to the acquisition, the Company was as a reseller of MIAM’s publishing products. As a part of this transaction, the existing fulfillment agreement between the two parties was cancelled. No gain or loss resulted from the settlement of this pre-existing relationship. Memory Matrix On June 1, 2005, the Company acquired 100% of Memory Matrix, Inc., (“Memory Matrix”) a Nevada corporation, in exchange for 109,302 shares of common stock. The acquisition was effected using a “reverse triangular” merger in which a wholly owned Shutterfly subsidiary was merged with and into Memory Matrix, resulting in Memory Matrix becoming a wholly owned subsidiary of Shutterfly. Memory Matrix was considered to be a “developmental stage” enterprise and did not meet the definition of a “business” under SFAS No. 141, Business Combinations, for business combination purposes. In accordance with SFAS No. 141, the acquisition of Memory Matrix was accounted for as an acquisition of assets. As additional consideration for the acquisition, the Company also issued 120,698 shares of common stock to the employees of Memory Matrix, subject to vesting and repurchase rights over a period of 18 months, in exchange for unvested Memory Matrix restricted shares held by such employees prior to the merger. $671,000 of deferred stock-based compensation was recorded based on the intrinsic value of the shares at the time of the acquisition. The Company recognized $0 and $94,000 of stock-based compensation expense for the year ended December 31, 2007 and 2006, respectively, relating to the vesting of the restricted shares. The total purchase price was $690,000, based on an estimated per share fair value of $6.00 on the date of the transaction, and was allocated to various tangible and intangible assets including: acquired workforce of $279,000 and purchased technology of $564,000. These were offset by other net liabilities of $153,000 which consisted primarily of a deferred tax liability of $336,000, other assumed liabilities of $100,000, and cash and other assets of $283,000. In addition, the Company recorded a deferred tax asset on the date of acquisition of $201,000, which was offset in full by a valuation allowance. In the fourth quarter of 2005, the valuation allowance was released, which reduced non-current intangibles accordingly. The acquired workforce intangible asset was amortized on a straight-line basis over one year. The net core technology asset is amortized on a straight-line basis over the asset’s life, which is estimated as three years. Note 6 — Commitments and Contingencies Leases The Company leases office and production space under various non-cancelable operating leases that expire no later than November 2014. Rent expense was $1,925,000, $1,295,000 and $1,181,000, for the years ended December 31, 2007, 2006 and 2005, respectively. Rent expense is recorded on a straight-line basis over the lease term. When a lease provides for fixed escalations of the minimum rental payments, the difference between the straight-line rent charged to expense, and the amount payable under the lease is recognized as deferred rent. 66 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. The Company leases certain equipment, software and colocation services under non-cancelable capital leases, operating leases or long-term agreements that expire at various dates through the year 2011. The leased equipment is subject to a security interest. The total outstanding obligation under capital leases at December 31, 2007 and 2006 was $915,000 and $3,703,000, respectively. At December 31, 2007, the total future minimum payments under non-cancelable scheduled rentals are as follows: Operating Leases Capital Leases In thousands Year Ending: 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total minimum lease payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: amount representing interest . . . . . . . . . . . . . . . . . . . . . . . . . Present value of future minimum lease payments. . . . . . . . . . . . . . . Less: current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-current portion of capital lease obligations . . . . . . . . . . . . . . . . $2,548 2,508 1,537 721 742 1,335 $9,391 $ 864 93 12 6 — — $ 975 (60) 915 (808) $ 107 Purchase obligations consist of non-cancelable marketing agreements, co-location services and printing equipment rental. As of December 31, 2007, the Company’s purchase obligations totaled $2,821,000. Indemnifications In the normal course of business, the Company enters into contracts and agreements that contain a variety of representation and warranties and provide for general indemnifications. The Company’s exposure under these agreements is unknown because it involves future claims that may be made against the Company, but have not yet been made. To date, the Company has not paid any claims or been required to defend any action related to its indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations. Contingencies From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. Legal Matters On August 29, 2006, our former Chief Financial Officer, Virender Ahluwalia, sued the Company in San Mateo County Superior Court alleging causes of action for reformation of contract, breach of contract and breach of fiduciary duty. The plaintiff claimed that he was entitled to exercise stock options for an additional 15,535 shares of the Company’s common stock because his vesting schedule should have been deemed to have started one year earlier than the date stated in the Company’s corporate records. In addition, the plaintiff claimed that the Company initially did not advise him that withholding taxes were due at the time of exercise of his nonqualified stock options 67 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. to purchase 292,674 shares of common stock in 2005, but that the Company later modified that tax advice, extended his option exercise date, and required that he make provision for the applicable withholding taxes at the time of exercise of such options. The plaintiff claimed he was damaged by having to immediately sell a portion of those shares upon his exercise in order to raise the funds necessary to pay applicable withholding taxes. He also claimed that the calculation of the fair market value of the shares for the purpose of calculating his tax liability was improper. The plaintiff was seeking compensatory and punitive damages. The case was stayed and sent to binding arbitration, and following a hearing on the legal issues and an evidentiary hearing, the Arbitrator issued a Final Award on November 16, 2007 finding the Company not liable and dismissed all claims brought by Mr. Ahluwalia. On or about June 18, 2007, Fotomedia Technologies, LLC filed suit in the United States District Court for the Eastern District of Texas, against the Company and several other defendants alleging patent infringement. The Fotomedia Complaint sought unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction. In lieu of answering the Fotomedia Complaint, the Company moved to dismiss it under Rule 12 of the Federal Rules of Civil Procedure, by joining in a motion to the same effect filed by co-defendant Photobucket.com, Inc. While the motion was pending and not yet decided, on or about November 6, 2007, Fotomedia filed an Amended Complaint. The Amended Complaint likewise alleges infringement of the same three patents and seeks unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction. However, the amended complaint dropped the allegations of willful infringement against the Company in connection with one of the patents-at-issue. Defendants moved to dismiss the Amended Complaint as well. The motion at this time is fully briefed but has not yet been ruled upon. As such, the Company has not yet been required to file an answer or other responsive pleading. On January 8, 2008, the court held a status conference and set May 28, 2009, as the date for the claims construction hearing, and set November 2, 2009 as the date for trial. Subsequently, the parties agreed upon and submitted orders that establish a case schedule, which the court entered on February 29, 2008. At this time, the Company does not believe that the amount of potential loss, if any, is reasonably estimable. On or about February 5, 2008, Parallel Networks, LLC filed a lawsuit in the Eastern District of Texas against the Company and other companies, alleging patent infringement. The Parallel Networks Complaint seeks damages of an unspecified amount, attorneys’ fees, and an injunction against all parties. The Company has not yet answered or otherwise responded to the complaint At this time, the Company does not believe that the amount of potential loss, if any, is reasonably estimable. From time to time, the Company may be involved in various legal proceedings arising in the ordinary course of business. At December 31, 2007, in the opinion of management, there are no other matters that are expected to have a material adverse effect on the Company’s financial position, results of operations or cash flows. Note 7 — Common Stock In October 2006, the Company completed its IPO of common stock in which it sold and issued 5,800,000 shares of common stock, at an issue price of $15.00 per share. As a result of the IPO, a total of $87.0 million in gross proceeds was raised, with net proceeds to the Company of $78.5 million after deducting underwriting fees and commissions of $6.1 million and other offering costs of $2.4 million. Upon the closing of the IPO, all shares of the Company’s redeemable convertible preferred stock outstanding automatically converted into 13,862,773 shares of common stock. Warrants for Common Stock During 2007, two warrant holders exercised their warrants for an aggregate of 27,299 shares of common stock. The transactions were effected through a net-exercise, and as a result, no cash proceeds were received by the Company. As of December 31, 2007, there were no remaining warrants outstanding. 68 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. Upon the effective date of the IPO, warrants to purchase 40,816 shares of redeemable convertible preferred stock converted into warrants to purchase 40,816 shares of common stock, and warrants to purchase 40,816 shares of redeemable convertible preferred stock expired. As discussed in Note 3, in 2005 the Company reclassified the freestanding preferred stock warrants as a liability and began adjusting the warrants to fair value at each reporting period until the completion of the IPO. 1999 Stock Plan In September 1999, the Company adopted the 1999 Stock Plan (the “1999 Plan”). Under the 1999 Plan, the Company issued shares of common stock and options to purchase common stock to employees, directors and consultants. Options granted under the Plan were incentive stock options or non-qualified stock options. Incentive stock options (“ISO”) were granted only to Company employees, which includes officers and directors of the Company. Non-qualified stock options (“NSO”) and stock purchase rights were able to be granted to employees and consultants. Options under the Plan were to be granted at prices not less than 85% of the deemed fair value of the shares on the date of the grant as determined by the Company’s Board of Directors (“the Board”), provided, however, that (i) the exercise price of an ISO and NSO was not less than 100% and 85% of the deemed fair value of the shares on the date of grant, respectively, and (ii) the exercise price of an ISO and NSO granted to a 10% stockholder was not less than 110% of the deemed fair value of the shares on the date of grant. The Board determined the period over which options become exercisable. The term of the options was to be no longer than five years for ISOs for which the grantee owns greater than 10% of the voting power of all classes of stock and no longer than ten years for all other options. Options granted under the 1999 Plan generally vested over four years. The Board of Directors determined that no further grants of awards under the 1999 Plan would be made after the Company’s IPO. 2006 Equity Incentive Plan In June 2006, the Board adopted, and in September 2006 the Company’s stockholders approved, the 2006 Equity Incentive Plan (the “2006 Plan”), and all shares of common stock available for grant under the 1999 Plan transferred to the 2006 Plan. The 2006 Plan provides for the grant of ISOs to employees (including officers and directors who are also employees) of the Company or of a parent or subsidiary of the Company, and for the grant of all other types of awards to employees, officers, directors, consultants, independent contractors and advisors of the Company or any parent or subsidiary of the Company, provided such consultants, independent contractors and advisors render bona-fide services not in connection with the offer and sale of securities in a capital-raising transaction. Other types of awards under the 2006 Plan include NSO restricted stock awards, stock bonus awards, restricted stock units, and performance shares. Options issued under the 2006 Plan are generally for periods not to exceed 10 years and are issued at the fair value of the shares of common stock on the date of grant as determined by the Board. Prior to the Company’s IPO, the Board determined the fair value of common stock in good faith based on the best information available to the Board and Company’s management at the time of the grant. Following the IPO, the fair value of the Company’s common stock is determined by the last sale price of such stock on the Nasdaq Global Market. Options issued under the 2006 Plan typically vest with respect to 25% of the shares one year after the options’ vesting commencement date, and the remainder ratably on a monthly basis over the following three years. Option holders under the 2006 Plan are allowed to exercise options prior to vesting. At the time of adoption of the 2006 Plan, there were 1,358,352 shares of common stock authorized for issuance under the 2006 Plan, plus 92,999 shares of common stock from the 1999 Plan that were unissued. The 2006 Plan provides for automatic replenishments on January 1 of 2008, 2009, and 2010, of the lesser of a) 4.62% of stock options issued and outstanding on the December 31 immediately prior to the date of increase or b) a lesser number as determined by the Board. 69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. Inducement Options During 2007, the Company offered employment inducement stock option grant awards to three executives. These inducement grants were approved by the Company’s Board of Directors and were not issued under a shareholder approved plan. A total of 380,000 NSOs were granted. These options have a 10 year term, and vest over a four year period from the initial date of hire of each of the executives. Stock Option Activity A summary of the status of the Company’s stock option plans at December 31, 2007 and changes during the periods then ended is presented in the table below (share numbers and aggregate intrinsic value in thousands): Shares Available for Grant Number of Options Outstanding Weighted Average Exercise Price Weighted Average Contractual Term (Years) Aggregate Intrinsic Value Balances, December 31, 2004 . . . . . . . . . . . . . . . . . Additional authorized . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited, cancelled or expired . . . . . . . . . . . . . . . Balances, December 31, 2005 . . . . . . . . . . . . . . . . . Additional authorized . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited, cancelled or expired . . . . . . . . . . . . . . . Balances, December 31, 2006 . . . . . . . . . . . . . . . . . Additional authorized (inducement grants) . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited, cancelled or expired . . . . . . . . . . . . . . . Balances, December 31, 2007 . . . . . . . . . . . . . . . . . Options vested and expected to vest at December 31, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Options vested at December 31, 2007 . . . . . . . . . . . 510 2,720 (2,372) — 501 1,359 2,055 (2,269) — 233 1,378 380 (2,217) — 560 1,336 — 2,372 (315) (375) 3,018 — 2,269 (52) (201) 5,034 — 2,217 (1,049) (560) 0.40 — 5.12 0.35 2.89 3.91 — 11.11 1.61 6.10 7.28 — 22.17 4.75 9.36 101 5,642 $13.39 5,165 1,917 $12.92 $ 7.05 8.1 8.0 6.9 $71,253 $67,468 $35,610 As of December 31, 2006 and 2005, there were 1,485,000 and 489,000 options vested, respectively. During the 12 months ended December 31, 2007, the Company granted stock options to purchase an aggregate of 2,216,694 shares of common stock with a weighted average grant-date fair value of $9.33 per share. Options granted in 2006 are grouped as follows: Options with exercise price less than reassessed market price on the grant date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Options with exercise price equal to reassessed market price on the grant date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,269 70 Options Granted Weighted Average Fair Value Weighted Average Exercise Price 255 $4.43 $10.00 2,014 $5.06 $4.99 $11.25 $11.11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. The total fair value of options that vested during the 12 months ended December 31, 2007 was $5,250,000. The total intrinsic value of options exercised during the twelve months ended December 31, 2007, 2006, and 2005 was $18,136,000, $531,000 and $3,274,000 respectively. Net cash proceeds from the exercise of stock options were $4,975,000 for the twelve months ended December 31, 2007. As permitted by SFAS 123R, the Company has deferred the recognition of its excess tax benefit from stock option exercises of approximately $5.3 million until it is actually realized. During 2007, the Company recognized $27,000 of non-qualified tax benefit in state tax jurisdictions where the Company did not have any net operating loss carry forwards. Early Exercise of Employee Options Stock options granted under the 1999 Plan provides employee option holders the right to elect to exercise unvested options in exchange for restricted common stock. Unvested shares, which amounted to 5,000, 31,000 and 138,000 at December 31, 2007, 2006 and 2005, respectively, were subject to a repurchase right held by the Company at the original issuance price in the event the optionees’ employment is terminated either voluntarily or involuntarily. For exercises of employee options, this right lapses 25% on the first anniversary of the vesting start date and in 36 equal monthly amounts thereafter. These repurchase terms are considered to be a forfeiture provision and do not result in variable accounting. In accordance with EITF No. 00-23, Issues Related to the Accounting for Stock Compensation under APB No. 25, the shares purchased by the employees pursuant to the early exercise of stock options are not deemed to be outstanding until those shares vest. In addition, cash received from employees for exercise of unvested options is treated as a refundable deposit shown as a liability in the Company’s financial statements. As of December 31, 2007, 2006 and 2005, cash received for early exercise of options of $0, $9,000 and $38,000, was included in refundable deposits, respectively. Amounts so recorded are transferred into common stock and additional paid-in capital as the shares vest. Stock-based Compensation Associated with Awards to Employees All options granted were intended to be exercisable at a price per share not less than fair market value of the shares of the Company’s stock underlying those options on their respective dates of grant. The Board determined these fair market values in good faith based on the best information available to the Board and Company’s management at the time of the grant. Although the Company believes these determinations accurately reflect the historical value of the Company’s common stock, management has retroactively revised the valuation of its common stock for the purpose of calculating stock-based compensation expense. Accordingly, in the periods ending December 31, 2004 and 2005 for such stock and options issued to employees, the Company has recorded deferred stock-based compensation of $2,299,000 and $1,225,000 respectively, net of cancellations, of which the Company amortized $1,000, $565,000 and $1,547,000 of stock-based compensation in the years ended December 31, 2007, 2006 and 2005, respectively. At December 31, 2007, the Company had deferred stock-based compensation under APB 25, as shown in the consolidated statement of redeemable convertible preferred stock and stockholders’ equity of $28,000, which is expected to be fully amortized in 2008. On July 28, 2004, the Company entered into a transition agreement with one of its executive officers whereby vesting of previously granted options was accelerated resulting in a new measurement date at the date of modification. This executive officer resigned effective January 31, 2005. A total of 316,000 shares would have been forfeited under the original option terms resulting in total compensation expense of $1,145,000. The total compensation expense was measured in accordance with guidance provided by Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB Opinion No. 25 (“FIN 44”), as the intrinsic value of the modified award at the date of modification in excess of the amount measured at the original measurement date. A total of $164,000 and $981,000 was recognized in the years ended December 31, 2005 and 2004, respectively. 71 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. On August 13, 2004 the Company entered into a transition agreement with one of its executive officers. Upon termination, the agreement provided for acceleration of 25% of the officer’s unvested options. The agreement also provided for an extension of the time to exercise any vested options, from 90 days to 270 days from the date of the officer’s termination. In February 2005, this executive officer resigned and 17,000 shares that would have been forfeited under the original option terms were accelerated, resulting in total stock-based compensation expense of $65,000. In November 2005, this executive officer exercised options for 293,000 shares. As expense recognition for the additional 276,000 shares was contingent on whether this executive officer took the benefit of the vesting extension, additional stock-based compensation expense was not recognized until the November exercise when $1,035,000 was recorded. Stock-based compensation expense for the February and November 2005 charges was measured in accordance with guidance provided by FIN 44 as the intrinsic value of the modified award at the date of modification in excess of the amount measured at the original measurement date. Adoption of SFAS No. 123R The Company adopted SFAS No. 123R on January 1, 2006. Under SFAS No. 123R, the Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model using the assumptions noted in the following table. Expected volatility is based on the historical and implied volatility of a peer group of publicly traded entities. The expected term of options gave consideration to historical exercises, post vest cancellations and the options contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the twelve months ended December 31, 2007 and December 31, 2006 were as follows Year Ended December 31, 2007 Year Ended December 31, 2006 Dividend yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Annual risk free rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected term (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 4.1% 45.0% 4.4 — 5.0% 45.8% 4.6 Employee stock-based compensation expense recognized during the periods ended December 31, 2007 and December 31, 2006 was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. As a result of adopting SFAS No. 123R on January 1, 2006, the Company’s net income for the twelve months ended December 31, 2006, was lower by $1,950,000 net of tax effect, than if the Company had continued to account for stock-based compensation under APB 25. Basic and diluted net income per share for the twelve months ended December 31, 2006 would have been higher by $0.23 if the Company had not adopted SFAS No. 123R. At December 31, 2007, the Company had $21,618,000 of total unrecognized compensation expense under SFAS No. 123R, net of estimated forfeitures, related to stock option plans that will be recognized over a weighted-average period of approximately three years. In accordance with SFAS No. 123R, unamortized com- pensation expense on stock option grants after January 1, 2006 is not included in deferred stock-based compen- sation on the equity statement. The balance in deferred stock-based compensation as of December 31, 2007 is $28,000, which is comprised primarily of employee stock option grants prior to January 1, 2006. In 2006, based on a reassessment of the value of its common stock during 2005, the Company offered to the employees who were granted options from January 2005 to October 2005 the ability to amend the terms of their options to increase the exercise prices in order to help them avoid potential adverse personal income tax consequences. On June 29, 2006 and December 22, 2006, options to purchase 1,789,217 and 3,480 shares, respectively, of the Company’s common stock that had been granted at exercise prices ranging from $5.00 to $5.50 per share were amended to exercise prices between $5.50 and $6.56 per share. No other terms of the option grants 72 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. were modified. The transactions were deemed to be modifications under SFAS No. 123R; deferred stock-based compensation computed under APB 25 was reduced by $526,000 which will be amortized under SFAS No. 123R, and there was no incremental stock-based compensation expenses from the amendments. Note 8 — Income Taxes The components of the provision for income taxes is as follows (in thousands): December 31, 2007 2006 2005 Federal: Current Deferred. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 206 5,146 $ 610 2,809 $ (187) (20,230) $5,352 $3,419 $(20,417) State: Current Deferred. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 216 734 $ 133 390 $ (40) (3,603) $ 950 $ 523 $ (3,643) Total income tax expense (benefit): Current Deferred. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 422 5,880 $ 743 3,199 $ (227) (23,833) $6,302 $3,942 $(24,060) The Company’s actual tax expense (benefit) differed from the statutory federal income tax rate of 34.0%, as follows: December 31, 2007 2006 2005 Income tax expense at statutory rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock-based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-qualified deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — Change in valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34.0% 34.0% 34.0% 4.5% 5.8% 5.8% 2.0% 4.3% 10.7% — (13.1)% — (527.7)% (2.1)% (3.7)% (3.5)% 38.4% 40.4% (493.8)% At December 31, 2007, the Company had approximately $31.0 million and $32.0 million of federal and state net operating loss carryforwards, respectively, to reduce future regular taxable income. These carryforwards will expire beginning in the year 2020 through 2022 for federal and 2011 through 2012 for state purposes, if not utilized. The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in the case of an “ownership change” of a corporation or separate return loss year limitations. Any ownership changes, as defined, may restrict utilization of carryforwards. The Company also had federal and state research and development credit carryforwards of approximately $1.0 million and $1.0 million for federal and state income tax purposes, respectively, at December 31, 2007. The research and development credits may be carried forward over a period of 20 years for federal tax purposes, and indefinitely for California tax purposes. 73 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. The components of the net deferred tax assets as of December 31, 2007 and 2006 are as follows (in thousands): December 31, 2007 2006 Deferred tax assets: Net operating loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reserves and other tax benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,481 3,485 2,715 1,196 94 $17,028 2,111 1,800 32 19 Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,971 20,990 Deferred tax liabilities: Other deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — — (107) (107) — Net deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,971 $20,883 As of January 1, 2007, the date of adoption of FIN 48, the Company had $1,200,000 of unrecognized tax benefits. The amount of unrecognized tax benefits that, if recognized, would decrease the Company’s provision for income taxes and increase net income is $1,000,000, net of the federal benefit for state taxes. There was no significant cumulative impact to retained earnings as a result of the adoption of FIN 48. The total unrecognized tax benefits relate to reserves against the Company’s research and development tax credits claimed on Federal and California returns. Subsequent to adoption and during the twelve-month period ended December 31, 2007, the Company revised its reserve estimate related to research and development tax credits as a result of the conclusion of an audit by the California Franchise Tax Board for the September 30, 2004 tax year. This change in estimate resulted in a decrease in unrecognized tax benefits from $1,200,000 to $497,000. The amount of unrecognized tax benefits that, if recognized, would decrease the Company’s provision of income taxes and increase net income is $448,000, net of the federal benefit for state taxes. As of December 31, 2007, the Company booked an additional $259,000 for unrecognized tax benefits for fiscal 2007. A reconciliation of the beginning and ending amounts of unrecognized income tax benefits during the 12-month period ended December 31, 2007 is as follows (in thousands): Balance of unrecognized tax benefits at January 1, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . Additions for tax positions of prior years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additions for tax positions related to 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reductions for tax positions of prior years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Settlement of franchise tax audit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lapses in statutes of limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200 — 259 (607) (96) — Balance of unrecognized tax benefits at December 31, 2007 . . . . . . . . . . . . . . . . . . . . . . . . $ 756 The company does not expect the balance of unrecognized tax benefits to significantly increase or decrease in the next 12 months. Our fiscal year end for federal and state tax purposes was September 30. During the period ended June 30, 2007, the taxing authorities granted our request to change our fiscal year end for tax purposes to December 31. In September 2007, we filed a short period income tax return for federal and state purposes covering October 1, 2006 through December 31, 2006. This filing did not have a material impact on our income tax provision. As of 74 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. December 31, 2007, the Company is subject to taxation in the United States, California, North Carolina, New Jersey, New York, and Arizona. The Company is subject to examination for tax years including and after 2003 for the United States, 2004 for California, and 2007 for the remaining jurisdictions. Note 9 — Employee Benefit Plan In 2000, the Company established a 401(k) plan under the provisions of which eligible employees may contribute an amount up to 50% of their compensation on a pre-tax basis, subject to IRS limitations. The Company matches employees’ contributions at the discretion of the Board. In 2007 and 2005, there were no discretionary contributions. In 2006, the Company made a discretionary contribution of $63,000. Note 10 — Related Party Transactions On June 1, 2005, the Company acquired Memory Matrix (see Note 5). Monaco Partners, L.P., a beneficial owner of the Company’s capital stock, owned 14.1% of Memory Matrix immediately prior to the closing of the acquisition. James H. Clark, who is a stockholder of the Company, and was a member of the Board, controlled Monaco Partners, L.P. Mr. Clark was a member of the board of directors of Memory Matrix immediately prior to the acquisition. Note 11 — Subsequent Events Nexo Acquisition: On January 4, 2008, the Company completed its acquisition of Nexo Systems for $10.0 million in cash and $4.0 million in restricted stock. In addition, the two founders of Nexo joined the Company as vice presidents. The acquisition was accounted for as a purchase business combination, and the restricted stock will be recorded as compensation expense over the vesting term of approximately two years. Intellectual Property License Agreement: On February 8, 2008, the Company entered into a license arrangement of certain of its patented technology to a third party. Under the terms of the license, the third party will pay the license fee in annual installments through March 2010, each of which will be recorded as a reduction of operating expense in the period that the license installment is received. Auction Rate Securities: At February 29, 2008, $52.3 million of our marketable securities portfolio was invested in AAA rated investments in auction-rate debt securities. Auction-rate securities are long-term variable rate bonds tied to short-term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates. Following such a failed auction, we would not be able to access our funds that are invested in the corresponding auction-rate securities until a future auction of these investments is successful or new buyers express interest in purchasing these securities in between reset dates. As a result of the current negative liquidity conditions in the global credit markets, in February 2008, auctions for $42.3 million of original par value of our auction-rate securities failed, rendering these securities temporarily illiquid through the normal auction process. At the time of our initial investment and through the date of this Report, all of our auction-rate securities remain AAA rated. The assets underlying each security are student loans and 95% of the principal amounts are guaranteed by the Federal Family Education Loan Program (FFELP). Since we cannot predict when future auctions related to $52.3 million of our auction-rate securities will be successful, it may become necessary to classify this amount as long-term marketable securities in our consolidated balance sheet in future periods. In addition, if the underlying issuers are unable to successfully clear future auctions or if their credit rating deteriorates and the deterioration is deemed to be other-than-temporary, we would be required to adjust the carrying 75 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SHUTTERFLY, INC. value of the auction-rate securities through an impairment charge to earnings. Any of these events could materially affect our results of operations and our financial condition. To access these funds in future periods, it may be necessary to attempt to sell these securities at an amount below our original purchase value. However, based on our ability to access our cash and cash equivalents and our other liquid investments, totaling $53.7 million at February 29, 2008, and our expected operating cash flows, we believe that we currently have adequate working capital resources to fund our operations. Note 12 — Quarterly Financial Data (Unaudited, in thousands) Net Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) allocable to common shareholders . . . Net income (loss) per common share: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2007 First Quarter Second Quarter Third Quarter Fourth Quarter $26,705 13,671 $ (1,060) $29,877 15,045 $ (2,439) $32,602 15,362 $ (3,314) $97,543 58,538 $16,909 $ (0.04) $ (0.04) $ (0.10) $ (0.10) $ (0.14) $ (0.14) $ 0.68 $ 0.63 Year Ended December 31, 2006 First Quarter Second Quarter Third Quarter Fourth Quarter $16,883 8,134 $ (1,565) $ (1,565) $19,637 9,881 $ (2,093) $ (2,093) $21,155 10,289 $ (2,747) $ (2,747) $65,678 39,558 $12,203 $12,203 $ (0.41) $ (0.41) $ (0.54) $ (0.54) $ (0.70) $ (0.70) $ 0.53 $ 0.50 76 Schedule II Valuation and Qualifying Accounts Allowance for Doubtful Accounts Receivable Year ended December 31, 2005 . . Year ended December 31, 2006 . . Year ended December 31, 2007 . . Deferred tax valuation allowance Balance at Beginning of Period $ — 21 $ — Year ended December 31, 2005 . . Year ended December 31, 2006 . . Year ended December 31, 2007 . . $25,008 — — Additions Charged to Costs and Expenses Charged to Other Accounts Deductions In thousands Balance at End of Period $37 — — $— — — $ — — — $ (16) (21) — $(230)(1) — — $(24,778)(2) — — $21 — — $— — — (1) Reflects amounts related to items with no income statement effect. (2) Decrease in the Valuation allowance is due to the reversal of the valuation allowance in the fourth quarter of 2005. 77 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE. Not applicable. ITEM 9A. CONTROLS AND PROCEDURES. Evaluation of Disclosure Controls and Procedures We carried out an evaluation required by the Securities Exchange Act of 1934, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as of December 31, 2007. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of December 31, 2007, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specific in the SEC’s rules and forms and to provide reasonable assurance that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures. Management’s Report on Internal Control over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. Management has assessed the effectiveness of our internal control over financial reporting as of December 31, 2007 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Com- mission. As a result of this assessment, management concluded that, as of December 31, 2007, our internal control over financial reporting was effective in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. PricewaterhouseCoopers LLP, the independent registered public accounting firm that also audited our financial statements included in this Annual Report on Form 10-K, audited the effectiveness of internal control over financial reporting as of December 31, 2007, and issued their related attestation report which is included herein. Changes in Internal Control Over Financial Reporting There were no changes in our internal control over financial reporting during the quarter ended December 31, 2007 that materially affected, or are reasonable likely to materially affect, our internal control over financial reporting. Limitation on Effectiveness of Controls Management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. ITEM 9B. OTHER INFORMATION. None. 78 PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. The information concerning our directors required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Proposal No. 1 — Election of Directors.” The information concerning our executive officers required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Executive Officers.” The information concerning compliance with Section 16(a) of the Securities Exchange Act of 1934 required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Section 16(a) Beneficial Ownership Reporting Compliance.” We have adopted a written code of ethics for financial employees that applies to our principal executive officer, principal financial officer, principal accounting officer, controller and other employees of the finance department designated by the Company’s Chief Financial Officer. This code of ethics, titled the “Code of Ethics for Chief Executive Officer and Senior Financial Department Personnel,” can be found on our website at www.shutterfly.com. We intend to make all required disclosures concerning any amendments to, or waivers from, our code of ethics on our website. The information concerning material changes to the procedures by which stockholders may recommend nominees to the Board of Directors required by this Item is incorporated by reference to information set forth in the Proxy Statement, in the section entitled “Information Regarding the Board of Directors and its Committees.” The information concerning the audit committee of the Board of Directors and the audit committee financial experts required by this Item is incorporated by reference to information set forth in the Proxy Statement, in the section entitled “Information Regarding the Board of Directors and its Committees.” ITEM 11. EXECUTIVE COMPENSATION. The information required by this Item with respect to executive compensation and the compensation committee of the Board of Directors is incorporated by reference to information set forth in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERS. The information required by this Item is incorporated by reference to information set forth in the Proxy Statement under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information.” ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. The information required by this Item with respect to director independence is incorporated by reference to information set forth in the Proxy Statement. The information concerning certain relationships and related transactions required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Certain Transactions.” ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. The information concerning principal accountant fees and services required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Ratification of Selection of Independent Registered Public Accounting Firm.” ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. (a) The following documents are filed as part of this annual report: PART IV 1. Financial Statements. The consolidated financial statements of Shutterfly, Inc. are incorporated by reference to Part II, Item 8 of this annual report. 2. Financial Statement Schedules. The Valuation and Qualifying Accounts schedule is incorporated by reference to Part II, Item 8 of this annual report. 79 3. Exhibits. Exhibit Number Exhibit Description Form File No. Incorporated by Reference Date of First Filing Exhibit Number Provided Herewith 3.01 Registrants’ Restated Certificate of S-1 333-135426 June 29, 2006 3.03 Incorporation. 10.01 10.02 10.03 as and 4.02 dated certain investors Agreement, common stock 3.02 Registrant’s Restated Bylaws. Form of Registrant’s 4.01 certificate. Fifth Amended and Restated Investors’ Rights of November 11, 2005, by and among the Registrant of Registrant. Form of Indemnity Agreement 1999 Stock Plan and forms of stock option agreement and a stock option exercise agreement.* 2006 Equity Incentive Plan and forms of stock option stock option agreement, stock exercise unit agreement, agreement, right agreement and stock bonus agreement.* Lease Agreement, as amended, dated July 5, 1999, by and between the Registrant and Westport Joint Venture, as amended to date. restricted stock appreciation agreement, restricted stock 10.04 10.06 10.05 Agreement of Lease, dated as of August 1, 2005, by and between the Registrant and DCT-CA 2004 RN Portfolio L, LP, as amended to date. Lease, dated as of March 7, 2000, by and between 3168 Corporate Place Associates, LLC, as amended to date. Lease, dated as of April 6, 2000, by and between 3168 Corporate Place Associates, LLC, as amended to date. the Registrant the Registrant 10.07 and and S-1 S-1 333-135426 333-135426 June 29, 2006 June 29, 2006 3.05 4.01 S-1 333-135426 June 29, 2006 4.02 S-1 S-1 333-135426 333-135426 June 29, 2006 June 29, 2006 10.01 10.02 S-1/A 333-135426 June 29, 2006 10.03 S-1 333-135426 June 29, 2006 10.04 S-1 333-135426 June 29, 2006 10.05 S-1 333-135426 June 29, 2006 10.06 S-1 333-135426 June 29, 2006 10.07 10.08 Offer letter dated January 5, 2005 for S-1 333-135426 June 29, 2006 10.08 Jeffrey T. Housenbold.* 10.09 Offer letter dated June 23, 2004 for S-1 333-135426 June 29, 2006 10.09 Stephen E. Recht.* 10.10 Offer letter dated July 22, 2001 for S-1 333-135426 June 29, 2006 10.10 Jeannine M. Smith Thomas.* 10.11 Offer letter dated July 12, 2001 for S-1 333-135426 June 29, 2006 10.11 Andrew F. Young.* 10.12 Offer letter dated March 25, 2005 for S-1 333-135426 June 29, 2006 10.12 Douglas J. Galen.* 10.13 Offer letter dated April 3, 2006 for S-1 333-135426 June 29, 2006 10.13 Stanford S. Au.* 80 Exhibit Number 10.14 Exhibit Description Form File No. Incorporated by Reference Date of First Filing Exhibit Number Provided Herewith agreement, Supply of September 15, 2005, by and between Registrant and Fuji Photo Film U.S.A., Inc.** dated as S-1 333-135426 June 29, 2006 10.14 10.15 Offer letter dated January 17, 2007 for 10-K 001-33031 March 20, 2007 10.15 Dwayne Black.* 10-K 001-33031 March 20, 2007 10.16 10-K 001-33031 March 20, 2007 10.17 10-Q 001-33031 August 1, 2007 10.18 10.16 Confidential Separation Agreement and General Release dated January 23, 2007, by and between the Registrant Jeannine M. Smith Thomas.* of Claims, and of Claims, 10.17 Confidential Separation Agreement and General Release dated January 19, 2007, by and between the Registrant and Andrew F. Young.* Supply Agreement, dated as of April 20, 2007, by and between the Registrant and FujiFilm U.S.A., Inc.** 10.18 10.19 Offer Letter dated May 17, 2007 for Kathryn E. Olson.* 10.20 Offer letter dated November 27, 2007 for Mark J. Rubash.* 10.22 of Claims, 10.21 Confidential Separation Agreement and General Release dated December 10, 2007, by and between the Registrant and Stephen E. Recht.* Lease Agreement, as amended, dated as of December 22, 2006, by and between the Registrant and 3915 Shopton Road, LLC, as amended to date. First Amendment to Lease (Expansion), dated as of April 30, 2007, by and between the Registrant and Westport Office Park, LLC, as amended to date. Subsidiaries of the Registrant 21.01 23.01 Consent of Independent Registered Public 10.23 24.01 Accounting Firm Power of Attorney. (See page 79 of this Form 10-K) 31.01 Certification of Chief Executive Officer to Securities Exchange Act Pursuant Rule 13a-14(a) 31.02 Certification of Chief Financial Officer to Securities Exchange Act Pursuant Rule 13a-14(a) 81 X X X X X X X X X X Exhibit Number Exhibit Description Form File No. Incorporated by Reference Date of First Filing Exhibit Number Provided Herewith 32.01 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 and Securities Act Rule 13a-14(b).*** Exchange 32.02 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 and Act Securities Rule 13a-14(b).*** Exchange X X Represents a management contract or compensatory plan. * ** Confidential treatment has been granted for certain portions of this document pursuant to an application for confidential treatment sent to the Securities and Exchange Commission. Such portions are omitted from this filing and were filed separately with the Securities and Exchange Commission. *** This certification is not deemed “filed” for purposes of Section 18 of the Securities Exchange Act, or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Shutterfly specifically incorporates it by reference. 82 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SIGNATURES SHUTTERFLY, INC. (Registrant) /s/ Mark J. Rubash Mark J. Rubash Sr. Vice President and Chief Financial Officer Dated: March 10, 2008 POWER OF ATTORNEY KNOWALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Jeffrey T. Housenbold and Mark J. Rubash, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K and to file same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and dates indicated. Signature Title Date /s/ Jeffrey T. Housenbold Jeffrey T. Housenbold /s/ Mark J. Rubash Mark J. Rubash /s/ Philip A. Marineau Philip A. Marineau /s/ Patricia A. House Patricia A. House /s/ Eric J. Keller Eric J. Keller /s/ Nancy J. Schoendorf Nancy J. Schoendorf /s/ James N. White James N. White /s/ Stephen J. Killeen Stephen J. Killeen President, Chief Executive Officer and Director (Principal Executive Officer) March 10, 2008 Sr. Vice President and Chief Financial Officer (Principal Financial Officer) March 10, 2008 Chairman of the Board of Directors March 10, 2008 March 10, 2008 March 10, 2008 March 10, 2008 March 10, 2008 March 10, 2008 Director Director Director Director Director 83 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 Exhibit 31.01 I, Jeffrey T. Housenbold, President and Chief Executive Officer of Shutterfly, Inc., certify that: 1. I have reviewed this annual report on Form 10-K of Shutterfly, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 10, 2008 /s/ Jeffrey T. Housenbold Jeffrey T. Housenbold President and Chief Executive Officer CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 Exhibit 31.02 I, Mark J. Rubash, Chief Financial Officer of Shutterfly, Inc., certify that: 1. I have reviewed this annual report on Form 10-K of Shutterfly, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 10, 2008 /s/ Mark J. Rubash Mark J. Rubash Sr. Vice President and Chief Financial Officer Exhibit 32.01 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 The undersigned, Jeffrey T. Housenbold, the President and Chief Executive Officer of Shutterfly, Inc. (the “Company”), pursuant to 18 U.S.C. § 1350, hereby certifies that: (i) the Annual Report on Form 10-K for the period ended December 31, 2007 of the Company (the “Report”) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (ii) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 10, 2008 /s/ Jeffrey T. Housenbold Jeffrey T. Housenbold President and Chief Executive Officer Exhibit 32.02 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 The undersigned, Mark J. Rubash, Chief Financial Officer of Shutterfly, Inc. (the “Company”), pursuant to 18 U.S.C. § 1350, hereby certifies: (i) the Annual Report on Form 10-K for the period ended December 31, 2007 of the Company (the “Report”) fully complies with the requirements of Section 13(a) and 15(d) of the Securities Exchange Act of 1934; and (ii) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 10, 2008 /s/ Mark J. Rubash Mark J. Rubash Sr. Vice President and Chief Financial Officer CORPORATE AND STOCKHOLDER INFORMATIONTrading InformationThe common stock of Shutterfly, Inc. is traded on the Nasdaq Stock Market (symbol: SFLY). If you wish to become a stockholder, please contact a stockbroker.Annual MeetingMay 22, 200811:00 a.m. (PT)1300 Island DriveRedwood City, CA 94065Transfer AgentInformation regarding stock certificates, change of address, ownership transfer or other stock matters can be obtained from: BNY Mellon Shareowner ServicesP.O. Box 358015Pittsburgh, PA 15252www.bnymellon.com/shareowner/isd877-905-1585Independent Public Accounting FirmPricewaterhouseCoopers LLPObtaining Financial StatementsA copy of our Annual Report on Form 10-K is posted on our website. You may also obtain a copy by written or email request to:Investor RelationsShutterfly, Inc.2800 Bridge ParkwayRedwood City, California 94065Email: IRinquiries@shutterfly.comBoard of DirectorsPhilip A. MarineauChairman of the Board and Former Chief Executive Officer, Levi Strauss, & CoJeffrey T. HousenboldPresident, Chief Executive Officer and Director, Shutterfly, Inc.Patricia A. HouseCo-founder Siebel SystemsEric J. KellerFormer President and Chief Executive Officer, MovarisStephen J. KilleenChief Executive Officer, The CarbonNeutral CompanyNancy J. SchoendorfManaging Partner, Mohr, Davidow VenturesJames N. WhiteManaging Director, Sutter Hill VenturesExecutive Management TeamJeffrey T. HousenboldPresident, Chief Executive Officer and DirectorMark J. RubashChief Financial OfficerStanford S. AuSenior Vice President, TechnologyDwayne A. BlackSenior Vice President, OperationsDouglas J. GalenSenior Vice President, Business and Corporate DevelopmentPeter A. Navin Vice President, Human ResourcesKathryn E. OlsonChief Marketing Officervisit our website at www.shutterfly.com“I’ve taken a lot of pictures of my son Addison this year, and I love the idea of using collages to show how much he’s grown. It’s a perfect way to capture Addison’s free spirit and share it with all our relatives.” – Kim B., Santa Rosa, CAShutterfly allows me to use my creative side...0%40%80%120%160%200%240%SFLYNasdaq CompositeMorgan Stanley Internet IndexPerformance GraphThe following graph compares the total cumulative stockholder return on the Company’s common stock with the total cumulative return of the Nasdaq Market Index and Morgan Stanley Internet Index on a monthly basis for calendar year 2007. Our stock performance shown in the graph below is not indicative of future stock price performance. The above graph and related information shall not be deemed “soliciting material” or be deemed to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filing, except to the extent that we specifically incorporate it by reference into such filing.BBC eBP - File Name: 31983_WO4_F39180_Cvrs.pdf Apr 12, 2008 - Page: 2 of 22007 ANNUAL REPORTShutterfly, Inc.LETTER TO STOCKHOLDERSwww.shutterfly.comSincerely, Jeff Housenbold, CEODear Shutterfly Stockholder: We are pleased to report performance for 2007. Founded in 1999, Shutterfly leads the markets for social expression and personal publishing with a growing product and services assortment, and an increasing base of highly satisfied customers. Our premium-quality products enable customers to “tell their stories” in unique and memorable ways – through innovative, personalized greeting cards, photo books, designer social stationery, calendars and other photo-based merchandise. Our customer-friendly website and archive policies make it easy for people to upload, share and preserve their memories securely, while our expanding array of collaboration services enables customers to celebrate life events and connect with their social networks of family and friends. 2007: Rapid Growth and Significant Accomplishments2007 was a record year of strong execution, and rapid, profitable growth for Shutterfly. Net revenues and annual Adjusted EBITDA1 increased 51% and 52%, respectively, over 2006. We expanded our award-winning photo book line-up to include new occasion-based design templates (such as Wedding and Baby), new holiday themes (such as Valentine’s Day and Halloween) and we introduced new Sesame Street™ and Dora the Explorer™ books. We also added new holiday card form factors and styles, collage posters and collage calendars, and we enhanced our already broad selection of photo-related merchandise. 2007 revenues from personal products and services increased 69% over 2006, comprising 56% of total revenues. Product innovations will continue in 2008, with a premium line of designer social stationery for birth announcements, invitations, thank you cards and additional new products. We extended awareness of Shutterfly’s premium lifestyle brand as the place to “Tell Your Story,” a tagline introduced with an all-new advertising campaign featuring real customers using Shutterfly to stay connected to family and friends. Strong growth in new customers resulted from targeted marketing and a loyal base of existing customers who evangelize the Shutterfly brand. In 2007, 2.4 million customers transacted with Shutterfly, a 37% increase over 2006, with approximately 74% of revenues coming from existing customers. Their enthusiastic word-of-mouth referrals – along with strategic partnerships with leading retailers and complementary brands, unique advertising and results-driven marketing, and outstanding media coverage by leading consumer publications and television news programs – contributed to Shutterfly’s impressive 2007 results. 2008: Becoming a More Meaningful Part of Our Customers’ LivesWhile still early, we believe that the markets for social expression and personal publishing present an enormous opportunity for Shutterfly. We intend to expand awareness of this category, and to further delight our customers while connecting the Shutterfly brand more meaningfully to their lives. We believe we can achieve our goals by innovating with value-added products and services and a sustained commitment to our corporate objectives. We also intend to increase awareness and trial of Shutterfly by supporting our viral and enthusiastic customer base, and by continuing focused advertising and marketing programs that convey consistent, actionable and compelling messages. In 2008 our investments in innovation will focus on services that enhance our customers’ experience at Shutterfly. We continue to evolve our website to enhance customers’ ability to discover new ways of sharing and preserving their memories. Forexample, newly-launched Shutterfly Gallery showcases our customers’ amazing photo book creations, and inspires people to tell their stories using our photo books, while simplifying the product creation process and stimulating product sales through our “make one like this” feature. Another example is our 2008 acquisition of Nexo Systems, Inc., a simple but sophisticated technology platform for online sharing and collaboration among members of social networks – including school groups, church groups, sports teams and many others. Shutterfly will also continue to drive manufacturing innovations. In 2007, we opened a second production facility in Charlotte, NC and it is performing very well. We believe we continue to benefit from many cost, quality and delivery advantages by controlling our manufacturing processes and technology.Shutterfly is well-positioned for 2008 and beyond. Our target markets are large and expanding, and we have a lengthening track record of strong execution in revenue growth, customer acquisition and retention, and increasing profits. We continue to innovate with new products and services to bind our customers more closely to our premium brand, while we successfully expand overall market awareness, market share and competitive differentiation. In conclusion, I want to extend heartfelt thanks to our employees (and their families) for their enthusiastic commitment to our customers, their tireless energy and their exceptional results. I thank our customers for their passionate evangelism of Shutterfly. On behalf of the entire team at Shutterfly, I thank our stockholders for their continued support of our Company.1Adjusted EBITDA is a non-GAAP financial measure defined as earnings before interest, taxes, depreciation, amortization, cumulative change in accounting principle, stock-based compensation, and a one-time, non-cash charitable contribution of $923,000 in 2006. For complete definitions and reconciliations, please refer to Shutterfly’s SEC filings.2800 Bridge ParkwayRedwood City, CA 94065BBC eBP - File Name: 31983_WO4_F39180_Cvrs.pdf Apr 12, 2008 - Page: 1 of 2

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