Tyler Technologies
Annual Report 2009

Plain-text annual report

Speaking from Experience 2009 Annual Report On the cover from left to right: Ken Miles, Courts & Justice Solutions Melissa Baer, Appraisal & Property Tax Solutions Mandye Perez, Public Safety Solutions  Every day, Tyler Technologies draws from our many years of experience to empower the people who serve the public. With best-in-class software solutions and deep domain expertise, Tyler helps local governments and schools manage their many complex operations—including financial management, property appraisal and assessment, school administration, court case management and law enforcement. Following an outstanding financial performance in 2008, Tyler once again grew revenues and earnings in 2009, delivering solid results for our shareholders, clients and employees. To Our Shareholders earnest commitment to our clients—we are positioned Tyler Technologies’ performance in 2009 better than anyone to anticipate and address the demonstrated how our business strategy was changing technology needs of the public sector. designed to perform in all economic environments. During a challenging recession year, we made meaningful progress under our long-term plans while growing both revenues and earnings. However, our commitment goes well beyond delivering solutions that work for our public sector clients. It’s about consistently delivering value for employees and shareholders as well. Building on a At Tyler, we have a unique vantage point due to our successful foundation, Tyler continues to provide singular focus on serving the public sector with a a solid return for shareholders. We remained broad product portfolio. From financial management committed to our long-term growth strategies and property taxes to courts and education, we even through a challenging financial climate create, deliver and support software solutions that and ended 2009 in a position of strength. make it easier for local governments and schools to manage their complex, day-to-day business functions. Tyler knows how to develop and support innovative software solutions for the market. We also have an insider’s insight to the market, as many of Tyler’s employees worked in the public sector prior to joining our team. With this knowledge and experience—along with focused innovation and an In 2009, Tyler was once again recognized for its business performance and leadership, as well as being honored as a top place to work. For the third straight year, Forbes named Tyler Technologies as one of “America’s 200 Best Small Companies.” In addition, Tyler was recognized as one of the “Best Places to Work in Maine,” as well as one of “The Dallas Morning News Top 100 Places to Work 2009.” 2 Tyler Technologies John S. Marr, Jr., President and CEO John M. Yeaman, Chairman of the Board Making Meaningful Progress we experienced lengthened sales cycles throughout In a difficult economic climate that saw many the year. New request for proposal activity continues software companies struggle, Tyler Technologies to support a very healthy sales pipeline. However, the was still able to make progress, both financially and timing of contract signings and revenue recognition strategically. We ended 2009 with 35 consecutive is less predictable, as many local governments’ quarters of profitability. Tyler closed the year with total purchasing processes are longer and more complex revenue of $290.3 million, up 10 percent from 2008. than in a more favorable economic environment. Gross margins increased 300 basis points to 44.4 percent, and our operating margin reached a new high of 15.4 percent. Earnings per diluted share totaled $0.74, and increased 21 percent over non-GAAP EPS Tyler was once again recognized for its for 2008, even as we continued to invest aggressively business performance and leadership, as in product development and competitive initiatives. well as being honored as a top place to Although Tyler achieved improved financial results work by our employees. by almost every meaningful measure, our growth has clearly been affected by the broader economic environment and by pressures on local government budgets. While our significant base of recurring In 2009, we experienced another year of strong revenues (now comprising approximately half of total cash flow generation, with total free cash flow of revenues) combined with the mission-critical nature of $40 million (excluding capital expenditures for our solutions provides us with a great deal of stability, office construction). We rely on this strong free Annual Report 2009 3 cash flow to make strategic investments that will While the timing of public sector investments in further strengthen our position for the future, technology is clearly affected by the economy, the while enhancing shareholder value. We also fact remains that the functions Tyler automates are repurchased $17 million of our common stock and essential to our clients, and our solutions enable them completed several acquisitions to augment our to operate more efficiently, doing more with less. appraisal and property tax and schools solutions. Tyler’s success follows a carefully designed business Given our consistent growth, significant plan that focuses on four key strategies: expanding recurring revenues, healthy cash flow and strong geographically, broadening our product offerings, market reputation, Tyler is in an excellent securing larger opportunities, and extending our position to build upon its competitive strengths relationships with existing clients. As we look as we move into 2010 and beyond. forward to 2010 and beyond, we intend to continue Speaking from our many years of experience, Tyler building upon these long-term strategies. Creating a Stronger Identity Since the late 1990s, Tyler has shown consistent empowers local governments and schools, and organic growth at above market rates—augmenting consistently delivers a solid return for shareholders. And it is with this experience that we move into 2010 with confidence in and commitment to our long-term opportunities and strategies. Building Lasting Success While many competitors target multiple vertical markets, Tyler has a singular focus—delivering essential software solutions that empower the public sector. And unlike many of our competitors that serve only a narrow niche of the public sector, we offer what we believe is the broadest range of software and solutions for local governments and schools. From the courtroom to the classroom, Tyler’s solutions serve as the backbone for core business functions. We devote all of our time, energy and resources to helping local governments and school districts streamline the many aspects of their financial management, court case, property tax, public safety, citizen services, public records and education systems. its market strength through targeted acquisitions. While this has afforded us the ability to broaden our product offerings and penetrate new markets, these acquisitions have also posed some challenges. As expected, each acquired business had its own identity, strategy and approach to sales and marketing—not to mention its own unique way of interfacing with clients. As these business units and products were integrated into the company, Tyler worked hard to create a unified corporate identity—bringing together strong products with long-standing reputations—under the Tyler name. In 2009, we launched a wide-scale rebranding effort to further strengthen Tyler’s identity and position in the public sector—a historically fragmented market. A cohesive identity allows us to build a stronger competitive advantage for Tyler to capture even more market share and build greater awareness as the leader in public sector software. And through new communication channels and branding efforts, we are also generating a renewed sense of energy and enthusiasm among Tyler employees and clients across all product groups. 4 Tyler Technologies Investing in the Future to the solution. In 2009, we also secured our first Throughout 2009, Tyler Technologies again “beta” client for Microsoft Dynamics AX—with demonstrated that success requires the right a general release slated for early 2011. combination of many factors—a well-designed strategy, consistent execution, feature-rich and industry-proven products, talented employees and a solid brand identity. Underscoring each of these components is the one fundamental question: how can we empower the people who serve the public? Moving Forward Although 2009 presented a challenging economic climate that we expect to continue in 2010, Tyler Technologies had a solid year in terms of financial performance. Looking to the future, it is our hope that 2010 will be a year of economic recovery for For us, the simplest answer is to develop, implement, the marketplace, providing Tyler a healthy mix of and support software solutions that deliver—again opportunity and challenge. Given our strong market and again. For our clients, this means delivering position and rich history of proven success, we the right types of systems to address their many are confident in our ability to generate reasonable complex needs. For our shareholders, this translates results in difficult times—while continuing to to delivering a solid return on their investment now invest in initiatives that we believe will put us and over the long term. And for our employees, this in an even stronger competitive position as the means fostering the right work environment—one market returns to more normal conditions. that encourages them to innovate, create, and achieve success personally and professionally. Tyler empowers local governments and schools, and consistently delivers a solid return for At Tyler, we consider research and development shareholders. And it is with this experience that we an essential investment in our future. And in move into 2010 with confidence in and commitment 2009—at a time when many companies chose, or to our long-term opportunities and strategies. were forced, to reduce discretionary spending for R&D and cut staff—Tyler aggressively invested in product development and added to our team. In addition to investing in product updates to enhance functionality and integrate new features and technologies in our existing products, Tyler has devoted substantial resources to the development of new products that we believe will provide meaningful growth opportunities in the future. This includes Microsoft Dynamics AX, a business management solution for the public sector that we are co- developing with Microsoft. During the fourth quarter of 2009, we expanded the scope of our multi-year arrangement with Microsoft, adding payroll, human resources, and budget formulation applications John S. Marr, Jr. President and Chief Executive Officer Annual Report 2009 5 Donna Martindale and John White ERP/Financial Solutions Speaking the Same Language. There’s a certain familiarity sharing his expertise to help local governments realize and comfort in sharing a common language with your the full power of Tyler’s financial management solutions. clients—something Donna Martindale and John White Like John, Donna was also a Tyler financial management understand firsthand. Both John and Donna were early solution end-user while in her role as finance director for adopters of Tyler products long before they ever joined Harker Heights, Texas. And for the past 12 years, Donna the company as employees. When he went to work for the has been helping local governments migrate to Tyler as Town of Shrewsbury, Massachusetts, John had the rare an implementation manager. “I sit with a client and can opportunity to design a town-wide information system relate to them,” Donna explains. “I can tell them ‘I did from the ground up. During this process, Tyler’s financial your job.’ It’s so incredible that I’m able to hand off a tool management solution was selected for implementation. to our clients—a tool that empowers them to make a real Today, as senior solution consultant at Tyler, John is still change in their city.” 6 Tyler Technologies Empowering the Public Sector During a time when many companies have struggled, Tyler Technologies has proven itself as a market leader. Drawing from our years of Tyler Technologies’ consistent, long-term success is the result of singularly focusing on serving experience, Tyler posted another successful year in the public sector, creating a sound vision, and 2009—even in the midst of a turbulent economy. executing our growth strategy with precision. Tyler delivers software and services solutions that enable city, county and state agencies of all sizes to efficiently and effectively manage their day-to- day business operations. In fact, no other company offers as wide a range of products as Tyler. Today, Tyler has more than 9,000 client installations in all 50 states, Puerto Rico, the U.S. Virgin Islands, Canada and the United Kingdom. Thanks to Tyler’s exceptional flexibility and comprehensive product portfolio, we are competitive at every level—from small rural communities to large metropolitan areas and statewide implementations. We have the financial strength and resources of a large company, yet we can act with the agility and ingenuity of an innovative entrepreneurial organization committed to building lasting relationships with our clients. Many people don’t appreciate the challenges that local governments and schools face in providing numerous mission-critical services every day—from routing school buses and managing jails to collecting taxes and paying firemen. To effectively oversee these activities, public sector organizations must have robust technology platforms available around the clock. Total Annual Revenues (In Millions) 2009 2008 2007 2006 2005 $290.3 $265.1 $219.8 $195.3 $170.5 Yet, like many private sector businesses today, local governments are increasingly facing pressure to be more efficient and more productive using fewer resources. Thus, governments must make smarter business decisions based on the needs of their agencies and the citizens they serve. From our years of experience in serving the public sector, Tyler understands that delivering software solutions that help our clients efficiently manage their many operations is just the beginning. Harnessing the true power and potential of Tyler’s product offerings— solutions backed by our highly experienced team—is realized through long-term partnerships with our clients. That’s why Tyler’s relationship with clients goes well beyond merely that of a vendor. We act as a trusted partner for local governments. It is this commitment that has helped us maintain an approximately 98 percent customer retention rate for many years. In fact, many of our first clients are still with Tyler today. With a deep understanding of how local governments operate, Tyler is well positioned to deliver solutions that address these unique needs now—and well into the future. Building a Strong Foundation As communities throughout the United States experience growth and face changes in budgets, demographics and technology, local governments must have the right systems in place to handle citizens’ evolving needs and demands—from parental access to student grades to the convenience of paying traffic tickets and utility bills online. Annual Report 2009 7 With Tyler’s performance in 2009, we have once again illustrated that focusing exclusively on one vertical market offers ample room for long-term growth. In fact, there are approximately 3,000 counties, 13,900 school Tyler Technologies experienced solid growth in key areas throughout 2009—and we will continue to districts, 36,000 cities and towns, and more than build upon this foundation in the years to come. 35,000 other local government agencies in the United States alone—each with multiple software systems. We believe that the majority of these systems are either Throughout the year, Tyler experienced a reasonable, “in-house” solutions or were purchased from vendors although not robust, level of new business activity, that are no longer competitive in the market—presenting creating a healthy pipeline of new business. However, great opportunities for Tyler to gain market share as longer sales cycles and delayed decision processes these systems are replaced over the coming years. made the timing of new business less predictable. In 2009, Tyler increased revenues by 10 percent, more than doubling the estimated market growth in a sluggish economy. Additionally, our recurring revenues from maintenance and subscriptions increased by 16 percent, and now make up almost half of our We ended 2009 with a total backlog of signed contracts of $233 million, down modestly from the end of 2008. Our backlog, combined with highly reliable recurring revenues, provides us with a high degree of visibility into our expected revenues. total revenues. This creates a solid base of reliable While Tyler has continued to refine our growth strategy revenues on which we can build sustainable growth. over the years, in 2009, we focused primarily on the same core initiatives—moving into new geographic areas, expanding our product offerings, securing larger contracts, and cross-selling additional products and services to existing clients. And in refreshing our brand identity in 2009, we now have a more cohesive $233.1 $249.8 $250.1 product portfolio under the Tyler name—helping us further solidify our position as the go-to leader for software solutions within the public sector. $205.9 $165.4 43% Maintenance 28% Software Services 15% Software Licenses 6% Appraisal Services 6% Subscriptions 2% Other Innovating for Tomorrow As Tyler has grown over the years, our market has matured as well. While there are fewer competitors now than a decade ago, there are always good companies vying with Tyler for market share. To stay competitive in this vertical market, it’s essential that Tyler stay at the forefront of innovation. Only then can we deliver the types of robust solutions local governments and schools need—when they need them. At Tyler, we believe this starts by having the best possible team in place. Tyler now has more than 2,000 professionals who bring unmatched expertise Backlog (In Millions) 2009 2008 2007 2006 2005 Revenue Mix 8 Tyler Technologies  Tyler Technologies experienced solid growth in key areas throughout 2009—and we will continue to build upon this foundation in the years to come. Johnnie Gordon, Amy Puckett and John Mathis Courts & Justice Solutions Speaking from Authority. From minor traffic citations to major develops the tools and functionality courts and justice criminal trials, courts and justice offices at the state, county offices rely on to serve their constituents. Having this level and municipal level face a tremendous task of streamlining of insight has also been invaluable for Amy Puckett who, like critical information. “The most important thing is first John, served in various roles for Denton County—including understanding their business processes, so we can help them emergency dispatcher and detention officer. For the past make the most out of their software environment,” explains 18 years, she has helped courts and justice offices fine- Johnnie Gordon, who was a courts and justice consultant tune their processes as a product manager. “At the end of prior to joining Tyler as a regional project manager for Tyler’s the day, there’s simply no substitute for this experience,” courts & justice solutions. Like Johnnie, developer John says Johnnie. “To me, what we do is more than just deliver Mathis spent many years in the public sector, including software—it’s about bringing value to courts and justice positions such as a system administrator for Denton County, offices and the people they serve through the experience and Texas. He came on board at Tyler in 1994, and today firsthand knowledge we have gained over the years.” Annual Report 2009 9 Melissa Belec, Marsha Craft and Larry Frazier School Solutions Speaking from Support. Fortunately, there are people her 35-year career—15 of those years spent serving in like Larry Frazier, Marsha Craft and Melissa Belec who a student information system role in a growing Missouri work behind the scenes to empower school personnel. school district—to help clients navigate changes, “Some people know the software, but it helps that I also address key issues and share best practices. Marketing know schools,” comments Larry, who held positions Program Specialist Melissa Belec understands the as a teacher, a principal and a technology coordinator advantage in having a client’s perspective. “I was prior to becoming an implementation analyst for a hands-on user of Tyler’s student transportation Tyler. “My experience makes it easier for me to help solutions for three years in a school district,” explains school districts use our school solutions to work more Melissa, who later joined Tyler in product and technical efficiently.” Like Larry, Marsha Craft is no stranger to support before moving into a marketing role. “I can educating others. As a senior trainer, she helps school speak their language and I understand their issues, district personnel realize the full power and potential of which really makes a big difference.” Tyler’s products. She brings the in-depth experience of 10 Tyler Technologies in technology development and deployment, as well as a deep understanding of how our clients operate. In fact, many of our employees held positions in the public sector prior to joining Tyler, providing a Tyler’s deep domain expertise gives us an insider’s insight into the unique needs of local governments. firsthand understanding of the many nuances of how With this knowledge, we deliver highly responsive local governments and schools work from day to day. software solutions that evolve as the public sector does. Some of our competitors reduced their workforce and cut expenditures in research and development last year in response to the recession. However, Tyler’s strong cash flow and above-market growth throughout the year enabled us to continue investing aggressively in product development and to expand our employee team—adding Assessment Evaluation Services Inc., which develops integrated property appraisal solutions and applications unique to California. 78 new employees over the course of the year. Additionally, we acquired technology that delivers Free Cash Flow (In Millions) 2009 2008 2007 2006 2005 $40.0 (a) $42.3 (a) $30.3 $22.5 $18.5 (a) excludes capital expenditures for office facilities of $9.4 million in 2009 and $16.0 million in 2008. specialized information and data warehouse solutions for K–12 school and local government markets. In January 2010, Tyler completed the acquisition of Wiznet, which provides software products and services that simplify the electronic filing and management of documents related to court cases. Looking to the future, we will continue to seek opportunities to expand our product offerings and customer base through strategic acquisitions at reasonable valuations. Delivering Greater Accessibility From the nation’s largest counties to the smallest rural agencies, Tyler Technologies understands that each of our clients deserves the best possible return on its technology investment—not to mention a high In addition to expanding our team, Tyler made significant degree of flexibility. Delivering long-term scalability by investments in our existing software portfolio to develop providing regular product updates with new features new features and functionality. We also continued to and functionality is particularly important in the invest in new products in the education market and in public sector because it’s not uncommon for local our Microsoft Dynamics AX development effort for the governments and schools to keep their systems for public sector that’s slated for release in early 2011. much longer than organizations in the private sector. Tyler also made several small acquisitions that As a result, many agencies are using a potpourri of augment our offerings in specific product or geographic software and hardware solutions that are no longer areas. To expand the geographic reach of our land supported—because the vendor is no longer in and vital records business, we acquired Parker-Lowe & business or simply hasn’t invested in new technology. Associates in North Carolina, which develops software It can also pose challenges for governments when designed for registering and retrieving deeds for land personnel with proprietary knowledge of these records and social services offices. We also acquired legacy systems retire or leave the organization. Annual Report 2009 11 Tyler’s Software-as-a-Service (SaaS) model gives clients seamless access to the innovative software solutions they need. Through a subscription-based arrangement, Tyler hosts and manages both software and data. By opting for the SaaS model, our clients can avoid making capital investments to overhaul their infrastructure and can access these sophisticated systems with significantly fewer in-house resources. Expanding Our Visibility Over the years, one of our core strategies for growth 2008-2009 Quarterly EPS (a) (In Dollars) Q1 Q2 Q3 Q4 $0.08 $0.16 $0.19 $0.17 $0.20 $0.20 $0.18 $0.17 has been to improve Tyler’s visibility and expand sales 2008 2009 in regions where our products previously had limited presence. By updating Tyler’s brand identity and messaging, we now have a more cohesive platform to effectively market our products in new regions—as well as existing ones where we already have a presence. Tyler continued adding new clients in key markets throughout 2009. For example, we secured a deal with Denver Public Schools for our transportation management system, a product we added to our portfolio in 2008. Tyler also introduced our financial management and citizen service solutions in five public sector agencies within California, and we secured a deal with the City of Nashville and Davidson County (Tennessee) for our courts & justice solutions. Given the exceptional breadth and depth of our product portfolio, many of our existing clients turn to Tyler when the time comes to upgrade or add new software applications. This provides Tyler a prime opportunity to cross-sell our broad line of software solutions. No matter how large or small, Tyler provides (a) 2008 EPS is non-GAAP and excludes non-cash legal settlement charge related to warrants of $0.16 in Q2, $0.04 in Q3 and $0.03 in Q4 Diluted Annual EPS (In Dollars) 2009 2008 (a) 2007 2006 2005 (b) $0.42 $0.34 $0.19 $0.74 $0.61 (a) 2008 EPS is non-GAAP and excludes non-cash legal settlement charge related to warrants of $0.23 (b) includes restructuring charge of $0.02 For example, we won a $2.5 million contract for our jail management and law enforcement solutions with Collin County, Texas, which has used Tyler’s court case management solution since 2006. We also secured a number of deals with clients who purchased multiple Tyler solutions at the same time. public sector organizations of all sizes access Tyler also integrated our transportation management to a broad range of innovative software solutions that address their unique needs. solution with our financial management solution for the Fort Worth (Texas) Independent School District to streamline invoicing, budgetary control, reconciliation, and account management. 12 Tyler Technologies Rita Lewis-Devereaux Appraisal & Property Tax Solutions Speaking from Passion. Rita Lewis-Devereaux is no used Tyler’s appraisal products for more than two decades. stranger to anticipating needs when it comes to helping Today, she helps appraisal jurisdictions of all sizes local governments effectively and efficiently appraise implement Tyler’s appraisal and property tax solutions. all types of properties. In fact, since 1973 she’s been It’s a role that suits her well, she says, not only because involved in the property tax field—including positions of her extensive understanding of the public sector with Dekalb County, Georgia, as deputy tax commissioner, and Tyler’s solutions—but, more importantly, because appraisal auditor and software project manager. Rita she enjoys guiding clients through the implementation also served as vice chairman of the Board of Assessors process. “I really love the creativity in what I do and for Fulton County (Atlanta), Georgia. Prior to joining the helping clients bring the software live,” Rita explains. Tyler team as a lead business analyst in 2001, Rita had “I couldn’t ask for a better job—it’s perfect for me.” Annual Report 2009 13  Tyler consistently expanded its presence in new geographic areas and secured larger deals in 2009—further solidifying our position as a market leader in public sector software. Brock Taylor Land & Vital Records Solutions Speaking from Service. Far beyond the “Comments most—and eventually is what led him to join Tyler. And for Welcome” box organizations once used, Brock Taylor, the past 12 years, Brock has been helping other land manager of the Land Records Office for Boulder County, records offices streamline their operations as a product Colorado, shared his wish list of software features directly manager. “Understanding the client experience is with the source—Tyler. Beyond the software’s ability to invaluable,” explains Brock. “I’m now able to reflect on streamline Boulder County’s Land Records Office, it was how clients use the software and appreciate the reasons Tyler’s client-centric approach that impressed Brock the behind their development requests.” 14 Tyler Technologies While Tyler has historically focused on serving the solutions and securing larger deals. We believe needs of small and mid-sized governments, in we are well positioned for new growth, particularly recent years we have gained a stronger foothold in with our Software-as-a-Service (SaaS) offerings. larger, metropolitan markets. These markets are especially significant as they provide considerable revenue growth and margin expansion potential. Tyler consistently expanded its presence in new geographic areas and secured larger deals in Whether delivering the right types of solutions for local governments, providing an exceptional workplace for employees, or producing a solid return on investment for shareholders, Tyler Technologies speaks from experience. It is with this insight that we plan for the future. We empower those who serve the public. And we make a difference to the communities we serve. 2009—further solidifying our position as a market Continuing the trend we’ve seen in recent years, many local governments—even those that had previously deployed Tyler software solutions on site—are now migrating to our SaaS model. Today, many of Tyler’s products are available in a hosted format. Based on client response, including our near perfect retention rate, this model is proving to be incredibly effective and efficient at delivering clients greater flexibility and scalability. Although only comprising 6 percent of our total revenues in 2009, subscription revenues represented our fastest-growing revenue line, with an increase of 20 percent over 2008. Among the larger SaaS contracts we signed in 2009 were a $1.4 million deal with the City of Enfield, Connecticut, and a $1.2 million deal with Tualatin Valley (Oregon) Fire & Rescue. leader in public sector software. Tyler secured a number of larger deals, including a $5.9 million contract with Hillsborough County, Florida, for Tyler’s integrated case management software. We also signed a $2.2 million contract with San Antonio, Texas, the nation’s seventh largest city, for our municipal court case management solution. In a deal valued at $3.5 million, Dakota County, Minnesota, the state’s fourth largest county, purchased our appraisal and property tax software. The cities of Bridgeport, Connecticut, and Chesapeake, Virginia, will implement our financial management solution under contracts valued at approximately $2 million each. Looking Ahead Closing out 2009, Tyler delivered another solid year by consistently executing our growth strategies. Given our extensive experience in delivering proven software solutions and our growing presence in key markets, we look to carry this momentum into 2010 and beyond. Tyler will continue to build upon the foundation we’ve established using our time-tested growth strategy of expanding into new geographic areas, enhancing our product offerings, cross-selling our Annual Report 2009 15 Tyler Technologies’ success in 2009 is a continuation of the strong foundation we’ve established in years past. Through careful planning, consistent execution and an unwavering commitment to our clients, Tyler has become the brand of choice for essential software solutions that can respond to the ever-changing needs of the public sector market. Building from our record-setting year in 2008, Tyler Technologies grew revenues, expanded gross and operating margins and increased earnings per share during 2009—even while aggressively investing in product development. The following financial statements detail our results. 16 Tyler Technologies Stock Market Data Our common stock is traded on the New York Stock Exchange under the symbol “TYL.” At December 31, 2009, we had approximately 2,115 stockholders of record. A number of our stockholders hold their shares in street name; therefore, there are substantially more than 2,115 beneficial owners of our common stock. The following table shows, for the calendar periods indicated, the high and low sales price per share of our common stock as reported on the New York Stock Exchange. 2008: First Quarter Second Quarter Third Quarter Fourth Quarter 2009: First Quarter Second Quarter Third Quarter Fourth Quarter High Low $ 14.70 15.97 18.47 15.17 $ 14.79 17.76 17.62 21.09 $ 12.29 13.33 13.29 9.79 $ 11.35 14.17 14.51 16.76 We did not pay any cash dividends in 2009 or 2008. Our bank credit agreement contains restrictions on the payment of cash dividends. We intend to retain earnings for use in the operation and expansion of our business, and, therefore, we do not anticipate declaring a cash dividend in the foreseeable future. During 2009, we purchased approximately $1.2 million shares of our common stock for an aggregate purchase price of $17.0 million. The repurchase program, which was approved by our board of directors, was announced in October 2002, and was amended in April and July 2003, October 2004, October 2005, May 2007, May 2008, October 2008 and May 2009. Our board of directors authorized the repurchase of an additional 2.0 million shares on May 14, 2009. As of December 31, 2009, we had remaining authorization to repurchase up to 2.3 million additional shares of our common stock. There is no expiration date specified for the authorization and we intend to repurchase stock under the plan from time to time. Our bank credit agreement contains restrictions on the amount of common stock we may purchase. Tyler Technologies Annual Report 2009 17 Selected Financial Data SELECTED FINANCIAL DATA (In thousands, except per share data) 2009 2008 2007 2006 2005 For the Years Ended December 31, STATEMENT OF OPERATIONS DATA: Revenues Costs and expenses: Cost of revenues (1) $ 290,286 $ 265,101 $ 219,796 $ 195,303 $ 170,457 161,523 155,314 135,371 120,499 108,970 Selling, general and administrative expenses (1) 70,115 62,923 51,724 48,389 43,821 Research and development expense Restructuring charge Amortization of customer and trade name intangibles Non-cash legal settlement related to warrants (2) Operating income Other (expense) income, net 11,159 — 2,705 — 7,286 — 2,438 9,045 4,443 — 1,478 — 3,322 — 1,318 — 2,421 1,260 1,266 — 44,784 28,095 26,780 21,775 12,719 (146) 1,181 1,800 1,080 906 Income from operations before income taxes 44,638 29,276 28,580 22,855 13,625 Income tax provision Net income Net income per diluted share Weighted average diluted shares STATEMENT OF CASH FLOWS DATA: 17,628 14,414 11,079 8,493 5,432 $ 27,010 $ 14,862 $ 17,501 $ 14,362 $ 8,193 $ 0.74 $ 0.38 $ 0.42 $ 0.34 $ 0.19 36,624 39,184 41,352 41,868 42,075 Cash flows provided by operating activities $ 42,941 $ 47,802 $ 34,111 $ 26,804 $ 21,187 Cash flows (used by) provided by investing activities Cash flows used by financing activities (13,658) (21,349) (9,554) (34,275) (24,326) 1,820 (46,128) (7,406) (5,999) (14,847) BALANCE SHEET DATA: Total assets Shareholders’ equity $ 270,670 $ 251,761 $ 241,508 $ 220,276 $ 194,437 134,358 114,262 137,211 125,875 112,197 (1) Effective January 1, 2006, we adopted the fair value recognition provisions of Accounting Standards Codification 718, Stock Compensation, using the modified-prospective method. In 2009, 2008, 2007 and 2006, respectively, cost of revenues included $540,000, $364,000, $227,000 and $147,000 share-based compensation expense. Selling, general and administrative expenses in 2009, 2008, 2007 and 2006, respectively, included $4.5 million, $3.5 million, $2.1 million and $1.8 million share-based compensation expense. In accordance with the standard, results of operations for the year 2005 are reported under the previous accounting standard and no expense was recorded. (2) On June 27, 2008, we settled outstanding litigation related to two Stock Purchase Warrants (the “Warrants”) owned by Bank of America, N. A. (“BANA”). The Warrants entitled BANA to acquire 1.6 million shares of Tyler common stock at an exercise price of $2.50 per share. Following court-ordered mediation, in July 2008, BANA paid us $2.0 million and we issued to BANA 801,883 restricted shares of Tyler common stock. Accordingly, we recorded a non-cash legal settlement related to warrants charge of $9.0 million, which was not tax deductible. 18 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations FORWARD-LOOKING STATEMENTS In addition to historical information, this Annual Report contains forward-looking statements. The forward-looking statements are made in reliance upon safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Readers should carefully review the risk factors described in documents we file from time to time with the SEC. When used in this Annual Report, the words “believes,” “expects,” “anticipates,” “foresees,” “forecasts,” “estimates,” “plans,” “intends,” “continues,” “may,” “will,” “should,” “projects,” “might,” “could” or the negative of such terms and similar expressions are intended to identify forward-looking statements. Similarly, statements that describe our business strategy, outlook, objectives, plans, intentions or goals also are forward-looking statements. OVERVIEW General We provide integrated information management solutions and services for the public sector, with a focus on local governments. We develop and market a broad line of software products and services to address the information technology (“IT”) needs of cities, counties, schools and other local government entities. In addition, we provide professional IT services to our customers, including software and hardware installation, data conversion, training and for certain customers, product modifications, along with continuing maintenance and support for customers using our systems. We also provide subscription-based services such as hosted solutions as well as property appraisal outsourcing services for taxing jurisdictions. Our products generally automate three major functional areas: • Financial Management and Education; • Courts and Justice; and • Property Appraisal and Tax and Other. We monitor and analyze several key performance indicators in order to manage our business and evaluate our financial and operating performance. These indicators include the following: • Revenues – We derive our revenues from five primary sources: sale of software licenses; subscription-based services; software services; maintenance and support; and appraisal services. Because the majority of the software we sell is “off-the- shelf,” increased sales of software products generally result in incrementally higher gross margins. Thus, the most significant driver to our business is the number and size of software license sales. In addition, new software license sales generally generate implementation services revenues as well as future maintenance and support revenues, which are a recurring revenue source. We also monitor our customer base and churn since our maintenance and support revenue should increase due to our historically low customer turnover. During 2009, approximately 43% of our revenue was attributable to ongoing support and maintenance agreements and our customer turnover was approximately 2%. • Cost of Revenues and Gross Margins – Our primary cost component is personnel expenses in connection with providing software implementation, subscription-based services, maintenance and support, and appraisal services to our customers. We can improve gross margins by controlling headcount and related costs and by expanding our revenue base, especially from those products and services that produce incremental revenue with minimal incremental cost, such as software licenses, subscription-based services, and maintenance and support. Our appraisal projects are seasonal in nature, and we often employ appraisal personnel on a short-term basis to coincide with the life of a project. As of December 31, 2009, our total employee count increased to 2,018 from 1,940 at December 31, 2008. Approximately a third of these additions were to our implementation and support staff, including additions that increased our capacity to deliver our backlog. Tyler Technologies Annual Report 2009 19 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations • Selling, General and Administrative (“SG&A”) Expenses – The primary components of SG&A expense are administrative and sales personnel salaries and commissions, marketing expense, share-based compensation expense, rent and professional fees. Sales commissions generally fluctuate with revenues but other administrative expenses tend to grow at a slower rate than revenues. • Liquidity and Cash Flows – The primary driver of our cash flows is net income. Uses of cash include acquisitions, capital investments in property and equipment and the discretionary purchases of treasury stock. In 2009, we purchased 1.2 million shares of our common stock for an aggregate purchase price of $17.0 million. We also paid $1.3 million for common stock repurchases accrued as of December 31, 2008. During 2009 we used cash of $2.9 million to acquire two companies and invested $12.4 million in property and equipment. Our investment in property and equipment included $9.4 million for an office building and we expect to pay the final retainage payment of $1.8 million for this office building by mid-2010. We also paid-down $8.0 million on our short-term revolving line of credit. Our working capital needs are fairly stable throughout the year with the significant components of cash outflows being payment of personnel expenses offset by cash inflows representing collection of accounts receivable and cash receipts from customers in advance of revenue being earned. • Balance Sheet – Cash, accounts receivable and days sales outstanding and deferred revenue balances are important indicators of our business. Acquisitions On July 16, 2009, we completed the acquisition of certain assets of KPL, Inc. d/b/a Parker-Lowe & Associates (“Parker- Lowe”) for $700,000 in cash. Parker-Lowe provides scanning and retrieval software and related services for land record and social services offices in local governments primarily in the North Carolina area. This acquisition was accounted for as a purchase of a business. On April 3, 2009, we completed the acquisition of all of the capital stock of Assessment Evaluation Services, Inc. (“AES”). AES develops integrated property appraisal solutions and specializes in applications that deal with the unique provisions of the California Revenue and Taxation Code. The purchase price was approximately $1.1 million in cash. In connection with these transactions we acquired total tangible assets of approximately $480,000 and assumed total liabilities of approximately $835,000, including $450,000 for contingent consideration for which we have paid $38,000 as of December 31, 2009. We recorded goodwill of approximately $1.3 million, all of which is expected to be deductible for tax purposes, and other intangible assets of approximately $820,000. The $820,000 of intangible assets is attributable to acquired software and customer relationships that will be amortized over a weighted average period of approximately 9 years. Our balance sheet as of December 31, 2009 reflects the allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the dates of acquisition. The operating results of these acquisitions are included in our results of operations since the date of acquisition. We believe these acquisitions will complement our business by expanding our presence in certain geographic areas and adding to our customer base. In the twelve months ended December 31, 2009, we also paid approximately $1.1 million for certain software assets to complement our tax and appraisal solutions and our student information management solutions. Outlook The financial market crisis has continued to disrupt credit and equity markets worldwide. Broad economic conditions remain uncertain and public sector entities continue to experience pressures that are reflected in longer than normal decision processes. Local and state governments may face financial pressures that could in turn affect our growth rate in the first quarter of 2010 and for the calendar year. While market conditions are not robust, we have great stability from the foundation of recurring revenues and high customer retention. Our base of recurring revenues from maintenance and support and subscription-based services is approximately 49% of total revenues. Consistent with our historical trends, we expect that first quarter 2010 earnings will not reach the level achieved in the fourth quarter of 2009 and will likely be below last year’s first quarter earnings. We also expect that in excess of 60% of our annual earnings will occur in the second half of 2010. 20 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements, the reported amounts of revenues, cost of revenues and expenses during the reporting period, and related disclosure of contingencies. The Notes to the Financial Statements included as part of this Annual Report describe our significant accounting policies used in the preparation of the financial statements. Significant items subject to such estimates and assumptions include the application of the percentage-of-completion and proportionate performance methods of revenue recognition, the carrying amount and estimated useful lives of intangible assets, determination of share-based compensation expense and valuation allowance for receivables. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. We recognize revenues in accordance with the provisions of Accounting Standards Codification (“ ASC”) 605, Revenue Recognition and ASC 985-605, Software Revenue Recognition. Our revenues are derived from sales of software licenses, subscription-based services, appraisal services, maintenance and support, and services that typically range from installation, training and basic consulting to software modification and customization to meet specific customer needs. For multiple element software arrangements, which do not entail the performance of services that are considered essential to the functionality of the software, we generally record revenue when the delivered products or performed services result in a legally enforceable and non-refundable claim. We maintain allowances for doubtful accounts and sales adjustments, which are provided at the time the revenue is recognized. Because most of our customers are governmental entities, we rarely incur a loss resulting from the inability of a customer to make required payments. In a limited number of cases, we encounter a customer who is dissatisfied with some aspect of the software product or our service, and we may offer a “concession” to such customer. In those limited situations where we grant a concession, we rarely reduce the contract arrangement fee, but alternatively may perform additional services, such as additional training or programming a minor feature the customer had in their prior software solution. These amounts have historically been nominal. In connection with our customer contracts and the adequacy of related allowances and measures of progress towards contract completion, our project managers are charged with the responsibility to continually review the status of each customer on a specific contract basis. Also, we review, on at least a quarterly basis, significant past due accounts receivable and the adequacy of related reserves. Events or changes in circumstances that indicate that the carrying amount for the allowances for doubtful accounts and sales adjustments may require revision, include, but are not limited to, deterioration of a customer’s financial condition, failure to manage our customer’s expectations regarding the scope of the services to be delivered, and defects or errors in new versions or enhancements of our software products. We use contract accounting, primarily the percentage-of-completion method, as discussed in ASC 605-35, Construction — Type and Certain Production — Type Contracts, for those software arrangements that involve significant production, modification or customization of the software, or where our software services are otherwise considered essential to the functionality of the software. We measure progress-to-completion primarily using labor hours incurred, or value added. In addition, we recognize revenue using the proportionate performance method of revenue recognition for our property appraisal projects, some of which can range up to five years. These methods rely on estimates of total expected contract revenue, billings and collections and expected contract costs, as well as measures of progress toward completion. We believe reasonably dependable estimates of revenue and costs and progress applicable to various stages of a contract can be made. At times, we perform additional and/or non-contractual services for little to no incremental fee to satisfy customer expectations. If changes occur in delivery, productivity or other factors used in developing our estimates of expected costs or revenues, we revise our cost and revenue estimates, and any revisions are charged to income in the period in which the facts that give rise to that revision first become known. In connection with these and certain other contracts, we may perform the work prior to when the services are billable and/or payable pursuant to the contract. The termination clauses in most of our contracts provide for the payment for the fair value of products delivered and services performed in the event of an early termination. Tyler Technologies Annual Report 2009 21 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations For subscription-based services such as application service provider arrangements and other hosting arrangements, we evaluate whether each of the elements in these arrangements represents a separate unit of accounting, as defined by ASC 605-25, Multiple Element Arrangements, using all applicable facts and circumstances, including whether (i) we sell or could readily sell the element unaccompanied by the other elements, (ii) the element has stand-alone value to the customer, (iii) there is objective reliable evidence of the fair value of the undelivered item, and (iv) there is a general right of return. We consider the applicability of ASC 605-55-121 and 122 with respect to arrangements that include the right to use software stored on another entity’s hardware on a contract-by-contract basis. In hosted term-based agreements, where the customer does not have the contractual right to take possession of the software, hosting fees are recognized on a monthly basis over the term of the contract commencing when the customer has access to the software. For professional services associated with hosting arrangements that we determine do not have stand-alone value to the customer, we recognize the services revenue ratably over the remaining contractual period once hosting has gone live and we may begin billing for the hosting services. We record amounts that have been invoiced in accounts receivable and in deferred revenue or revenues, depending on whether the revenue recognition criteria have been met. In connection with certain of our contracts, we have recorded retentions receivable or unbilled receivables consisting of costs and estimated profit in excess of billings as of the balance sheet date. Many of the contracts which give rise to unbilled receivables at a given balance sheet date are subject to billings in the subsequent accounting period. Management reviews unbilled receivables and related contract provisions to ensure we are justified in recognizing revenue prior to billing the customer and that we have objective evidence which allows us to recognize such revenue. In addition, we have a sizable amount of deferred revenue which represents billings in excess of revenue earned. The majority of this liability consists of maintenance billings for which payments are made in advance and the revenue is ratably earned over the maintenance period, generally one year. We also have deferred revenue for those contracts in which we receive a deposit and the conditions in which to record revenue for the service or product has not been met. On a periodic basis, we review by customer the detail components of our deferred revenue to ensure our accounting remains appropriate. Intangible Assets and Goodwill. Our business acquisitions typically result in the creation of goodwill and other intangible asset balances, and these balances affect the amount and timing of future period amortization expense, as well as expense we could possibly incur as a result of an impairment charge. The cost of acquired companies is allocated to identifiable tangible and intangible assets based on estimated fair value, with the excess allocated to goodwill. Accordingly, we have a significant balance of acquisition date intangible assets, including software, customer related intangibles, trade name and goodwill. In addition, we capitalize software development costs incurred subsequent to the establishment of technological feasibility. These intangible assets are amortized over their estimated useful lives. All intangible assets with definite and indefinite lives are reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of goodwill is generally measured by a comparison of the carrying amount of an asset to its fair value, generally determined by estimated future net cash flows expected to be generated by the asset. We evaluate goodwill for impairment annually as of April, or more frequently if impairment indicators arise. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. The fair values calculated in our impairment tests are determined using discounted cash flow models involving several assumptions. These assumptions include, but are not limited to, anticipated operating income growth rates, our long-term anticipated operating income growth rate and the discount rate. Our cash flow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. The assumptions that are used are based upon what we believe a hypothetical marketplace participant would use in estimating fair value. We have identified two reporting units for impairment testing. Our reporting units are the same as our reportable segments and consistent with the reporting units tested for impairment in prior years. Assets, liabilities and goodwill have been assigned to reporting units based on assets acquired and liabilities assumed as of the date of acquisition. We evaluate the reasonableness of the fair value calculations of our reporting units by comparing the total of the fair value of all of our reporting units to our total market capitalization. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. 22 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Recoverability of other intangible assets is generally measured by comparison of the carrying amount to estimated undiscounted future cash flows. The assessment of recoverability or of the estimated useful life for amortization purposes will be affected if the timing or the amount of estimated future operating cash flows is not achieved. Such indicators may include, among others: a significant decline in expected future cash flows; a sustained, significant decline in stock price and market capitalization; a significant adverse change in legal factors or in the business climate; unanticipated competition; and reductions in growth rates. In addition, products, capabilities, or technologies developed by others may render our software products obsolete or non-competitive. Any adverse change in these factors could have a significant impact on the recoverability of goodwill or other intangible assets. Our annual goodwill impairment analysis, which we performed during the second quarter of 2009, did not result in an impairment charge. During 2009 we did not identify any triggering events which would require an update to our annual impairment. A hypothetical 10% decrease in the fair value of either of our reporting units as of December 31, 2009 would have had no impact on the carrying value of our goodwill. Share-Based Compensation. We have a stock option plan that provides for the grant of stock options to key employees, directors and non-employee consultants. We estimate the fair value of share-based awards on the date of grant using the Black-Scholes option valuation model. Share-based compensation expense includes the estimated effects of forfeitures, which will be adjusted over the requisite service period to the extent actual forfeitures differ, or are expected to differ from such estimates. Changes in estimated forfeitures are recognized in the period of change and will also impact the amount of expense to be recognized in future periods. Forfeiture rate assumptions are derived from historical data. We estimate stock price volatility at the date of grant based on the historical volatility of our common stock. Estimated option life is determined using the “simplified method” in accordance with Staff Accounting Bulletin No. 110. Determining the appropriate fair-value model and calculating the fair value of share-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. ANALYSIS OF RESULTS OF OPERATIONS AND OTHER The following discussion compares the historical results of operations on a basis consistent with GAAP for the years ended December 31, 2009, 2008 and 2007. 2009 Compared to 2008 Revenues The following table sets forth a comparison of the key components of our revenues for the following years ended December 31: ($ in thousands) Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Total revenues Change 2009 % of Total 2008 % of Total $ $ 42,131 17,181 80,405 124,512 18,740 7,317 15% $ 41,490 16% 6 28 43 6 2 14,374 74,997 107,458 19,098 7,684 5 28 41 7 3 $ 641 2,807 5,408 17,054 (358) (367) % 2% 20 7 16 (2) (5) $ 290,286 100% $ 265,101 100% $ 25,185 10% Software licenses. Software license revenues consist of the following components for the following years ended December 31: ($ in thousands) 2009 % of Total 2008 % of Total $ % Change Financial management and education Courts and justice Appraisal and tax and other $ 25,708 13,801 2,622 33 6 61% $ 29,124 70% $ (3,416) (12)% 10,128 24 3,673 2,238 6 384 641 36 17 2% Total software license revenues $ 42,131 100% $ 41,490 100% $ Tyler Technologies Annual Report 2009 23 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations In 2009 we signed 74 large new contracts with average software license fees of approximately $307,000, compared to 72 large new contracts signed in 2008 with average software license fees of approximately $311,000. We consider contracts with a license fee component of $100,000 or more to be large. Although a contract is signed in a particular year, the year in which the revenue is recognized may be different because we recognize revenue according to our revenue recognition policy as described in Note 1 in the Notes to Financial Statements. Changes in software license revenues consist of the following components: • Software license revenue related to our financial management and education solutions declined $3.4 million compared to the prior year. We acquired several student information and financial management solutions for K-12 schools from January through August 2008. Excluding the impact of these acquisitions software license revenue would have declined $4.3 million. The decline was due to several factors. In 2009 our sales cycle to negotiate and close contracts which have reached the request for proposal phase lengthened slightly mainly due to budgetary constraints related to declining economic conditions. As a result the purchasing processes for some of our customers have been extended to include more approval and documentation requirements. The software installation period for most of our financial management and education solutions is relatively short and delays in the timing of signing new contracts will impact our results in the short term. In addition, a few contracts have included requirements to construct interfaces to existing systems or other essential functionality which results in recognizing revenue over a longer period of time. While we expect to continue to experience longer than normal sales cycles in 2010 and continued weakness through mid-2010, we currently expect financial management and education solutions software license revenues for 2010 to be slightly higher than 2009. • Software license revenue related to our courts and justice software solutions increased $3.7 million in 2009 compared to 2008. Both 2009 and 2008 included approximately $1.7 million of revenue from contracts which had been deferred in accordance with the terms of these contracts. Courts and justice software license revenues were higher in 2009 due to contract arrangements that included more software license revenue than in the comparable prior year periods, slight price increases and improved installation processes as our primary courts and justice solution matures. In addition approximately $1.0 million of the increase related to achieving certain milestones for several contracts. We do not expect similar large adjustments to courts and justice software solutions revenue in 2010 due to recognition of revenue previously deferred in accordance with contract language. Therefore we currently expect courts and justice software solutions software license revenue in 2010 to increase at a much slower rate compared to 2009. Subscriptions. Subscription-based services revenue primarily consists of revenues derived from application service provider (“ASP”) arrangements and other hosted service offerings, software subscriptions and disaster recovery services. ASP and other software subscription agreements are typically for periods of three to six years and automatically renew unless either party cancels the agreement. Disaster recovery and miscellaneous other hosted service agreements are typically renewable annually. New customers for ASP and other hosted service offerings as well as existing customers who converted to our ASP model provided the majority of the subscription revenue increase with the remaining increase due to slightly higher rates for disaster recovery services. In June 2008, as a result of changes in its technology organization, one customer terminated its ASP arrangement with us and elected, as provided in the ASP contract, to purchase the software instead. This contract contributed approximately $450,000 of subscription revenue in each of the first two quarters of 2008. Software services. Changes in software services revenues consist of the following components: • Software services revenue related to financial management and education solutions, which comprise approximately 60% of our software services revenue in the periods presented, increased 5% compared to 2008. We acquired several student information and financial management solutions for K-12 schools from January through August 2008. Excluding the impact of these acquisitions, software services revenue increased 3%, which was mainly due to additions to our implementation and support staff as well as leverage in the utilization of our implementation and support staff. • Software services revenue related to courts and justice solutions comprise approximately 30% of our software services revenues in the periods presented and increased 21% compared to 2008. These increases reflect our increased capacity to deliver backlog following additions to our implementation and support staff and slightly higher rates on some arrangements. Also, increased contract volume in our municipal courts software solutions, primarily in Texas, generated higher related services revenue. 24 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Maintenance. We provide maintenance and support services for our software products and third party software. Maintenance revenues increased 16% in 2009 compared to 2008. Maintenance and support services grew 14% in 2009, excluding the impact of acquisitions. This increase was due to growth in our installed customer base and slightly higher maintenance rates on most of our product lines. Appraisal services. Appraisal services revenue declined 2% in 2009 compared to 2008. The appraisal services business is somewhat cyclical and driven in part by statutory revaluation cycles in various states. We substantially completed several large appraisal projects mid-2009. We began several new revaluation contracts late 2009 and as a result currently expect appraisal revenues to increase slightly in 2010. Cost of Revenues and Gross Margins The following table sets forth a comparison of the key components of our cost of revenues and those components stated as a percentage of related revenues for the following years ended December 31: ($ in thousands) Software licenses Acquired software Appraisal services Hardware and other Total cost of revenues Software services, maintenance and subscriptions 137,199 2009 % of Related Revenues 2008 % of Related Revenues Change $ % $ 5,440 13% $ 9,224 22% $ (3,784) (41)% 1,411 11,518 5,955 3 62 61 81 1,799 126,247 12,251 5,793 4 64 64 75 (388) 10,952 (733) 162 (22) 9 (6) 3 $ 161,523 56% $ 155,314 59% $ 6,209 4% The following table sets forth a comparison of gross margin percentage by revenue type for the periods presented for the following years ended December 31: Gross Margin Percentages Software licenses and acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Overall gross margin 2009 2008 Change 83.7% 73.4% 10.3% 38.2 38.5 18.6 35.9 35.9 24.6 44.4% 41.4% 2.3 2.6 (6.0) 3.0% Software license and acquired software. Amortization expense for capitalized development costs on certain software products comprised approximately 15% of our cost of software license revenues in 2009 compared to approximately 50% of our cost of software license in 2008. The remaining balance is made up of third party software costs. Once a product is released, we begin to amortize, over the estimated useful life of the product, any capitalized costs associated with its development. Amortization expense is determined on a product-by-product basis at an annual rate not less than straight-line basis over the product’s estimated life, which is generally five years. Development costs consist mainly of personnel costs, such as salary and benefits paid to our developers, and rent for related office space. Cost of acquired software includes amortization expense for software acquired through acquisitions. We completed several acquisitions in the period 2007 through 2009 and these costs are being amortized over a weighted average period of approximately 5 years. In late 2008 software associated with one significant acquisition completed in December 2003 became fully amortized. In 2009, our software license gross margin percentage rose significantly compared to the prior year periods because several products became fully amortized in late 2008, as did software acquired related to a significant acquisition in December 2003. We did not capitalize any internal software development costs in 2009 or 2008. Software services, maintenance and subscription-based services. Cost of software services, maintenance and subscriptions primarily consists of personnel costs related to installation of our software, conversion of customer data, training customer personnel and support activities and various other services such as ASP and disaster recovery. In 2009, the software services, Tyler Technologies Annual Report 2009 25 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations maintenance and subscriptions gross margin increased compared to the prior year partly because maintenance and various other services such as ASP and disaster recovery costs typically grow at a slower rate than related revenues due to leverage in the utilization of our support and maintenance staff and economies of scale. We have increased our implementation and support staff for both the financial management and education solutions and courts and justice solutions by 51employees since 2008 in order to expand our capacity to implement our contract backlog. This increase was offset somewhat by 24 fewer employees for appraisal and tax solutions. The software services, maintenance and subscription-based services gross margin also benefited from slightly higher rates for certain services. Appraisal services. Our appraisal gross margin increased compared to 2008 as the result of cost savings and operational efficiencies experienced on an unusually complex project. A high proportion of the costs of appraisal services revenue are variable, as we often hire temporary employees to assist in appraisal projects whose term of employment generally ends with the projects’ completion. Our blended gross margin for 2009 was higher than 2008 due to lower amortization expense of software development costs described above. The gross margin also benefited from leverage in the utilization of our support and maintenance staff and economies of scale and slightly higher rates on certain services. Selling, General and Administrative Expenses Selling, general and administrative (“SG&A”) expenses consist primarily of salaries, employee benefits, travel, share-based compensation expense, commissions and related overhead costs for administrative and sales and marketing employees as well as, professional fees, trade show activities, advertising costs and other marketing related costs. The following table sets forth a comparison of our SG&A expenses for the following years ended December 31: ($ in thousands) 2009 % of Revenues 2008 % of Revenues $ % Selling, general and administrative expenses $ 70,115 24% $ 62,923 24% $ 7,192 11% Change The increase in SG&A expenses included higher share-based compensation expense, commission costs and marketing expenses. Marketing expenses in 2009 include costs associated with the launch of a new corporate branding initiative. Our SG&A employee count increased 4% from 2008. Research and Development Expense Research and development expenses consist primarily of salaries, employee benefits and related overhead costs associated with product development and enhancements and upgrades provided to existing customers under maintenance plans. The following table sets forth a comparison of our research and development expense for the following years ended December 31: ($ in thousands) 2009 % of Revenues 2008 % of Revenues $ % Research and development expense $ 11,159 4% $ 7,286 3% $ 3,873 53% Change Research and development expense consist mainly of costs associated with the Microsoft Dynamics AX project, in addition to costs associated with other new product development efforts. We have increased our research and development staff by 72 employees since 2008. In January 2007, we entered into a Software Development and License Agreement, which provided for a strategic alliance with Microsoft Corporation (“Microsoft”) to jointly develop core public sector functionality for Microsoft Dynamics AX to address the accounting needs of public sector organizations worldwide. In September 2007, Tyler and Microsoft signed an amendment to the Software Development and License Agreement, which grants Microsoft intellectual property rights in and to certain portions of the software code provided and developed by Tyler into Microsoft Dynamics AX products to be marketed and sold outside of the public sector in exchange for reimbursement payments to partially offset the research and development costs. In 2009 and 2008, we offset our research and development expense by $3.5 million and $1.8 million, respectively, which were the amounts earned under the terms of our agreement with Microsoft. In September 2008, Tyler and Microsoft signed a 26 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations statement of work under the Amended Software Development and License Agreement for which we currently expect to recognize offsets to our research and development expense by approximately $850,000 each quarter through the end of 2010. In addition, in October 2009, the scope of the project was further expanded that will result in additional offsets to research and development expense, varying in amount from quarter to quarter, with the first payment to be invoiced on August 31, 2010 and invoiced quarterly through March 31, 2012 for a total of approximately $6.2 million. The actual amount and timing of future research and development costs and related reimbursements and whether they are capitalized or expensed may vary. Non-Cash Legal Settlement Related to Warrants On June 27, 2008, we settled outstanding litigation related to the Warrants owned by Bank of America, N. A. (“ BANA”). As disclosed in prior SEC filings, the Warrants entitled BANA to acquire 1.6 million shares of Tyler common stock at an exercise price of $2.50 per share. Following court-ordered mediation, in July 2008, BANA paid us $2.0 million and we issued to BANA 801,883 restricted shares of Tyler common stock. Accordingly, we recorded a non-cash legal settlement related to warrants charge of $9.0 million, which was not tax deductible. Amortization of Customer and Trade Name Intangibles Acquisition intangibles are comprised of the excess of the purchase price over the fair value of net tangible assets acquired that is allocated to acquired software and customer and trade name intangibles. The remaining excess purchase price is allocated to goodwill that is not subject to amortization. Amortization expense related to acquired software is included with cost of revenues, while amortization expense of customer and trade name intangibles is recorded as other operating expense. The estimated useful lives of both customer and trade name intangibles are 5 to 25 years. The following table sets forth a comparison of amortization of customer and trade name intangibles for the following years ended December 31: ($ in thousands) 2009 2008 $ % Amortization of customer and trade name intangibles $ 2,705 $ 2,438 $ 267 11% Change In 2009 we completed several acquisitions and purchased certain software assets to complement our tax and appraisal solutions and our student information management solutions. These transactions increased amortizable customer and trade name intangibles by approximately $625,000. This amount will be amortized over approximately 10 years. Estimated annual amortization expense relating to customer and trade name acquisition intangibles, excluding acquired software for which the amortization expense is recorded as cost of revenues, for the next five years is as follows (in thousands): 2010 2011 2012 2013 2014 $ 2,654 2,638 2,586 2,427 2,426 Other Other (expense) income in 2009 and 2008 includes non-usage and other fees associated with a credit agreement entered into in October 2008. Other income in 2008 also included $1.1 million of interest income which declined due to significantly lower invested cash balances in 2009. Our invested cash balances declined due to purchases of treasury stock and investments in office facilities in late 2008 and 2009. Income Tax Provision The following table sets forth a comparison of our income tax provision for the following years ended December 31: ($ in thousands) Income tax provision Effective income tax rate Change 2009 2008 $ % $ 17,628 $ 14,414 $ 3,214 22% 39.5% 49.2% Tyler Technologies Annual Report 2009 27 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Our effective income tax rate declined compared to 2008 mainly due to a non-cash legal settlement related to warrants charge of $9.0 million in 2008, which was not deductible. In addition to the impact of the non-deductible non-cash legal settlement charge in 2008, the effective income tax rate for both years were different from the statutory United States federal income tax rate of 35% due to state income taxes, non-deductible share-based compensation expense, the qualified manufacturing activities deduction, and non-deductible meals and entertainment costs. Approximately 40% of our stock option awards qualify as incentive stock options (“ISOs”) for income tax purposes. As such, a tax benefit is not recorded at the time the compensation cost related to the options is recorded for book purposes due to the fact that an ISO does not ordinarily result in a tax benefit unless there is a disqualifying disposition. Non-qualified stock options result in the creation of a deferred tax asset, which is a temporary difference, until the time that the option is exercised. Due to the treatment of ISOs for tax purposes, our effective tax rate from year to year is subject to variability. 2008 Compared to 2007 Revenues The following table sets forth a comparison of the key components of our revenues for the following years ended December 31: ($ in thousands) Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Total revenues Change 2008 % of Total 2007 % of Total $ $ 41,490 16% $ 35,063 16% 14,374 74,997 107,458 19,098 7,684 5 28 41 7 3 10,406 60,283 85,411 21,318 7,315 5 27 39 10 3 $ 6,427 3,968 14,714 22,047 (2,220) 369 % 18% 38 24 26 (10) 5 $ 265,101 100% $ 219,796 100% $ 45,305 21% Software licenses. Software license revenues consist of the following components for the following years ended December 31: ($ in thousands) 2008 % of Total 2007 % of Total $ Change Financial management and education Courts and justice Appraisal and tax and other Total software license revenues $ 29,124 10,128 2,238 $ 41,490 70% 24 6 100% $ 27,236 5,987 1,840 $ 35,063 78% 17 5 $ 1,888 4,141 398 100% $ 6,427 18% % 7% 69 22 Changes in software license revenues consist of the following components: • Software license revenue related to our financial management and education solutions for 2008 increased 7% compared to the prior year. Revenue from student information management solutions as well as student transportation management solutions acquired in the last twelve months contributed substantially to the increase. The remaining increase was mainly due to contract arrangements that included more software license revenue than in the past. • Software license revenue related to our courts and justice software solutions increased 69% for 2008 compared to the prior year. New statewide contracts in Indiana and New Mexico contributed approximately two-thirds of the increase. The remaining increase was primarily due to an expanded presence in the markets for municipal courts software solutions and public safety software solutions. Subscriptions. New ASP customers and existing customers converting to ASP arrangements provided the majority of the subscription revenue increase with the remaining increase due to new disaster recovery customers and slightly higher rates for disaster recovery services. 28 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Software services. Changes in software services revenues consist of the following components: • Software services revenue related to financial management and education solutions, which comprises slightly more than half of our software services revenue in the years presented, increased substantially compared to 2007. This increase was driven in part by increased capacity to deliver backlog following additions to our implementation and support staff since 2007 and due to larger and more complex contracts, which include more programming and project management services. In addition, we acquired a student transportation management solution in January 2008 which contributed approximately $3.9 million to software service revenues in 2008. Excluding the impact of acquisitions, we added approximately 95 employees to our financial management and education implementation and training staff during 2008. • Software services revenue related to our courts and justice solutions experienced strong increases compared to 2007, reflecting increased capacity to deliver backlog following additions to our implementation and support staff since mid-2007. In addition, increased contract volume for municipal courts software solutions and public safety software solutions also generated higher related services revenue. We added approximately 12 employees to our courts and justice implementation and training staff during 2008. Maintenance. Maintenance revenues increased 26% in 2008 compared to 2007. Excluding the impact of acquisitions, maintenance and support services grew 16% in 2008. This increase was due to growth in our installed customer base and slightly higher maintenance rates on most of our product lines. Appraisal services. Appraisal services revenue declined 10% in 2008 compared to 2007. In late 2007, we substantially completed several projects related to the Ohio revaluation cycle, which occurs every six years, as well as a few other large contracts. Appraisal revenues for the first six months of 2008 were down 23% compared to the first six months of 2007. In mid-2008 we began a complete reappraisal of real property in Orleans Parish, Louisiana. As a result of this contract and an overall increase in contract volume, appraisal revenues for the last six months of 2008 increased 4% over the last six months of 2007. Cost of Revenues and Gross Margins The following table sets forth a comparison of the key components of our cost of revenues and those components stated as a percentage of related revenues for the following years ended December 31: ($ in thousands) Software licenses Acquired software Appraisal services Hardware and other Total cost of revenues Software services, maintenance and subscriptions 126,247 2008 % of Related Revenues 2007 % of Related Revenues Change $ % $ 9,224 22% $ 7,953 23% $ 1,271 16% 1,799 12,251 5,793 4 64 64 75 2,279 104,993 14,467 5,679 7 67 68 78 (480) 21,254 (2,216) (21) 20 (15) 114 2 $ 155,314 59% $ 135,371 62% $ 19,943 15% The following table sets forth a comparison of gross margin percentage by revenue type for the periods presented for the following years ended December 31: Gross Margin Percentages Software licenses and acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Overall gross margin 2008 2007 Change 73.4% 70.8% 2.6% 35.9 35.9 24.6 32.7 32.1 22.4 3.2 3.8 2.2 41.4% 38.4% 3.0% Software license. In 2008, our software license gross margin percentage rose compared to the prior year mainly due to strong license fee revenue increases. Because approximately one-half of our cost of software license revenues in both periods is comprised of amortization of capitalized development costs, increased license fee revenues inherently result in higher gross margins. Tyler Technologies Annual Report 2009 29 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Software services, maintenance and subscription-based services. In 2008, the software services, maintenance and subscriptions gross margin increased compared to the prior year partly because maintenance and various other services such as ASP and disaster recovery costs typically grow at a slower rate than related revenues due to leverage in the utilization of our support and maintenance staff and economies of scale. We increased our implementation and support staff by 215 employees during 2008 in order to expand our capacity to implement our contract backlog. This increase includes 102 employees related to acquisitions completed in 2008. Appraisal services. Our appraisal gross margin for 2008 was higher than the prior year due to cost savings associated with a significant complex reappraisal project. Our blended gross margin in 2008 was higher than the prior year in large part due to leverage in the utilization of our support and maintenance staff and economies of scale, with resulting increases in gross margin for each revenue category. Selling, General and Administrative Expenses The following table sets forth a comparison of our SG&A expenses for the following years ended December 31: ($ in thousands) 2008 % of Revenues 2007 % of Revenues $ % Selling, general and administrative expenses $ 62,923 24% $ 51,724 24% $ 11,199 22% Change Excluding the impact of acquisitions, our SG&A employee count increased 9% during 2008. Research and Development Expense The following table sets forth a comparison of our research and development expense for the following years ended December 31: ($ in thousands) 2008 % of Revenues 2007 % of Revenues $ % Research and development expense $ 7,286 3% $ 4,443 2% $ 2,843 64% Change Research and development expense consist mainly of costs associated with the Microsoft Dynamics AX project, in addition to costs associated with other new product development efforts. In 2008 and 2007, we offset our research and development expense by $1.8 million and $1.6 million, respectively, which were the amounts earned under the terms of our research and development agreement with Microsoft. Non-Cash Legal Settlement Related to Warrants On June 27, 2008, we settled outstanding litigation related to the Warrants owned by BANA. The Warrants entitled BANA to acquire 1.6 million shares of Tyler common stock at an exercise price of $2.50 per share. Following court-ordered mediation, in July 2008, BANA paid us $2.0 million and we issued to BANA 801,883 restricted shares of Tyler common stock. Accordingly, we recorded a non-cash legal settlement related to warrants charge of $9.0 million, which was not tax deductible. Amortization of Customer and Trade Name Intangibles The following table sets forth a comparison of amortization of customer and trade name intangibles for the following years ended December 31: ($ in thousands) 2008 2007 $ % Change Amortization of customer and trade name intangibles $ 2,438 $ 1,478 $ 960 65% In 2008, we completed three acquisitions, which increased amortizable customer and trade name intangibles by $12.3 million. 30 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Other Interest income was the main component of other income in both 2008 and 2007. Other income in 2008 also includes non-usage and other fees associated with a credit agreement entered into in October 2008. Interest income in 2008 was $1.1 million compared to $1.8 million in 2007. Interest income declined due to lower invested cash balances and slightly lower interest rates. Our invested cash balances declined due to purchases of treasury stock and investments in office facilities in 2008. Income Tax Provision The following table sets forth a comparison of our income tax provision for the following years ended December 31: ($ in thousands) Income tax provision Effective income tax rate Change 2008 2007 $ % $ 14,414 $ 11,079 $ 3,335 30% 49.2% 38.8% Our effective income tax rate increased approximately twelve points compared to the prior year due to a non-cash legal settlement related to warrants charge of $9.0 million, which was not deductible. The effective income tax rates were different from the statutory United States federal income tax rate of 35% primarily due to non-cash legal settlement related to warrants charge which was not deductible, as well as state income taxes, non-deductible share-based compensation expense, the qualified manufacturing activities deduction, and non-deductible meals and entertainment costs. BUSINESS SEGMENT DISCUSSION Enterprise Software Solutions Revenue Gross margin Gross margin percentage Segment operating income 2009 % Change 2008 % Change 2007 $ 250,059 11% $ 225,887 24% $ 182,065 $ 114,309 46% $ 97,214 43% $ 71,684 39% $ 55,639 17% $ 47,698 37% $ 34,833 In 2009 software license revenues were flat compared to 2008. Growth in recurring revenues from subscription-based services and maintenance experienced a 14% increase, excluding the impact of acquisitions, and was the primary factor for the increase in overall revenue and segment operating income for the Enterprise Software Solutions segment. This increase was due to growth in our installed customer base and slightly higher maintenance rates on most of our product lines. New customers for ASP and other hosted service offerings as well as existing customers converting to ASP arrangements and slightly higher rates for disaster recovery services also contributed to this increase. The gross margin and segment operating income rose in 2009 due to lower amortization expense of software development costs. The gross margin and segment operating income also benefited from leverage in the utilization of our support and maintenance staff and economies of scale and slightly higher rates on certain services. In 2008 software license revenues were 18% higher than 2007 mainly due to higher courts and justice contract volume as a result of an expanded presence in Indiana and New Mexico. 2008 software license revenue also benefitted from student information management solutions and transportation solutions acquired in early 2008. Excluding the impact of acquisitions in 2008, revenues from subscription-based arrangements and maintenance grew by 19% compared to 2007 primarily due to growth in our customer base. Our gross margin and segment operating income in 2008 was higher than 2007 in large part due to leverage in the utilization of our support and maintenance staff and economies of scale and higher software license revenues. Appraisal and Tax Software Solutions and Services Revenue Gross margin Gross margin percentage Segment operating income 2009 % Change 2008 % Change 2007 $ 40,776 $ 15,489 38% 5% $ 38,868 $ 13,231 34% 1% $ 38,649 $ 12,966 34% $ 6,949 28% $ 5,448 8% $ 5,040 Tyler Technologies Annual Report 2009 31 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations In 2009 overall revenues for the Appraisal and Tax Software Solutions and Services segment increased compared to 2008 mainly due to a 16% increase in subscription-based arrangements and maintenance due to growth in our customer base and slightly higher rates. Excluding the results of acquisitions, subscription-based arrangements and maintenance increased 15% compared to 2008. This increase was offset slightly by 2% lower appraisal services. The appraisal services business is somewhat cyclical and driven in part by scheduled revaluation cycles in various states. We substantially completed several large appraisal projects mid-2009. Our appraisal gross margin and segment operating income increased compared to 2008 as the result of cost savings and operational efficiencies experienced on an unusually complex appraisal project. A high proportion of the costs of appraisal services revenue are variable, as we often hire temporary employees to assist in appraisal projects whose term of employment generally ends with the projects’ completion. Overall appraisal and tax revenues in 2008 were flat compared to 2007. Although maintenance revenues increased 8%, appraisal services revenues declined 10%. In late 2007, we substantially completed several appraisal projects related to the Ohio revaluation cycle, which occurs every six years, as well as a few other large contracts. The gross margin for 2008 was flat compared to 2007 due to cost savings associated with a significant complex reappraisal project which offset declines from lower contract volume. FINANCIAL CONDITION AND LIQUIDITY As of December 31, 2009, we had cash and cash equivalents (including restricted cash equivalents) of $15.7 million and current and non-current investments of $2.0 million, compared to cash and cash equivalents (including restricted cash equivalents) of $6.8 million and current and non-current investments of $4.6 million at December 31, 2008. As of December 31, 2009, we had no outstanding borrowings and outstanding letters of credit totaling $7.3 million to secure surety bonds required by some of our customer contracts. These letters of credit expire through mid-2010. The following table sets forth a summary of cash flows for the years ended December 31: ($ in thousands) Cash flows provided by (used by): Operating activities Investing activities Financing activities Net increase (decrease) in cash and cash equivalents 2009 2008 2007 $ 42,941 $ 47,802 $ 34,111 (13,658) (9,554) (34,275) (21,349) (46,128) (7,406) $ 7,934 $ (7,880) $ (7,570) Net cash provided by operating activities continues to be our primary source of funds to finance operating needs and capital expenditures. Other capital resources include cash on hand, public and private issuances of debt and equity securities, and bank borrowings. The capital and credit markets have become more volatile and tightened as a result of adverse conditions that have caused the failure and near failure of a number of large financial services companies. It is possible that our ability to access the capital and credit markets may be limited by these or other factors. Notwithstanding the foregoing, we believe that cash provided by operating activities, cash on hand and our revolving credit agreement are sufficient to fund our working capital requirements, capital expenditures, income tax obligations, and share repurchases for the foreseeable future. In 2009, operating activities provided net cash of $42.9 million, primarily generated from net income of $27.0 million, non-cash depreciation and amortization charges of $9.5 million, non-cash share-based compensation expense of $5.0 million and a decrease in working capital of $2.7 million offset slightly by a $1.7 million decrease related to deferred income taxes. Working capital declined due to higher accounts payable and accrued liabilities pertaining to timing of payments on vendor invoices and income tax liabilities and an accrued liability of $1.8 million for a retention payment related to construction of an office building. Other sources of working capital were deferred revenue related to December maintenance billings and a decrease in prepaid expenses. These working capital declines were offset somewhat by an increase in annual software maintenance billings as a result of growth in our installed customer base. The increase in accounts receivable was offset slightly by the collection of several large customer billings, one of which had been outstanding for over twelve months. 32 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Cash flows provided by operating activities in 2008 included several advance payments from customers. In general, changes in the balance of deferred revenue are cyclical and primarily driven by the timing of our maintenance renewal billings. Our renewal dates occur throughout the year but our heaviest renewal cycles occur in the second and fourth quarters. Non-current investments available-for-sale consist of two auction rate municipal securities (“ARS”) which are collateralized debt obligations supported by municipal and state agencies and do not include mortgage-backed securities. Short-term investments available-for-sale consists of the portion of one of these ARS which was partially redeemed at par during the period January 1, 2010 through February 22, 2010. These ARS are debt instruments with stated maturities ranging from 22 to 33 years, for which the interest rate is designed to be reset through Dutch auctions approximately every 30 days. However, due to events in the credit markets, auctions for these securities have not occurred since February 2008. Both of our ARS have had very small partial redemptions at par in the period from July 2009 through February 2010. As of December 31, 2009 we have continued to earn and collect interest on both of our ARS. Because quoted prices in active markets are no longer available we determined the estimated fair values of these securities utilizing a discounted trinomial model. The model considers the probability of three potential occurrences for each auction event through the maturity date of each ARS. The three potential outcomes for each auction are (i) successful auction/early redemption, (ii) failed auction and (iii) issuer default. Inputs in determining the probabilities of the potential outcomes include but are not limited to, the securities’ collateral, credit rating, insurance, issuer’s financial standing, contractual restrictions on disposition and the liquidity in the market. The fair value of each ARS is determined by summing the present value of the probability-weighted future principal and interest payments determined by the model. Since there can be no assurances that auctions for these securities will be successful in the near future, we have classified our ARS as non-current investments. In association with this estimate of fair value, we have recorded an after-tax temporary unrealized loss on our non-current ARS of $18,000, net of related tax effects of $10,000 in 2009, which is included in accumulated other comprehensive loss on our balance sheet. The unrealized loss includes the impact of adjusting previously recorded unrealized losses of approximately $120,000, net of related tax effects of $65,000 as of December 31, 2008 for several ARS which were subsequently redeemed for $2.5 million at par during 2009. We consider the impairment in our ARS as temporary because we do not have the intent to sell, nor is it more-likely-than-not that we will be required to sell these securities before recovery of their cost basis. We believe that this temporary decline in fair value is due entirely to liquidity issues, because the underlying assets of these securities are supported by municipal and state agencies and do not include mortgage-backed securities, have redemption features which call for redemption at 100% of par value and have a current credit rating of A or AAA. The ratings on the ARS take into account credit support through insurance policies guaranteeing each of the bonds’ payment of principal and accrued interest, if it becomes necessary. In addition, both ARS have had very small partial redemptions at par in the period July 2009 through February 2010. Based on our cash and cash equivalents balance of $15.7 million and expected operating cash flows, we do not believe a lack of liquidity associated with our ARS will adversely affect our ability to conduct business, and believe we have the ability to hold the securities throughout the currently estimated recovery period. We will continue to evaluate any changes in the market value of our ARS and in the future, depending upon existing market conditions, we may be required to record an other-than- temporary decline in market value. At December 31, 2009, our days sales outstanding (“DSOs”) were 98 days compared to DSOs of 99 days at December 31, 2008. DSOs are calculated based on accounts receivable (excluding long-term receivables, but including unbilled receivables) divided by the quotient of annualized quarterly revenues divided by 360 days. Investing activities used cash of $13.7 million in 2009 compared to $9.6 million in 2008. In connection with plans to consolidate our workforce and support planned long-term growth, we paid $9.4 million for construction of an office building and expect to pay the final retainage of $1.8 million by mid-2010. We also liquidated $2.5 million of investments in ARS for cash at par. In 2009 we completed the acquisition of all of the capital stock of Assessment Evaluation Services, Inc. for $1.1 million in cash, paid $700,000 in cash for certain assets of KPL, Inc. d/b/a Parker-Lowe & Associates and acquired various software assets for $1.1 million in cash. Capital expenditures and acquisitions were funded from cash generated from operations. Tyler Technologies Annual Report 2009 33 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations In 2008, we liquidated $36.4 million of ARS investments for cash at par, and we completed the acquisitions of School Information Systems, Inc., VersaTrans Solutions Inc. and certain assets of Olympia Computing Company, Inc. d/b/a Schoolmaster to expand our presence in the education market. The combined purchase price, excluding cash acquired and including transaction costs, was approximately $23.9 million in cash and approximately 196,000 shares of Tyler common stock valued at $2.9 million. We paid $3.3 million, which included $2.1 million for land, for an office development. We also paid $12.7 million for an office building, land, and a related tenant lease in Yarmouth, Maine. Cash used in financing activities was primarily comprised of purchases of treasury shares, net of proceeds from stock option exercises, payments on our revolving credit line and contributions from our employee stock purchase plan. During 2009, we purchased 1.2 million shares of our common stock for an aggregate purchase price of $17.0 million. We also paid $1.3 million for common stock repurchases accrued as of December 31, 2008. The repurchase program, which was approved by our board of directors, was announced in October 2002, and was amended in April and July 2003, October 2004, October 2005, May 2007, May 2008, October 2008 and May 2009. Our board of directors authorized the repurchase of an additional 2.0 million shares on May14, 2009. As of December 31, 2009, we had remaining authorization to repurchase up to 2.3 million additional shares of our common stock. Our share repurchase program allows us to repurchase shares at our discretion and market conditions influence the timing of the buybacks and the number of shares repurchased. These share repurchases are funded using our existing cash balances as well as borrowings under our revolving credit agreement and may occur through open market purchase and transactions structured through investment banking institutions, privately negotiated transactions and/or other mechanisms. There is no expiration date specified for the authorization and we intend to repurchase stock under the plan from time to time. Our bank credit agreement contains restrictions on the amount of common stock we may purchase. During 2008, we purchased 4.3 million shares of our common stock for an aggregate purchase price of $59.0 million. In 2009 we issued 425,000 shares of common stock and received $2.3 million in aggregate proceeds upon exercise of stock options. In 2008 we received $1.8 million from the exercise of options to purchase approximately 379,000 shares of our common stock under our employee stock option plan and during 2007, we received $3.6 million from the exercise of options to purchase approximately 878,000 shares of our common stock under our employee stock option plan. In 2009 we received $1.5 million from contributions to the Tyler Technologies, Inc. Employee Stock Purchase Plan (“ESPP”). In both 2008 and 2007, we received $1.2 million from contributions to the ESPP. Subsequent to December 31, 2009 and through February 22, 2010 we purchased approximately 59,000 shares of our common stock for an aggregate cash purchase price of $1.1 million. In October 2008, we entered into a revolving bank credit agreement (the “Credit Facility”) and a related pledge and security agreement which originally matured October 19, 2009. We amended and extended the related pledge and security agreement in October 2009. The Credit Facility matures October 18, 2010 and provides for total borrowings of up to $25.0 million and a $10.0 million Letter of Credit facility which can either be cash collateralized or issued using availability under the Credit Facility. The Credit Facility is secured by substantially all of our property. The Credit Facility requires us to maintain certain financial ratios and other financial conditions and prohibits us from making certain investments, advances, cash dividends or loans, restricts the amount of our common stock we may purchase and limits incurrence of additional indebtedness and liens. As of December 31, 2009, we were in compliance with those covenants. We expect borrowings to fund discretionary purchases of our common stock or fund acquisitions. As of December 31, 2009, we had no outstanding borrowings and unused available borrowing capacity of $23.7 million under the Credit Facility. In addition, as of December 31, 2009, our bank had issued outstanding letters of credit totaling $7.3 million to secure surety bonds required by some of our customer contracts. These letters of credit have been collateralized by restricted cash balances of $6.0 million and $1.3 million of our available borrowing capacity and expire through mid-2010. We paid income taxes, net of refunds received, of $18.1 million in 2009, $15.7 million in 2008, and $8.7 million in 2007. 34 Tyler Technologies Annual Report 2009 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations In the first quarter of 2010 we acquired all the assets of Wiznet, Inc. (“Wiznet”) for a cash purchase price of $9.5 million. Wiznet provides electronic document filing solutions for courts and law offices throughout the United States and is currently integrated with our primary courts and justice solution. We have not finalized the allocation of the purchase price. Excluding acquisitions and final retainage payment of $1.8 million for an office building, we anticipate that 2010 capital spending will be between $3.7 million and $4.2 million. We expect the majority of our capital spending in 2010 will consist of computer equipment and software for infrastructure expansion. We currently do not expect to capitalize significant amounts related to software development in 2010, but the actual amount and timing of those costs, and whether they are capitalized or expensed may result in additional capitalized software development. Capital spending in 2010 is expected to be funded from existing cash balances and cash flows from operations. From time to time we engage in discussions with potential acquisition candidates. In order to pursue such opportunities, which could require significant commitments of capital, we may be required to incur debt or to issue additional potentially dilutive securities in the future. No assurance can be given as to our future acquisition opportunities and how such opportunities will be financed. We lease office facilities, as well as transportation, computer and other equipment used in our operations under non-cancelable operating lease agreements expiring at various dates through 2014. Most leases contain renewal options and some contain purchase options. Following are the future obligations under non-cancelable leases at December 31, 2009 (in thousands): Future rental payments under operating leases $ 6,033 $ 5,265 $ 3,954 $ 2,365 $ 1,721 $ — $ 19,338 2010 2011 2012 2013 2014 Thereafter Total As of December 31, 2009, we do not have any off-balance sheet arrangements, guarantees to third parties or material purchase commitments, except for the operating lease commitments listed above. CAPITALIZATION At December 31, 2009, our capitalization consisted of $134.4 million of shareholders’ equity. NEW ACCOUNTING PRONOUNCEMENTS In September 2009, the Financial Accounting Standards Board issued ASU 2009-13, Multiple Element Arrangements. ASU 2009-13 addresses the determination of when the individual deliverables included in a multiple arrangement may be treated as separate units of accounting. ASU 2009-13 also modifies the manner in which the transaction consideration is allocated across separately identified deliverables and establishes definitions for determining fair value of elements in an arrangement. This new update is effective for fiscal years beginning on or after June 15, 2010. Early adoption is allowed. The new standard may impact our application service provider arrangements to recognize revenues, such as installation and data conversion, which are generally provided at the beginning of the arrangement as incurred instead of ratably over the life of the initial hosting term. The adoption of this standard is not expected to have a material impact on our financial condition or results of operation. Tyler Technologies Annual Report 2009 35 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and interest rates. Our investments available-for-sale consist of auction rate municipal securities (“ARS”) which are collateralized debt obligations supported by municipal and state agencies and do not include mortgage-backed securities. Non-current investments available-for-sale consist of two ARS with stated maturities ranging from 22 to 33 years, for which the interest rate is designed to be reset through Dutch auctions approximately every 30 days which would have qualified as Level 1 under ASC 820, Fair Value Measurements. However, due to events in the credit markets, auctions for these securities have not occurred since February 2008. Therefore, quoted prices in active markets are no longer available and we determined the estimated fair values of these securities as of December 31, 2009, utilizing a discounted trinomial model. In association with this estimate of fair value, we have recorded an after-tax temporary unrealized loss on our non-current ARS of $18,000, net of related tax effects of $10,000 in 2009, which is included in accumulated other comprehensive loss on our balance sheet. The unrealized loss includes the impact of adjusting previously recorded unrealized losses of approximately $120,000, net of related tax effects of $65,000 as of December 31, 2008 for several ARS which were subsequently redeemed for $2.5 million at par during 2009. We consider the impairment in our ARS as temporary because we do not have the intent to sell, nor is it more-likely-than-not that we will be required to sell these securities before recovery of their cost basis. We believe that this temporary decline in fair value is due entirely to liquidity issues, because the underlying assets of these securities are supported by municipal and state agencies and do not include mortgage-backed securities, have redemption features which call for redemption at 100% of par value and have a current credit rating of A or AAA. The ratings on the ARS take into account credit support through insurance policies guaranteeing each of the bonds’ payment of principal and accrued interest, if it becomes necessary. In addition, both ARS have had very small partial redemptions at par in the period July 2009 through February 2010. Based on our cash and cash equivalents balance of $15.7 million and expected operating cash flows, we do not believe a lack of liquidity associated with our ARS will adversely affect our ability to conduct business, and believe we have the ability to hold the securities throughout the currently estimated recovery period. We will continue to evaluate any changes in the market value of our ARS and in the future, depending upon existing market conditions, we may be required to record an other-than-temporary decline in market value. 36 Tyler Technologies Annual Report 2009 Management’s Report on Internal Control Over Financial Reporting MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Evaluation of Disclosure Controls and Procedures – We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act) designed to provide reasonable assurance that the information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. These include controls and procedures designed to ensure that this information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosures. Management, with the participation of the chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2009. Based on this evaluation the chief executive officer and chief financial officer have concluded that our disclosure controls and procedures were effective as of December 31, 2009. Management’s Report on Internal Control Over Financial Reporting – Tyler’s management is responsible for establishing and maintaining effective internal control over financial reporting as defined in Securities Exchange Act Rule 13a-15(f). Tyler’s internal control over financial reporting is designed to provide reasonable assurance to Tyler’s management and board of directors regarding the preparation and fair presentation of published financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Management assessed the effectiveness of Tyler’s internal control over financial reporting as of December 31, 2009. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on our assessment, we concluded that, as of December 31, 2009, Tyler’s internal control over financial reporting was effective based on those criteria. Tyler’s internal control over financial reporting as of December 31, 2009 has been audited by Ernst & Young LLP, the independent registered public accounting firm who also audited Tyler’s financial statements. Ernst & Young’s attestation report on Tyler’s internal control over financial reporting appears on page 38 hereof. Changes in Internal Control Over Financial Reporting – During the quarter ended December 31, 2009, there were no changes in our internal control over financial reporting, as defined in Securities Exchange Act Rule 13a-15(f), that are materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Tyler Technologies Annual Report 2009 37 Report of Independent Registered Public Accounting Firm REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Tyler Technologies, Inc. We have audited Tyler Technologies, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Tyler Technologies, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying “Managements’ Report on Internal Control Over Financial Reporting.” Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. 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 (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) 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 (3) 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. In our opinion, Tyler Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of Tyler Technologies, Inc. as of December 31, 2009 and 2008, and the related statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009 and our report dated February 25, 2010 expressed an unqualified opinion thereon. Dallas, Texas February 25, 2010 38 Tyler Technologies Annual Report 2009 Report of Independent Registered Public Accounting Firm REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Tyler Technologies, Inc. We have audited the accompanying balance sheets of Tyler Technologies, Inc. as of December 31, 2009 and 2008, and the related statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Tyler Technologies, Inc. at December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Tyler Technologies, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2010 expressed an unqualified opinion thereon. Dallas, Texas February 25, 2010 Tyler Technologies Annual Report 2009 39 2009 2008 2007 $ 42,131 $ 41,490 17,181 14,374 80,405 74,997 124,512 107,458 18,740 19,098 7,317 7,684 $ 35,063 10,406 60,283 85,411 21,318 7,315 290,286 265,101 219,796 5,440 1,411 9,224 1,799 137,199 126,247 11,518 12,251 5,955 5,793 7,953 2,279 104,993 14,467 5,679 161,523 155,314 135,371 128,763 109,787 84,425 70,115 62,923 51,724 11,159 2,705 — 7,286 2,438 9,045 4,443 1,478 — 44,784 28,095 26,780 (146) 1,181 44,638 29,276 17,628 14,414 $ 27,010 $ 14,862 $ $ 0.77 0.74 $ $ 0.39 0.38 35,240 37,714 36,624 39,184 1,800 28,580 11,079 $ 17,501 $ $ 0.45 0.42 38,735 41,352 Statements of Operations STATEMENTS OF O PERATIONS For the years ended December 31 In thousands, except per share amounts Revenues: Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Total revenues Cost of revenues: Software licenses Acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Total cost of revenues Gross profit Selling, general and administrative expenses Research and development expense Amortization of customer and trade name intangibles Non-cash legal settlement related to warrants Operating income Other (expense) income, net Income before income taxes Income tax provision Net income Earnings per common share: Basic Diluted Basic weighted average common shares outstanding Diluted weighted average common shares outstanding See accompanying notes. 40 Tyler Technologies Annual Report 2009 BALANCE SHEETS December 31 In thousands, except share and per share amounts ASSETS Current assets: Cash and cash equivalents Restricted cash equivalents Short-term investments available-for-sale Balance Sheets 2009 2008 $ 9,696 $ 1,762 6,000 50 5,082 775 Accounts receivable (less allowance for losses of $2,389 in 2009 and $2,115 in 2008) 81,245 76,989 Prepaid expenses Other current assets Deferred income taxes Total current assets Accounts receivable, long-term portion Property and equipment, net Non-current investments available-for-sale Other assets: Goodwill Customer related intangibles, net Software, net Trade name, net Sundry LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities: Accounts payable Accrued liabilities Short-term revolving line of credit Deferred revenue Income taxes payable Total current liabilities Deferred income taxes Commitments and contingencies Shareholders’ equity: Preferred stock, $10.00 par value; 1,000,000 shares authorized, none issued Common stock, $0.01 par value; 100,000,000 shares authorized; 48,147,969 shares issued in 2009 and 2008 Additional paid-in capital Accumulated other comprehensive loss, net of tax Retained earnings 7,921 1,437 3,338 8,602 1,444 2,570 109,687 97,224 1,018 197 35,750 26,522 1,976 3,779 90,258 25,490 88,791 27,438 4,218 2,063 210 5,112 2,471 227 $ 270,670 $ 251,761 $ 3,807 26,110 — $ 2,617 22,913 8,000 99,116 95,773 220 166 129,253 129,469 7,059 8,030 — 481 — 481 153,734 151,245 (405) (387) 77,504 50,494 Treasury stock, at cost; 13,027,838 and 12,333,549 shares in 2009 and 2008, respectively (96,956) (87,571) Total shareholders’ equity See accompanying notes. 134,358 $ 270,670 114,262 $ 251,761 Tyler Technologies Annual Report 2009 41 Statements of Shareholders’ Equity STATEMENTS OF SHAREHOLDERS’ EQUITY For the years ended December 31, 2009, 2008 and 2007 Common Stock Shares Amount Additional Paid-in Capital Accumulated Other Comprehensive Retained Income (Loss) Earnings Treasury Stock Shares Amount Total Shareholders’ Equity In thousands Balance at December 31, 2006 48,148 $ 481 $ 151,627 $ (10) $ 18,131 (9,256) $ (44,354) $ 125,875 149,568 — 35,632 (9,528) (48,470) 137,211 Comprehensive income: Net income Unrealized gain on investment — — — — 17,501 securities, net of tax — — — 10 — Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to — — — — — — (7,339) — 2,365 — — — Employee Stock Purchase Plan — — (2) — Federal income tax benefit related to exercise of stock options — Balance at December 31, 2007 48,148 — 481 2,917 — Comprehensive income: Net income Unrealized loss on investment — — — — 14,862 securities, net of tax — — — (387) — Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to — — — — — — (3,495) — 3,820 — — — Employee Stock Purchase Plan — — (186) — Federal income tax benefit related to exercise of stock options — — 822 — Issuance of shares in connection with legal settlement Issuance of shares for acquisitions — — Balance at December 31, 2008 48,148 — — 481 455 261 — — Comprehensive income: Net income Unrealized loss on investment — — — — 27,010 securities, net of tax — — — (18) — Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to — — — — — — (3,774) — 5,045 — — — Employee Stock Purchase Plan — — (118) — — — — 17,501 — 10 17,511 — — — — — 878 10,928 — — 3,589 2,365 (1,250) (16,163) (16,163) 100 1,119 1,117 — — 2,917 — — — 14,862 — (387) 14,475 379 — 5,310 — 1,815 3,820 (4,283) (58,984) (58,984) 101 1,376 1,190 — — 822 802 196 10,595 11,050 2,602 2,863 — — — — — — — — — — 27,010 — (18) 26,992 — — — — — 425 — 6,069 — 2,295 5,045 (1,235) (17,000) (17,000) 115 1,546 1,428 — — 1,336 151,245 (387) 50,494 (12,333) (87,571) 114,262 1,336 — $ 153,734 $ (405) $ 77,504 (13,028) $ (96,956) $ 134,358 Federal income tax benefit related to exercise of stock options — Balance at December 31, 2009 48,148 — $ 481 See accompanying notes. 42 Tyler Technologies Annual Report 2009 STATEMENTS OF C ASH FLOWS For the years ended December 31 In thousands Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Non-cash legal settlement related to warrants Share-based compensation expense Provision for losses – accounts receivable Excess tax benefit from exercises of share-based arrangements Deferred income tax benefit Changes in operating assets and liabilities, exclusive of effects of acquired companies: Accounts receivable Income tax payable Prepaid expenses and other current assets Accounts payable Accrued liabilities Deferred revenue Net cash provided by operating activities Cash flows from investing activities: Proceeds from sales of investments Purchases of investments Cost of acquisitions, net of cash acquired Additions to property and equipment Investment in software development costs Acquired lease (Increase) decrease in restricted investments Decrease in other Statements of Cash Flows 2009 2008 2007 $ 27,010 $ 14,862 $ 17,501 9,497 — 5,045 1,538 (1,125) (1,730) 12,611 9,045 3,820 1,764 (666) (2,151) 11,211 — 2,365 753 (1,891) (1,598) (6,277) (11,853) (1,575) 1,391 1,377 1,190 1,960 3,065 42,941 827 (338) (870) 3,420 17,331 47,802 3,919 (304) (1,955) (1,619) 7,304 34,111 2,500 45,065 45,480 — (8,625) (67,545) (2,934) (12,352) (23,868) (20,143) — — (918) 46 — (1,387) (620) 24 (9,005) (3,678) (167) — 500 140 Net cash used by investing activities (13,658) (9,554) (34,275) Cash flows from financing activities: (Decrease) increase in net borrowings on revolving credit facility (8,000) 8,000 — Purchase of treasury shares Contributions from employee stock purchase plan Proceeds from exercise of stock options Excess tax benefits from exercise of share-based arrangements Warrant exercise in connection with legal settlement (18,263) (59,847) (14,037) 1,494 2,295 1,125 — 1,233 1,815 666 2,005 1,151 3,589 1,891 — Net cash used by financing activities (21,349) (46,128) (7,406) Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year See accompanying notes. 7,934 1,762 (7,880) 9,642 $ 9,696 $ 1,762 (7,570) 17,212 $ 9,642 Tyler Technologies Annual Report 2009 43 Notes to Financial Statements (Tables in thousands, except per share data) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DESCRIPTION OF BUSINESS We provide integrated software systems and related services for the public sector, with a focus on local governments. We develop and market a broad line of software solutions and services to address the information technology (“IT”) needs of cities, counties, schools and other local government entities. In addition, we provide professional IT services, including software and hardware installation, data conversion, training, and for certain customers, product modifications, along with continuing maintenance and support for customers using our systems. We also provide subscription-based services such as application service provider arrangements and other hosting services as well as property appraisal outsourcing services for taxing jurisdictions. CASH AND CASH EQUIVALENTS Cash in excess of that necessary for operating requirements is invested in short-term, highly liquid, income-producing investments. Investments with original maturities of three months or less are classified as cash and cash equivalents, which primarily consist of money market funds. Cash and cash equivalents are stated at cost, which approximates market value. As of December 31, 2009, we had issued outstanding letters of credit totaling $7.3 million in connection with our surety bond program. These letters of credit have been collateralized by restricted cash balances of $6.0 million and $1.3 million of our available borrowing capacity. We do not believe these letters of credit will be required to be drawn upon. The letters of credit expire through mid-2010. INVESTMENTS Investments consist of auction rate municipal securities. These investments are classified as available-for-sale securities and are stated at fair value in accordance with Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures. Unrealized holding gains and losses, net of the related tax effect, if any, are not reflected in earnings but are reported as a separate component of other comprehensive income until realized. The cost basis of securities sold is the specific cost of the auction rate municipal security. We account for the transactions as “Proceeds from sales of investments” for the security relinquished, and a “Purchases of investments” for the security purchased, in the accompanying Statements of Cash Flows. REVENUE RECOGNITION Software Arrangements: We earn revenue from software licenses, subscriptions, software services, post-contract customer support (“PCS” or “maintenance”), and hardware. PCS includes telephone support, bug fixes, and rights to upgrades on a when-and-if available basis. We provide services that range from installation, training, and basic consulting to software modification and customization to meet specific customer needs. In software arrangements that include rights to multiple software products, specified upgrades, PCS, and/or other services, we allocate the total arrangement fee among each deliverable based on the relative fair value of each. We typically enter into multiple element arrangements, which include software licenses, software services, PCS and occasionally hardware. The majority of our software arrangements are multiple element arrangements, but for those arrangements that involve significant production, modification or customization of the software, or where software services are otherwise considered essential to the functionality of the software in the customer’s environment, we use contract accounting and apply the provisions of the Construction — Type and Production — Type Contracts as discussed in ASC 605-35. If the arrangement does not require significant production, modification or customization or where the software services are not considered essential to the functionality of the software, revenue is recognized when all of the following conditions are met: 44 Tyler Technologies Annual Report 2009 Notes to Financial Statements i. persuasive evidence of an arrangement exists; ii. delivery has occurred; iii. our fee is fixed or determinable; and iv. collectability is probable. For multiple element arrangements, each element of the arrangement is analyzed and we allocate a portion of the total arrangement fee to the elements based on the fair value of the element using vendor-specific objective evidence of fair value (“VSOE”), regardless of any separate prices stated within the contract for each element. Fair value is considered the price a customer would be required to pay if the element was sold separately based on our historical experience of stand-alone sales of these elements to third parties. For PCS, we use renewal rates for continued support arrangements to determine fair value. For software services, we use the fair value we charge our customers when those services are sold separately. We monitor our transactions to insure we maintain and periodically revise VSOE to reflect fair value. In software arrangements in which we have the fair value of all undelivered elements but not of a delivered element, we apply the “residual method”, in compliance with ASC 985-605, Software Revenue Recognition, in accounting for any element of a multiple element arrangement involving software that remains undelivered such that any discount inherent in a contract is allocated to the delivered element. Under the residual method, if the fair value of all undelivered elements is determinable, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered element(s) and is recognized as revenue assuming the other revenue recognition criteria are met. In software arrangements in which we do not have VSOE for all undelivered elements, revenue is deferred until fair value is determined or all elements for which we do not have VSOE have been delivered. Alternatively, if sufficient VSOE does not exist and the only undelivered element is services that do not involve significant modification or customization of the software, the entire fee is recognized over the period during which the services are expected to be performed. Software Licenses We recognize the revenue allocable to software licenses and specified upgrades upon delivery of the software product or upgrade to the customer, unless the fee is not fixed or determinable or collectability is not probable. If the fee is not fixed or determinable, including new customers whose payment terms are three months or more from shipment, revenue is generally recognized as payments become due from the customer. If collectability is not considered probable, revenue is recognized when the fee is collected. Arrangements that include software services, such as training or installation, are evaluated to determine whether those services are essential to the product’s functionality. A majority of our software arrangements involve “off-the-shelf” software. We consider software to be off-the-shelf software if it can be added to an arrangement with minor changes in the underlying code and it can be used by the customer for the customer’s purpose upon installation. For off-the-shelf software arrangements, we recognize the software license fee as revenue after delivery has occurred, customer acceptance is reasonably assured, that portion of the fee represents a non-refundable enforceable claim and is probable of collection, and the remaining services such as training are not considered essential to the product’s functionality. For arrangements that involve significant production, modification or customization of the software, or where software services are otherwise considered essential, we recognize revenue using contract accounting. We generally use the percentage-of- completion method to recognize revenue from these arrangements. We measure progress-to-completion primarily using labor hours incurred, or value added. The percentage-of-completion method generally results in the recognition of reasonably consistent profit margins over the life of a contract because we have the ability to produce reasonably dependable estimates of contract billings and contract costs. We use the level of profit margin that is most likely to occur on a contract. If the most likely profit margin cannot be precisely determined, the lowest probable level of profit in the range of estimates is used until the results can be estimated more precisely. These arrangements are often implemented over an extended time period and occasionally require us to revise total cost estimates. Amounts recognized in revenue are calculated using the progress-to- completion measurement after giving effect to any changes in our cost estimates. Changes to total estimated contract costs, if any, are recorded in the period they are determined. Estimated losses on uncompleted contracts are recorded in the period in which we first determine that a loss is apparent. Tyler Technologies Annual Report 2009 45 Notes to Financial Statements For arrangements that include new product releases for which it is difficult to estimate final profitability except to assume that no loss will ultimately be incurred, we recognize revenue under the completed contract method. Under the completed contract method, revenue is recognized only when a contract is completed or substantially complete. Historically these amounts have been immaterial. Subscription-Based Services Subscription-based services primarily consist of revenues derived from application service provider (“ASP”) arrangements and other hosted service offerings, software subscriptions and disaster recovery services. We recognize revenue for ASP and other hosting services, software subscriptions, term license arrangements with renewal periods of twelve months or less and disaster recovery ratably over the period of the applicable agreement as services are provided. Disaster recovery agreements and other hosting services are typically renewable annually. ASP and software subscriptions are typically for periods of three to six years and automatically renew unless either party cancels the agreement. The majority of the ASP and other hosting services and software subscriptions also include professional services as well as maintenance and support. In certain ASP arrangements, the customer also acquires a license to the software. For ASP and other hosting arrangements, we evaluate whether each of the elements in these arrangements represents a separate unit of accounting, as defined by ASC 605-25, Multiple Element Arrangements and ASC 985-605, Software Revenue Recognition, using all applicable facts and circumstances, including whether (i) we sell or could readily sell the element unaccompanied by the other elements, (ii) the element has stand-alone value to the customer, (iii) there is objective reliable evidence of the fair value of the undelivered item, and (iv) there is a general right of return. We consider the applicability of ASC 605-55-121 and 122 with respect to arrangements that include the right to use software stored on another entity’s hardware on a contract-by-contract basis. In hosted term-based agreements, where the customer does not have the contractual right to take possession of the software, hosting fees are recognized on a monthly basis over the term of the contract commencing when the customer has access to the software. For professional services associated with hosting arrangements that we determine do not have stand-alone value to the customer, we recognize the services revenue ratably over the remaining contractual period once hosting has gone live and we may begin billing for the hosting services. We record amounts that have been invoiced in accounts receivable and in deferred revenue or revenues, depending on whether the revenue recognition criteria have been met. If we determine that the customer has the contractual right to take possession of our software at any time during the hosting period without significant penalty, and can feasibly maintain the software on the customer’s hardware or enter into another arrangement with a third party to host the software, we recognize the license, professional services and hosting services revenues pursuant to ASC 985-605, Software Revenue Recognition. Software Services Some of our software arrangements include services considered essential for the customer to use the software for the customer’s purposes. For these software arrangements, both the software license revenue and the services revenue are recognized as the services are performed using the percentage-of-completion contract accounting method. When software services are not considered essential, the fee allocable to the service element is recognized as revenue as we perform the services. Computer Hardware Equipment Revenue allocable to computer hardware equipment, which is based on VSOE, is recognized when we deliver the equipment and collection is probable. Postcontract Customer Support Our customers generally enter into PCS agreements when they purchase our software licenses. Our PCS agreements are typically renewable annually. Revenue allocated to PCS is recognized on a straight-line basis over the period the PCS is provided. All significant costs and expenses associated with PCS are expensed as incurred. Fair value for the maintenance and support obligations for software licenses is based upon the specific sale renewals to customers. 46 Tyler Technologies Annual Report 2009 Notes to Financial Statements Allocation of Revenue in Statement of Operations In our statement of operations, we allocate revenue to software licenses, software services, maintenance and hardware and other based on the VSOE of fair value for elements in each revenue arrangement and the application of the residual method for arrangements in which we have established VSOE of fair value for all undelivered elements. In arrangements where we are not able to establish VSOE of fair value for all undelivered elements, revenue is first allocated to any undelivered elements for which VSOE of fair value has been established. We then allocate revenue to any undelivered elements for which VSOE of fair value has not been established based upon management’s best estimate of fair value of those undelivered elements and apply a residual method to determine the license fee. Management’s best estimate of fair value of undelivered elements for which VSOE of fair value has not been established is based upon the VSOE of similar offerings and other objective criteria. Appraisal Services: For our property appraisal projects, we recognize revenue using the proportionate performance method of revenue recognition since many of these projects are implemented over one to three year periods and consist of various unique activities. Under this method of revenue recognition, we identify each activity for the appraisal project, with a typical project generally calling for bonding, office set up, training, routing of map information, data entry, data collection, data verification, informal hearings, appeals and project management. Each activity or act is specifically identified and assigned an estimated cost. Costs which are considered to be associated with indirect activities, such as bonding costs and office set up, are expensed as incurred. These costs are typically billed as incurred and are recognized as revenue equal to cost. Direct contract fulfillment activities and related supervisory costs such as data collection, data entry and verification are expensed as incurred. The direct costs for these activities are determined and the total contract value is then allocated to each activity based on a consistent profit margin. Each activity is assigned a consistent unit of measure to determine progress towards completion and revenue is recognized for each activity based upon the percentage complete as applied to the estimated revenue for that activity. Progress for the fulfillment activities is typically based on labor hours or an output measure such as the number of parcel counts completed for that activity. Estimated losses on uncompleted contracts are recorded in the period in which we first determine that a loss is apparent. Other: The majority of deferred revenue consists of unearned support and maintenance revenue that has been billed based on contractual terms in the underlying arrangement with the remaining balance consisting of payments received in advance of revenue being earned under software licensing, subscription-based services, software and appraisal services and hardware installation. Unbilled revenue is not billable at the balance sheet date but is recoverable over the remaining life of the contract through billings made in accordance with contractual agreements. The termination clauses in most of our contracts provide for the payment for the fair value of products delivered and services performed in the event of an early termination. Prepaid expenses and other current assets include direct and incremental costs, consisting primarily of commissions associated with arrangements for which revenue recognition has been deferred and third party subcontractor payments. Such costs are expensed at the time the related revenue is recognized. USE OF ESTIMATES The preparation of our financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include the application of the percentage-of-completion and proportionate performance methods of revenue recognition, the carrying amount and estimated useful lives of intangible assets, determination of share-based compensation expense and valuation allowance for receivables. Actual results could differ from estimates. Tyler Technologies Annual Report 2009 47 Notes to Financial Statements PROPERTY AND EQUIPMENT, NET Property, equipment and purchased software are recorded at original cost and increased by the cost of any significant improvements after purchase. We expense maintenance and repairs when incurred. Depreciation and amortization is calculated using the straight-line method over the shorter of the asset’s estimated useful life or the term of the lease in the case of leasehold improvements. For income tax purposes, we use accelerated depreciation methods as allowed by tax laws. RESEARCH AND DEVELOPMENT COSTS We expensed research and development costs of $11.2 million during 2009, $7.3 million during 2008 and $4.4 million during 2007. We reduced our research and development expense by approximately $3.5 million in 2009, $1.8 million in 2008 and $1.6 million in 2007, which was the amount earned under the terms of our strategic alliance with a development partner. INCOME TAXES Income taxes are accounted for under the asset and liability method. Deferred taxes arise because of different treatment between financial statement accounting and tax accounting, known as “temporary differences.” We record the tax effect of these temporary differences as “deferred tax assets” (generally items that can be used as a tax deduction or credit in the future periods) and “deferred tax liabilities” (generally items that we received a tax deduction for, which have not yet been recorded in the income statement). The deferred tax assets and liabilities are measured using enacted tax rules and laws that are expected to be in effect when the temporary differences are expected to be recovered or settled. A valuation allowance would be established to reduce deferred tax assets if it is likely that a deferred tax asset will not be realized. SHARE-BASED COMPENSATION We have a stock option plan that provides for the grant of stock options to key employees, directors and non-employee consultants. Stock options vest after three to five years of continuous service from the date of grant and have a contractual term of ten years. We account for share-based compensation utilizing the fair value recognition pursuant to ASC 718, Stock Compensation. See Note 10 – “Share-Based Compensation” for further information. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill We have used the purchase method of accounting for all of our business combinations. Our business acquisitions result in the allocation of the purchase price to goodwill and other intangible assets. We first allocate the cost of acquired companies to identifiable assets based on estimated fair values. The excess of the purchase price over the fair value of identifiable assets acquired, net of liabilities assumed, is recorded as goodwill. We review goodwill impairment annually as of April or more frequently whenever events or changes in circumstances indicate its carrying value may not be recoverable. We have identified two reporting units for impairment testing. Our reporting units are the same as our reportable segments and consistent with the reporting units tested for impairment in prior years. Assets, liabilities and goodwill have been assigned to reporting units based on assets acquired and liabilities assumed as of the date of acquisition. The provisions of ASC 350, Intangibles — Goodwill and Other, require that we perform a two-step impairment test on goodwill. In the first step, we compare the fair value of each reporting unit to its carrying value. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not considered impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then we must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds the asset’s implied fair value, then we would record an impairment loss equal to the difference. The fair values calculated in our impairment tests are determined using discounted cash flow models involving several assumptions. These assumptions include, but are not limited to, anticipated operating income growth rates, our long-term anticipated operating income growth rate and the discount rate. Our cash flow forecasts are based on 48 Tyler Technologies Annual Report 2009 Notes to Financial Statements assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. The assumptions that are used are based upon what we believe a hypothetical marketplace participant would use in estimating fair value. We evaluate the reasonableness of the fair value calculations of our reporting units by comparing the total of the fair value of all of our reporting units to our total market capitalization. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. A significant amount of judgment is involved in determining if an indicator of impairment has occurred between testing dates. Such indicators may include, among others: a significant decline in expected future cash flows; a sustained, significant decline in stock price and market capitalization; a significant adverse change in legal factors or in the business climate; unanticipated competition; and reductions in growth rates. In addition, products, capabilities, or technologies developed by others may render our software products obsolete or non-competitive. Any adverse change in these factors could have a significant impact on the recoverability of goodwill. Our annual goodwill impairment analysis, which we performed during the second quarter of 2009, did not result in an impairment charge. Other Intangible Assets We make judgments about the recoverability of purchased intangible assets other than goodwill whenever events or changes in circumstances indicate that an impairment may exist. Customer base constitutes approximately 80% of our purchased intangible assets other than goodwill. We review our customer turnover each year for indications of impairment. Our customer turnover has historically been very low (approximately 2%). If indications of impairment are determined to exist, we measure the recoverability of assets by a comparison of the carrying amount of the asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of the assets exceeds their estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the assets exceeds the fair value of the assets. There have been no significant impairments of intangible assets in any of the periods presented. IMPAIRMENT OF LONG-LIVED ASSETS We periodically evaluate whether current facts or circumstances indicate that the carrying value of our property and equipment or other long-lived assets to be held and used may not be recoverable. If such circumstances are determined to exist, we measure the recoverability of assets to be held and used by a comparison of the carrying amount of the asset or appropriate grouping of assets and the estimated undiscounted future cash flows expected to be generated by the assets. If the carrying amount of the assets exceeds their estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. There have been no significant impairments of long-lived assets in any of the periods presented. COSTS OF COMPUTER SOFTWARE We capitalize software development costs upon the establishment of technological feasibility and prior to the availability f the product for general release to customers. We did not capitalize any software development costs in 2009 or 2008. We capitalized software development costs of approximately $167,000 during 2007. Software development costs primarily consist of personnel costs and rent for related office space. We begin to amortize capitalized costs when a product is available for general release to customers. Amortization expense is determined on a product-by-product basis at a rate not less than straight-line basis over the product’s remaining estimated economic life, but not to exceed five years. Amortization of software development costs was approximately $743,000 in 2009, $4.7 million in 2008, and $4.6 million in 2007, and is included in cost of software license revenue in the accompanying statements of operations. FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and cash equivalents, accounts receivables, accounts payables, short-term obligations, deferred revenues and certain other assets at cost approximate fair value because of the short maturity of these instruments. Our investments available-for- sale are recorded at fair value as of December 31, 2009 based upon the level of judgment associated with the inputs used to measure their fair value. See Note 3 – “Fair Value of Financial Instruments” for further information. Tyler Technologies Annual Report 2009 49 Notes to Financial Statements CONCENTRATIONS OF CREDIT RISK AND UNBILLED RECEIVABLES Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash and cash equivalents, investments in auction rate securities and accounts receivable from trade customers. Our cash and cash equivalents primarily consists of money market fund investments which are maintained at one major financial institution and the balances often exceed insurable amounts. As of December 31, 2009 we had cash and cash equivalents (including restricted cash) of $15.7 million. We perform periodic evaluations of the credit standing of this financial institution. Concentrations of credit risk with respect to receivables are limited due to the size and geographical diversity of our customer base. Historically, our credit losses have not been significant. As a result, we do not believe we have any significant concentrations of credit risk as of December 31, 2009. We maintain allowances for doubtful accounts and sales adjustments, which are provided at the time the revenue is recognized. Since most of our customers are domestic governmental entities, we rarely incur a loss resulting from the inability of a customer to make required payments. Events or changes in circumstances that indicate that the carrying amount for the allowances for doubtful accounts and sales adjustments may require revision, include, but are not limited to, deterioration of a customer’s financial condition, failure to manage our customer’s expectations regarding the scope of the services to be delivered, and defects or errors in new versions or enhancements of our software products. The following table summarizes the changes in the allowances for doubtful accounts and sales adjustments: Years ended December 31, Balance at beginning of year Provisions for losses – accounts receivable Collection of accounts previously written off Deductions for accounts charged off or credits issued Balance at end of year 2009 2008 2007 $ 2,115 1,538 — $ 1,851 1,764 10 $ 2,971 753 — (1,264) (1,510) (1,873) $ 2,389 $ 2,115 $ 1,851 The termination clauses in most of our contracts provide for the payment for the fair value of products delivered or services performed in the event of early termination. Our property appraisal outsourcing service contracts can range up to three years and, in a few cases, as long as five years in duration. In connection with these contracts, as well as certain software service contracts, we may perform work prior to when the software and services are billable and/or payable pursuant to the contract. We have historically recorded such unbilled receivables (costs and estimated profit in excess of billings) in connection with (1) property appraisal services contracts accounted for using proportionate performance accounting in which the revenue is earned based upon activities performed in one accounting period but the billing normally occurs shortly thereafter and may span another accounting period; (2) software services contracts accounted for using the percentage-of-completion method of revenue recognition using labor hours as a measure of progress towards completion in which the services are performed in one accounting period but the billing for the software element of the arrangement may be based upon the specific phase of the implementation; (3) software revenue for which we have objective evidence that the customer-specified objective criteria has been met but the billing has not yet been submitted to the customer; (4) some of our contracts provide for an amount to be withheld from a progress billing (generally a 10% retention) until final and satisfactory project completion is achieved; and (5) in a limited number of cases, we may grant extended payment terms generally to existing customers with whom we have a long-term relationship and favorable collection history. In connection with this activity, we have recorded unbilled receivables of $13.8 million and $11.2 million at December 31, 2009 and 2008, respectively. We also have recorded retention receivable of $4.0 million at both December 31, 2009 and 2008 and these retentions become payable upon the completion of the contract or completion of our field work and formal hearings. Unbilled receivables and retention receivables expected to be collected in excess of one year have been classified as accounts receivable, long-term portion in the accompanying balance sheets. INDEMNIFICATION Most of our software license agreements indemnify our customers in the event that the software sold infringes upon the intellectual property rights of a third party. These agreements typically provide that in such event we will either modify or replace 50 Tyler Technologies Annual Report 2009 Notes to Financial Statements the software so that it becomes non-infringing or procure for the customer the right to use the software. We have recorded no liability associated with these indemnifications, as we are not aware of any pending or threatened infringement actions that are possible losses. We believe the estimated fair value of these intellectual property indemnification clauses is minimal. We have also agreed to indemnify our officers and board members if they are named or threatened to be named as a party to any proceeding by reason of the fact that they acted in such capacity. A form of the indemnification agreement was filed as Exhibit 10.1 to our Form 10-K for the year ended December 31, 2002. We maintain directors’ and officers’ insurance coverage to protect against any such losses. We have recorded no liability associated with these indemnifications. Because of our insurance coverage, we believe the estimated fair value of these indemnification agreements is minimal. NEW ACCOUNTING PRONOUNCEMENTS In September 2009, the Financial Accounting Standards Board issued ASU 2009-13, Multiple Element Arrangements. ASU 2009-13 addresses the determination of when the individual deliverables included in a multiple arrangement may be treated as separate units of accounting. ASU 2009-13 also modifies the manner in which the transaction consideration is allocated across separately identified deliverables and establishes definitions for determining fair value of elements in an arrangement. This new update is effective for fiscal years beginning on or after June 15, 2010. Early adoption is allowed. The new standard may impact our application service provider arrangements to recognize revenues, such as installation and data conversion, which are generally provided at the beginning of the arrangement as incurred instead of ratably over the life of the initial hosting term. The adoption of this standard is not expected to have a material impact on our financial condition or results of operation. (2) ACQUISITIONS On July 16, 2009, we completed the acquisition of certain assets of KPL, Inc. d/b/a Parker-Lowe & Associates (“Parker- Lowe”) for $700,000 in cash. Parker-Lowe provides scanning and retrieval software and related services for land record and social services offices in local governments primarily in the North Carolina area. This acquisition was accounted for as a purchase of a business. On April 3, 2009, we completed the acquisition of all of the capital stock of Assessment Evaluation Services, Inc. (“AES”). AES develops integrated property appraisal solutions and specializes in applications that deal with the unique provisions of the California Revenue and Taxation Code. The purchase price was approximately $1.1 million in cash. In connection with these transactions we acquired total tangible assets of approximately $480,000 and assumed total liabilities of approximately $835,000, including $450,000 for contingent consideration for which we have paid $38,000 as of December 31, 2009. The remaining contingent consideration is expected to be paid over the next two years. We recorded goodwill of approximately $1.3 million, all of which is expected to be deductible for tax purposes, and other intangible assets of approximately $820,000. The $820,000 of intangible assets is attributable to acquired software and customer relationships that will be amortized over a weighted average period of approximately 9 years. Our balance sheet as of December 31, 2009 reflects the allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the dates of acquisition. The operating results of these acquisitions are included in our results of operations since the date of acquisition. We believe these acquisitions will complement our business by expanding our presence in certain geographic areas and adding to our customer base. In 2009, we also paid approximately $1.1 million for certain software assets to complement our tax and appraisal solutions and our student information management solutions. In August 2008, we completed the acquisition of all the capital stock of School Information Systems, Inc., which develops and sells a full suite of student information and financial management systems for K-12 schools. The purchase price, including transaction costs and excluding cash balances acquired, was approximately $9.9 million in cash and approximately 70,000 shares of Tyler common stock valued at $1.2 million. Tyler Technologies Annual Report 2009 51 Notes to Financial Statements In the first quarter of 2008, we completed the acquisitions of all of the capital stock of VersaTrans Solutions Inc. (“VersaTrans”) and certain assets of Olympia Computing Company, Inc. d/b/a Schoolmaster (“Schoolmaster”). VersaTrans is a provider of student transportation management software solutions for school districts and school transportation providers across North America, including solutions for school bus routing and planning, redistricting, GPS fleet tracking, fleet maintenance and field trip planning. Schoolmaster provides a full suite of student information systems, which manage such functions as grading, attendance, scheduling, guidance, health, admissions and fund raising. The combined purchase price for these transactions excluding cash acquired and including transaction costs was approximately $13.9 million in cash and approximately 126,000 shares of Tyler common stock valued at $1.7 million. In September 2007, we completed the acquisition of all the capital stock of EDP Enterprises, Inc. (“EDP”), which develops and sells financial and student information and management systems for public school districts in Texas. In February 2007, we completed the acquisition of all of the capital stock of Advanced Data Systems, Inc. (“ADS”), which develops and sells fund accounting solutions, primarily in New England. The combined purchase price, including transaction costs along with an office building used in ADS’s business and excluding cash balances acquired, for these acquisitions as well as miscellaneous other software asset purchases was $9.0 million. (3) FAIR VALUE OF FINANCIAL INSTRUMENTS Assets recorded at fair value in the balance sheet as of December 31, 2009 are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by ASC 820, Fair Value Measurements and Disclosures, are directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets, are as follows: Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date; Level 2 – Inputs other than Level 1 inputs that are either directly or indirectly observable; and Level 3 – Unobservable inputs, for which little or no market data exist, therefore requiring an entity to develop its own assumptions. As of December 31, 2009 we held certain items that are required to be measured at fair value on a recurring basis. The following tables summarize the fair value of these financial assets: December 31, 2009 Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total $ 15,696 $ 15,696 $ — $ — 50 1,976 $ 17,722 50 — — — $ 15,746 $ — — 1,976 $ 1,976 December 31, 2008 Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total $ 6,844 $ 6,844 $ — $ — 775 3,779 $ 11,398 775 — — — $ 7,619 $ — — 3,779 $ 3,779 Cash and cash equivalents Short-term investments available-for-sale Non-current investments available-for-sale Cash and cash equivalents Short-term investments available-for-sale Non-current investments available-for-sale 52 Tyler Technologies Annual Report 2009 Notes to Financial Statements Cash and cash equivalents consist primarily of money market funds with original maturity dates of three months or less, for which we determine fair value through quoted market prices. These money market funds did not experience any declines in fair value in 2009. Investments available-for-sale consist of two auction rate municipal securities (“ARS”) which are collateralized debt obligations supported by municipal and state agencies and do not include mortgage-backed securities. Short-term investments available- for-sale consists of the portion of one of these ARS, which was partially redeemed at par during the period January 1, 2010 through February 22, 2010. These ARS are debt instruments with stated maturities ranging from 22 to 33 years, for which the interest rate is designed to be reset through Dutch auctions approximately every 30 days. However, due to events in the credit markets, auctions for these securities have not occurred since February 2008. Both of our ARS have had very small partial redemptions at par in the period from July 2009 through February 2010. As of December 31, 2009 we have continued to earn and collect interest on both of our ARS. Because quoted prices in active markets are no longer available we determined the estimated fair values of these securities utilizing a discounted trinomial model. The model considers the probability of three potential occurrences for each auction event through the maturity date of each ARS. The three potential outcomes for each auction are (i) successful auction/early redemption, (ii) failed auction and (iii) issuer default. Inputs in determining the probabilities of the potential outcomes include but are not limited to, the securities’ collateral, credit rating, insurance, issuer’s financial standing, contractual restrictions on disposition and the liquidity in the market. The fair value of each ARS is determined by summing the present value of the probability-weighted future principal and interest payments determined by the model. Since there can be no assurances that auctions for these securities will be successful in the near future, we have classified our ARS as non-current investments. The par and carrying values, and related cumulative unrealized loss for our non-current ARS as of December 31, 2009 are as follows: Non-current investments available-for-sale Par Value Temporary Impairment Carrying Value $ 2,600 $ 624 $ 1,976 In association with this estimate of fair value, we have recorded an after-tax temporary unrealized loss on our non-current ARS of $18,000, net of related tax effects of $10,000 in 2009, which is included in accumulated other comprehensive loss on our balance sheet. The unrealized loss includes the impact of adjusting previously recorded unrealized losses of approximately $120,000, net of related tax effects of $65,000 as of December 31, 2008 for several ARS which were subsequently redeemed for $2.5 million at par during 2009. We consider the impairment in our ARS as temporary because we do not have the intent to sell, nor is it more-likely-than-not that we will be required to sell these securities before recovery of their cost basis. We believe that this temporary decline in fair value is due entirely to liquidity issues, because the underlying assets of these securities are supported by municipal and state agencies and do not include mortgage-backed securities, have redemption features which call for redemption at 100% of par value and have a current credit rating of A or AAA. The ratings on the ARS take into account credit support through insurance policies guaranteeing each of the bonds’ payment of principal and accrued interest, if it becomes necessary. In addition, both ARS have had very small partial redemptions at par in the period July 2009 through February 2010. Based on our cash and cash equivalents balance of $15.7 million and expected operating cash flows, we do not believe a lack of liquidity associated with our ARS will adversely affect our ability to conduct business, and believe we have the ability to hold the securities throughout the currently estimated recovery period. We will continue to evaluate any changes in the market value of our ARS and in the future, depending upon existing market conditions, we may be required to record an other-than- temporary decline in market value. Tyler Technologies Annual Report 2009 53 Notes to Financial Statements The following table reflects the activity for assets measured at fair value using Level 3 inputs for the years ended December 31: Balance as of December 31, 2007 Transfers into level 3 Transfers out of level 3 Unrealized losses included in accumulated other comprehensive loss Balance as of December 31, 2008 Transfers into level 3 Transfers out of level 3 Purchases, sales, issuances and settlements Unrealized losses included in accumulated other comprehensive loss Balance as of December 31, 2009 (4) PROPERTY AND EQUIPMENT, NET Property and equipment, net consists of the following at December 31: Land Computer equipment and purchased software Furniture and fixtures Building and leasehold improvements Transportation equipment Accumulated depreciation and amortization Property and equipment, net $ — 5,150 (775) (596) 3,779 — (75) (1,700) (28) $ 1,976 Useful Lives (years) 2009 2008 — 3–5 5 $ 3,349 21,394 6,467 $ 3,349 19,553 5,103 5–39 26,208 16,248 5 329 266 57,747 44,519 (21,997) (17,997) $ 35,750 $ 26,522 Depreciation expense was $4.4 million during 2009, $3.5 million during 2008, and $2.8 million during 2007. We own an office building in Yarmouth, Maine, which is leased to third-party tenants and a building in Lubbock, Texas, for which a small portion is leased to a third-party tenant. These leases expire between 2011 and 2015 and are expected to provide rental income of approximately $1.5 million during 2010, $1.1 million during 2011, $628,000 during 2012, $391,000 during 2013, $222,000 during 2014 and $74,000 thereafter. The lease agreements in Yarmouth, Maine, expire between 2011 and 2013, at which time we expect to begin occupying the facility. Rental income associated with these leases was $1.3 million and $662,000 in 2009 and 2008, respectively and was included as a reduction of selling, general and administrative expenses. (5) GOODWILL AND OTHER INTANGIBLE ASSETS Intangible assets and related accumulated amortization consists of the following at December 31: Gross carrying amount of acquisition intangibles: Goodwill Customer related intangibles Software acquired Trade name Lease acquired Accumulated amortization Acquisition intangibles, net Post acquisition software development costs Accumulated amortization Post acquisition software costs, net 54 Tyler Technologies Annual Report 2009 2009 2008 $ 90,258 $ 88,791 39,512 38,887 23,403 22,143 1,971 1,387 1,971 1,387 156,531 153,179 (35,217) (30,825) $ 121,314 $ 122,354 $ 36,701 $ 36,701 (35,986) (35,243) $ 715 $ 1,458 Notes to Financial Statements Total amortization expense, for acquisition related intangibles and post acquisition software development costs, was $5.1 million during 2009, $9.1 million during 2008, and $8.4 million during 2007. The allocation of acquisition intangible assets is summarized in the following table: Non-amortizable intangibles: Goodwill Amortizable intangibles: Customer related intangibles Software acquired Trade name Lease acquired December 31, 2009 December 31, 2008 Gross Carrying Amount Weighted Average Amortization Period Accumulated Amortization Gross Carrying Amount Weighted Average Amortization Period Accumulated Amortization $ 90,258 — $ — $ 88,791 — $ — 39,512 23,403 1,971 1,387 18 years 5 years 19 years 5 years 14,022 19,900 879 416 38,887 22,143 1,971 1,387 18 years 5 years 19 years 5 years 11,449 18,489 749 138 The changes in the carrying amount of goodwill for the two years ended December 31, 2009 are as follows: Balance as of December 31, 2007 Goodwill acquired during the year related to the purchase of VersaTrans Goodwill acquired during the year related to the purchase of SIS Goodwill acquired during the year related to the purchase of Schoolmaster Other Balance as of December 31, 2008 Goodwill acquired during the year related to the purchase of AES Goodwill acquired during the year related to the purchase of Parker-Lowe Other Balance as of December 31, 2009 Enterprise Software Solutions Appraisal and Tax Software Solutions and Services $ 66,966 $ 4,711 9,278 6,351 1,475 10 — — — — Total $ 71,677 9,278 6,351 1,475 10 84,080 4,711 88,791 — 430 158 879 — — 879 430 158 $ 84,668 $ 5,590 $ 90,258 Estimated annual amortization expense relating to acquisition intangibles, including acquired software for which the amortization expense is recorded as cost of revenues and acquired leases for which amortization expense is recorded as selling, general and administrative expenses, is as follows: Years ending December 31, 2010 2011 2012 2013 2014 (6) ACCRUED LIABILITIES Accrued liabilities consist of the following at December 31: Accrued wages, bonuses and commissions Other accrued liabilities Accrued building construction costs Accrued health claims Accrued third party contract costs $4,387 3,805 3,538 2,973 2,498 2009 2008 $ 15,945 5,378 1,816 1,551 1,420 $ 26,110 $ 13,908 5,737 — 1,921 1,347 $ 22,913 Tyler Technologies Annual Report 2009 55 Notes to Financial Statements (7) SHORT-TERM REVOLVING LINE OF CREDIT In October 2008, we entered into a revolving bank credit agreement (the “Credit Facility”) and a related pledge and security agreement which originally matured October 19, 2009. We amended and extended the related pledge and security agreement in October 2009. The Credit Facility matures October 18, 2010 and provides for total borrowings of up to $25.0 million and a $10.0 million Letter of Credit facility which can either be cash collateralized or issued using availability under the Credit Facility. Borrowings under the Credit Facility bear interest at a rate of either the Wall Street Journal prime rate minus .5% or the 30, 60 or 90-day LIBOR rate plus 2%; however, a minimum interest rate of 3.25% will apply. As of December 31, 2009, our effective interest rate was 3.25% under the Credit Facility. The effective average interest rate for borrowings during the twelve months ended December 31, 2009 was 1.8%. The Credit Facility is secured by substantially all of our assets. The Credit Facility requires us to maintain certain financial ratios and other financial conditions and prohibits us from making certain investments, advances, cash dividends or loans, restricts the amount of our common stock we may purchase and limits incurrence of additional indebtedness and liens. As of December 31, 2009, we were in compliance with those covenants. As of December 31, 2009, we had no outstanding borrowings and unused available borrowing capacity of $23.7 million under the Credit Facility. In addition, as of December 31, 2009, our bank had issued outstanding letters of credit totaling $7.3 million to secure surety bonds required by some of our customer contracts. These letters of credit have been collateralized by restricted cash balances of $6.0 million and $1.3 million of our available borrowing capacity and expire through mid-2010. The carrying amount of the Credit Facility approximates fair value due to the short-term nature of the instrument. We paid interest of $174,000 in 2009. (8) INCOME TAX The income tax provision (benefit) on income from operations consists of the following: Years ended December 31, 2009 2008 2007 Current: Federal State Deferred $ 16,822 2,536 19,358 $ 14,320 2,245 16,565 $ 10,593 2,084 12,677 (1,730) (2,151) (1,598) $ 17,628 $ 14,414 $ 11,079 Reconciliation of the U.S. statutory income tax rate to our effective income tax expense rate for operations follows: Years ended December 31, Income tax expense at statutory rate State income tax, net of federal income tax benefit Non-deductible business expenses Qualified manufacturing activities Other, net 2009 2008 2007 $ 15,623 1,634 965 (586) (8) $ 10,247 1,089 3,988 (700) (210) $ 10,003 1,321 608 (490) (363) $ 17,628 $ 14,414 $ 11,079 In 2008, non-deductible business expenses included the impact of a non-cash legal settlement related to warrants charge of $9.0 million, which was not tax deductible. See Note 14 – “Commitments and Contingencies” for more information. Approximately 40% of our unvested stock option awards qualify as incentive stock options (“ISOs”) for income tax purposes. As such, a tax benefit is not recorded at the time the compensation cost related to the options is recorded for book purposes due to the fact that an ISO does not ordinarily result in a tax benefit unless there is a disqualifying disposition. Stock option grants of non-qualified options result in the creation of a deferred tax asset, which is a temporary difference, until the time that the option is exercised. Due to the treatment of ISOs for tax purposes, our effective tax rate from year to year is subject to variability. 56 Tyler Technologies Annual Report 2009 The tax effects of the major items recorded as deferred tax assets and liabilities as of December 31 are: Notes to Financial Statements Deferred income tax assets: Operating expenses not currently deductible Employee benefit plans Capital loss carryforward Property and equipment Total deferred income tax assets Deferred income tax liabilities: Intangible assets Other Total deferred income tax liabilities Net deferred income tax liabilities 2009 2008 $ 2,068 3,628 230 230 $ 1,466 2,528 221 203 6,156 4,418 (9,720) (9,697) (157) (9,877) $ (3,721) (181) (9,878) $ (5,460) Although realization is not assured, we believe it is more likely than not that all the deferred tax assets at December 31, 2009 and 2008 will be realized. Accordingly, we believe no valuation allowance is required for the deferred tax assets. However, the amount of the deferred tax asset considered realizable could be adjusted in the future if estimates of reversing taxable temporary differences are revised. No reserves for uncertain income tax positions have been recorded pursuant to ASC 740-10, Income Taxes. We are subject to U.S. federal tax as well as income tax of multiple state and local jurisdictions. We are no longer subject to United States federal income tax examinations for years before 2006. We are no longer subject to state and local income tax examinations by tax authorities for the years before 2004. We paid income taxes, net of refunds received, of $18.1 million in 2009, $15.7 million in 2008, and $8.7 million in 2007. (9) SHAREHOLDERS’ EQUITY The following table details activity in our common stock: Years ended December 31, 2009 2008 2007 Shares Amount Shares Amount Shares Amount Purchases of common stock (1,235) $ (17,000) (4,283) $ (58,984) (1,250) $ (16,163) Stock option exercises Employee stock plan purchases Shares issued for acquisitions Shares issued in connection with legal settlement 425 115 — — 2,295 1,428 — — 379 101 196 802 1,815 1,190 2,863 11,050 878 100 — — 3,589 1,117 — — Subsequent to December 31, 2009 and through February 22, 2010, we repurchased 59,000 shares for an aggregate purchase price of $1.1 million. As of February 22, 2010 we had authorization from our board of directors to repurchase up to 2.2 million additional shares of our common stock. In 2008, we settled outstanding litigation related to two Stock Purchase Warrants owned by Bank of America, N. A. (“BANA”). In July 2008, as a result of this settlement, BANA paid us $2.0 million and we issued to BANA 801,883 restricted shares of Tyler common stock. See Note 14 – “Commitments and Contingencies” for further information. (10) SHARE-BASED COMPENSATION Share-Based Compensation Plan We have a stock option plan that provides for the grant of stock options to key employees, directors and non-employee consultants. Stock options vest after three to five years of continuous service from the date of grant and have a contractual Tyler Technologies Annual Report 2009 57 Notes to Financial Statements term of ten years. Once options become exercisable, the employee can purchase shares of our common stock at the market price on the date we granted the option. We account for share-based compensation utilizing the fair value recognition pursuant to ASC 718, Stock Compensation. As of December 31, 2009, there were 176,000 shares available for future grants under the plan from the 11.0 million shares previously approved by the stockholders. Determining Fair Value of Stock Compensation Valuation and Amortization Method. We estimate the fair value of share-based awards granted using the Black-Scholes option valuation model. We amortize the fair value of all awards on a straight-line basis over the requisite service periods, which are generally the vesting periods. Expected Life. The expected life of awards granted represents the period of time that they are expected to be outstanding. As provided by ASC 718-10, Stock Compensation, we use the “simplified” method which is allowed for those companies that cannot reasonably estimate expected life of options based on its historical share option exercise experience. We use the “simplified” method to estimate expected life due to insufficient historical exercise data for the current optionee group. In 2005 we established a practice of granting options to a consistent optionee group. This optionee group has not been in place long enough to generate sufficient historical data to estimate the expected period of time an option award would be expected to be outstanding. Expected Volatility. Using the Black-Scholes option valuation model, we estimate the volatility of our common stock at the date of grant based on the historical volatility of our common stock. Risk-Free Interest Rate. We base the risk-free interest rate used in the Black-Scholes option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award. Expected Dividend Yield. We have not paid any cash dividends on our common stock in the last ten years and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. Expected Forfeitures. We use historical data to estimate pre-vesting option forfeitures. We record stock-based compensation only for those awards that are expected to vest. The following weighted average assumptions were used for options granted: Years ended December 31, Expected life (in years) Expected volatility Risk-free interest rate Expected forfeiture rate 2009 6.5 2008 6.5 2007 6.5 37.2% 40.9% 42.6% 3.1% 3% 3.5% 3% 4.5% 3% The following table summarizes share-based compensation expense related to share-based awards which is recorded in the statement of operations: Years ended December 31, Cost of software services, maintenance and subscriptions Selling, general and administrative expense Total share-based compensation expense Tax benefit Net decrease in net income 58 Tyler Technologies Annual Report 2009 2009 2008 2007 $ 540 4,505 5,045 (1,233) $ 3,812 $ 364 3,456 3,820 (846) $ 2,974 $ 227 2,138 2,365 (451) $ 1,914 Stock Option Activity Options granted, exercised, forfeited and expired are summarized as follows: Outstanding at December 31, 2006 Granted Exercised Forfeited Outstanding at December 31, 2007 Granted Exercised Forfeited Outstanding at December 31, 2008 Granted Exercised Forfeited Outstanding at December 31, 2009 Exercisable at December 31, 2009 Notes to Financial Statements Weighted Average Exercise Price Weighted Average Remaining Contractual Life (Years) Aggregate Intrinsic Value $ 5.32 13.42 4.09 8.29 7.16 14.38 4.79 10.82 9.69 17.25 5.40 7.80 Number of Shares 4,087 773 (878) (10) 3,972 1,750 (379) (34) 5,309 835 (425) (15) 5,704 2,765 11.12 $ 7.50 7 5 $ 50,139 $ 34,314 As of December 31, 2009, we had unvested options to purchase 2.9 million shares with a weighted average grant date fair value of $6.70. As of December 31, 2009, we had $15.8 million of total unrecognized compensation cost related to unvested options, net of expected forfeitures, which is expected to be amortized over a weighted average amortization period of 3.6 years. Other information pertaining to option activity was as follows during the twelve months ended December 31: Weighted average grant-date fair value of stock options granted Total fair value of stock options vested Total intrinsic value of stock options exercised 2009 2008 2007 $ 7.38 4,346 4,656 $ 6.73 2,600 3,929 $ 6.69 1,710 8,793 Employee Stock Purchase Plan Under our Employee Stock Purchase Plan (“ESPP”) participants may contribute up to 15% of their annual compensation to purchase common shares of Tyler. The purchase price of the shares is equal to 85% of the closing price of Tyler shares on the last day of each quarterly offering period. As of December 31, 2009, there were 341,000 shares available for future grants under the ESPP from the 1.0 million shares originally reserved for issuance. (11) EARNINGS PER SHARE Basic earnings and diluted earnings per share data were computed as follows: Years Ended December 31, 2009 2008 2007 Numerator for basic and diluted earnings per share Net income Denominator: Weighted-average basic common shares outstanding Assumed conversion of dilutive securities: Stock options Warrants Potentially dilutive common shares Denominator for diluted earnings per share – Adjusted weighted-average shares Earnings per common share: Basic Diluted $ 27,010 $ 14,862 $ 17,501 35,240 37,714 38,735 1,384 1,470 1,715 — 1,384 36,624 — 1,470 39,184 902 2,617 41,352 $ 0.77 $ 0.74 $ 0.39 $ 0.38 $ 0.45 $ 0.42 Tyler Technologies Annual Report 2009 59 Notes to Financial Statements Stock options representing the right to purchase common stock of 2.6 million shares in 2009, 1.6 million shares in 2008, and 128,000 shares in 2007 were not included in the computation of diluted earnings per share because their inclusion would have had an anti-dilutive effect. (12) LEASES We lease office facilities for use in our operations, as well as transportation, computer and other equipment. We also have an office facility lease agreement with a shareholder. Most of our leases are non-cancelable operating lease agreements and they expire at various dates through 2014. In addition to rent, the leases generally require us to pay taxes, maintenance, insurance and certain other operating expenses. Rent expense was approximately $6.3 million in 2009, $5.9 million in 2008, and $4.9 million in 2007, which included rent expense associated with related party lease agreements of $2.0 million in 2009 and $1.8 million in both 2008 and 2007. Future minimum lease payments under all non-cancelable leases at December 31, 2009 are as follows: Years ending December 31, 2010 2011 2012 2013 2014 Thereafter $ 6,033 5,265 3,954 2,365 1,721 — $ 19,338 Included in future minimum lease payments are non-cancelable payments due to related parties of $1.9 million in 2010, $1.8 million in 2011, $1.7 million in 2012, $1.7 million in 2013, $1.7 million in 2014 and none thereafter. (13) EMPLOYEE BENEFIT PLANS We provide a defined contribution plan for the majority of our employees meeting minimum service requirements. The employees can contribute up to 30% of their current compensation to the plan subject to certain statutory limitations. We contribute up to a maximum of 3% of an employee’s compensation to the plan. We made contributions to the plan and charged operations $2.6 million during 2009, $2.0 million during 2008, and $1.7 million during 2007. (14) COMMITMENTS AND CONTINGENCIES On November 3, 2008, a putative collective action complaint was filed against us in the United States District Court for the Eastern District of Texas (the “Court”) on behalf of current and former telephone and remote customer support personnel (“Category 1”), computer hardware and software set up and maintenance personnel (“Category 2”), implementation personnel (“Category 3”), sales support personnel (“Category 4”), and quality assurance analysts (“Category 5”). The petition alleges that we misclassified these groups of employees as “exempt” rather than “non-exempt” under the Fair Labor Standards Act and that we therefore failed to properly pay overtime wages. The suit was initiated by six former employees working out of our Longview, Texas, office and seeks to recover damages in the form of lost overtime pay, liquidated damages equal to the amount of lost overtime pay, interest, costs, and attorneys’ fees. On June 23, 2009, the Court issued an Order granting Plaintiffs’ motion for conditional certification for the purpose of providing notice to potential plaintiffs about the litigation. Accordingly, the plaintiffs sent the court ordered notice to all current and former employees who worked in the foregoing job classifications at any time from June 23, 2006 until June 23, 2009. On October 26, 2009, the “opt in” period for plaintiffs and potential plaintiffs closed. There are a total of 78 plaintiffs in the litigation consisting of the following: 31 in Category 1; 4 in Category 2; 39 in Category 3; 2 in Category 4; and 2 in Category 5. We intend to vigorously defend the action. Given the preliminary nature of the alleged claims and the inherent unpredictability of litigation, we cannot at this time estimate the possible outcome of any such action. 60 Tyler Technologies Annual Report 2009 Notes to Financial Statements On June 27, 2008, we settled outstanding litigation related to two Stock Purchase Warrants (the “Warrants”) owned by Bank of America, N. A. (“BANA”). As disclosed in prior SEC filings, the Warrants entitled BANA to acquire 1.6 million shares of Tyler common stock at an exercise price of $2.50 per share. The Warrants expired on September 10, 2007. Prior to their expiration, BANA attempted to exercise the Warrants; however, the parties disputed whether or not BANA’s exercise was effective. We filed suit for declaratory judgment seeking a court’s determination on the matter, and BANA asserted numerous counterclaims against us, including breach of contract and misrepresentation. Following court-ordered mediation, in July 2008, BANA paid us $2.0 million and we issued to BANA 801,883 restricted shares of Tyler common stock. Accordingly, as a result of the settlement, we recorded a non-cash legal settlement related to warrants charge of $9.0 million, which was not tax deductible. Other than ordinary course, routine litigation incidental to our business and except as described in this Annual Report, there are no material legal proceedings pending to which we are party or to which any of our properties are subject. (15) SUBSEQUENT EVENTS On January 6, 2010, we acquired all the assets of Wiznet, Inc. (“Wiznet”) for a cash purchase price of $9.5 million. Wiznet provides electronic document filing solutions for courts and law offices throughout the United States and is currently integrated with our primary courts and justice applications. We have not finalized the allocation of the purchase price. We evaluate events and transactions that occur after the balance sheet date as potential subsequent events. We performed this evaluation through February 25, 2010, the date on which we issued our financial statements. (16) SEGMENT AND RELATED INFORMATION We are a major provider of integrated information management solutions and services for the public sector, with a focus on local governments. Factors used to identify our reportable operating segments include the financial information regularly utilized for evaluation by our chief operating decision-maker (CODM) in making decisions about how to allocate resources and in assessing our performance. We have determined that our CODM is our Chief Executive Officer. We provide our software systems and services and appraisal services through four business units: • financial management and education software solutions; • financial management and municipal courts and justice software solutions; • courts and justice software solutions; and • appraisal and tax software solutions and property appraisal services. Historically, we have reported one segment. In 2009 we reexamined the economics of our businesses, and found that the financial metrics for our appraisal and tax software solutions and services unit were becoming dissimilar from our enterprise software solutions units. Accordingly, we now report two segments: (1) Enterprise Software Solutions and (2) Appraisal and Tax Software Solutions and Services. In accordance with ASC 280-10, Segment Reporting, the financial management and education software solutions unit, financial management and municipal courts and justice software solutions unit and the courts and justice software solutions unit meet the criteria for aggregation and are presented in one segment, “Enterprise Software Solutions.” The Enterprise Software Solutions segment provides municipal and county governments and schools with software systems to meet their information technology and automation needs for mission-critical “back-office” functions such as financial management and courts and justice processes. The Appraisal and Tax Software Solutions and Services segment provides systems and software that automate the appraisal and assessment of real and personal property as well as property appraisal outsourcing services for local governments and taxing authorities. Property appraisal outsourcing services include: the physical inspection of commercial and residential properties; data collection and processing; computer analysis for property valuation; preparation of tax rolls; community education; and arbitration between taxpayers and the assessing jurisdiction. We evaluate performance based on several factors, of which the primary financial measure is business segment operating income. We define segment operating income as income before noncash amortization of intangible assets associated with their acquisition, share-based compensation expense, interest expense and income taxes. Segment operating income includes Tyler Technologies Annual Report 2009 61 Notes to Financial Statements intercompany transactions. The majority of intercompany transactions relate to contracts involving more than one unit and are valued based on the contractual arrangement. Segment operating income for corporate primarily consists of compensation costs for the executive management team and certain accounting and administrative staff and share-based compensation expense for the entire company. The accounting policies of the reportable segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” Segment assets include net accounts receivable, prepaid expenses and other current assets, net property and equipment and intangibles associated with their acquisition. Corporate assets consist of cash and investments, prepaid insurance, deferred income taxes and net property and equipment mainly related to unallocated information and technology assets. Enterprise Software Solutions segment capital expenditures in 2009 and 2008 include $11.2 million and $16.0 million, respectively for the purchase of buildings in connection with plans to consolidate workforces and support long-term growth. 2009 capital expenditures include a $1.8 million accrued retainage payment we expect to pay by mid-2010. In 2009 and 2008 the Appraisal and Tax Software Solutions and Services segment had one appraisal services customer which accounted for 10.4% and 12.6%, respectively, of this segment’s total revenues. As of and year ended December 31, 2009 Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Corporate Totals Revenues Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Intercompany Total revenues $ 39,910 $ 2,221 $ 311 9,229 10,275 18,740 16,870 71,176 114,237 — 6,248 1,618 — — 1,069 (1,618) — — — — — $ 42,131 17,181 80,405 124,512 18,740 7,317 — $ 250,059 $ 40,776 $ (549) $ 290,286 Depreciation and amortization expense 8,031 608 858 9,497 55,639 6,949 (13,688) 48,900 13,361 192 614 $ 220,135 $ 25,597 $ 24,938 14,167 $ 270,670 Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Corporate Totals $ 39,936 $ 1,554 $ 14,352 65,906 98,383 — 6,354 956 22 9,091 9,075 19,098 26 2 $ 225,887 $ 38,868 $ 11,596 510 — — — — — 1,304 (958) 346 505 $ 41,490 14,374 74,997 107,458 19,098 7,684 — $ 265,101 12,611 47,698 5,448 (11,769) 41,377 17,563 420 2,160 $ 208,868 $ 24,409 $ 18,484 20,143 $ 251,761 Segment operating income Capital expenditures Segment assets As of and year ended December 31, 2008 Revenues Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Intercompany Total revenues Depreciation and amortization expense Segment operating income Capital expenditures Segment assets 62 Tyler Technologies Annual Report 2009 As of and year ended December 31, 2007 Revenues Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Intercompany Total revenues Notes to Financial Statements Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Corporate Totals $ 33,789 $ 1,274 $ 10,406 52,784 77,012 — 7,294 780 — 7,499 8,399 21,318 21 138 — — — — — — (918) $ 35,063 10,406 60,283 85,411 21,318 7,315 — $ 182,065 $ 38,649 $ (918) $ 219,796 Depreciation and amortization expense 10,310 542 359 11,211 Segment operating income Capital expenditures Segment assets 34,833 5,040 (9,336) 30,537 2,449 412 817 3,678 $ 157,981 $ 22,869 $ 60,658 $ 241,508 Reconciliation of reportable segment operating income to the Company’s consolidated totals: Total segment operating income Amortization of acquired software Amortization of customer and trade name intangibles Non-cash legal settlement related to warrants Other (expense) income Income before income taxes 2009 2008 2007 $ 48,900 $ 41,377 $ 30,537 (1,411) (1,799) (2,705) (2,438) — (9,045) (146) $ 44,638 1,181 $ 29,276 (2,279) (1,478) — 1,800 $ 28,580 (17) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following table contains selected financial information from unaudited statements of operations for each quarter of 2009 and 2008. 2009 2008 Quarters Ended Dec. 31 Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 (A) Mar. 31 Revenues Gross profit $ 74,217 $ 74,332 $ 72,172 $ 69,565 $ 69,544 $ 68,637 $ 67,569 $ 59,351 33,239 33,235 31,997 30,292 28,945 29,950 29,089 21,803 Income before income taxes 10,922 12,421 11,334 9,961 9,845 12,335 2,026 5,070 Net income 6,656 7,475 6,873 6,006 5,131 6,359 Earnings per diluted share 0.18 0.20 0.19 0.16 0.14 0.16 246 0.01 3,126 0.08 Shares used in computing diluted earnings per share 36,600 36,487 36,723 36,747 37,604 40,019 39,633 39,527 (A) On June 27, 2008, we settled outstanding litigation related to two Stock Purchase Warrants (the “Warrants”) owned by Bank of America, N. A. (“BANA”). The Warrants entitled BANA to acquire 1.6 million shares of Tyler common stock at an exercise price of $2.50 per share. Following court-ordered mediation, in July 2008, BANA paid us $2.0 million and we issued to BANA 801,883 restricted shares of Tyler common stock. Accordingly, we recorded a non-cash legal settlement related to warrants charge of $9.0 million, which was not tax deductible, during the three months ended June 30, 2008. Tyler Technologies Annual Report 2009 63 Performance Graph The following table compares total Shareholder returns for Tyler over the last five years to the Standard and Poor’s 500 Stock Index and the Standard and Poor’s 600 Information Technology Index assuming a $100 investment made on December 31, 2004. Each of the three measures of cumulative total return assumes reinvestment of dividends. The stock performance shown on the graph below is not necessarily indicative of future price performance. COMPARISON OF CUMULATIVE FIVE YEAR TOTAL RETURN $250 $200 $150 $100 $50 $0 2004 2005 2006 2007 2008 2009 100 100 100 105.02 104.91 99.76 168.18 121.48 109.17 154.19 128.16 119.32 143.30 80.74 71.15 238.16 102.11 105.41 Tyler Technologies, Inc. S&P 500 Index S&P 600 Information Technology Index 64 Tyler Technologies Annual Report 2009 Corporate Headquarters 5949 Sherry Lane Suite 1400 Dallas, Texas 75225 972.713.3700 www.tylertech.com Transfer Agent and Registrar American Stock Transfer & Trust Company 59 Maiden Lane Plaza Level New York, New York 10038 800.937.5449 tel 718.236.2641 fax www.amstock.com Independent Registered Public Accounting Firm Ernst & Young LLP Dallas, Texas Annual Meeting of Stockholders Our Annual Meeting will be held on Thursday, May 13, 2010, at 9:30 a.m. Central time at The Park City Club, 5956 Sherry Lane, Suite 1700, Dallas, Texas 75225. Certifications We submitted an unqualified Annual CEO Certification to the New York Stock Exchange (NYSE) as required by the NYSE Listed Company rules. We also filed with the Securities and Exchange Commission the Chief Executive Officer and Chief Financial Officer certifications required under Section 302 of the Sarbanes-Oxley Act as exhibits to our Annual Report on Form 10-K. Investor Information Our Annual Report on Form 10-K is available on the Company’s website at www.tylertech.com. A copy of the Form 10-K or other information may also be obtained by contacting the Investor Relations Department at corporate headquarters. Investor Relations Tyler Technologies, Inc. 972.713.3714 info@tylertech.com Common Stock Listed on the New York Stock Exchange under the symbol “TYL” Corporate Officers John M. Yeaman Chairman of the Board John S. Marr, Jr. President and Chief Executive Officer Dustin R. Womble Executive Vice President Brian K. Miller Executive Vice President Chief Financial Officer and Treasurer H. Lynn Moore, Jr. Executive Vice President General Counsel and Secretary Samantha B. Crosby Vice President Marketing Rick L. Hoff Vice President Chief Technology Officer Robert J. Sansone Vice President Human Resources W. Michael Smith Vice President Chief Accounting Officer Terri L. Alford Controller Board of Directors John M. Yeaman1 Chairman of the Board Tyler Technologies, Inc. John S. Marr, Jr.1 President and Chief Executive Officer Tyler Technologies, Inc. Donald R. Brattain2,3 President Brattain and Associates, LLC J. Luther King, Jr.2,4 Chief Executive Officer Luther King Capital Management G. Stuart Reeves2,3,4 Retired Executive Vice President Electronic Data Systems Corporation Michael D. Richards3,4 Executive Vice President Republic Title of Texas, Inc. Dustin R. Womble1 Executive Vice President Tyler Technologies, Inc. 1 Executive Committee 2 Audit Committee 3 Nominating and Governance Committee 4 Compensation Committee 5949 Sherry Lane Suite 1400 Dallas, Texas 75225 972.713.3700 www.tylertech.com 

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