2011 Annual Report laws of performance 5949 Sherry Lane Suite 1400 Dallas, Texas 75225 972.713.3700 www.tylertech.com The physical world is governed by basic laws of physics — the unwavering rules that equip us with valuable insights about how and why things happen as they do. At Tyler Technologies, we believe they can be applied equally to the business world. These are the laws of performance that empower us to navigate dynamic markets with strength, stability and confidence. Tyler Technologies 2011 Annual Report 1 Tyler posted record revenues, earnings and free cash flow in 2011, driven largely by strength in our recurring revenues. This marks 11 consecutive years of profitability for the company. to our shareholders Business performance is measured in many ways. And by virtually every financial indicator, I’m pleased to report that 2011 was the strongest year yet for Tyler Technologies. Total revenue reached $309.4 million — a 7.2 percent increase over 2010 and a new high for Tyler. Recurring revenues drove our growth as we continued to expand our maintenance base, and our software as a service (SaaS) model continued to gain popularity, attracting new clients and prompting many existing clients to make the switch from traditional on-premise installations. Bookings showed strong growth in the second half of the year, pushing backlog to a record high of $339.8 million. Cash flow grew as well, reaching our highest-ever level of $44.2 million ($50.8 million before real estate expenditures). Tyler’s earnings also grew in 2011, and we posted our 43rd consecutive profitable quarter in December. For the year, diluted earnings per share rose 17 percent to $0.83. We created significant shareholder value with the repurchase of approximately 3 million shares of our common stock at an average price of $23.90 per share. Our return on average equity for the year was 29.8 percent, compared to 20.8 percent in 2010. In October, we completed our largest acquisition since 1999 — the $23.8 million purchase of Windsor Management Group, which provides financial and human capital management solutions to the K–12 education market. With 800 school district clients in 31 states, this acquisition significantly broadens Tyler’s geographic reach in K–12 schools, especially in Western states including Arizona, New Mexico and Colorado, where we did not have a sizable presence in the education market. Through Windsor’s flagship product, Infinite Visions®, Tyler also gains meaningful recurring revenues. Milestones and Accolades 2011 marked the company’s 45th year in business — and in October, our executive leadership team rang the New York Stock Exchange Closing Bell to mark the occasion. We believe Tyler’s staying power is a testament to our ability to adapt to the changing needs of the public sector without sacrificing the fundamentals of our business — providing superior service to our clients, being a good steward of each client’s investment in our products, delivering value to shareholders, maintaining a fiscally disciplined business, and investing in the future of our company, as well as that of our clients and employees. Our company’s 45th anniversary was only one of several milestones we reached in 2011. Once again, Tyler was included on the Forbes list of America’s Best Small Companies. We’ve made the list in four of the last five years and currently rank 76th. Criteria included companies with revenues from $5 million to $1 billion, a share price no lower than $5, a healthy return on equity, sustained sales and earnings growth, and solid stock performance in comparison to industry peers. Tyler Technologies 2011 Annual Report 2 With the release of Microsoft Dynamics® AX 2012 with public sector functionality, Tyler opens up a new stream of incremental revenue while improving our competitive advantage as we pursue a broader range of enterprise resource planning (ERP) system opportunities. In addition, Tyler was included in the 2011 Software 500 ranking, published by Software Magazine. This is our fourth consecutive year on the list. Tyler ranked 155th, measured by 2010 software and services revenue. We’re pleased to be included on these prestigious lists because they reinforce the value that our singular focus on the public sector brings to our company, clients and shareholders. By delivering perpetual upgrades and integrated solutions specifically designed for local governments and schools, Tyler continues to earn client loyalty and strengthen our position as a market leader and valued partner for the public sector. Rolling Out a New Solution with Microsoft After more than four years of joint development, Microsoft Dynamics AX 2012 with public sector functionality was released in August. The city of Redmond, Washington, was our pilot client, going live in July as an early adopter of Dynamics AX 2012, along with Tyler’s payroll and cashiering systems. This implementation represents a successful collaboration not only with Tyler and Microsoft, but also with end users in Microsoft’s home city of Redmond. These local government employees provided valuable feedback through Microsoft’s Technology Adoption Program. As a Microsoft partner, Tyler now sells Microsoft Dynamics AX 2012 along with our other financial solutions. We believe the product gives us an alternative offering that will strengthen our competitive position in certain opportunities and ultimately enable us to increase our market share. Microsoft Dynamics AX 2012 also opens up a new stream of revenue for Tyler with royalties on public sector sales by other Microsoft partners. The product will also be sold by other Microsoft partners around the world, including those in markets where Tyler doesn’t currently compete, such as the federal government and international markets. Tyler receives royalties on both the license fee and the maintenance stream from all public sector sales of Microsoft Dynamics worldwide. While we are pleased with the progress of the Dynamics AX 2012 project, it’s still very early in the sales cycle, and we don’t expect to see meaningful contributions before 2013. Navigating the Economy Despite difficult economic conditions and a challenging new business environment in the last two years, we’ve stayed true to our business strategy. Perhaps more important than the growth in our revenues and earnings was maintaining our aggressive level of development spending in 2011, which has shown a meaningful return in terms of our strong competitive position and improved win rates against key competitors. In addition, we have a strong balance sheet and an expanding base of recurring revenues generating reliable cash flow. Tyler Technologies 2011 Annual Report 3 (left) John S. Marr Jr. President and CEO (right) John M. Yeaman Chairman of the Board At Tyler, our deep domain expertise is a vital part of our value proposition. Despite the lower level of new business activity in the marketplace in the last two years, we maintained a relatively stable headcount. Although lower professional services staff utilization put pressure on margins, retaining highly experienced staff and continuing to invest in product development at a high level means that we’re well positioned to support our growing backlog. While the public sector software market is still far from robust, the market showed signs in the second half of 2011 that it is beginning to strengthen. We are confident that Tyler’s strong competitive position will enable us to continue to gain market share as the economic environment returns to more normal conditions. To all of our shareholders, employees and clients, thank you for your confidence in Tyler. Together, we are empowering people who serve the public — each and every day. John S. Marr Jr. President and Chief Executive Officer Tyler Technologies 2011 Annual Report 4 tyler at a glance With more than 2,000 employees and more than 10,000 government and school clients across the United States, Canada and the Caribbean, Tyler Technologies is the largest software company in the nation with an exclusive focus on the public sector. We’re more than software developers — we’re training and support partners whose client relationships span decades. From appraisal services for an 800-acre island to a financial management system for a city with 1 million residents, Tyler’s perpetual upgrades and comprehensive services empower our clients to serve the public with accuracy, accessibility and fiscal responsibility. Recurring Revenues in millions Revenue Mix . 7 7 7 1 $ . 0 9 5 1 $ . 7 1 4 1 $ . 8 1 2 1 $ . 8 5 9 $ 7 0 0 2 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 47.4% Maintenance 22.5% Software Services 10.5% Software Licenses 10.1% Subscriptions 7.5% Appraisal Services 2.0% Hardware and Other ERP | FINANCIAL More than 4,000 agencies rely on Tyler’s financial ERP solutions for efficient management of their core functions — managing $116 billion in public sector funds annually, processing paychecks for more than 1 million public sector employees and facilitating more than 100 million utility billing transactions. COURTS & JUSTICE APPRAISAL & TAX SCHOOLS LAND & VITAL RECORDS From paperless court case As a leading provider of Tyler offers a full suite of From land records and birth management to e-filing appraisal and tax solutions, solutions to help educators certificates to social service portals, Tyler’s courts and Tyler delivers the accurate and administrators put documents and enterprise-wide justice products offer a market values and students first — including content management, Tyler’s broad range of functionality secure revenue collection student information, school solutions manage the land, for courts, prosecutors, law technologies that empower financials, data warehouse vital and official records for enforcement, corrections and 1,300 jurisdictions and student transportation. 19 million residents across the supervision staff. Eight states throughout the United States In fact, Tyler School Solutions U.S. and store more than 380 and more than 400 counties and Canada. Offerings include manage transportation for one million land and vital records. and 750 municipalities use computer-assisted mass out of every 10 U.S. schools, If printed, these records laid our integrated solutions to appraisal (CAMA) solutions, which means on any given end-to-end would wrap around streamline operations while tax billing and collections day, 7 million students ride the Earth almost three times. enhancing service. software, and turnkey or on school buses routed by targeted reassessment and Tyler software. revaluation services. FIRST LAW OF PERFORMANCE an object in motion stays in motion At Tyler, product development is the dynamic force that drives our evergreen service model. By anticipating client needs and delivering perpetual upgrades, our innovations continue to move the company and our public sector clients forward. Tyler Technologies 2011 Annual Report 7 Free Cash Flow(a) in millions . 8 0 5 $ . 3 2 4 $ . 0 0 4 $ . 3 0 3 $ . 7 1 3 $ 7 0 0 2 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 (a) excludes capital expenditures for real estate Backlog in millions . 8 9 3 3 $ . 4 1 8 2 $ . 1 0 5 2 $ . 8 9 4 2 $ . 1 3 3 2 $ 7 0 0 2 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 Q&A: Despite ongoing budget pressures throughout the public sector, in 2011 Tyler Technologies posted our strongest financial performance yet. With this question and answer format, we hope to lend context to the many factors that shaped our performance. How has the recession affected Tyler’s new business? For the past couple of years, sales cycles increased significantly as a result of weak economic conditions. As local governments experienced budget pressures, decision processes became more complex, with more people involved and greater spending justification required. In many cases, public sector organizations postponed the purchase of new software, opting to continue using outdated legacy systems longer than planned. This significantly lengthened many sales cycles and led to a pipeline of new business prospects that is at a historically high level. Although local government budget woes are well publicized, Tyler has continued to sign new clients. What drives new business in this weak economy? The factors that create demand for Tyler products and services don’t really change with the economy, even though our clients’ budgetary constraints sometimes compel them to postpone the implementation of a new system. Our clients generally begin a process to replace older systems when they become unreliable, are no longer supported, are difficult to maintain with in-house resources or run on obsolete hardware. When the systems reach any of these points, the decision to replace them is somewhat non-discretionary, as mission- critical tasks like paying employees and running the courts and jails must continue without interruption. In addition, the implementation of a new system virtually always leads to improvements in efficiency and productivity, allowing governments to “do more with less,” a common mantra in the public sector today. Is the public sector showing signs of recovery? It’s hard to generalize, because there are so many local entities — about 90,000 in the United States alone — and even neighboring towns can have very different budgetary situations. That said, a January 2012 report from the Nelson A. Rockefeller Institute of Government indicates that although state tax revenues have yet to return to peak levels, they have rebounded to pre-recession performance following seven consecutive quarters of growth. In general, it looks as though much of the public sector has seen the worst of the down market. In addition, while many prospects deferred purchases of new software due to budget pressures over the past several quarters, we believe that some of their needs have now reached more critical stages and can no longer be postponed. Tyler Technologies 2011 Annual Report 8 ERP | FINANCIAL Munis Version 9.1, enhanced with Microsoft® Silverlight® functionality, is now in general release, with a significantly increased competitive position. Incode V.X continues to gain momentum with both deployed and SaaS clients. In 2011, we added more than 80 new ERP clients, including Putnam County, New York ($4.1 million); Ottawa County, Michigan ($1.2 million); and Sussex County, Delaware ($1.1 million). Our Incode financial solution played a vital role in a number of multi-solution agreements including contracts for the cities of Greenville and Georgetown, Texas, and Valencia County, New Mexico. As 2011 progressed, we began to see the pace of activity in our sales pipeline pick up modestly — although it’s important to note that it’s still a longer process on average than we’ve seen in a normal market. The timing of new business awards also remains less predictable than normal, and as our average contract size increases, the timing of large contracts can cause significant fluctuations in bookings from quarter to quarter. For the year 2011, our bookings grew more than nine percent from the prior year. While we’re optimistic that the market will continue its gradual return to more normal levels of business, we’d like to see more sustained new business growth before we consider it a trend. Tyler signed a number of significant new contracts in 2011. What are some of the highlights? With significant investments in our products and technology, as well as in branding and marketing, we’ve continued to pursue large-scale opportunities — and in 2011, we gained considerable momentum on that front with the signing of our two biggest contracts in company history. The first was a $31 million court system for the state of Oregon, which was approximately twice the size of our previous largest software deal. The second was a $45 million court system for the state of Maryland, which replaces legacy systems and applications with a single integrated solution. Both will be multi-year implementations, which provide increased revenue visibility down the road. Other notable wins included a $3.4 million ERP contract with the Guam Department of Education; a Versatrans student transportation management contract with Ohio’s Columbus City Schools, a client that already uses our Munis ERP system; and an agreement with Florida’s Pasco County Schools totaling almost $8 million — our largest ERP contract of the year. Tyler Technologies 2011 Annual Report 9 Going paperless not only saves natural resources and enhances operational efficiencies — it’s also becoming a requirement in a growing number of jurisdictions. Recurring revenues accounted for the majority of Tyler’s growth in 2011. Do you anticipate this trend continuing, and if so, how will that impact your business? Recurring revenues grew almost 12 percent in 2011 and comprised 57 percent of our total revenues for the year. In particular, our subscription revenues have grown more than 30 percent in each of the last two years. We have added more SaaS product offerings over the past three years, and the mix of new business has gradually increased. Even so, we expect the majority of our new business will continue to favor the perpetual license model for some time to come. Despite a weak new business market, maintenance revenues have grown steadily — a combination of maintenance revenues from new clients, as well as with annual price increases for existing clients and a low attrition rate. Recurring revenues are important to our business in a number of ways. First of all, they offer a high level of predictability and consistency that helps to balance out the dynamic nature of new license and services revenues. Secondly, these services tie in perfectly with our evergreen model — providing updates and new releases to clients as part of their maintenance or subscription fee. Our extremely high renewal rates have contributed to solid performance even in a tough new business environment, and we believe this will be the case going forward as well. What were some of the key SaaS contracts you signed in 2011? We signed a four-year appraisal and tax software contract in Loudoun County, Virginia, one of the state’s largest counties. They’ve chosen our iasWorld® Online product to enhance their existing CAMA capabilities. Not only will Tyler’s SaaS solution deliver the operational benefits of integrated access, but it will do so without the up-front capital expenditure of an on-premise implementation. SECOND LAW OF PERFORMANCE the greater the mass, the greater the amount of force needed As Tyler continues to pursue large-scale opportunities in the public sector, we’re confident our investments in enterprise-wide technologies, including our collaboration with Microsoft on Dynamics AX 2012, will be a powerful force to fuel our success. Tyler Technologies 2011 Annual Report 11 COURTS & JUSTICE With a market-leading position in courts technology, Tyler signed its two largest contracts to date — a $45 million Odyssey® case management system for the state of Maryland, and a $31 million system for the state of Oregon. These multi-year implementations will enable those states to streamline court processes, reduce costs related to handling and storing paper, and provide 24/7 access to court documents. Minnesota purchased a statewide license for our SessionWorks Judge Edition, a powerful touch-screen application used by trial judges to access case information while court is in session. Additionally, New Mexico expanded its e-filing (Odyssey File & Serve) agreement statewide. A number of new small and mid-sized clients like Matagorda County, Texas, are choosing our Odyssey Online courts and justice solution to help them do more with less. Clay County, Florida, an existing Odyssey client, transitioned its operations to our SaaS model as well. In addition, a longtime Tyler Munis ERP client, the Kentucky Department of Education, is moving to the cloud from systems deployed on-premises at each school district in the state. We’re converting an average of 10 Kentucky districts to SaaS every month, resulting in a meaningful increase in our recurring revenues. By the end of 2011, 173 of the state’s 174 school districts had signed up for the cloud, and 64 had been converted. And finally, the city of Eugene, Oregon, became one of the first SaaS clients to adopt our Incode V.X municipal court system. What does the migration toward a SaaS delivery model mean for your traditional offerings? Traditional on-premise implementations will remain an important part of our business, and we expect they will continue to make up the majority of our new business for the foreseeable future. After all, clients who have functional infrastructures already in place are compelled to make the most of those assets, and Tyler will continue to provide perpetual upgrades and ongoing maintenance for those systems. Should those clients eventually choose to adopt our SaaS model, we’ll be here to help them make a seamless transition. All of our major products are offered either as a traditional model or as a SaaS model, so our company is a bit of a hybrid. With both models, however, we’re growing recurring revenues — whether through maintenance agreements or SaaS subscriptions. How is the popularity of the SaaS model affecting revenues for new licenses? With SaaS contracts, license and service revenues aren’t generally recognized up front; instead, they’re bundled into the contract and recognized over the terms of the agreements, which typically range from three to seven years. While the increase in new SaaS clients dampened new license revenue recognized in 2011, subscription backlog grew 35 percent in 2011. How did transaction-based revenues figure into the financial picture for 2011? We’re especially pleased with the growth in the transaction-based revenues included in our subscriptions line. Our Odyssey File & Serve e-filing engine that we acquired with Wiznet in 2010, allows attorneys to file briefs, motions, lawsuits and other legal documents electronically, and then flow seamlessly through our court case management system. Many of our new File & Serve implementations are being done on a revenue-sharing basis, which means there are low or no up-front costs for the client. Under this model, even clients with budget pressures have the flexibility to implement the system and achieve the efficiencies associated with going paperless. In turn, Tyler receives all or a part of the filing fees charged to users, resulting in high-margin recurring revenues based on these transactions. Tyler Technologies 2011 Annual Report 12 2011 Quarterly Earnings Per Share in dollars 7 2 0 $ . . 3 2 0 $ . 7 1 0 $ . 7 1 0 $ 1 1 Q 1 1 1 Q 2 1 1 Q 3 1 1 Q 4 Annual Earnings Per Share in dollars 3 8 0 $ . 4 7 0 $ . 1 7 0 $ . 1 6 0 $ . 2 4 0 $ . 7 0 0 2 ) a ( 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 (a) 2008 EPS is non-GAAP and excludes non-cash legal settlement charge related to warrants of $0.23 In addition, we have established a growing revenue stream from online payment processing for transactions such as utility bills and traffic tickets. For these clients, we host the payment portals and process the transactions, earning revenues from convenience fees and hosting fees. Together, online payments and e-filing contributed $6.7 million in revenues in 2011, up 25 percent from the prior year. Increasingly, factors such as government directives for paperless operations and public demand for online accessibility are driving opportunities for transaction-based revenues. For example, New Mexico recently signed a statewide e-filing contract for its courts in response to that state’s paperless filing mandate. And in many jurisdictions, secure payment portals for utility bills, taxes and more are becoming the norm. Our solutions that generate transaction-based revenues represent one more way Tyler is empowering the public sector to adapt to changing conditions. From an efficiency standpoint, what are some of the advantages that Tyler solutions offer? Doing more with less while improving customer service is a common theme among the clients we serve. No matter what state the economy is in, local governments and schools have an obligation to provide a consistent level of service to the public. The public sector can’t always add personnel to meet growing demands for services such as online payment options and document access. In fact, they’re often being forced to reduce staff in response to budget pressures. Their best option is to increase productivity, which is precisely what our solutions are designed to do. Our systems help clients eliminate redundant and manual processes, enhance service offerings, reduce wait times and provide online access to public documents — empowering them to accomplish more tasks, more accurately, with the same or fewer personnel. Our e-filing solution for courts is a great example of efficiency in action. Not only does electronic filing help expedite the process and keep lines manageable, but it also removes paper documents from the equation and eliminates the need for physical space for document storage. Tyler Technologies 2011 Annual Report 13 APPRAISAL & TAX Our Appraisal & Tax division experienced solid revenue and margin growth. Notable new contracts included a $1.9 million SaaS-based appraisal and tax solution for Loudoun County, Virginia; a $1.1 million appraisal agreement with the Northeastern Connecticut Council of Governments; a $2 million iasWorld contract with Lucas County, Ohio; and an appraisal contract with Fairfield County, Ohio, totaling nearly $1 million. We completed a statewide implementation of our Orion® appraisal solution in Kansas, went live with statewide implementations of iasWorld in Tennessee, and further refined our offerings with the release of iasWorld 7.0 with user interface enhancements. Many of your clients have won awards for the efficiencies they’ve achieved, correct? Yes. In fact, more than half of the winners of the 2011 Digital Counties Survey awards use a Tyler solution. Winners showed how their IT initiatives are helping their governments reduce costs, adapt their operations to compensate for smaller work forces, and enhance customer service. Tyler is proud of the positive effect our products and services are having in the communities we serve, whether or not they’ve received awards for their efforts. Microsoft Dynamics AX 2012, a product you co-developed for the public sector, went live in 2011. How would you characterize your first deployment? Our first client was the city of Redmond, Washington — home to approximately 54,000 residents and 5,500 businesses, including Microsoft’s headquarters. This was the culmination of more than four years of collaborative development between Tyler and Microsoft, and it was a very successful implementation. Solutions included the Microsoft Dynamics AX core financial solution, as well as Tyler’s payroll and cashiering applications, and Redmond city officials have noted significant improvements. We’re looking forward to the expected release of additional Dynamics AX 2012 modules, including Payroll, Human Resources and Budgeting, in late 2012. How did Tyler put its cash to work in 2011? The strong cash flow characteristics of our business give us the flexibility to be opportunistic with both of our primary uses of cash — acquisitions and stock repurchases. We continued to be extremely active with our repurchase program in 2011, buying back 3 million shares of Tyler stock at an average price of approximately $23.90 per share. In the last two years, we have repurchased approximately 19 percent of our common stock. Through our repurchase program since 2002, we’ve created significant value for shareholders. THIRD LAW OF PERFORMANCE for every action, there is an equal and opposite reaction As public sector budgets tightened, Tyler reacted positively by increasing investments in our products and our people. As the economy recovers, we have the momentum to capture a greater share of a growing market. Tyler Technologies 2011 Annual Report 15 We expect to continue an active buyback program into the future, as well as pursue strategic acquisitions at reasonable valuations to expand our product and services offerings or to add clients. With our $150 million revolving credit facility, we have the ability to use a reasonable amount of leverage to supplement cash flow as needed to repurchase stock or make acquisitions. This credit facility gives us the flexibility to take on low-cost debt to take advantage of high-value opportunities that benefit our company, our clients and our shareholders. SCHOOLS Tyler had a significant acquisition during the year. How does it fit into the company’s long-term strategies? We take a disciplined approach to acquisitions, and the October purchase of Windsor Tyler’s financial management solutions help school districts streamline their most essential Management Group of Tempe, Arizona, was no exception. Founded by former school business business functions, and our administrators and management experts, Windsor products provide financial and human resources data management solutions to the K–12 education market. The $23.8 million 2011 contract highlights included a $7.9 million acquisition broadens our geographic reach, boosting Tyler’s presence in an eight-state region agreement with Pasco County in which we had a limited number of clients in the K–12 market. Windsor’s more than Schools, Florida, and a $3.4 60 employees are now a part of Tyler, which now serves the Infinite Visions client base of million agreement with the Guam more than 800 school districts in 31 states. Windsor’s operations contributed approximately Department of Education. $2.6 million of revenues during the two-and-a-half months that it was a part of Tyler in 2011. Also of note, Tyler was selected by competitive bid to offer Tyler SIS (v9) to school districts across Missouri. Districts may also select optional Tyler products without going to bid, including Tyler financial and human resources management products, Tyler Food Service, Tyler Pulse, Tyler Special Education and our newly enhanced Versatrans® solution with My Stop and Calendar & Scheduler functionality. Product development has always been a priority for Tyler. How does the company manage that expense? The fact that we have such a broad product range enables us to leverage much of our investment in products. For example, Tyler Content Manager is a product that manages documents and workflow across many of our product suites. Instead of each product group duplicating development efforts for these common functions, we’re able to leverage the development of these solutions. That said, Tyler is committed to continually enhancing the functionality and competitiveness of our public sector solutions — and our strategic stewardship of shared research and development funds also makes it possible for us to invest aggressively in product development, even in a challenging business environment. How does your approach to product development relate to Tyler’s evergreen service model? The two are inextricably connected. When schools or governments purchase solutions from Tyler, they’re not just getting the latest software as of the date they sign their contract; as part of their annual maintenance agreement they’re also getting the benefit of perpetual upgrades, as they happen, without paying additional licensing fees. The town of Glastonbury, Connecticut, is a great example of this relationship. Since Glastonbury’s initial Tyler ERP software implementation in 1989, we’ve added extensive functionality and enhancements to deliver an up-to-date system that empowers employees to better serve the public. Glastonbury remains a Tyler client to this day — and in all that time, the city has never paid upgrade or relicensing fees for its Tyler solution. Tyler Technologies 2011 Annual Report 16 Public sector and development expertise runs deep at Tyler. What does that mean for your clients? When we talk about our expertise, there are two key elements to consider. First, many of our employees have firsthand experience in the public sector, which helps us see the challenges and opportunities of everyday operations from the inside out. Second, the average tenure at Tyler is incredibly long compared to most corporations and, in particular, to technology companies. In fact, more than half of our employees have at least five years of tenure, nearly one-third have more than 10 years of experience with Tyler — and more than 200 individuals have been with the company for 20 or more years. Having so many knowledgeable experts and longtime employees on our team translates to consistency for our clients. Our in-depth understanding of the public sector, combined with our ongoing commitment to channel that domain expertise toward relevant solutions, has resulted in client relationships that span decades. LAND & VITAL RECORDS We continued to grow our presence in the Texas market as five counties signed agreements for Tyler’s Eagle solutions in 2011. The counties of Brazoria, Clay, Jasper, Loving and Randall will join 30 other Texas counties that already use our land and vital records In 2011, the company launched a social networking platform called Tyler solutions. Other notable Community. What can you tell us about that? contracts included agreements Tyler Community allows our clients and employees to informally engage with each other in Roosevelt County, New to solve problems and share product knowledge. It doesn’t take the place of Tyler’s support Mexico; Weld County, Colorado; organization; it’s just another support tool to share experiences with peers in the public and Mohave County, Arizona. sector. Much like other social media platforms, users actually create much of the content, which includes industry information, tips and tricks, best practices, product training In addition, our Eagle solutions and online forums. were an integral part of a multi-solution agreement for Valencia County, New Mexico, worth nearly $1 million. The contract also included appraisal and tax applications as well as Incode® financials. Community service is an integral part of Tyler’s corporate culture. What are some of the ways Tyler empowers its employees to help those in need? At every Tyler location, our team members are engaged in outreach efforts with nonprofits and charities. Thanks to employee donations and Tyler Foundation contributions, we supported tsunami relief efforts in Japan and tornado relief in the southeastern United States in 2011. Tyler employees also were active in walkathons, bike rides, toy drives and other participatory events to raise money for organizations such as the American Lung Association, American Heart Association, Susan G. Komen Foundation and many others. We’re immensely proud of the initiative our employees have shown at the local level, and we look forward to accomplishing even more through company-wide charitable initiatives in the future. The preceding Q&A is a composite representation of the views of Tyler management regarding company performance and market perspectives. For further information, visit www.tylertech.com or contact our investor relations team at info@tylertech.com. Tyler Technologies 2011 Annual Report 17 Stock Market Data Our common stock is traded on the New York Stock Exchange under the symbol “TYL.” At December 31, 2011, we had approximately 1,939 stockholders of record. A number of our stockholders hold their shares in street name; therefore, there are substantially more than 1,939 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. 2010: First Quarter Second Quarter Third Quarter Fourth Quarter 2011: First Quarter Second Quarter Third Quarter Fourth Quarter High Low $ 21.52 19.83 20.46 22.19 $ 23.77 27.14 27.56 32.94 $ 17.13 15.44 15.00 19.49 $ 19.99 23.09 22.15 24.00 We did not pay any cash dividends in 2011 or 2010. 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 2011, we purchased approximately 3.0 million shares of our common stock for an aggregate purchase price of $71.8 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, May 2009, July 2010, October 2010 and September 2011. As of December 31, 2011, we had remaining authorization to repurchase up to 1.7 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. 18 Tyler Technologies 2011 Annual Report Selected Financial Data SELECTED FINANCIAL DATA (In thousands, except per share data) 2011 2010 2009 2008 2007 For the Years Ended December 31, STATEMENT OF OPERATIONS DATA: Revenues Costs and expenses: Cost of revenues $ 309,391 $ 288,628 $ 290,286 $ 265,101 $ 219,796 167,479 160,311 161,523 155,314 135,371 Selling, general and administrative expenses 75,650 69,480 70,115 62,923 51,724 Research and development expense 16,414 13,971 11,159 Amortization of customer and trade name intangibles 3,331 Non-cash legal settlement related to warrants (1) — 3,225 — 2,705 — 7,286 2,438 9,045 4,443 1,478 — Operating income Other (expense) income, net 46,517 41,641 44,784 28,095 26,780 (2,404) (1,742) (146) 1,181 1,800 Income from operations before income taxes 44,113 39,899 44,638 29,276 28,580 Income tax provision Net income 16,556 14,845 17,628 14,414 11,079 $ 27,557 $ 25,054 $ 27,010 $ 14,862 $ 17,501 Net income per diluted share $ 0.83 $ 0.71 $ 0.74 $ 0.38 $ 0.42 Weighted average diluted shares 33,154 35,528 36,624 39,184 41,352 STATEMENT OF CASH FLOWS DATA: Cash flows provided by operating activities $ 56,435 $ 35,350 $ 42,941 $ 47,802 $ 34,111 Cash flows used by investing activities (28,809) (8,694) (13,658) (9,554) (34,275) Cash flows used by financing activities (28,414) (34,238) (21,349) (46,128) (7,406) BALANCE SHEET DATA: Total assets Revolving line of credit Shareholders’ equity $ 295,391 $ 264,032 $ 270,670 $ 251,761 $ 241,508 60,700 26,500 — — — 78,110 106,972 134,358 114,262 137,211 (1) 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. Tyler Technologies 2011 Annual Report 19 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. These 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 revisions to these forward-looking statements. Readers should carefully review the risk factors described in documents we file from time to time with the Securities and Exchange Commission. 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 and state 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 as well as state governments. 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. In 2010 we began providing electronic document filing solutions (“e-filings”) for courts and law offices which simplify the filing and management of court related documents. Revenues for e-filings are generally derived from transaction fees. Our products generally automate three major functional areas (1) financial management and education, (2) courts and justice and (3) property appraisal and tax and we report our results in two segments. The Enterprise Software Solutions (“ESS”) segment provides municipal and county governments and schools with software systems and services 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 (“ATSS”) 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 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. Subscription-based services and maintenance and support services are considered recurring revenue sources and comprised approximately 57% of our revenue in 2011. The number of new subscription-based customers and the number of existing customers who convert from our traditional software arrangements to our subscription-based service arrangements are a significant driver to our business together with new software license sales and maintenance rate increases. In addition, we also monitor our customer base and churn as we historically have experienced very low customer turnover. During 2011, our customer turnover was approximately 2%. 20 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations – 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 cyclical 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, 2011, our total employee count increased to 2,091 from 2,054 at December 31, 2010. This increase includes 64 employees added as a result of an acquisition completed in 2011. – Selling, General and Administrative (“SG&A”) Expenses – The primary components of SG&A expenses are administrative and sales personnel salaries and commissions, marketing expense, share-based compensation expense, rent and professional fees. Sales commissions typically fluctuate with revenues and share-based compensation expense generally increases when the market price of our stock increases. 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 discretionary purchases of treasury stock. In 2011, we purchased 3.0 million shares of our common stock for an aggregate purchase price of $71.8 million. During 2011 we invested $12.3 million in property and equipment and paid $16.4 million in cash for all of the capital stock of Windsor Management Group, L.L.C. Our investment in property and equipment included $6.6 million related to the purchase of approximately 27 acres of land and a building in Plano, Texas. We also borrowed $60.7 million on our revolving line of credit mainly to assist in funding discretionary purchases of treasury stock. 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. Acquisition In October 2011, we acquired all of the capital stock of Windsor Management Group, L.L.C. (“Windsor”) for a cash purchase price of $16.4 million, net of cash acquired of $7.4 million. Windsor provides a suite of financial and human capital management software solutions to the K-12 education market, primarily in the Southwest. In connection with this transaction we recorded customer relationship of approximately $5.6 million, acquired software of $2.4 million, deferred revenue of $6.2 million and net assets of $1.5 million. We recorded goodwill of approximately $13.3 million, all of which is expected to be deductible for tax purposes. Customer relationships and acquired software will be amortized over a weighted average period of eight years. We believe likely market participants for this transaction would be software companies with a presence in the K-12 school market. Therefore, the goodwill of $13.3 million arising from the acquisition is primarily attributed to our ability to maximize the value of the customer base through Tyler’s software product suite that targets the K-12 school market and to a much lesser extent, the assembled workforce of Windsor. Our balance sheet as of December 31, 2011, reflects the allocation of the purchase price to the assets acquired based on their estimated fair values at the date of acquisition. The operating results of this acquisition are included in our results of operations since the date of acquisition. Outlook Consistent with 2011, we expect to continue to invest aggressively in product development in 2012. We believe that our competitive position is strong and that we are well-positioned to take advantage of an eventual return to a stronger economic environment. However, until we see indications of sustained improvement, we are expecting that the new business environment in 2012 will continue to be both challenging and unpredictable, and that the majority of our growth will again come from recurring revenues. Tyler Technologies 2011 Annual Report 21 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 proportional 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 creating additional custom reports. 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 proportional 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 22 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 value of products delivered and services performed in the event of an early termination. For ASP and other hosting arrangements, we evaluate whether the customer has the contractual right to take possession of our software at any time during the hosting period without significant penalty and whether the customer can feasibly maintain the software on the customer’s hardware or enter into another arrangement with a third party to host the software. 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. For ASP and other hosting arrangements that do not meet the criteria for recognition under ASC 985-605, we account for the elements under ASC 605-25, Multiple Element Arrangements using all applicable facts and circumstances, including whether (i) the element has stand-alone value, (ii) there is a general right of return and (iii) the revenue is contingent on delivery of other elements. We allocate the contract value to each element of the arrangement that qualifies for treatment as a separate element based on vendor-specific objective evidence of fair value (“VSOE”), and if VSOE is not available, third party evidence, and if third party evidence is unavailable, estimated selling price. For professional services associated with ASP and hosting arrangements that we determine do not have stand- alone value to the customer or are contingent on delivery of other elements, 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 (other than goodwill) are amortized over their estimated useful lives. We currently have no intangible assets with indefinite lives other than goodwill. Tyler Technologies 2011 Annual Report 23 Management’s Discussion and Analysis of Financial Condition and Results of Operations We evaluate goodwill for impairment annually as of April, or more frequently if impairment indicators arise. 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 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. 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. Our annual goodwill impairment analysis, which we performed during the second quarter of 2011, did not result in an impairment charge. During 2011 we did not identify any triggering events which would require an update to our annual impairment review. 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 other intangible assets is 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. 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 ASC 718-10, Stock Compensation. 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. 24 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations 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, 2011, 2010 and 2009. Revenues: Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Total revenues Operating Expenses: Cost of software licenses and acquired software Cost of software services, maintenance and subscriptions Cost of appraisal services Cost of hardware and other Selling, general and administrative expenses Research and development expense Amortization of customer base and trade name intangibles Operating income Other expenses, net Income before income taxes Income tax provision Net income 2011 Compared to 2010 Revenues Software licenses. % of Total Revenues 2011 2010 2009 10.5% 12.1% 14.5% 10.1 22.5 47.4 7.5 2.0 8.1 23.7 47.0 7.1 2.0 5.9 27.7 42.9 6.5 2.5 100.0 100.0 100.0 1.3 46.5 4.7 1.6 24.5 5.3 1.1 15.0 0.7 14.3 5.4 1.8 47.8 4.5 1.5 24.1 4.8 1.1 14.4 0.6 13.8 5.1 2.4 47.3 4.0 2.0 24.2 3.8 0.9 15.4 0.0 15.4 6.1 8.9% 8.7% 9.3% The following table sets forth a comparison of our software license revenues for the years ended December 31: ($ in thousands) Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Total software license revenues Change 2011 2010 $ % $ 30,194 2,400 $ 32,594 $ 32,757 2,156 $ 34,913 $ (2,563) (8)% 244 11 $ (2,319) (7)% In October 2011, we acquired Windsor, which provides a suite of financial and human capital management software solutions to the K-12 education market and is included in our ESS segment. Excluding the impact of this acquisition, total software license revenue declined by 8% and ESS software license revenue declined 9% compared to 2010. The decrease in software license revenues is mainly attributable to longer sales cycles and postponements of customer purchasing decisions mainly due to budgetary constraints related to economic conditions. In addition, a portion of the decline was due to a growing number of customers choosing our subscription-based options, rather than purchasing the software under a traditional perpetual software license arrangement. Subscription-based arrangements result in Tyler Technologies 2011 Annual Report 25 Management’s Discussion and Analysis of Financial Condition and Results of Operations lower software license revenues in the initial year as compared to traditional perpetual software license arrangements but generate higher overall subscription-based services revenue over the term of the contract. We had 47 new customers that entered into subscription-based arrangements in 2011 compared to 19 new customers in 2010. We expect ESS software license revenues in 2012 to be higher than 2011 but the mix of software license arrangements and subscription-based arrangements may reduce the degree of the increase. Subscriptions. The following table sets forth a comparison of our subscription revenues for the years ended December 31: ($ in thousands) 2011 2010 $ % Enterprise Software Solutions $ 30,400 $ 22,975 $ 7,425 Appraisal and Tax Software Solutions and Services 760 323 437 Total subscription revenues $ 31,160 $ 23,298 $ 7,862 32% 135 34% Change 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. We also provide e-filings for courts and law offices which simplify the filing and management of court related documents. Revenues from e-filings are generally derived from transaction fees. ASP and other software subscription agreements are typically for periods of three to six years. 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 together with slightly higher rates for other hosted services. In 2011, we added 47 new customers and 40 existing customers elected to convert to our hosted offerings. E-filing services also contributed approximately $500,000 of the subscription revenue increase as a result of several counties and one state adopting or expanding mandatory e-filing for court documents in the last half of 2011. Software services. The following table sets forth a comparison of our software services revenues for the years ended December 31: ($ in thousands) Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Total software services revenues Change 2011 2010 $ % $ 60,840 8,777 $ 69,617 $ 58,371 9,969 $ 68,340 $ 2,469 (1,192) $ 1,277 4% (12) 2% Software services revenues primarily consists of professional services billed in connection with the installation of our software, conversion of customer data, training customer personnel and consulting. New customers who purchase our proprietary software licenses generally also contract with us to provide for the related software services. Existing customers also periodically purchase additional training, consulting and minor programming services. Excluding the impact of the Windsor acquisition, software services increased 1%. In 2011 software services revenue included more third party vendor services to build certain software interfaces associated with a state-wide contract, and reflected slightly higher billing rates. 26 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Maintenance. The following table sets forth a comparison of our maintenance revenues for the years ended December 31: ($ in thousands) 2011 2010 $ % Enterprise Software Solutions $ 130,999 $ 120,764 $ 10,235 Appraisal and Tax Software Solutions and Services 15,499 14,891 608 Total maintenance revenues $ 146,498 $ 135,655 $ 10,843 8% 4 8% Change We provide maintenance and support services for our software products and certain third party software. Excluding the impact of the Windsor acquisition, maintenance revenue grew 7% from 2010. This increase was due to growth in our installed customer base and slightly higher maintenance rates on most of our product lines. Our annual maintenance revenue growth rate has been reduced somewhat by the effect of existing installed customers converting to our hosted offering, which results in a loss of maintenance revenue offset by a larger increase in subscription revenue. Appraisal services. The following table sets forth a comparison of our appraisal service revenues for the years ended December 31: ($ in thousands) Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Total appraisal services revenues Change 2011 2010 $ % $ — 23,228 $ 23,228 $ — 20,554 $ 20,554 $ — 2,674 $ 2,674 —% 13 13% Appraisal services revenue increased 13% in 2011 compared to 2010. The appraisal services business is somewhat cyclical and driven in part by statutory revaluation cycles in various states. We began work on several new large revaluation contracts in late 2009 and mid-2010 which provided the majority of the increase in appraisal services revenues. Several of these large contracts were completed in the last half of 2011 and we expect appraisal revenues for 2012 will decline slightly compared to 2011. Cost of Revenues and Gross Margins The following table sets forth a comparison of the key components of our cost of revenues for the years ended December 31: ($ in thousands) Software licenses Acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Total cost of revenues Change 2011 2010 $ % $ 3,034 $ 3,456 $ (422) (12)% 1,125 143,776 14,550 4,994 1,592 138,085 12,910 4,268 $ 167,479 $ 160,311 (467) (29) 5,691 1,640 726 $ 7,168 4 13 17 4% Tyler Technologies 2011 Annual Report 27 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table sets forth a comparison of gross margin percentage by revenue type for the years ended December 31: Gross margin percentage Software license and acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Overall gross margin 2011 2010 Change 87.2% 85.5% 1.7% 41.9 37.4 20.7 39.2 37.2 27.3 2.7 0.2 (6.6) 45.9% 44.5% 1.4% Software license and acquired software. Cost of software license and acquired software is comprised of third party software costs, amortization of acquired software and amortization of capitalized development costs on certain software products. Cost of third party software comprised approximately 70% of our cost of software license revenues in 2011 compared to approximately 60% of our cost of software license in 2010. Third party software sales were slightly higher than the prior year. Costs of acquired software, which is comprised of amortization expense for software acquired through acquisitions, was approximately 27% of our cost of software license revenues in 2011 compared to approximately 32% of our cost of software license in 2010. We completed several acquisitions in the period 2007 through 2011 and these costs are being amortized over a weighted average period of approximately five years. Cost of acquired software declined because several products became fully amortized early 2011. The remaining cost of software license balance relates to amortization expense for capitalized development cost which 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. These costs comprised less than 10% of total software license and acquired software costs in 2011 and 2010. We did not capitalize any internal software development costs in 2011 or 2010. In 2011, our software license gross margin percentage increased compared to the prior year period because several acquired software solutions became fully amortized in early 2011. 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, e-filings and disaster recovery. 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. In 2011, the software services, maintenance and subscriptions gross margin increased compared to the prior year partly because we improved our utilization of our support and maintenance staff and due to annual rate increases on certain services. We are managing costs and staff levels to ensure they are in line with demand for professional services. Excluding 56 additional employees added with the Windsor acquisition, our implementation and support staff declined by 4 employees since December 31, 2010. Appraisal services. Our appraisal services gross margin was flat compared to 2010. 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 2011 increased 1.4% from 2010 mainly due to leverage in the utilization of our support, maintenance and subscription-based services staff and economies of scale and slightly higher rates on certain services. The gross margin also benefited from lower acquired software amortization costs. 28 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Selling, General and Administrative Expenses 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) 2011 2010 $ % Selling, general and administrative expenses $ 75,650 $ 69,480 $ 6,170 9% Change SG&A as a percentage of revenues was 24.5% in 2011 compared to 24.1% in 2010. SG&A expenses in 2011 included costs associated with consolidating office space in our new Yarmouth, Maine facility and other facilities related costs. Research and Development Expense Research and development expense consists primarily of salaries, employee benefits and related overhead costs associated with product development. The following table sets forth a comparison of our research and development expense for the years ended December 31: ($ in thousands) 2011 2010 $ % Research and development expense $ 16,414 $ 13,971 $ 2,443 17% Change Research and development expense consist mainly of costs associated with development of new products and new software platforms from which we do not currently generate revenue. These include the Microsoft Dynamics AX project, as well as other new product development efforts related to our proprietary products. We increased our research and development staff by seven employees during 2011. In January 2007, we entered into a Software Development and License Agreement, which provides 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 April 2011, Tyler and Microsoft entered into an amended and superseded Master Software Development and License Agreement, which among other things, grants Microsoft intellectual property rights in the remaining portions of the software code developed by Tyler in exchange for certain other concessions. Under the new agreement, Tyler will continue to receive the previously agreed to reimbursement payments. In addition, Tyler has agreed to commit certain resources to the development of the next version of Dynamics AX and will receive software and maintenance royalties on direct and indirect sales of the solutions co-developed under this arrangement. Our research and development expense increased $2.4 million in 2011 compared to 2010. The increase is mainly due to lower reimbursements from Microsoft in 2011. In 2011 we offset our research and development expense by $3.5 million, which were the amounts earned under the terms of our agreement with Microsoft, compared to $5.1 million in 2010. Prior to December 31, 2010, we received offsets from Microsoft to our research and development expense of approximately $850,000 each quarter from mid-2008 through the end of 2010 as specified in a statement of work under the Amended Software Development and License Agreement with Microsoft. In addition, Tyler Technologies 2011 Annual Report 29 Management’s Discussion and Analysis of Financial Condition and Results of Operations in October 2009, the scope of the project was further expanded which will result in additional offsets to research and development expense, varying in amount from quarter to quarter through 2012 for a total of approximately $6.2 million. As of December 31, 2011, we have recorded $5.2 million in cumulative offsets under this agreement from Microsoft and expect to record the remaining $1.0 million in the last half of 2012. The actual amount and timing of future research and development costs and related reimbursements and whether they are capitalized or expensed are subject to change. Amortization of Customer and Trade Name Intangibles Acquisition intangibles are comprised of the excess of the purchase price over the fair value of net tangible assets acquired that is allocated to acquired software and customer and trade name intangibles. The remaining excess purchase price is allocated to goodwill that is not subject to amortization. Amortization expense related to acquired software is included with cost of revenues, while amortization expense of customer and trade name intangibles is recorded as other operating expense. The estimated useful lives of both customer and trade name intangibles are five to 25 years. The following table sets forth a comparison of amortization of customer and trade name intangibles for the years ended December 31: ($ in thousands) 2011 2010 $ % Amortization of customer and trade name intangibles $ 3,331 $ 3,225 $ 106 3% Change In October 2011 we completed an acquisition that increased amortizable customer and trade name intangibles by approximately $5.6 million. This amount is being amortized over 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): 2012 2013 2014 2015 2016 $ 3,711 3,552 3,551 3,551 3,551 Other The following table sets forth a comparison of other expense, net for the following years ended December 31: ($ in thousands) Other expense, net 2011 2010 $ % $ 2,404 $ 1,742 $ 662 38% Change Other expense is primarily comprised of interest expense, non-usage and other fees associated with our revolving line of credit agreement. Interest expense was higher in 2011 than 2010 due to higher debt levels associated with our stock repurchases and the acquisition of Windsor in October 2011. The effective interest rate in 2011 was 3.3% compared to 3.4% in 2010. 30 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Income Tax Provision The following table sets forth a comparison of our income tax provision for the years ended December 31: ($ in thousands) Income tax provision Effective income tax rate Change 2011 2010 $ % $ 16,556 $ 14,845 $ 1,711 12% 37.5% 37.2% The effective income tax rates 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, the research and development tax credit and non-deductible meals and entertainment costs. Approximately 35% of our stock option expense is related to incentive stock options (“ISOs”). 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. 2010 COMPARED TO 2009 Revenues Software licenses. The following table sets forth a comparison of our software license revenues for the years ended December 31: ($ in thousands) Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Total software license revenues Change 2010 2009 $ % $ 32,757 2,156 $ 34,913 $ 39,484 2,647 $ 42,131 $ (6,727) (17)% (491) (19) $ (7,218) (17)% In 2010, ESS software license revenues recognized declined substantially compared to the prior year period. The decrease in software license revenues is mainly attributable to longer sales cycles and postponements of customer purchasing decisions mainly due to budgetary constraints related to economic conditions. In addition, a portion of the decline was due to a number of customers choosing our subscription-based options, rather than purchasing the software under a traditional perpetual software license arrangement. Subscriptions. The following table sets forth a comparison of our subscription revenues for the years ended December 31: ($ in thousands) 2010 2009 $ Enterprise Software Solutions $ 22,975 $ 16,870 $ 6,105 Appraisal and Tax Software Solutions and Services 323 311 12 Total subscription revenues $ 23,298 $ 17,181 $ 6,117 % 36% 4 36% Change In January 2010, we acquired Wiznet Inc., which provides primarily subscription-based electronic document filing solutions for courts and law offices and is included in our ESS segment. Excluding the impact of this acquisition, ESS and total subscription revenues grew by 18% in 2010. Existing customers who converted to our ASP model as well as new customers for ASP and other hosted service offerings provided the majority of the subscription revenue increase with the remaining increase due to slightly higher rates for disaster recovery services. Tyler Technologies 2011 Annual Report 31 Management’s Discussion and Analysis of Financial Condition and Results of Operations Software services. The following table sets forth a comparison of our software service revenues for the years ended December 31: ($ in thousands) Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Total software services revenues Change 2010 2009 $ % $ 58,371 9,969 $ 68,340 $ 70,041 10,364 $ 80,405 $ (11,670) (17)% (395) (4) $ (12,065) (15)% The decline in software services revenues in 2010 is principally due to lower new software license contract activity in recent quarters due to weak economic conditions. In addition, the increase in the mix of customers choosing our subscription-based solutions was a factor contributing to lower software services revenues. Maintenance. The following table sets forth a comparison of our maintenance revenues for the years ended December 31: ($ in thousands) 2010 2009 $ Enterprise Software Solutions $ 120,764 $ 110,404 $ 10,360 Appraisal and Tax Software Solutions and Services 14,891 14,108 783 Total maintenance revenues $ 135,655 $ 124,512 $ 11,143 % 9% 6 9% Change Maintenance revenues increased due to growth in our installed customer base and slightly higher maintenance rates on most of our product lines. Our annual maintenance and support growth rate has declined compared to previous year’s growth rate due to a number of customers converting to ASP arrangements as well as new customers choosing our subscription-based options, rather than purchasing the software under a traditional perpetual software license arrangement. Appraisal services. The following table sets forth a comparison of our appraisal service revenues for the years ended December 31: ($ in thousands) Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Total appraisal services revenues Change 2010 2009 $ $ — 20,554 $ 20,554 $ — 18,740 $ 18,740 $ — 1,814 $ 1,814 % —% 10 10% Appraisal services revenue increased 10% in 2010 compared to 2009. 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 in late 2009 which contributed to the revenue growth in 2010. 32 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Cost of Revenues and Gross Margin The following table sets forth a comparison of the key components of our cost of revenues for the years ended December 31: ($ in thousands) Software licenses Acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Total cost of revenues Change 2010 2009 $ % $ 3,456 $ 5,440 $ (1,984) (36)% 1,592 138,085 12,910 1,411 137,199 11,518 181 886 1,392 13 1 12 4,268 5,955 (1,687) (28) $ 160,311 $ 161,523 $ (1,212) (1)% The following table sets forth a comparison of gross margin percentage by revenue type for the years ended December 31: Gross margin percentage Software license and acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Overall gross margin 2010 2009 Change 85.5% 83.7% 1.8% 39.2 37.2 27.3 38.2 38.5 18.6 1.0 (1.3) 8.7 44.5% 44.4% 0.1% Software license and acquired software. Cost of third party software comprised approximately 60% of our cost of software license revenues in 2010 compared to approximately 69% of our cost of software license in 2009. Third party software sales declined due to lower proprietary software sales. Costs of acquired software comprises approximately 32% of our cost of software license revenues in 2010 compared to approximately 21% of our cost of software license in 2009. Cost of acquired software includes amortization expense for software acquired through acquisitions. The balance is made up of amortization of capitalized development costs on other software products. We did not capitalize any internal software development costs in 2010 or 2009. In 2010, our software license gross margin percentage increased compared to the prior year period because our product mix included less third party software. Software services, maintenance and subscription-based services. In 2010, 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, as well as annual rate increases on certain services. Appraisal services. Our appraisal services gross margin declined compared to 2009. Our appraisal services gross margin in 2009 included the positive impact of cost savings and operational efficiencies experienced on an unusually complex reappraisal project that ended in mid-2009. Our blended gross margin for 2010 increased compared to 2009 due to lower third party software expense which offset the impact of a revenue mix that included less software license revenues. The gross margin also benefited from leverage in the utilization of our support, maintenance and subscription-based service staff and economies of scale and slightly higher rates on certain services. Tyler Technologies 2011 Annual Report 33 Management’s Discussion and Analysis of Financial Condition and Results of Operations Selling, General and Administrative Expenses The following table sets forth a comparison of our SG&A expenses for the years ended December 31: ($ in thousands) 2010 2009 $ Selling, general and administrative expenses $ 69,480 $ 70,115 $ (635) % (1)% Change SG&A expenses declined in 2010 compared to 2009 due to lower commission costs and marketing expenses which were offset somewhat by higher share-based compensation expense. Marketing expenses in 2009 include costs associated with the launch of a new corporate branding initiative. Research and Development Expense The following table sets forth a comparison of our research and development expense for the years ended December 31: ($ in thousands) 2010 2009 $ % Change Research and development expense $ 13,971 $ 11,159 $ 2,812 25% Research and development expense consist of costs associated with the Microsoft Dynamics AX project, in addition to costs associated with other new product development efforts. In 2010 and 2009, we offset our research and development expense by $5.1 million and $3.5 million, respectively, which were the amounts earned under the terms of our agreement with Microsoft. Amortization of Customer and Trade Name Intangibles The following table sets forth a comparison of amortization of customer and trade name intangibles for the years ended December 31: ($ in thousands) 2010 2009 $ % Amortization of customer and trade name intangibles $ 3,225 $ 2,705 $ 520 19% Change In January 2010 we completed an acquisition that increased amortizable customer and trade name intangibles by approximately $5.5 million. This amount is being amortized over 10 years. Other The following table sets forth a comparison of other expense, net for the years ended December 31: ($ in thousands) Other expense, net 2010 $ 1,742 2009 $ 146 Change $ % $ 1,596 NA In 2010, over half of other expense is comprised of interest expense, non-usage and other fees associated with a credit agreement entered into in August 2010. Other expense in 2009 is mainly comprised of interest expense, non-usage fees and other bank fees. Interest expense was higher in 2010 than 2009 due to higher debt levels associated with our stock repurchases. In addition the effective interest rate in 2010 was 3.4% compared to 1.8% in 2009. Income Tax Provision The following table sets forth a comparison of our income tax provision for the years ended December 31: ($ in thousands) Income Tax Provision Effective income tax rate Change 2010 2009 $ % $ 14,845 $ 17,628 $ (2,783) (16)% 37.2% 39.5% 34 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Our effective income tax rate declined compared to 2009 mainly due to a $579,000 research and development tax credit in 2010. In addition to the impact of the research and development tax credit in 2010, the effective income tax rates 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. FINANCIAL CONDITION AND LIQUIDITY As of December 31, 2011, we had cash and cash equivalents of $1.3 million and investments available-for-sale of $2.0 million, compared to cash and cash equivalents of $2.1 million and investments available-for-sale of $2.2 million at December 31, 2010. As of December 31, 2011, we had $60.7 million outstanding borrowings and outstanding letters of credit totaling $8.3 million. Some of our customers, primarily those for our property appraisal services, require that we secure performance bonds before they will select us as a vendor. The maximum potential amount of an outstanding performance bond would be the remaining cost of work to be performed under our contracts. The notional amount of performance guarantees outstanding as of December 31, 2011 was estimated to be $61.3 million. We provide letters of credit as security for the issuance of performance bonds. We do not believe these letters of credit will be required to be drawn upon. These letters of credit expire through mid-2012. We believe our $150.0 million revolving line of credit provides us with sufficient flexibility to meet our long-term financial needs. The following table sets forth a summary of cash flows for the years ended December 31: ($ in thousands) Cash flows provided by (used by): Operating activities Investing activities Financing activities Net (decrease) increase in cash and cash equivalents 2011 2010 2009 $ 56,435 $ 35,350 $ 42,941 (28,809) (8,694) (13,658) (28,414) (34,238) (21,349) $ (788) $ (7,582) $ 7,934 Net cash provided by operating activities continues to be our primary source of funds to finance operating needs and capital expenditures. Other potential capital resources include cash on hand, public and private issuances of debt and equity securities, and bank borrowings. It is possible that our ability to access the capital and credit markets in the future may be limited by economic conditions or other factors. We currently believe that cash provided by operating activities, cash on hand and available credit are sufficient to fund our working capital requirements, capital expenditures, income tax obligations, and share repurchases for at least the next twelve months. In 2011, operating activities provided net cash of $56.4 million, primarily generated from net income of $27.6 million, non-cash depreciation and amortization charges of $10.7 million and non-cash share-based compensation expense of $6.3 million. Working capital, excluding cash, declined $17.7 million mainly due to the timing of payments on income tax liabilities and higher accrued bonus liabilities in 2011 compared to 2010 as a result of improved financial performance. Our accounts receivable and deferred revenue balances were also higher than 2010 due to an increase in annual software maintenance billings as a result of growth in our installed customer base. In addition, our growth in subscription-based arrangements has also contributed to larger deferred revenue balances. 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. At December 31, 2011, our days sales outstanding (“DSOs”) were 99 days compared to DSOs of 102 days at December 31, 2010. 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. Tyler Technologies 2011 Annual Report 35 Management’s Discussion and Analysis of Financial Condition and Results of Operations Investments available-for-sale consist of two auction rate municipal securities (“ARS”) which are collateralized debt obligations supported by municipal agencies and do not include mortgage-backed securities. Short-term investments available-for-sale consists of a portion of one of these ARS which was partially redeemed at par during the period January 1, 2012 through February 23, 2012. These ARS are debt instruments with stated maturities of 20 to 30 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 2012. As of December 31, 2011 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 connection with this estimate of fair value, we have recorded an after-tax temporary unrealized loss on our non-current ARS of $80,000, net of related tax effects of $43,000 in 2011, which is included in accumulated other comprehensive loss on our balance sheet. 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 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 AA. 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 2012. Based on our cash and cash equivalents balance of $1.3 million, expected operating cash flows and a $150.0 million revolving credit line, 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 fair 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. Investing activities used cash of $28.8 million in 2011 compared to $8.7 million in 2010. In 2011, we completed the acquisition of Windsor. The purchase price, net of cash acquired, was approximately $16.4 million. In March 2011 we paid $6.6 million for approximately 27 acres of land and a building in Plano, Texas. The acquisition and capital expenditures were funded from cash generated from operations. In January 2010, we completed the acquisition of the assets of Wiznet, Inc. for $9.5 million in cash. Also, in connection with plans to consolidate workforces and support planned long-term growth, we paid $1.3 million in 2010 compared to $9.4 million in 2009 for construction of an office building in Lubbock, Texas. The impact of these investing activities in 2010 was offset somewhat by the release of $6.0 million of restricted cash. In August 2010, we elected to replace our cash-collateralized letters of credit with ones issued under our revolving line of credit. In 2009, we liquidated $2.5 million of investments in ARS for cash at par. In 2009 we also 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. 36 Tyler Technologies 2011 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Cash used in financing activities was primarily comprised of purchases of treasury shares, net of proceeds from stock option exercises, borrowings and payments on our revolving credit line and contributions from our employee stock purchase plan. During 2011, we purchased 3.0 million shares of our common stock for an aggregate purchase price of $71.8 million. These purchases were primarily funded by borrowings under our revolving credit line and cash from operations. 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, May 2009, July 2010, October 2010 and September 2011. As of December 31, 2011, we had remaining authorization to repurchase up to 1.7 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, as well as the volume of employee stock option exercises. These share repurchases are funded using our existing cash balances and borrowings under our revolving credit agreement and may occur through open market purchases 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. During 2010, we purchased 3.6 million shares of our common stock for an aggregate purchase price of $65.8 million and during 2009, we purchased 1.2 million shares of our common stock for an aggregate purchase price of $17.0 million. In 2011 we issued 582,000 shares of common stock and received $3.6 million in aggregate proceeds upon exercise of stock options. In 2010 we received $3.2 million from the exercise of options to purchase approximately 615,000 shares of our common stock under our employee stock option plan and during 2009, we received $2.3 million from the exercise of options to purchase approximately 425,000 shares of our common stock under our employee stock option plan. In 2011, 2010 and 2009 we received $2.0 million, $1.9 million and $1.5 million, respectively, from contributions to the Tyler Technologies, Inc. Employee Stock Purchase Plan. We have a $150.0 million Credit Agreement (the “Credit Facility”) and a related pledge and security agreement with a group of seven financial institutions, with Bank of America, N.A., as Administrative Agent. The Credit Facility provides for a revolving credit line of $150.0 million (which may be increased up to $200.0 million subject to our obtaining commitments for such increase), with a $25.0 million sublimit for letters of credit. The Credit Facility matures on August 11, 2014. Borrowings under the Credit Facility may be used for general corporate purposes, including working capital requirements, acquisitions and share repurchases. In 2010 we paid $2.0 million in related debt issuance costs. Borrowings under the Credit Facility bear interest at a rate of either (1) the Bank of America’s prime rate plus a margin of 1.50% to 2.75% or (2) the 30, 60, 90 or 180-day LIBOR rate plus a margin of 2.50% to 3.75%, with the margin determined by our consolidated leverage ratio. In 2011 and 2010 our effective average interest rate for borrowings was 3.3% and 3.4%, respectively. As of December 31, 2011 our interest rate was 3.4%. The Credit Facility is secured by substantially all of our assets, excluding real 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, and limits incurrence of additional indebtedness and liens. As of December 31, 2011, we were in compliance with those covenants. As of December 31, 2011, we had $60.7 million in outstanding borrowings and unused available borrowing capacity of $81.0 million under the Credit Facility. In addition, as of December 31, 2011, our bank had issued outstanding letters of credit totaling $8.3 million to secure surety bonds required by some of our customer contracts. These letters of credit reduce our available borrowing capacity and expire through mid-2012. Tyler Technologies 2011 Annual Report 37 Management’s Discussion and Analysis of Financial Condition and Results of Operations We paid income taxes, net of refunds received, of $13.4 million in 2011, $15.8 million in 2010, and $18.1 million in 2009. Excluding acquisitions and investments in office buildings, we anticipate that 2012 capital spending will be between $6.0 million and $7.0 million. We expect the majority of this capital spending will consist of computer equipment and software for infrastructure replacements and expansion. We currently do not expect to capitalize significant amounts related to software development in 2012, but the actual amount and timing of those costs, and whether they are capitalized or expensed may result in additional capitalized software development. We also plan to spend approximately $16.7 million over the next two years in connection with the construction of an office building in Plano, Texas. We expect approximately $9.0 million of the total cost will be paid in 2012 with the remaining $7.7 million paid in 2013. Capital spending, including the construction of an office facility, is expected to be funded from existing cash balances and cash flows from operations. In January 2012, we acquired substantially all of the assets of Akanda Innovation, Inc., a provider of web-based solutions to the public sector which are integrated with our property tax software, for a total purchase price of $2.9 million. The purchase price included certain liabilities assumed by us of approximately $800,000, resulting in net cash paid to the sellers of $2.1 million, of which $900,000 was paid prior to December 31, 2011 and is included with other current assets. 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 2018. Most leases contain renewal options and some contain purchase options. Summarized in the table below are our obligations to make future payments under our long-term revolving credit agreement and lease obligations at December 31, 2011 (in thousands): 2012 2013 2014 2015 2016 Thereafter Total Revolving line of credit Lease obligations $ — $ — $ 60,700 $ — $ — $ — $ 60,700 6,004 4,687 2,598 2,430 2,303 2,341 20,363 Total future payment obligations $ 6,004 $ 4,687 $ 63,298 $ 2,430 $ 2,303 $ 2,341 $ 81,063 As of December 31, 2011, 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, 2011, our capitalization consisted of $60.7 million in long-term obligations and $78.1 million of shareholders’ equity. Our total debt-to-capital ratio was 43.7% at December 31, 2011. 38 Tyler Technologies 2011 Annual Report 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. As of December 31, 2011 we had $60.7 million in outstanding borrowings under the Credit Facility. These borrowings bear interest at a rate of either (1) the Bank of America’s prime rate plus a margin of 1.50% to 2.75% or (2) the 30, 60, 90 or 180-day LIBOR rate plus a margin of 2.50% to 3.75%, with the margin determined by our consolidated leverage ratio. In 2011 and 2010 our effective average interest rate for borrowings was 3.3% and 3.4%, respectively. As of December 31, 2011 our interest rate was 3.4%. Assuming borrowings of $60.7 million, a hypothetical 10% increase in our interest rate at December 31, 2011 for a one year period would result in approximately $206,000 of additional interest rate expense. Investments available-for-sale consist of two ARS with stated maturities of 20 to 30 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, 2011, 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 $80,000, net of related tax effects of $43,000 in 2011, which is included in accumulated other comprehensive loss on our balance sheet. 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 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 AA. 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 2012. Based on our cash and cash equivalents balance of $1.3 million, expected operating cash flows and a $150.0 million revolving credit line, 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 fair 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 2011 Annual Report 39 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, 2011. 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, 2011. 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, 2011. 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, 2011, Tyler’s internal control over financial reporting was effective based on those criteria. Tyler’s internal control over financial reporting as of December 31, 2011 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 40 hereof. Changes in Internal Control Over Financial Reporting — During the quarter ended December 31, 2011, there were no changes in our internal control over financial reporting, as defined in Securities Exchange Act Rule 13a-15(f), that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 40 Tyler Technologies 2011 Annual Report 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, 2011, 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 “Management’s 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, 2011, 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, 2011 and 2010, and the related statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011 and our report dated February 23, 2012 expressed an unqualified opinion thereon. Dallas, Texas February 23, 2012 Tyler Technologies 2011 Annual Report 41 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, 2011 and 2010, and the related statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. 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, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, 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, 2011, 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 23, 2012 expressed an unqualified opinion thereon. Dallas, Texas February 23, 2012 42 Tyler Technologies 2011 Annual Report Statements of Income STATEMENTS OF INCOME 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 Operating income Other expense, 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. 2011 2010 2009 $ 32,594 $ 34,913 $ 42,131 31,160 23,298 17,181 69,617 68,340 80,405 146,498 135,655 124,512 23,228 20,554 18,740 6,294 5,868 7,317 309,391 288,628 290,286 3,034 1,125 3,456 1,592 5,440 1,411 143,776 138,085 137,199 14,550 12,910 11,518 4,994 4,268 5,955 167,479 160,311 161,523 141,912 128,317 128,763 75,650 69,480 70,115 16,414 13,971 11,159 3,331 3,225 2,705 46,517 41,641 44,784 2,404 1,742 146 44,113 39,899 44,638 16,556 14,845 17,628 $ 27,557 $ 25,054 $ 27,010 $ $ 0.88 0.83 $ $ 0.74 0.71 $ $ 0.77 0.74 31,267 34,075 35,240 33,154 35,528 36,624 BALANCE SHEETS December 31, In thousands, except share and per share amounts ASSETS Current assets: Cash and cash equivalents Short-term investments available-for-sale Tyler Technologies 2011 Annual Report 43 Balance Sheets 2011 2010 $ 1,326 $ 2,114 25 25 Accounts receivable (less allowance for losses of $990 in 2011 and $1,603 in 2010) 90,012 81,860 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 Other intangibles, net Sundry LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities: Accounts payable Accrued liabilities Deferred revenue Total current liabilities Revolving line of credit Deferred income taxes Commitments and contingencies Shareholders’ equity: 8,348 2,286 5,095 7,801 3,543 3,106 107,092 98,449 2,095 1,231 40,915 34,851 1,953 2,126 106,094 92,831 35,628 32,307 1,614 2,237 $ 295,391 $ 264,032 $ 3,211 $ 2,626 24,751 19,433 123,678 102,590 151,640 124,649 60,700 26,500 4,941 5,911 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 2011 and 2010 Additional paid-in capital Accumulated other comprehensive loss, net of tax Retained earnings 481 481 152,859 153,576 (355) (275) 130,115 102,558 Treasury stock, at cost; 18,176,050 and 15,854,205 shares in 2011 and 2010, respectively (204,990) (149,368) Total shareholders’ equity See accompanying notes. 78,110 106,972 $ 295,391 $ 264,032 44 Tyler Technologies 2011 Annual Report Statements of Shareholders’ Equity STATEMENTS OF S HAREHOLDERS’ EQUITY For the years ended December 31, 2011, 2010 and 2009 Common Stock Shares Amount Additional Accumulated Other Paid-in Comprehensive Retained Income (Loss) Earnings Capital Treasury Stock Total Shareholders’ Shares Amount Equity In thousands Balance at December 31, 2008 48,148 $ 481 $ 151,245 $ (387) $ 50,494 (12,333) $ (87,571) $ 114,262 Comprehensive income: Net income Unrealized loss on investment — — — — 27,010 securities, net of tax — — — (18) — — — — 27,010 — (18) 26,992 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 — — — 425 — 6,069 — 2,295 5,045 — — — (1,235) (17,000) (17,000) Employee Stock Purchase Plan — — (118) — — 115 1,546 1,428 Federal income tax benefit related to exercise of stock options — — 1,336 — — — — 1,336 Balance at December 31, 2009 48,148 481 153,734 (405) 77,504 (13,028) (96,956) 134,358 Comprehensive income: Net income Unrealized gain on investment — — — — 25,054 securities, net of tax — — — 130 — — — — 25,054 — 130 25,184 Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to — — — — — — (8,157) — 6,132 — — — 615 — 11,338 — 3,181 6,132 — — — (3,559) (65,793) (65,793) Employee Stock Purchase Plan — — (218) — — 118 2,043 1,825 Federal income tax benefit related to exercise of stock options — — 2,085 — — — — 2,085 Balance at December 31, 2010 48,148 481 153,576 (275) 102,558 (15,854) (149,368) 106,972 Comprehensive income: Net income Unrealized loss on investment — — — — 27,557 securities, net of tax — — — (80) — — — — 27,557 — (80) 27,477 Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to — — — — — — (10,352) — 6,253 — — — 582 — 13,905 — 3,553 6,253 — — — (3,004) (71,802) (71,802) Employee Stock Purchase Plan — — (230) — — 100 2,275 2,045 Federal income tax benefit related to exercise of stock options — — 3,612 — — — — 3,612 Balance at December 31, 2011 48,148 $ 481 $ 152,859 $ (355) $ 130,115 (18,176) $ (204,990) $ 78,110 See accompanying notes. Tyler Technologies 2011 Annual Report 45 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 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 Cost of acquisitions, net of cash acquired Additions to property and equipment Decrease (increase) in restricted investments Decrease (increase) in other Net cash used by investing activities Cash flows from financing activities: Statements of Cash Flows 2011 2010 2009 $ 27,557 $ 25,054 $ 27,010 10,676 10,788 9,497 6,253 805 (3,590) (2,916) 6,132 5,045 1,161 1,538 (2,000) (959) (1,125) (1,730) (8,544) (1,989) (6,277) 6,084 (214) 575 (34) 1,391 104 1,377 (1,181) 1,190 4,887 (5,200) 1,960 14,862 3,474 3,065 56,435 35,350 42,941 50 75 2,500 (17,298) (9,661) (2,934) (12,278) (4,930) (12,352) — 717 6,000 (178) (918) 46 (28,809) (8,694) (13,658) Increase (decrease) in net borrowings on revolving line of credit 34,200 26,500 (8,000) Purchase of treasury shares Contributions from employee stock purchase plan Proceeds from exercise of stock options Debt issuance costs Excess tax benefits from exercise of share-based arrangements (71,802) (65,793) (18,263) 2,045 3,553 1,901 1,494 3,181 2,295 — (2,027) — 3,590 2,000 1,125 Net cash used by financing activities (28,414) (34,238) (21,349) Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year See accompanying notes. (788) (7,582) 7,934 2,114 9,696 1,762 $ 1,326 $ 2,114 $ 9,696 46 Tyler Technologies 2011 Annual Report 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 and state 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 as well as state governments. 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, 2011, we had outstanding letters of credit totaling $8.3 million. Some of our customers, primarily those for our property appraisal services, require that we secure performance bonds before they will select us as a vendor. The maximum potential amount of an outstanding performance bond would be the remaining cost of work to be performed under our contracts. The notional amount of performance guarantees outstanding as of December 31, 2011 was estimated to be $61.3 million. We provide letters of credit as security for the issuance of performance bonds. These letters of credit are issued under our revolving line of credit and reduce our available borrowing capacity. We do not believe these letters of credit will be required to be drawn upon. These letters of credit expire through mid-2012. 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. Tyler Technologies 2011 Annual Report 47 Notes to Financial Statements 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, Multiple Elements Arrangements. 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: 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 relative 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 determine that 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, software license 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. 48 Tyler Technologies 2011 Annual Report Notes to Financial Statements 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. 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, document processing transaction fees and disaster recovery services. We recognize revenue for ASP and other hosting services, software subscriptions 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. 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 the customer has the contractual right to take possession of our software at any time during the hosting period without significant penalty and whether the customer can feasibly maintain the software on the customer’s hardware or enter into another arrangement with a third party to host the software. 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. For ASP and other hosting arrangements that do not meet the criteria for recognition under ASC 985-605, we account for the elements under ASC 605-25, Multiple Element Arrangements using all applicable facts and circumstances, including whether (i) the element has stand-alone value, (ii) there is a general right of return and (iii) the revenue is contingent on delivery of other elements. We allocate contract value to each element of the arrangement that qualifies for treatment as a separate element based on VSOE, and if VSOE is not available, third party evidence, and if third party evidence is unavailable, estimated selling price. For professional services associated with ASP and hosting arrangements that we determine do not have stand-alone value to the customer or are contingent on delivery of other elements, 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. Tyler Technologies 2011 Annual Report 49 Notes to Financial Statements Document processing transaction fees primarily pertain to documents filed with the courts by attorneys and other third parties via our e-filing services and retrieval of filed documents via our access services, and the elements for these arrangements are accounted for under ASC 605-25. For each document filed with a court, the filer generally pays a transaction fee and a court filing fee to us and we remit a portion of the transaction fee and the filing fee to the court. We record as revenue the transaction fee, and the portion of the transaction fee remitted to the courts is recorded as cost of sales as we are acting as a principal in the arrangement. Court filing fees collected on behalf of the courts and remitted to the courts are recorded on a net basis and do not affect the statement of income or the balance sheet. 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 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. VSOE of fair value for the maintenance and support obligations for software licenses is based upon the specific sale renewals to customers. Allocation of Revenue in Statements of Income In our statements of income, 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 proportional 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 50 Tyler Technologies 2011 Annual Report Notes to Financial Statements 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 our contracts generally 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 proportional 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. 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 $16.4 million during 2011, $14.0 million during 2010 and $11.2 million during 2009. We reduced our research and development expense by approximately $3.5 million in 2011, $5.1 million in 2010 and $3.5 million in 2009, which was the amount earned under the terms of our strategic alliance with a development partner. Tyler Technologies 2011 Annual Report 51 Notes to Financial Statements 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 more likely than not 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 four to six 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 acquisition 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. 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 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 52 Tyler Technologies 2011 Annual Report Notes to Financial Statements 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 2011, 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 85% 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. 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 of the product for general release to customers. We did not capitalize any internal software development costs in 2011, 2010 or 2009. 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 $125,000 in 2011, $430,000 in 2010, and $743,000 in 2009, and is included in cost of software license revenue in the accompanying statements of income. FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and cash equivalents, accounts receivables, accounts payables, short-term obligations 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, 2011 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. The fair value of our revolving line of credit approximates book value as of December 31, 2011. Tyler Technologies 2011 Annual Report 53 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 insured amounts. As of December 31, 2011 we had cash and cash equivalents of $1.3 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, 2011. 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 reserved Deductions for accounts charged off or credits issued Balance at end of year 2011 2010 2009 $ 1,603 805 (142) $ 2,389 1,161 4 $ 2,115 1,538 — (1,276) (1,951) (1,264) $ 990 $ 1,603 $ 2,389 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 proportional 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 $7.2 million and $11.7 million at December 31, 2011 and 2010, respectively. We also have recorded retention receivables of $1.9 million and $2.4 million at December 31, 2011 and 2010, respectively 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 included with accounts receivable, long-term portion in the accompanying balance sheets. 54 Tyler Technologies 2011 Annual Report Notes to Financial Statements As of December 31, 2010 our accounts receivable balance included $4.2 million associated with one customer that terminated its arrangement with us for convenience and, in addition, had disputed certain amounts we invoiced prior to the termination. In December 2011, we negotiated a final settlement with this customer which did not have a material impact on the financial statements. 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 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. 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 Accounting Standards Update (“ASU”) 2011-08 amends existing guidance by giving an entity the option to first assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount. If this is the case, companies will need to perform a more detailed two-step goodwill impairment test which is used to identify potential goodwill impairments and to measure the amount of goodwill impairment losses to be recognized, if any. ASU 2011-08 will be effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, which for us will be in our 2012 second quarter, with early adoption permitted. We do not believe the adoption of this update will have a material impact on our financial statements. In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income, which amends certain guidance in ASC 220, Comprehensive Income. ASU 2011-05 revises the manner in which entities present comprehensive income in their financial statements. ASU 2011-05 removes the presentation options in ASC 220 and requires entities to report components of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. ASU 2011-05 is effective for interim and annual reporting periods beginning after December 15, 2011 and will be applied on a retrospective basis. (2) ACQUISITIONS 2011 On October 14, 2011, we acquired all of the capital stock of Windsor Management Group, L.L.C. (“Windsor”) for a cash purchase price of $16.4 million, net of cash acquired of $7.4 million. Windsor provides a suite of financial and human capital management solutions to the K-12 education market, primarily in the Southwest. In connection with this transaction we recorded customer relationship of approximately $5.6 million, acquired software of $2.4 million, deferred revenue of $6.2 million and net assets of $1.5 million. We recorded goodwill of approximately $13.3 million, all of which is expected to be deductible for tax purposes. Customer relationships and acquired software will be amortized over a weighted average period of eight years. We believe likely market participants for this transaction would be software companies with a presence in the K-12 school market. Therefore, Tyler Technologies 2011 Annual Report 55 Notes to Financial Statements the goodwill of $13.3 million arising from the acquisition is primarily attributed to our ability to maximize the value of the customer base through Tyler’s software product suite that targets the K-12 school market and to a much lesser extent, the assembled workforce of Windsor. Our balance sheet as of December 31, 2011 reflects the allocation of the purchase price to the assets acquired based on their estimated fair values at the date of acquisition. The operating results of this acquisition are included in our results of operations from the date of acquisition. 2010 On January 1, 2010 we acquired all of 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 integrated with our primary courts and justice solution. 2009 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 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. (3) FAIR VALUE OF FINANCIAL INSTRUMENTS Assets recorded at fair value in the balance sheet as of December 31, 2011 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, 2011 we held investments available-for-sale that are required to be measured at fair value on a recurring basis. The following tables summarize the fair value of these financial assets as well as cash and cash equivalents: Cash and cash equivalents Investments available-for-sale December 31, 2011 Quoted Prices in Significant Other Active Markets for Identical Assets (Level 1) Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) $ 1,326 $ — 25 — $ 1,351 $ — $ — 1,953 $ 1,953 Total $ 1,326 1,978 $ 3,304 56 Tyler Technologies 2011 Annual Report Notes to Financial Statements Cash and cash equivalents Investments available-for-sale December 31, 2010 Quoted Prices in Significant Other Active Markets for Identical Assets (Level 1) Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) $ 2,114 $ — 25 — $ 2,139 $ — $ — 2,126 $ 2,126 Total $ 2,114 2,151 $ 4,265 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 2011. Investments available-for-sale consist of two auction rate municipal securities (“ARS”) which are collateralized debt obligations supported by municipal agencies and do not include mortgage-backed securities. Short-term investments available-for-sale consists of a portion of one of these ARS which was partially redeemed at par during the period January 1, 2012 through February 23, 2012. These ARS are debt instruments with stated maturities of 20 and 30 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 2012. As of December 31, 2011 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, 2011 are as follows: Non-current investments available-for-sale Par Value Temporary Impairment Carrying Value $ 2,500 $ 547 $ 1,953 In association with this estimate of fair value, we have recorded an after-tax temporary unrealized loss on our non-current ARS of $80,000, net of related tax effects of $43,000 in 2011, which is included in accumulated other comprehensive loss on our balance sheet. 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 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 AA. The ratings on the ARS take into account credit support through insurance policies guaranteeing each Tyler Technologies 2011 Annual Report 57 Notes to Financial Statements 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 2012. Based on our cash and cash equivalents balance of $1.3 million, expected operating cash flows, and a $150.0 million credit line, 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 fair 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. 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, 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 Transfers into level 3 Transfers out of level 3 Purchases, sales, issuances and settlements Unrealized gains included in accumulated other comprehensive loss Balance as of December 31, 2010 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, 2011 (4) PROPERTY AND EQUIPMENT, NET Property and equipment, net consists of the following at December 31: Land Building and leasehold improvements Computer equipment and purchased software Furniture and fixtures Transportation equipment Accumulated depreciation and amortization Property and equipment, net $ 3,779 — (75) (1,700) (28) 1,976 — (25) (25) 200 2,126 — (25) (25) (123) $ 1,953 Useful Lives (Years) 2011 2010 — 5-39 3-5 5 5 $ 7,549 29,299 21,303 7,656 248 $ 3,959 26,396 23,408 7,601 305 66,055 61,669 (25,140) (26,818) $ 40,915 $ 34,851 Depreciation expense was $5.3 million during 2011, $5.1 million during 2010, and $4.4 million during 2009. We own office buildings in Yarmouth, Maine, Lubbock, Texas, and Dayton, Ohio. We lease a small amount of space in two of these buildings to third-party tenants. These leases expire between 2013 and 2015 and are expected to provide rental income of approximately $640,000 during 2012, $404,000 during 2013, $235,000 during 2014, $78,000 during 2015, and none thereafter. Rental income associated with third party tenants was $1.2 million in 2011, $1.4 million in 2010 and $1.3 million in 2009, respectively and was included as a reduction of selling, general and administrative expenses. 58 Tyler Technologies 2011 Annual Report Notes to Financial Statements (5) GOODWILL AND OTHER INTANGIBLE ASSETS Other intangible assets and related accumulated amortization consists of the following at December 31: Gross carrying amount of acquisition intangibles: 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 Total other intangibles 2011 2010 $ 50,552 26,363 2,211 1,387 $ 44,992 23,983 1,971 1,387 80,513 72,333 (45,045) (40,311) $ 35,468 $ 32,022 $ 36,701 $ 36,701 (36,541) (36,416) $ 160 $ 285 $ 35,628 $ 32,307 Total amortization expense, for acquisition related intangibles and post acquisition software development costs, was $4.9 million during 2011, $5.5 million during 2010, and $5.1 million during 2009. The allocation of acquisition intangible assets is summarized in the following table: December 31, 2011 December 31, 2010 Gross Carrying Amount Weighted Average Amortization Period Accumulated Amortization Gross Carrying Amount Weighted Average Amortization Accumulated Amortization Period $ 106,094 — $ — $ 92,831 — $ — Non-amortizable intangibles: Goodwill Amortizable intangibles: Customer related intangibles 50,552 16 years Software acquired 26,363 5 years Trade name Lease acquired 2,211 1,387 18 years 5 years 20,409 22,617 1,048 44,992 17 years 23,983 5 years 1,971 19 years 971 1,387 5 years 17,163 21,492 963 693 The changes in the carrying amount of goodwill for the two years ended December 31, 2011 are as follows: Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Total Balance as of December 31, 2009 $ 84,668 $ 5,590 $ 90,258 Goodwill acquired during the year related to the purchase of Wiznet 2,573 — 2,573 Balance as of December 31, 2010 87,241 5,590 92,831 Goodwill acquired during the year related to the purchase of Windsor 13,263 — 13,263 Balance as of December 31, 2011 $ 100,504 $ 5,590 $ 106,094 Tyler Technologies 2011 Annual Report 59 Notes to Financial Statements 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, 2012 2013 2014 2015 2016 (6) ACCRUED LIABILITIES Accrued liabilities consist of the following at December 31: Accrued wages, bonuses and commissions Other accrued liabilities Accrued health claims (7) REVOLVING LINE OF CREDIT $ 5,255 4,690 4,215 4,036 3,947 2011 2010 $ 16,971 $ 11,762 6,510 6,367 1,270 1,304 $ 24,751 $ 19,433 On August 11, 2010, we entered into a new $150.0 million Credit Agreement (the “Credit Facility”) and a related pledge and security agreement with a group of seven financial institutions, with Bank of America, N.A., as Administrative Agent. The Credit Facility provides for a revolving credit line of $150.0 million (which may be increased up to $200.0 million subject to our obtaining commitments for such increase), with a $25.0 million sublimit for letters of credit. The Credit Facility matures on August 11, 2014. Borrowings under the Credit Facility may be used for general corporate purposes, including working capital requirements, acquisitions and share repurchases. Borrowings under the Credit Facility bear interest at a rate of either (1) the Bank of America’s prime rate plus a margin of 1.50% to 2.75% or (2) the 30, 60, 90 or 180-day LIBOR rate plus a margin of 2.50% to 3.75%, with the margin determined by our consolidated leverage ratio. In 2011 and 2010, our effective average interest rate for borrowings was 3.3% and 3.4%, respectively. As of December 31, 2011, our interest rate was 3.4%. The Credit Facility is secured by substantially all of our assets, excluding real 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, and limits incurrence of additional indebtedness and liens. As of December 31, 2011, we were in compliance with those covenants. As of December 31, 2011, we had $60.7 million in outstanding borrowings and unused available borrowing capacity of $81.0 million under the Credit Facility. In addition, as of December 31, 2011, our bank had issued outstanding letters of credit totaling $8.3 million to secure surety bonds required by some of our customer contracts. These letters of credit reduce our available borrowing capacity and expire through mid-2012. We paid interest of $1.9 million in 2011 and $689,000 in 2010. 60 Tyler Technologies 2011 Annual Report Notes to Financial Statements (8) INCOME TAX The income tax provision (benefit) on income from operations consists of the following: Years ended December 31, 2011 2010 2009 Current: Federal State Deferred $ 17,239 2,233 19,472 (2,916) $ 13,552 $ 16,822 2,252 15,804 2,536 19,358 (959) (1,730) $ 16,556 $ 14,845 $ 17,628 Reconciliation of the U.S. statutory income tax rate to our effective income tax expense rate for operations follows: Years ended December 31, Federal income tax expense at statutory rate State income tax, net of federal income tax benefit Non-deductible business expenses Qualified manufacturing activities Research and development credit Other, net 2011 2010 2009 $ 15,440 1,238 $ 13,965 1,218 $ 15,623 1,634 918 (840) (177) (23) 976 (728) (579) (7) 965 (586) — (8) $ 16,556 $ 14,845 $ 17,628 Approximately 35% of our stock option expense is derived from incentive stock options (“ISOs”). 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. The tax effects of the major items recorded as deferred tax assets and liabilities as of December 31 are: 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 assets (liabilities) 2011 2010 $ 4,597 5,156 $ 2,642 4,020 203 397 160 195 10,353 7,017 (10,043) (9,673) (156) (149) (10,199) (9,822) $ 154 $ (2,805) Although realization is not assured, we believe it is more likely than not that all the deferred tax assets at December 31, 2011 and 2010 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. Tyler Technologies 2011 Annual Report 61 Notes to Financial Statements The Internal Revenue Service (“IRS”) is examining our U.S. income tax return for the year 2010. As of February 22, 2012, no significant adjustments have been proposed by the IRS. We are unable to make a reasonable estimate as to when cash settlements, if any, will occur. 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 2008. We are no longer subject to state and local income tax examinations by tax authorities for the years before 2007. We paid income taxes, net of refunds received, of $13.4 million in 2011, $15.8 million in 2010, and $18.1 million in 2009. (9) SHAREHOLDERS’ EQUITY The following table details activity in our common stock: Years ended December 31, 2011 2010 2009 Shares Amount Shares Amount Shares Amount Purchases of common stock (3,004) $ (71,802) (3,559) $ (65,793) (1,235) $ (17,000) Stock option exercises Employee stock plan purchases 582 100 3,553 2,045 615 118 3,181 1,825 425 115 2,295 1,428 As of February 22, 2012 we had authorization from our board of directors to repurchase up to 1.7 million additional shares of our common stock. (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 four to six years of continuous service from the date of grant and have a contractual 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, 2011, there were 3.5 million shares available for future grants under the plan from the 16.0 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 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. 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. 62 Tyler Technologies 2011 Annual Report Notes to Financial Statements 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 share-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 2011 6.7 2010 6.7 33.1% 35.0% 1.7% 3% 2.7% 3% 2009 6.5 37.2% 3.1% 3% The following table summarizes share-based compensation expense related to share-based awards which is recorded in the statements of income: 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 Stock Option Activity Options granted, exercised, forfeited and expired are summarized as follows: Outstanding at December 31, 2008 Granted Exercised Forfeited Outstanding at December 31, 2009 Granted Exercised Forfeited Outstanding at December 31, 2010 Granted Exercised Forfeited Outstanding at December 31, 2011 Exercisable at December 31, 2011 Number of Shares 5,309 835 (425) (15) 5,704 765 (615) (18) 5,836 831 (582) (26) 6,059 3,177 2011 2010 2009 $ 871 5,382 6,253 $ 739 5,393 6,132 $ 540 4,505 5,045 (1,545) (1,475) (1,233) $ 4,708 $ 4,657 $ 3,812 Weighted Average Exercise Price Weighted Average Remaining Contractual Life (Years) Aggregate Intrinsic Value $ 9.69 17.25 5.40 7.80 11.12 18.82 5.17 16.59 12.74 26.83 6.10 15.78 15.31 $ 11.44 6 5 $ 89,646 $ 59,293 Tyler Technologies 2011 Annual Report 63 Notes to Financial Statements We had unvested options to purchase 2.7 million shares with a weighted average grant date value of $19.35 as of December 31, 2011 and unvested options to purchase 2.7 million shares with a weighted average grant date value of $16.04 as of December 31, 2010. As of December 31, 2011, we had $18.9 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 four 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 intrinsic value of stock options exercised Employee Stock Purchase Plan 2011 2010 2009 $ 9.91 12,289 $ 7.70 8,119 $ 7.38 4,656 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, 2011, there were 129,000 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, 2011 2010 2009 Numerator for basic and diluted earnings per share Net income Denominator: $ 27,557 $ 25,054 $ 27,010 Weighted-average basic common shares outstanding 31,267 34,075 35,240 Assumed conversion of dilutive securities: Stock options Denominator for diluted earnings per share – Adjusted weighted-average shares Earnings per common share: Basic Diluted 1,887 33,154 1,453 35,528 1,384 36,624 $ 0.88 $ 0.74 $ 0.83 $ 0.71 $ 0.77 $ 0.74 Stock options representing the right to purchase common stock of 714,000 shares in 2011, 1.8 million shares in 2010, and 2.6 million shares in 2009 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 an entity in which an executive’s father and brother have a 100% ownership interest. The executive does not have an interest in the entity that leases the property to us and the lease arrangement existed at the time we acquired the division that occupies this property. Most of our leases are non-cancelable operating lease agreements and they expire at various dates through 2018. In addition to rent, the leases generally require us to pay taxes, maintenance, insurance and certain other operating expenses. Rent expense was approximately $5.9 million in 2011, $5.4 million in 2010, and $6.3 million in 2009, which included rent expense associated with related party lease agreements of $1.8 million in 2011, $1.9 million in 2010 and $2.0 million in 2009. 64 Tyler Technologies 2011 Annual Report Notes to Financial Statements Future minimum lease payments under all non-cancelable leases at December 31, 2011 are as follows: Years ending December 31, 2012 2013 2014 2015 2016 Thereafter $ 6,004 4,687 2,598 2,430 2,303 2,341 $ 20,363 Included in future minimum lease payments are non-cancelable payments due to related parties of $1.7 million in 2012, $1.7 million in 2013, $1.7 million in 2014, $1.7 million in 2015, $1.7 million in 2016, and $1.7 million 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 $2.9 million during 2011, $2.8 million during 2010, and $2.6 million during 2009. (14) COMMITMENTS AND CONTINGENCIES 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) 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 and state governments. We provide our software systems and services and appraisal services through four business units which focus on the following products: – financial management and education software solutions; – financial management and municipal courts software solutions; – courts and justice software solutions; and – appraisal and tax software solutions and property appraisal services. In accordance with ASC 280-10, Segment Reporting, the financial management and education software solutions unit, financial management and municipal courts software solutions unit and the courts and justice software solutions unit meet the criteria for aggregation and are presented in one reportable segment, Enterprise Software Solutions (“ESS”). The ESS segment provides municipal and county governments and schools with software systems and services 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 (“ATSS”) 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. Tyler Technologies 2011 Annual Report 65 Notes to Financial Statements 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 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. Corporate segment operating income also includes revenues and expenses related to a company-wide user conference. 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. ESS segment capital expenditures in 2011 and 2009 included $6.6 million and $11.2 million, respectively for the purchase of buildings and land in connection with plans to consolidate workforces and support long-term growth. In 2009 the ATSS segment had one appraisal services customer which accounted for 10.4% of this segment’s total revenues. The ATSS segment did not have any customers in 2011 and 2010 that accounted for 10% or more of their total revenues. As of and year ended December 31, 2011 Revenues Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Intercompany Total revenues Enterprise Software Solutions Appraisal and Tax Software Solutions and Services Corporate Totals $ 30,194 $ 2,400 $ 30,400 60,840 130,999 — 5,199 2,103 760 8,777 15,499 23,228 — — — — — — — 1,095 (2,103) $ 32,594 31,160 69,617 146,498 23,228 6,294 — $ 259,735 $ 50,664 $ (1,008) $ 309,391 Depreciation and amortization expense 8,516 650 1,510 10,676 Segment operating income Capital expenditures Segment assets 56,856 9,786 (15,669) 50,973 11,143 137 998 12,278 $ 448,015 $ 56,389 $ (209,013) $ 295,391 66 Tyler Technologies 2011 Annual Report Notes to Financial Statements As of and year ended December 31, 2010 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 $ 32,757 $ 2,156 $ 22,975 58,371 120,764 — 5,727 1,978 323 9,969 14,891 20,554 6 — — — — — — 135 (1,978) $ 34,913 23,298 68,340 135,655 20,554 5,868 — $ 242,572 $ 47,899 $ (1,843) $ 288,628 Depreciation and amortization expense 8,903 683 1,202 10,788 Segment operating income Capital expenditures Segment assets 51,942 8,883 (14,367) 46,458 2,960 350 310 3,620 $ 373,432 $ 45,957 $ (155,357) $ 264,032 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 $ 39,484 $ 2,647 $ 16,870 70,041 110,404 — 6,113 1,618 311 10,364 14,108 18,740 135 — — — — — — 1,069 (1,618) $ 42,131 17,181 80,405 124,512 18,740 7,317 — $ 244,530 $ 46,305 $ (549) $ 290,286 Depreciation and amortization expense 8,031 608 858 9,497 Segment operating income Capital expenditures Segment assets 54,825 7,763 (13,688) 48,900 13,361 192 614 14,167 $ 220,135 $ 25,597 $ 24,938 $ 270,670 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 Other expense, net Income before income taxes 2011 2010 2009 $ 50,973 $ 46,458 $ 48,900 (1,125) (3,331) (1,592) (3,225) (2,404) (1,742) (1,411) (2,705) (146) $ 44,113 $ 39,899 $ 44,638 Tyler Technologies 2011 Annual Report 67 Notes to Financial Statements (16) SUBSEQUENT EVENT In January 2012, we acquired substantially all of the assets of Akanda Innovation, Inc., a provider of web-based solutions to the public sector which are integrated with our property tax software, for a total purchase price of $2.9 million. The purchase price included certain liabilities we assumed of approximately $800,000, resulting in net cash paid to the sellers of $2.1 million, of which $900,000 was paid prior to December 31, 2011 and is included with other current assets. (17) QUARTERLY FINANCIAL INFORMATION (unaudited) The following table contains selected financial information from unaudited statements of income for each quarter of 2011 and 2010. 2011 2010 Quarters ended Dec. 31 Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 Mar. 31 Revenues Gross profit $ 82,079 $ 77,184 $ 76,735 $ 73,393 $ 72,439 $ 73,769 $ 72,600 $ 69,820 39,020 36,132 34,137 32,623 32,616 33,207 32,475 30,019 Income before income taxes 13,504 11,818 9,309 9,482 10,159 11,263 10,383 8,094 Net income 8,699 7,506 5,624 5,728 7,210 6,723 6,249 4,872 Earnings per diluted share 0.27 0.23 0.17 0.17 0.21 0.19 0.17 0.13 Shares used in computing diluted earnings per share 32,031 32,960 33,848 33,720 33,895 35,410 36,203 36,655 68 Tyler Technologies 2011 Annual Report 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, 2006. 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 C UMULATIVE FIVE YEAR TOTAL RETURN $250 $200 $150 $100 $50 $0 2006 2007 2008 2009 2010 2011 100 100 100 91.68 105.49 109.30 85.21 66.46 65.18 141.61 84.05 96.57 147.65 96.71 120.32 214.15 98.76 115.48 Tyler Technologies, Inc. S&P 500 Index S&P 600 Information Technology Index 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 Matthew B. Bieri Vice President Chief Information Officer Samantha B. Crosby Vice President Chief Marketing 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 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 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 10, 2012, at 9:30 a.m. Central Time at The Park City Club, 5956 Sherry Lane, 17th Floor, 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” Design by Eisenberg And Associates 5949 Sherry Lane Suite 1400 Dallas, Texas 75225 972.713.3700 www.tylertech.com