The following discussion and analysis should be read in conjunction with our consolidated financial statements, the accompanying notes to these financial statements, and the other financial information that appear elsewhere in this Annual Report on Form 10-K. This discussion contains predictions, estimates, and other forward-looking statements that involve a number of risks and uncertainties. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue"; the negative of these terms; or other comparable terminology. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including those set forth in the section entitled "Risk Factors" and elsewhere in this Annual Report on Form 10-K.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Except as required by law, we are under no duty to update or revise any of the forward-looking statements, whether as a result of new information, future events, or otherwise, after the date of Annual Report on Form 10-K.
Overview
athenahealth provides business services that help medical caregivers achieve and sustain financial health by collecting more money and exercising more control over their administrative tasks. These services are designed to reduce the administrative burden of complex billing rules, quality measurement and reporting, clinical documentation and data exchange, patient communication and referrals, and many of the related tasks that distract medical care givers and staff from delivering care. Our services are delivered and consumed through a single instance of our cloud-based platform, athenaNet. We differentiate our services by regularly deploying updates and improvements through athenaNet to clients without any action on the part of the client. athenaNet enables us to quickly implement our solution at a low up-front cost and to seamlessly work in tandem with our clients in real time.
The services provided through our single-instance cloud are currently packaged as four integrated components: athenaCollector for revenue cycle management, athenaClinicals for electronic health record management, athenaCommunicator for patient communication management, and athenaCoordinator for referral cycle management. The use of our single-instance platform allows all clients to benefit from the collective knowledge of all of our other clients through our patented billing Rules Engine and our clinical Quality Management Engine. Our clients use these rules engines to monitor and benchmark their performance with peer practices across the network. Complementing athenaCollector is our business intelligence offering, Anodyne Solutions, which provides physicians and practice managers with comprehensive, detailed insight into practice performance, and Healthcare Data Services, which offers practices a better understanding of the cost and quality of the care they provide to their patients.
Each service we provide is supported by a model comprised of three distinct components: Software, Knowledge, and Work. The cloud-based software is provided at no extra charge to users but is the primary conduit through which we exchange information between clients, payers, and our staff of experts. Knowledge is infused into each of our services via our Rules Engine as we work with clients, payers, and other partners to codify rules associated with reimbursement, clinical quality measures, and other factors related to our clients' performance. The third component to each of our services is the Work that we perform on behalf of our clients. Wherever possible, we replace manual processes with automation, but where automation is not possible, we provide that manual labor rather than returning it to clients to be completed. This unique service model of Software, Knowledge, and Work has allowed us to align our success with our clients' performance, creating a continual cycle of improvement and efficiency. We charge clients a percentage of collections in most cases, so our financial results are a direct reflection of our ability to drive revenue to medical practices.
For the year ended December 31, 2012, we generated revenue of $422.3 million from the sale of our services compared to $324.1 million for the year ended December 31, 2011, and $245.5 million for the year ended December 31, 2010. Given the scope of our market opportunity, we have increased our spending each year on growth, innovation, and infrastructure.
Our revenue is predominately derived from business services that we provide on an ongoing basis. This revenue is generally determined as a percentage of payments collected by us on behalf of our clients, so the key drivers of our revenue include growth in the number of physicians and other medical providers working within our client accounts, the collections of these physicians, and the number of services purchased. To provide these services, we incur expenses in several categories, including direct operating, selling and marketing, research and development, general and administrative, and depreciation and amortization expense. In general, our direct operating expense increases as our volume of work increases, whereas our selling and marketing expense increases in proportion to our intended growth rate of adding new accounts to our network of physician clients. Our other expense categories are less directly related to growth of revenues and relate more to our planning for the

future, our overall business management activities, and our infrastructure. We manage our cash and our use of credit facilities to ensure adequate liquidity, in adherence to related financial covenants. Recent Developments
Epocrates, Inc.
On January 7, 2013, the Company entered into a definitive agreement to acquire Epocrates, Inc. ("Epocrates"), a leading provider of clinical content to healthcare providers via a mobile device at the point of care. Upon the consummation of the acquisition, the issued and outstanding shares of Epocrates common stock will be canceled and automatically converted into the right to receive $11.75 in cash, without interest, and all outstanding options and restricted stock unit awards under Epocrates' equity compensation plans will be assumed by the Company. Each outstanding option and restricted stock unit award shall be exercisable or shall be settled upon the same terms and conditions as under the applicable Epocrates equity compensation plan, except that each option shall be exercisable for, and each restricted stock unit shall be converted into the right to receive, shares of the Company's common stock using an exchange ratio based on the average closing sales prices per share of the Company's common stock for the ten trading days ending on the second trading day prior to the closing of the acquisition. The acquisition is expected to enable the Company to accelerate awareness of athenahealth's services across the physician market and deliver high-value information to the clinical community. The transaction is expected to close in the early part of 2013 and is subject to various closing conditions, including the requisite Epocrates stockholder approval and the expiration or termination of any waiting period under Hart-Scott Rodino Antitrust Improvements Act of 1976, as amended. During the year ended December 31, 2012, the Company incurred legal and professional fees in connection with the acquisition of $0.5 million, which are included in general and administrative expenses.
Watertown, MA Corporate Headquarters - Arsenal on the Charles On December 5, 2012, we entered into a purchase and sale agreement with the President and Fellows of Harvard College to acquire the real estate commonly known as the Arsenal on the Charles, an expansive 29 acre, multi-building, commercial property situated less than 10 miles outside of downtown Boston where we currently lease our headquarters, and related operating activities. The purchase price will be approximately $169 million, subject to the terms and conditions of the purchase and sale agreement, and the transaction is expected to close in the second quarter of 2013, subject to the satisfactory completion of due diligence by athenahealth. We have incurred legal and professional fees in connection with the acquisition of $0.7 million during the year ended December 31, 2012, which are included in general and administrative expenses. 2013 Commitment Letter
On January 7, 2013, we entered into a commitment letter, pursuant to which Bank of America, N.A. committed to increase its commitment to provide revolving loans under our credit facility by an amount up to $55 million as a source of funding for the Epocrates transaction.
Critical Accounting Policies
Our discussion and analysis of our results of operations and liquidity and capital resources are based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States (GAAP). In connection with the preparation of our consolidated financial statements, we are required to make assumptions and estimates about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates and judgments to ensure that our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material.
The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Significant estimates and assumptions are used for, but are not limited to:
(1) revenue recognition; including our estimated expected customer life;
(2) asset impairments; (3) depreciable lives of assets; (4) fair value of stock options; (5) allocation of direct and indirect expenses; (6) fair value of contingent consideration and acquired intangible assets in a business combination; and (7) litigation reserves. Future events and their effects cannot be predicted with certainty, and accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our consolidated financial statements will change as new events occur, as more experience is acquired, as additional information is

obtained, and as our operating environment changes. We evaluate and update our assumptions and estimates on an ongoing basis and may employ outside experts to assist in our evaluations. Actual results could differ from the estimates we have used.
Our significant accounting policies are discussed in Note 1, Nature of Operations and Summary of Significant Accounting Policies, to our accompanying consolidated financial statements. We believe the following accounting policies are the most critical to aid in fully understanding and evaluating our reported financial results, as they require management to make difficult, subjective or complex judgments, and to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting policies and related disclosures with the audit committee of our board of directors.

                                  Judgment and          Effect if Actual Results
       Description                Uncertainties          Differ from Assumptions

   Revenue Recognition

We derive our revenue       We recognize revenue when   Although we believe that
from business services      all of the following        our approach to estimates
associated with revenue     conditions are satisfied:   and judgments as
cycle management,            - there is evidence of     described herein is
electronic health record    an arrangement;             reasonable, actual
management, patient          - the service has been     results could differ and
communication management,   provided to the client;     we may be exposed to
referral cycle management    - the collection of the    increases or decreases in
and analytics offerings     fees is reasonably          revenue that could be
and from implementation     assured; and                material.
and other services.          - the amount of fees to
                            be paid by the client is
Our clients typically       fixed or determinable.
purchase one-year
contracts that renew        All revenue, other than
automatically upon          implementation revenue,
completion. In most         is recognized when the
cases, our clients may      service is performed.
terminate their             Relative to our business
agreements with 90 days     services offering that is
notice without cause. We    based on the collections
typically retain the        of amounts by our
right to terminate client   customers; we do not
agreements in a similar     recognize revenue until
timeframe. Our clients      our customers have been
are billed monthly, in      paid.
arrears, based either
upon a percentage of        Each deliverable within a
collections posted to       multiple deliverable
athenaNet, minimum fees,    revenue arrangement is
flat fees, or per-claim     accounted for as a
fees where applicable.      separate unit if both of
Invoices are generated      the following criteria
within the first two        are met: (1) the
weeks of the subsequent     delivered item or items
month and delivered to      have value to the
clients primarily by        customer on a standalone
email. For most of our      basis and (2) for an
clients, fees are then      arrangement that includes
deducted from a             a general right of return
pre-defined bank account    relative to the delivered
one week after invoice      item(s), delivery or
receipt via an auto-debit   performance of the
transaction. Amounts that   undelivered item(s) is
have been accrued are       considered probable and
recorded as revenue or      substantially in our
deferred revenue, as        control. We consider a
appropriate, and are        deliverable to have
included in our accounts    standalone value if we
receivable balances.        sell this item separately
                            or if the item is sold by
                            another vendor or could
                            be resold by the
                            customer. Further, our
                            revenue arrangements
                            generally do not include
                            a general right of return
                            relative to delivered
                            products.

                            Deliverables not meeting
                            the criteria for being a
                            separate unit of
                            accounting are combined
                            with a deliverable that
                            does meet that criterion.
                            The appropriate
                            allocation of arrangement
                            consideration and
                            recognition of revenue is
                            then determined for the
                            combined unit of
                            accounting. If and when
                            we are not able to
                            deliver all separate
                            units of account in the
                            same period, we allocate
                            arrangement consideration
                            to each deliverable in an
                            arrangement based on its
                            relative selling price.

                                  Judgment and          Effect if Actual Results
       Description                Uncertainties          Differ from Assumptions

We recognize our            As the implementation       Our estimate of expected
non-refundable up-front     service is not separable    performance period may
fees over the contract      from the ongoing business   prove to be inaccurate,
term or estimated           services, we record         in which case we may have
expected customer life,     implementation fees as      understated or overstated
whichever is longer.        deferred revenue until      the revenue recognized in
                            the implementation          an accounting period. For
                            service is complete, at     example, if in the
                            which time we recognize     future, we need to
                            revenue ratably on a        increase our estimated
                            monthly basis over the      expected performance
                            longer of the estimated     period to a period longer
                            expected customer life or   than 12 years, the amount
                            contract life.              we would recognize in
                                                        each accounting period
                            The determination of the    would decrease. On the
                            amount of revenue we can    other hand, if in the
                            recognize each accounting   future, we need to
                            period requires             decrease our estimated
                            management to make          expected performance
                            estimates and judgments     period to a period
                            on the estimated expected   shorter than 12 years,
                            customer life. We           the amount we would
                            determined the estimated    recognize in each
                            customer life considering   accounting period would
                            the following key           increase. The amount of
                            factors:                    deferred revenue related
                                                        to non-refundable
                             - Renewal rate             up-front fees is $53.7
                            considerations              million as of
                             - Economic life of the     December 31, 2012.
                            product or service
                             - Industry data

                            The estimated customer
                            life, or expected
                            performance period, for
                            the years presented is 12
                            years.

                                  Judgment and          Effect if Actual Results
       Description                Uncertainties          Differ from Assumptions

 Business Combinations:
Purchased Intangibles and
Contingent Consideration

Business Combinations,      The accounting for          Future business and
including purchased         business combinations       economic conditions, as
intangibles and             requires estimates and      well as differences
contingent consideration,   judgment as to              actually related to any
are accounted for at fair   expectations for future     of the assumptions, could
value. Acquisition costs    cash flows of the           materially impact the
are generally expensed as   acquired business, the      financial statements
incurred and recorded in    allocation of those cash    through impairment of
general and                 flows to identifiable       goodwill and intangibles,
administrative expenses.    intangible assets,          acceleration of the
All changes to purchase     estimated useful lives of   amortization period of
accounting that do not      these intangible assets     the purchased intangibles
qualify as measurement      and a                       which are finite-lived
period adjustments are      probability-weighted        assets or changes in fair
included in current         income approach based on    value of the contingent
period earnings.            scenarios in estimating     consideration from the
                            achievement of operating    date of acquisition.
                            results and earn-out        Increases or decreases in
                            targets related to          the fair value of the
                            estimating the value of     contingent consideration
                            the contingent              obligations can result
                            considerations.             from changes in the
                            Significant judgment is     estimates of earn out
                            employed in determining     results. We have $48.1
                            the appropriateness of      million and $21.6 million
                            these assumptions as of     carrying amount of
                            the acquisition date and    goodwill and purchased
                            for each subsequent         intangibles, as of
                            period. We review           December 31, 2012,
                            acquired intangibles for    respectively. We have a
                            impairment whenever         liability of $0.4 million
                            events or changes in        of contingent
                            circumstances indicate      consideration related to
                            that the carrying amount    $5.0 million in potential
                            of such assets may not be   payments as of December
                            recoverable. Each period    31, 2012, related to the
                            we revalue the contingent   Proxsys business
                            consideration obligations   combinations cross sell
                            associated with certain     earn out. For the initial
                            acquisitions to their       purchase price
                            then fair value and         allocation, we estimated
                            record increases in the     the fair value of this
                            fair value as contingent    contingent consideration
                            consideration expense and   related to the Proxsys
                            record decreases in the     acquisition in August of
                            fair value as a reduction   2011 to be $4.4 million.
                            of contingent               To date, we have paid out
                            consideration expense.      an insignificant amount
                                                        and decreased the fair
                                                        value by $3.9 million.

Financial Operations Overview
Revenue. We derive our revenue from two sources: from business services associated with our revenue cycle management, electronic health record management, patient communication management, referral cycle management and analytics offerings and from implementation and other services. Implementation and other revenue consist primarily of professional services fees related to assisting clients with the initial implementation of our services and for ongoing training and related support services. Business services accounted for approximately 97% of our total revenues for the year ended December 31, 2012 and 2011. Business services revenue are typically 2% to 8% of a practice's total collections depending upon the services purchased, the size, complexity, and other characteristics of the practice, plus a per-statement charge for billing statements that are generated for patients. Accordingly, business services revenue is largely driven by: the number of physician practices and other service providers we serve, the number of physicians and other medical providers working in those physician practices, the volume of activity and related collections of those physicians, the mix of our services used by those physician practices and other medical providers, and our contracted rates. There is moderate seasonality in the activity level of physician practices. Typically, discretionary use of physician services declines in the late summer and during the holiday season, which leads to a decline in collections by our physician clients about 30 to 50 days later. Additionally, the volume of activity and related collections vary from year to year based in large part on the severity, length and timing of the onset of the flu season. While we believe that the severity, length and timing of the onset of the cold and flu season will continue to impact collections by our physician clients, there can be no assurance that our future sales of these services will necessarily follow historical patterns. Implementation and other revenue are largely driven by the increase in the volume of our new business. As a result, we expect implementation and other revenue to increase in absolute terms for the foreseeable future but to remain relatively consistent as a percentage of total

revenue. None of our clients accounted for more than 10% of our total revenues for the years ended December 31, 2012, 2011, and 2010.
Direct Operating Expense. Direct operating expense consists primarily of salaries, benefits, claim processing costs, other direct expenses, and stock-based compensation related to personnel who provide services to clients, including staff who implement new clients. We expense implementation costs as incurred. We include in direct operating expense all service costs associated with athenaCollector, athenaClinicals, athenaCommunicator, athenaCoordinator, Anodyne Solutions and Healthcare Data Services. We expect to increase our overall level of automation as we become a larger operation, with higher volumes of work in particular functions, geographies, and medical specialties. Although we expect that direct operating expense will increase in absolute terms for the foreseeable future, the direct operating expense is expected to decline as a percentage of revenue as we increase automation. Direct operating expense does not include allocated amounts for rent, occupancy and other indirect costs (including building maintenance and utilities), depreciation, and amortization, except for amortization related to purchased intangible assets.
Selling and Marketing Expense. Selling and marketing expense consists primarily of marketing programs (including trade shows, brand messaging, and on-line initiatives) and personnel-related expense for sales and marketing employees (including salaries, benefits, commissions, stock-based compensation, non-billable travel, lodging, and other out-of-pocket employee-related expenses). Although we recognize substantially all of our revenue when services have been delivered, we recognize a large portion of our sales commission expense at the time of contract signature and at the time our services commence. . . .