Stock-Based Compensation

12 Months Ended

Dec. 31, 2012

Stock-Based Compensation

Stock-Based Compensation

9. Stock-Based Compensation

Stock Option Plans

On December 29, 2009, the Board of Directors adopted the 2009 Amended and Restated Management Equity Plan. The 2009 plan modified all stock options that were outstanding under the 2007 Management Equity Plan.

The 2009 plan provides for the granting of stock awards with service-, performance- and market-based components to executive officers and other key employees. An aggregate of 1,102,500 shares of the common stock of Holdings are reserved for issuance of options, plus an additional number of rollover options, described below. Option awards are granted by the compensation committee, with an exercise price equal to or greater than the fair value of our stock at the date of grant. Service-based awards generally vest over five years of continuous service. Performance- and market-based awards contingently vest over five years of continuous service and become exercisable only when they have both time vested and met the performance and market condition requirements specified in the award.

Options granted under the 2009 plan have a ten year contractual term and are divided into three equal tranches. Tranche 1 and tranche 2 awards are subject to a five-year service-based vesting period with 20% vesting on each anniversary date based on the original grant date. Tranche 3 time vest in the same manner as tranche 1 and 2 awards and only become fully vested and exercisable upon the achievement of performance- and market-based vesting conditions. The performance- and market-based conditions of tranche 3 awards require specified levels of investment return to be realized by the majority of common stock holders through certain transactions specified in the plan.

The awards provide for accelerated vesting if there is a change in control, as defined in the 2009 plan. As of December 31, 2012, the performance conditions for tranche 3 awards were not deemed probable of achievement and therefore no stock-based compensation expense had been recognized for tranche 3 awards. When the performance conditions are deemed to be probable of achievement, the related stock-based compensation expense will then be recognized based on the service-based vesting achieved at that time.

Rollover Options

In connection with our acquisition by affiliates of Bain Capital, certain members of management elected to reinvest their equity in fully vested stock option awards outstanding from 2006 and earlier Guitar Center stock option plans. The options granted in this reinvestment, authorized under the 2009 plan, are referred to as rollover options. During the fourth quarter of 2010, all outstanding rollover options, with exercise prices ranging from $15.31 to $15.75, were exercised in a cashless exercise, whereby shares were surrendered to satisfy the exercise price. Concurrently with the cashless exercise, 224,210 new options were granted to replace the surrendered shares. The replacement options were fully vested with a contractual term of ten years from the grant date and had an exercise price of $22.82, equal to the estimated fair value of Holdings’ common stock on the grant date. We recognized compensation cost of $1.5 million in 2010 related to the grant of vested replacement options. Compensation cost in 2011 related to rollover options was not material. We did not have any compensation cost related to rollover options in 2012.

Option Valuation

We use the Black-Scholes-Merton method to value stock option grants that do not have market-based vesting conditions. We use a binomial model to value stock option grants having market-based vesting conditions. We use a combination of historical data and internally-developed expectations about employees’ option exercise and post-vesting departure behavior to estimate the expected term of the options. Separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve on the grant date. Because our shares are not publicly traded, there is no market price for our stock and volatility of the fair value of our stock is not readily calculable. We estimate the fair value of our stock annually during the first quarter, or whenever a transaction requires a valuation, using a combination of observed market multiples for similar publicly-traded companies and a discounted cash flow analysis. The discounted cash flow analysis is based on internally-developed cash flow forecasts, discounted using our weighted-average cost of capital, and considers our net assets and credit risk to arrive  at net enterprise value. We discount the calculated fair value to account for illiquidity of our shares. We estimate the expected volatility based on the average historical volatility of similar entities with publicly traded shares.

Holdings granted 22,610 options in 2012, 236,829 options in 2011 and 409,710 options in 2010.

We recognized total stock-based compensation expense of $1.1 million in 2012, $1.6 million in 2011 and $3.2 million in 2010. This expense is included in selling, general, and administrative expenses in the consolidated statements of comprehensive income or loss.

As of December 31, 2012, there was approximately $2.4 million of total unrecognized compensation cost related to stock option grants under the 2009 plan, of which $1.5 million relates to tranche 1 and 2 options and $0.9 million relates to tranche 3 options. This cost is expected to be recognized over the weighted-average period of 2.5 years, assuming full achievement of related performance and market conditions.