Employee Benefit Plans

The Company grants options and RSUs under the 2016 Incentive Plan (the "2016 Plan"), under which awards may be granted to all employees. Award vesting periods for this plan are generally four years. In May 2018, the Company adopted amendments to the 2016 Plan which increased the number of shares of the Company’s common stock that may be issued under the 2016 plan by an additional 1.7 million shares. As of September 30, 2018, approximately 1.8 million shares were reserved for future grants under the 2016 Plan.

Additionally, the Company sponsors an ESPP, pursuant to which eligible employees may contribute up to 10% of compensation, subject to certain income limits, to purchase shares of the Company’s common stock. The terms of the plan include a look-back feature that enables employees to purchase stock semi-annually at a price equal to 85% of the lesser of the fair market value at the beginning of the offering period or the purchase date. The duration of each offering period is generally six-months. As of September 30, 2018, approximately 0.7 million shares were available for issuance under the ESPP.

Option Activity

Stock option activity during the nine months ended September 30, 2018 was as follows:



	Number of shares		Weighted Average Exercise Price Per Share
	(In thousands)		(In dollars)
Outstanding as of December 31, 2017	1,879		$	34.08
Granted	378		69.70
Exercised	(226	)	23.02
Expired	(6	)	21.45
Outstanding as of September 30, 2018	2,025		$	42.00

RSU Activity

RSU activity during the nine months ended September 30, 2018 was as follows:



	Number of shares		Weighted Average Grant Date Fair Value Per Share
	(In thousands)		(In dollars)
Outstanding as of December 31, 2017	1,130		$	43.22
Granted	933		68.27
Vested	(410	)	40.94
Cancelled	(53	)	54.78
Outstanding as of September 30, 2018	1,600		$	58.04

Valuation and Expense Information

The Company measures stock-based compensation at the grant date based on the estimated fair value of the award. Estimated compensation cost relating to RSUs is based on the closing fair market value of the Company’s common stock on the date of grant. The fair value of options granted and the purchase rights granted under the ESPP is estimated on the date of grant using a Black-Scholes-Merton option valuation model that uses the assumptions noted in the following table. The estimated expected term of options granted is derived from historical data on employee exercise and post-vesting employment termination behavior. The risk free interest rate of options granted and the purchase rights granted under the ESPP is based on the implied yield currently available on U.S. Treasury securities with a remaining term commensurate with the estimated expected term. Expected volatility of options granted and the purchase rights granted under the ESPP is based on historical volatility over the most recent period commensurate with the estimated expected term.

The table below sets forth the weighted average assumptions used to estimate the fair value of option grants and purchase rights granted under the ESPP during the three and nine months ended September 30, 2018 and October 1, 2017.



	Three Months Ended							Nine Months Ended
	Stock Options			ESPP				Stock Options				ESPP
	September 30, 2018		October 1, 2017	September 30, 2018		October 1, 2017		September 30, 2018		October 1, 2017		September 30, 2018		October 1, 2017
Expected life (in years)	4.4		NA	0.5		0.5		4.4		4.4		0.5		0.5
Risk-free interest rate	2.79	%	NA	2.22	%	1.12	%	2.36	%	1.65	%	2.00	%	0.93	%
Expected volatility	33.5	%	NA	38.8	%	31.3	%	31.1	%	31.6	%	37.9	%	29.7	%
Dividend yield	—		NA	—		—		—		—		—		—

The following table sets forth the stock-based compensation expense resulting from stock options, RSUs and the ESPP included in the Company’s unaudited condensed consolidated statements of operations and includes $0.9 million expenses related to Arlo's equity grants described more fully in the section below:



	Three Months Ended				Nine Months Ended
	September 30, 2018		October 1, 2017		September 30, 2018		October 1, 2017
	(In thousands)
Cost of revenue	$	853	$	499	$	2,571	$	1,477
Research and development	1,907		1,056		5,431		3,748
Sales and marketing	2,728		1,654		7,847		4,339
General and administrative	4,066		2,374		10,825		6,848
Total stock-based compensation	$	9,554	$	5,583	$	26,674	$	16,412

As of September 30, 2018, $11.4 million of unrecognized compensation cost related to stock options is expected to be recognized over a weighted-average period of 2.5 years. $77.3 million of unrecognized compensation cost related to unvested RSUs is expected to be recognized over a weighted-average period of 2.7 years,

Arlo Grants

In connection with the Arlo IPO discussed in Note 4, Planned Separation of Arlo, Arlo granted to certain individuals from its executive team performance-based options to purchase 2.8 million shares of Arlo common stock at weighted average exercise price of $16.00 per share to create incentives for continued long-term success and to closely align executive pay with the Company’s stockholders’ interests in the achievement of significant milestones. Additionally, during the three months ended September 30, 2018, in connection with Arlo's annual long-term incentive compensation cycle, Arlo granted and additional 0.6 million shares of stock options and 60,000 shares of RSUs. $0.9 million of expenses related to these Arlo's equity grants were recognized in the three months ended September 30, 2018.

Arlo measures stock-based compensation at the grant date based on the estimated fair value of the award. Arlo calculates the fair value of the option using the Black-Scholes-Merton option pricing model.The grant date fair value of Arlo's RSUs was based on the Arlo's closing stock price on the date of grant.

Arlo’s common stock did not have a history of being publicly traded at grant date, the estimated term of Arlo’s options granted was determined using a combination of simplified method, using an average of the contractual term and vesting period of the stock options and by using managements best estimate of the expected term. The risk-free interest rate of options granted was based on the implied yield currently available on U.S. Treasury securities, with a remaining term commensurate with the estimated expected term. The estimated volatility assumption was calculated based on a compensation peer group analysis of stock price volatility with an eight-year look back period ending on the grant date.

The table below sets forth the weighted average assumptions used to estimate the fair value of Arlo's option grants during the three months ended September 30, 2018.



	Three Months Ended
	September 30, 2018
Expected life (in years)	6.3
Risk-free interest rate	2.86	%
Expected volatility	40.0	%
Dividend yield	—

As of September 30, 2018, $19.2 million of unrecognized compensation cost related to Arlo’s stock options was expected to be recognized over a weighted-average period of 3.6 years. $0.9 million of unrecognized compensation cost related to unvested Arlo’s RSUs was expected to be recognized over a weighted-average period of 1.7 years.

The Company expects that certain of NETGEAR's outstanding stock options and unvested restricted stock units held by both NETGEAR and Arlo employees on the date of the Distribution will be converted to equivalent options or restricted stock units, as applicable, with respect to Arlo’s common stock. These modified awards will otherwise have substantially the same terms and conditions, including term and vesting provisions, as the existing NETGEAR's equity awards at the time of conversion. Additionally, in connection with the Distribution, the Company expects to proportionately adjust the number and exercise prices of certain options, RSUs granted to NETGEAR and Arlo employees that are outstanding at the time of the spin-off and to maintain the aggregate intrinsic value of such awards at the date of the spin-off, pursuant to the terms of these awards.