7. Equity Incentive Plans

We account for stock-based compensation by measuring and recognizing the fair value of all stock-based payment awards made to employees based on the estimated grant date fair values, including employee stock options and our employee stock purchase plan. We use the Black-Scholes option pricing model to estimate the value of employee stock options which requires a number of assumptions to determine the model inputs. These include the expected volatility of the stock’s market price, the expected term of the stock-based awards, the expected risk free rate of interest and any dividend yields. As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. We estimate and adjust forfeiture rates based on a periodic review of recent forfeiture activity and expected future employee turnover. As we have been operating as a public company for a period of time that is shorter than our estimated expected option life, we concluded that our historical price volatility does not provide a reasonable basis for input assumptions within the Black-Scholes valuation model when determining the fair value of its stock options. As a result, our expected volatility is based on the historical volatility of a peer group of publicly traded companies.

The following table summarizes our stock-based compensation expense by line item in the condensed consolidated statements of operations (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Cost of sales	$	471	$	171	$	556	$	506
Research and development		6,356		3,588		19,421		8,904
Selling, general and administrative		5,648		4,127		15,752		11,327

Total	$	12,475	$	7,886	$	35,729	$	20,737

CEO Stock Option Grant

On August 13, 2012, to create incentives for continued long term success beyond the Model S program and to closely align executive pay with increases in stockholder value, our Board of Directors granted 5,274,901 stock options to Elon Musk, our Product Architect and Chief Executive Officer (CEO Grant). The CEO Grant consists of ten vesting tranches with a vesting schedule based entirely on the attainment of both performance conditions and market conditions, assuming continued employment and service to us through each vesting date.

Each of the following ten vesting tranches requires a combination of one of the performance achievements outlined below and an incremental increase in our market capitalization of $4.0 billion, as compared to the initial market capitalization of $3.2 billion.

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Successful completion of the Model X Engineering Prototype (Alpha);

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Successful completion of the Model X Vehicle Prototype (Beta);

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Completion of the first Model X Production Vehicle;

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Successful completion of the Gen III Engineering Prototype (Alpha);

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Successful completion of the Gen III Vehicle Prototype (Beta);

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Completion of the first Gen III Production Vehicle;

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Gross margin of 30% or more for four consecutive quarters;

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Aggregate vehicle production of 100,000 vehicles;

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Aggregate vehicle production of 200,000 vehicles; and

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Aggregate vehicle production of 300,000 vehicles.

The term of the CEO Grant will be ten years, so that if any vesting tranches remain unvested after expiration of the CEO Grant, they will be forfeited. In addition, Mr. Musk will forfeit any unvested options if he is terminated as CEO of the Company, whether for cause or otherwise.

We measured the fair value of the CEO Grant using a Monte Carlo simulation approach with the following assumptions: risk-free interest rate of 1.65%, expected term of 10 years, expected volatility of 55% and dividend yield of 0%. Stock-based compensation expense related to the CEO Grant was $0.4 million for the three months ended September 30, 2012.