Stock-Based Compensation Plans

Our stock-based compensation program is a broad-based program designed to attract and retain employees while also aligning employees’ interests with the interests of our shareholders. In addition, members of our Board of Directors participate in our stock-based compensation program in connection with their service on our board. Share-based awards issued to employees include non-qualified stock options, restricted stock awards and performance-based awards. Compensation costs resulting from share-based payment transactions are recognized primarily within selling, general and administrative expenses, at fair value over the requisite service period (typically three years) on a straight-line basis. Under the 2011 Omnibus Incentive Plan, the number of shares initially available for awards was 18 million. As of December 31, 2013, there were approximately 10 million shares of common stock available for future grants.

We measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The calculated compensation cost is adjusted based on an estimate of awards ultimately expected to vest. The fair value of a non-qualified stock option is determined on the date of grant using a binomial lattice pricing model incorporating multiple and variable assumptions over time, including assumptions such as employee exercise patterns, stock price volatility and changes in dividends. The fair value of restricted stock and performance-based share awards are determined using the closing price on date of grant.

Total share-based compensation costs recognized for 2013, 2012 and 2011 were $27 million, $22 million, and $13 million, respectively. We recognized less than $1 million of share-based compensation costs within Restructuring and asset impairment charges during 2013, which relates to the acceleration of certain unamortized compensation expense for share-based compensation of restructured employees. A significant component of the charges in 2011 related to costs allocated to Xylem for ITT Corporate employees as well as other ITT employees not solely dedicated to Xylem. These awards and related amounts are not necessarily indicative of awards and amounts that would have been granted if we were an independent, publicly traded company for that period.

The unamortized compensation expense related to our stock options, restricted shares and performance-based shares was $6 million, $17 million and $1 million, respectively, at December 31, 2013 and is expected to be recognized over a weighted average period of 1.5, 1.7 and 2.2 years, respectively.

The amount of cash received from the exercise of stock options was $22 million for 2013 with a tax benefit of $8 million realized associated with stock option exercises and vesting of restricted stock. We classify as a financing activity the cash flows attributable to excess tax benefits arising from stock option exercises and restricted stock vestings.

Stock Option Grants

Options are awarded with a contractual term of ten years and generally vest over or at the conclusion of a three-year period and are exercisable in seven to ten-year periods, except in certain instances of death, retirement or disability. The exercise price per share is the fair market value of the underlying common stock on the date each option is granted. At December 31, 2013, there were options to purchase an aggregate of 3.5 million shares of common stock. The following is a summary of the changes in outstanding stock options for 2013:



(shares in thousands)	Shares		Weighted Average Exercise Price / Share		Weighted Average Remaining Contractual Term (Years)
Outstanding at January 1, 2013	4,083		$	26.46	6.4
Granted	817		$	27.43	10.0
Exercised	(850	)	$	25.01	3.4
Forfeited	(546	)	$	27.86	6.1
Outstanding at December 31, 2013	3,504		$	26.80	6.4
Options exercisable at December 31, 2013	1,994		$	26.71	4.9
Vested and non-vested expected to vest at December 31. 2013	3,438		$	26.79	6.4

The amount of non-vested options outstanding was 1.5 million and 2.2 million at a weighted average grant date fair value of $26.90 and $27.14 as of December 31, 2013 and January 1, 2013, respectively. The aggregate intrinsic value of the outstanding, exercisable and vested and non-vested stock options expected to vest at December 31, 2013 was $28 million, $16 million and $27 million respectively. The total intrinsic value of options exercised (which is the amount by which the stock price exceeded the exercise price of the options on the date of exercise) during 2013 was $7 million.

Stock Option Fair Value

The fair value of each option grant was estimated on the date of grant using the binomial lattice pricing model which incorporates multiple and variable assumptions over time, including assumptions such as employee exercise patterns, stock price volatility and changes in dividends. The following are weighted-average assumptions for 2013.



	2013			2012			2011
Dividend yield	1.69		%	1.52		%	1.51		%
Volatility	31.10		%	33.40		%	36.30		%
Risk-free interest rate	1.28		%	1.42		%	1.50		%
Expected term (in years)	6.62			7.00			6.40
Weighted-average fair value per share	$	7.58		$	8.10		$	7.88

Expected volatility is calculated based on an analysis of historic and implied volatility measures for a set of peer companies. We use historical data to estimate option exercise and employee termination behavior within the valuation model. Employee groups and option characteristics are considered separately for valuation purposes. The expected term represents an estimate of the period of time options are expected to remain outstanding. The expected term provided above represents the weighted average of expected behavior for certain groups of employees who have historically exhibited different behavior. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of option grant.

Restricted Stock Grants

As part of the 2011 Omnibus Incentive Plan, we are authorized to issue shares of restricted stock to eligible employees and directors. Restricted shares granted to employees become fully vested upon the third anniversary of the date of grant, and certain liability-based restricted shares to international employees settle in cash. Prior to the time a restricted share becomes fully vested, the awardees cannot transfer, pledge, hypothecate or encumber such shares. Prior to the time a restricted share is fully vested, the awardees have certain rights of a stockholder and may include the right to vote and receive dividends. If an employee leaves prior to vesting, whether through resignation or termination for cause, the restricted stock and related accrued dividends are forfeited. If an employee retires or is terminated other than for cause, a pro rata portion of the restricted stock may vest in accordance with the terms of the grant agreements. Restricted shares granted to Board members become fully vested upon the date of the next annual meeting.

Our restricted stock activity was as follows for 2013:



(shares in thousands)	Shares		Weighted Average Grant Date Fair Value Per Share
Outstanding at January 1, 2013	1,588		$	26.92
Granted	568		$	28.18
Vested	(691	)	$	26.44
Forfeited	(190	)	$	28.84
Outstanding at December 31, 2013	1,275		$	27.67

Performance-Based Share Grants

As part of the annual March 2013 grant under the long-term incentive plan, performance-based shares were granted to all executive officers of the Company. The performance-based shares vest based upon performance by the Company over a three-year period against targets approved by the compensation committee of the Company's Board of Directors prior to the grant date. For the 2013-2015 performance period, the performance-based shares were granted at a target of 100% with actual payout contingent upon the achievement of a pre-set, three-year adjusted Return on Invested Capital and cumulative adjusted net income performance target. Compensation costs resulting from share-based payment transactions are recognized primarily within selling, general and administrative expenses, at fair value over the requisite service period (typically three years) on a straight-line basis. The calculated compensation cost is adjusted based on an estimate of awards ultimately expected to vest and our assessment of the probable outcome of the performance condition. The fair value of performance-based share awards at 100% target is determined using the closing price of our common stock on date of grant.

Our performance-based share activity was as follows for 2013:



(shares in thousands)	Shares		Weighted Average Grant Date Fair Value Per Share
Outstanding at January 1, 2013	—		$	—
Granted	119		$	27.49
Vested	—		$	—
Forfeited	(67	)	$	27.49
Outstanding at December 31, 2013	52		$	27.49