STOCK-BASED COMPENSATION

Under our stock-based employee compensation plan, referred to as the Fuel Tech, Inc. Incentive Plan (Incentive Plan), awards may be granted to participants in the form of Non-Qualified Stock Options, Incentive Stock Options, Stock Appreciation Rights, Restricted Stock, Restricted Stock Units (“RSUs”), Performance Awards, Bonuses or other forms of share-based or non-share-based awards or combinations thereof. Participants in the Incentive Plan may be our directors, officers, employees, consultants or advisors (except consultants or advisors in capital-raising transactions) as the directors determine are key to the success of our business. The amount of shares that may be issued or reserved for awards to participants under a 2004 amendment to the Incentive Plan is 12.5% of outstanding shares calculated on a diluted basis. At December 31, 2013, we had approximately 671,000 equity awards available for issuance under the Incentive Plan

Stock-based compensation is included in selling, general and administrative costs in our consolidated statements of operations.

The components of stock-based compensation for the years ended December 31, 2013, 2012 and 2011 were as follows:



	For the Year Ended December 31,
	2013		2012		2011
Stock options	(245	)	(66	)	2,077
Restricted stock units	2,043		1,314		672
Deferred directors fees	—		58		61
Total stock-based compensation expense	1,798		1,306		2,810
Tax benefit of stock-based compensation expense	(671	)	(472	)	(959	)
After-tax effect of stock based compensation	1,127		834		1,851

As of December 31, 2013, there was $2,795 of total unrecognized compensation cost related to all non-vested share-based compensation arrangements granted under the Incentive Plan. That cost is expected to be recognized over the remaining requisite service period of 1.7 years.

Stock Option Exchange Program

On June 1, 2011, the Company commenced an exchange program that offered to certain employees the right to exchange eligible options to purchase shares of common stock of the Company for a lesser number of replacement awards of restricted stock units. The exchange offer expired on June 29, 2011. Pursuant to the exchange offer, 814,500 eligible options were tendered by 97 employees and the Company granted 267,372 restricted stock units in exchange for those options. As a result of the exchange, which is deemed a modification of the original stock option awards under generally accepted accounting principles, additional stock-based compensation of approximately $252 was recognized over the two year vesting period associated with the replacement awards commencing June 30, 2011. The additional stock compensation was determined by comparing the fair value of the options tendered immediately prior to the exchange to the intrinsic value of the RSUs granted immediately after the exchange. The fair value of the options was calculated using the Black-Scholes option pricing model. The Company recognized $63, $126 and $63 of additional stock-based compensation during the years ended December 31, 2013, 2012 and 2011, respectively, as a result of the stock option exchange program, which is included in the stock compensation related to RSUs in the table above. Additional information regarding the stock option exchange program may be found on the Company’s Tender Offer Statement on Schedule TO filed with the SEC on June 1, 2011.

Stock Options

The stock options granted to employees under the Incentive Plan have a 10-year life and they vest as follows: 50% after the second anniversary of the award date, 25% after the third anniversary, and the final 25% after the fourth anniversary of the award date. Fuel Tech calculates stock compensation expense for employee option awards based on the grant date fair value of the award, less expected annual forfeitures, and recognizes expense on a straight-line basis over the four-year service period of the award. Stock options granted to members of our Board of Directors vest immediately. Stock compensation for these awards is based on the grant date fair value of the award and is recognized in expense immediately.

Fuel Tech uses the Black-Scholes option pricing model to estimate the grant date fair value of employee stock options. The principal variable assumptions utilized in valuing options and the methodology for estimating such model inputs include: (1) risk-free interest rate – an estimate based on the yield of zero–coupon treasury securities with a maturity equal to the expected life of the option; (2) expected volatility – an estimate based on the historical volatility of Fuel Tech’s Common Stock for a period equal to the expected life of the option; and (3) expected life of the option – an estimate based on historical experience including the effect of employee terminations.

Based on the results of the model, the weighted-average fair value of the stock options granted during the 12-month periods ended December 31, 2013, 2012 and 2011, respectively, were $1.79, $1.72 and $4.08 per share using the following weighted average assumptions:



	2013		2012		2011
Expected dividend yield	—	%	—	%	—	%
Risk-free interest rate	1.01	%	0.67	%	1.80	%
Expected volatility	55.2	%	58.6	%	57.2	%
Expected life of option	4.7 years		4.8 years		5.0 years

The following table presents a summary of our stock option activity and related information for the years ended December 31:



	2013				2012				2011
	Number of Options		Weighted- Average Exercise Price		Number of Options		Weighted- Average Exercise Price		Number of Options		Weighted- Average Exercise Price
Outstanding at beginning of year	1,914,000		$	11.38	1,902,000		$	11.51	2,856,125		$	14.68
Granted	80,000		3.85		70,000		3.55		60,000		8.16
Exchanged for RSUs	—		—		—		—		(814,500	)	22.06
Exercised	(195,000	)	4.16		—		—		(81,500	)	4.61
Expired or forfeited	(110,500	)	10.93		(58,000	)	6.33		(118,125	)	18.48
Outstanding at end of year	1,688,500		$	11.88	1,914,000		$	11.38	1,902,000		$	11.51
Exercisable at end of year	1,678,500		$	11.92	1,833,500		$	11.48	1,718,062		$	11.72
Weighted-average fair value of options granted during the year			$	1.79			$	1.72			$	4.08

The following table provides additional information regarding our stock option activity for the 12 months ended December 31, 2013:



	Number of Options		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life	Aggregate Intrinsic Value
Outstanding on January 1, 2013	1,914,000		$	11.38
Granted	80,000		3.85
Exercised	(195,000	)	4.16
Expired or forfeited	(110,500	)	10.93
Outstanding on December 31, 2013	1,688,500		$	11.88	3.8 years	$	1,038
Exercisable on December 31, 2013	1,678,500		$	11.92	3.8 years	$	1,027

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on our closing stock price of $7.09 as of December 31, 2013, which would have been received by the option holders had those options holders exercised their stock options as of that date.

The following table summarizes information about stock options outstanding at December 31, 2013:



Options Outstanding					Options Exercisable
Range of Exercise Prices	Number of Options	Weighted- Average Remaining Contractual Life	Weighted- Average Exercise Price		Number of Options	Weighted- Average Exercise Price
$ 3.55 - $ 5.51	328,500	5.3 years	$	4.44	328,500	$	4.44
$ 5.52 - $11.03	775,875	4.0 years	8.88		765,875	8.92
$11.04 - $22.06	267,250	2.2 years	14.57		267,250	14.57
$22.07 - $27.57	316,875	3.0 years	24.69		316,875	24.69
$ 3.55 - $27.57	1,688,500	3.8 years	$	11.88	1,678,500	$	11.92

Non-vested stock option activity for the 12 months ended December 31, 2013 was as follows:



	Non-Vested Stock Options Outstanding		Weighted-Average Grant Date Fair Value
Outstanding on January 1, 2013	80,500		$	5.35
Granted	80,000		1.79
Vested	(148,000	)	3.53
Forfeited	(2,500	)	5.98
Outstanding on December 31, 2013	10,000		3.58

As of December 31, 2013, there was $20 of total unrecognized compensation cost related to non-vested stock options granted under the Incentive Plan. That cost is expected to be recognized over a weighted average period of 0.7 years. Fuel Tech received proceeds from the exercise of stock options of $811, $0 and $376 in the years ended December 31, 2013, 2012 and 2011, respectively. The intrinsic value of options exercised in the years ended December 31, 2013, 2012 and 2011 was $520, $0 and $256, respectively. It is our policy to issue new shares upon option exercises, loan conversions, and vesting of restricted stock units. We have not used cash and do not anticipate any future use of cash to settle equity instruments granted under share-based payment arrangements.

Restricted Stock Units

Restricted stock units (RSUs) granted to employees vest over time based on continued service (typically vesting over a period between two and four years). Such time-vested RSUs are valued at the date of grant using the intrinsic value method based on the closing price of the Common Shares on the grant date. Compensation cost, adjusted for estimated forfeitures, is amortized on a straight-line basis over the requisite service period.

In addition to the time vested RSUs described above, commencing in 2011, on an annual basis we entered into performance-based RSU agreements (the Agreements) with our President/Chief Executive Officer, Treasurer/Chief Financial Officer, Executive Vice President of Marketing & Sales, and Executive Vice President of Worldwide Operations. Commencing in 2013, the Senior Vice President, General Counsel, and Secretary also entered into an agreement. The Agreements provide each participating executive the opportunity to earn three types of awards with each award type specifying a targeted number of RSUs that may be granted to each executive based on either the individual performance of the executive or our relative performance compared to a peer group, as determined by the award type. The Compensation Committee of our Board of Directors (the Committee) determines the extent to which, if any, RSUs will be granted based on the achievement of the applicable performance criteria specified in the Agreement. This determination will be made following the completion of the applicable performance period (each a Determination Date). Such performance based awards include the following:

•

The first type of award is based on individual performance during the respective calendar year as determined by the Committee based on performance criteria specified in the Agreement. These awards will vest over a three-year period beginning on the Determination Date. We estimated the fair value of these performance-based RSU awards on the date of the Agreement using the trading price of the Company’s stock and our estimate of the probability that the specified performance criteria will be met. The fair value measurement and probability estimate will be re-measured each reporting date until the Determination Date, at which time the final award amount will be known. For these job performance-based awards, we amortize compensation costs over the requisite service period, adjusted for estimated forfeitures, for each separately vesting tranche of the award.

•

The second type of RSU award contains a targeted number of RSUs to be granted based on our revenue growth relative to a specified peer group during a period of two calendar years. These awards vest 67% on the second anniversary of the Agreement date and 33% on the third anniversary of the Agreement date. We estimated the fair value of these performance-based RSU awards on the Agreement date using the trading price of the Company’s stock and our estimate of the probability that the specified performance criteria will be met. For these revenue growth performance-based awards, we amortize compensation costs over the requisite service period, adjusted for estimated forfeitures, for each separately vesting tranche of the award.

•

The third type of RSU award contains a targeted number of RSUs to be granted based on the total shareholder return (TSR) of our Common Shares relative to a specified peer group during a period of two calendar years. These awards vest 67% on the second anniversary of the Agreement date and 33% on the third anniversary of the Agreement date. We estimated the fair value of these market-based RSU awards on the Agreement date using a Monte Carlo valuation methodology and amortize the fair value over the requisite service period for each separately vesting tranche of the award. The principal variable assumptions utilized in valuing these RSUs under this valuation methodology include the risk-free interest rate, stock volatility and correlations between our stock price and the stock prices of the peer group of companies.

We recorded expense of approximately $2,043, $1,314 and $672 associated with our restricted stock unit awards in 2013, 2012 and 2011, respectively. At December 31, 2013 there was $2,775 of unrecognized compensation costs related to restricted stock unit awards to be recognized over a weighted average period of 1.7 years. During the years ended December 31, 2013 and 2012, there were 394,938 and 72,250 restricted stock units that vested with a fair value of $1,728 and $307, respectively.

A summary of restricted stock unit activity for the years ended December 31, 2013, 2012 and 2011 is as follows:



	Shares		Weighted Average Grant Date Fair Value
Unvested restricted stock units at January 1, 2011	149,000		$	8.63
Granted	80,000		9.14
Converted from stock options	267,372		6.53
Forfeited	(9,207	)	6.76
Vested	—		—
Unvested restricted units at December 31, 2011	487,165		7.59
Granted	349,000		4.82
Forfeited	(11,891	)	7.15
Vested	(72,250	)	8.63
Unvested restricted stock units at December 31, 2012	752,024		6.21
Granted	485,000		4.62
Forfeited	(70,070	)	5.58
Vested	(394,938	)	2.94
Unvested restricted stock units at December 31, 2013	772,016		5.35

Deferred Directors Fees

In addition to the Incentive Plan, Fuel Tech has a Deferred Compensation Plan for Directors (Deferred Plan). Under the terms of the Deferred Plan, Directors can elect to defer Directors’ fees for shares of Fuel Tech Common Stock that are issuable at a future date as defined in the agreement. In accordance with ASC 718, Fuel Tech accounts for these awards as equity awards as opposed to liability awards. In 2013, 2012 and 2011, we recorded $0, $58 and $61 respectively, of stock-based compensation expense under the Deferred Plan.