Share-Based Payment Arrangements

12 Months Ended

Dec. 31, 2011

Notes to Financial Statements

Share-Based Payment Arrangements

(8) Share-Based Payment Arrangements

On January 11, 2011, the Company entered into a Stand-Alone Stock Option Agreement (“McNiel Option Agreement”) with James P. McNiel, the Company’s President and Chief Executive Officer. The McNiel Option Agreement, which was approved by stockholders on May 9, 2011, provides for the grant to Mr. NcNiel of options to purchase up to 1,220,000 shares of the Company’s common stock at an exercise price of $3.22 per share, which vest over a three-year period commencing January 11, 2012 at 33%, 33% and 34% annually.

On July 1, 2011, the total shares available for issuance under the FalconStor Software, Inc., 2006 Incentive Stock Plan (the “2006 Plan”), totaled 2,334,722. Pursuant to the 2006 Plan, if, on July 1^st of any calendar year in which the 2006 Plan is in effect, the number of shares of stock as to which options, restricted shares and restricted stock units may be granted under the 2006 Plan is less than five percent (5%) of the number of outstanding shares of stock, then the number of shares of stock available for issuance under the 2006 Plan is automatically increased so that the number equals five percent (5%) of the shares of stock outstanding. In no event shall the number of shares of stock subject to the 2006 Plan in the aggregate exceed twenty million shares, subject to adjustment as provided in the 2006 Plan. On July 1, 2011, the number of outstanding shares of the Company’s common stock totaled 46,694,436. Pursuant to the 2006 Plan, as amended, the total shares available for issuance under the 2006 Plan thus increased by 2,116,843 shares from 217,879 to 2,334,722 shares available for issuance as of July 1, 2011.

The following table summarizes the plans under which the Company was able to grant equity compensation as of December 31, 2011:

	Shares		Shares Available		Shares		Last Date for Grant
Name of Plan	Authorized		for Grant		Outstanding		of Shares
FalconStor Software, Inc., 2006 Incentive Stock Plan		12,044,957		1,417,161		8,528,559		May 17, 2016
FalconStor Software, Inc., 2010 Outside Directors Equity		400,000		330,000		63,400		May 8, 2020
Compensation Plan

The following table summarizes the plans which have expired but still have equity awards outstanding as of December 31, 2011:

	Shares Available		Shares
Name of Plan	for Grant		Outstanding
FalconStor Software, Inc., 2000 Stock Option Plan		—		4,621,552
1994 Outside Directors Stock Option Plan		—		110,500
2004 Outside Directors Stock Option Plan		—		250,000
FalconStor Software, Inc., 2007 Outside Directors Equity		—		188,600
Compensation Plan
Stand-Alone Stock Option Agreement between		—		1,220,000
the Company and James P. McNiel

A summary of the Company’s stock option activity for 2011 is as follows:

						Weighted
				Weighted		Average
				Average		Remaining		Aggregate
	Number of			Exercise		Contractual		Intrinsic
	Options			Price		Life  (Years)		Value
Options Outstanding at December 31, 2010		12,192,884		$	5.58
Granted		4,449,500		$	3.50
Exercised		(346,453	)	$	2.66
Canceled		(683,709	)	$	7.29
Forfeited		(1,155,500	)	$	5.29
Options Outstanding at December 31, 2011		14,456,722		$	4.95		6.44	$	506,487
Options Exercisable at December 31, 2011		8,276,675		$	6.11		4.52	$	324,077
Options Expected to Vest after December 31, 2011 (1)		5,019,184		$	3.38		9.04	$	—
(1) Options expected to vest after December 31, 2011 reflect an estimated forfeiture rate

Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the years ended December 31, 2011, 2010 and 2009 was $920,106, $409,889 and $35,520, respectively. The total intrinsic value of stock options exercised during the years ended December 31, 2011, 2010 and 2009 was $422,136, $2,881,294 and $358,495, respectively.

The Company realized share-based compensation expense for all awards issued under the Company’s stock plans in the following line items in the consolidated statement of operations:

	Years ended December 31,
	2011		2010		2009
Cost of revenues - Product	$	2,960	$	31,779	$	26,398
Cost of revenues - Support and Service		461,735		1,117,550		1,534,208
Research and development costs		1,302,129		2,987,146		3,030,747
Selling and marketing		2,023,370		3,379,518		3,107,877
General and administrative		1,727,864		1,169,576		1,128,211
	$	5,518,058	$	8,685,569	$	8,827,441

The Company did not recognize any tax benefits related to share-based compensation expense during the years ended December 31, 2011 and December 31, 2010. During the year ended December 31, 2009, the Company recognized approximately $388,000, of tax benefits related to share-based compensation expense.

The Company has the ability to issue both restricted stock and restricted stock units. The fair value of the restricted stock awards and restricted stock units are expensed at either (i) the fair value per share at date of grant (directors, officers and employees), or (ii) the fair value per share as of each reporting period (non-employee consultants). A summary of the total stock-based compensation expense related to restricted stock awards and restricted stock units, which is included in the Company’s total share-based compensation expense for each respective year, is as follows:

	Years ended December 31,
	2011		2010		2009
Directors, officers and employees	$	1,358,107	$	2,524,914	$	2,667,745
Non-employee consultants		21,882		760,661		123,249
	$	1,379,989	$	3,285,575	$	2,790,994

As of December 31, 2011, an aggregate of 2,821,054 shares of restricted stock have been issued, of which, 1,854,007 have vested and 446,990 have been forfeited. As of December 31, 2010, an aggregate of 2,658,872 shares of restricted stock had been issued, of which, 1,446,082 had vested and 417,485 had been forfeited. As of December 31, 2009, an aggregate of 2,178,854 shares of restricted stock had been issued, of which, 622,425 had vested and 393,180 had been forfeited.

As of December 31, 2011, an aggregate of 90,412 restricted stock units have been issued, of which, 73,580 have vested and 11,000 have been forfeited. As of December 31, 2010, an aggregate of 90,412 restricted stock units had been issued, of which, 43,975 had vested and 2,500 had been forfeited. As of December 31, 2009, an aggregate of 90,412 restricted stock units had been issued, of which none had vested or been forfeited.

A summary of the Company’s restricted stock activity for 2011 is as follows:

	Number of Restricted
	Stock Awards / Units
Non-Vested at December 31, 2010		839,422
Granted		162,182
Vested		(437,710	)
Forfeited		(38,005	)
Non-Vested at December 31, 2011		525,889

Restricted stock and restricted stock units are fulfilled with new shares of common stock. The total intrinsic value of restricted stock for which the restrictions lapsed during the years ended December 31, 2011, 2010 and 2009 was $1,941,382, $2,905,735 and $1,405,901, respectively.

Options granted to non-employee consultants have exercise prices equal to the fair market value of the stock on the date of grant and a contractual term of ten years. Restricted stock awards granted to non-employee consultants have a contractual term equal to the lapse of restriction(s) of each specific award. Vesting periods for share-based awards granted to non-employee consultants range from immediate vesting to three years depending on service requirements. A summary of the total stock-based compensation expense related to share-based awards granted to non-employee consultants, which is included in the Company’s total share-based compensation expense for each respective year, is as follows:

	Years ended December 31,
	2011		2010		2009
Non-qualified stock options	$	2,487	$	58,524	$	152,231
Restricted stock awards		21,882		760,661		123,249
	$	24,369	$	819,185	$	275,480

The Company estimates the fair value of share-based payments using the Black-Scholes option-pricing model. The Company believes that this valuation technique and the approach utilized to develop the underlying assumptions are appropriate in estimating the fair value of the Company’s share-based payments granted during the years ended December 31, 2011, 2010, and 2009. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by the employees who receive equity awards.

The per share weighted average fair value of share-based payments granted during the years ended December 31, 2011, 2010, and 2009 was $2.11, $1.95 and $1.77, respectively. In addition, to the exercise and grant date prices of the awards, certain weighted average assumptions that were used to estimate the fair value of share-based payment grants in the respective periods are listed in the table below:

	Years ended December 31,
	2011			2010			2009
Expected dividend yield		0	%		0	%		0	%
Expected volatility		56 – 61%			54 -60%			51 - 60%
Risk-free interest rate		1.0 -2.5%			1.6 - 3.0%			1.8 – 3.9%
Expected term (years)		5.5			5.5			5.5
Discount for post-vesting restrictions		N/A			N/A			N/A

Options granted to officers, employees and directors during fiscal 2011, 2010, and 2009 have exercise prices equal to the fair market value of the stock on the date of grant, a contractual term of ten years, and a vesting period generally of three years. Based on each respective group’s historical vesting experience and expected trends, the estimated forfeiture rate for officers, employees, and directors, as adjusted, was 11%, 24% and 0%, respectively.

The Company estimates expected volatility based primarily on historical daily volatility of the Company’s stock and other factors, if applicable. The risk-free interest rate is based on the United States treasury yield curve in effect at the time of grant. The expected option term is the number of years that the Company estimates that options will be outstanding prior to exercise. The expected term of the awards was determined based upon an estimate of the expected term of “plain vanilla” options as prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 110.

As of December 31, 2011, there was approximately $8,683,538 total unrecognized compensation cost related to the Company’s unvested stock options, restricted stock and restricted stock unit awards granted under the Company’s stock plans. The unrecognized compensation cost is expected to be recognized over a weighted-average period of 1.96 years.

As of December 31, 2011, the Company had 16,729,772 shares of common stock reserved for issuance upon the exercise of stock options, restricted stock and restricted stock units.