(2) Share-Based Payment Arrangements

6 Months Ended

Jun. 30, 2012

Notes to Financial Statements

(2) Share-Based Payment Arrangements

The following table summarizes the plans under which the Company was able to grant equity compensation as of June 30, 2012:

	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	2,197,887	7,336,713	May 17, 2016
FalconStor Software, Inc., 2010 Outside Directors Equity	400,000	280,000	90,300	May 8, 2020
Compensation Plan

On July 1, 2012, the total shares available for issuance under the FalconStor Software, Inc., 2006 Incentive Stock Plan (the “2006 Plan”) totaled 2,197,887. 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, 2012, the total number of outstanding shares of the Company’s common stock totaled 47,541,262. Pursuant to the 2006 Plan, as amended, the total shares available for issuance under the 2006 Plan thus increased by 179,176 shares from 2,197,887 to 2,377,063 shares available for issuance as of July 1, 2012.

The following table summarizes the Company’s equity plans that have expired but that still have equity awards outstanding as of June 30, 2012:

	Shares Available	Shares
Name of Plan	for Grant	Outstanding
FalconStor Software, Inc., 2000 Stock Option Plan	--	3,265,212
1994 Outside Directors Stock Option Plan	--	40,000
2004 Outside Directors Stock Option Plan	--	250,000
FalconStor Software, Inc., 2007 Outside Directors Equity	--	175,000
Compensation Plan
Stand-Alone Stock Option Agreement between	--	1,220,000
the Company and James P. McNiel

All options granted under the Company’s equity plans have terms of ten years.

The following table summarizes stock option activity during the six months ended June 30, 2012:

	Number of	Exercise	Contractual	Intrinsic
	Options	Price	Life  (Years)	Value
Options Outstanding at December 31, 2011	14,456,722	$4.95
Granted	521,200	$2.94
Exercised	(82,900)	$2.45
Canceled	(10,000)	$7.98
Forfeited	(428,290)	$6.88
Options Outstanding at March 31, 2012	14,456,732	$4.83	6.12	$       5,497,712
Granted	408,000	$3.21
Exercised	(187,680)	$2.24
Canceled	(666,380)	$5.09
Forfeited	(1,846,570)	$4.28
Options Outstanding at June 30, 2012	12,164,102	$4.89	6.46	$          453,155
Options Exercisable at June 30, 2012	4,146,502	$5.69	5.20	$          432,455

Stock option exercises are fulfilled with new shares of common stock. The total cash received from stock option exercises for the three months ended June 30, 2012 and 2011 was $421,290 and $85,421, respectively. The total cash received from stock option exercises for the six months ended June 30, 2012 and 2011 was $624,155 and $552,774, respectively. The total intrinsic value of stock options exercised during the three months ended June 30, 2012 and 2011 was $188,609 and $56,526, respectively. The total intrinsic value of stock options exercised during the six months ended June 30, 2012 and 2011 was $266,862 and $314,822, respectively.

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

	Three months ended June 30,
	2012	2011
Cost of revenues - Product	$                49	$               741
Cost of revenues - Support and Service	(21,124)	129,714
Research and development costs	125,231	329,369
Selling and marketing	398,031	462,555
General and administrative	587,889	417,974
	$    1,090,076	$     1,340,353

	Six months ended June 30,
	2012	2011
Cost of revenues - Product	$                99	$            1,473
Cost of revenues - Support and Service	49,844	273,201
Research and development costs	444,188	808,411
Selling and marketing	884,656	885,279
General and administrative	1,159,591	686,936
	$    2,538,378	$     2,655,300

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 period, is as follows:

	Three months ended June 30,
	2012	2011
Directors, officers and employees	$       130,164	$        326,964
Non-employee consultants	-	19,290
	$       130,164	$        346,254

	Six months ended June 30,
	2012	2011
Directors, officers and employees	$       407,580	$        721,498
Non-employee consultants	-	21,882
	$       407,580	$        743,380

As of June 30, 2012, an aggregate of 2,871,054 shares of restricted stock had been issued, of which, 2,193,552 had vested and 464,889 had been canceled. As of June 30, 2011, an aggregate of 2,803,554 shares of restricted stock had been issued, of which, 1,776,429 had vested and 444,645 had been canceled.

As of June 30, 2012, an aggregate of 90,412 restricted stock units had been issued, of which 78,555 had vested and 11,347 had been canceled. As of June 30, 2011, an aggregate of 90,412 restricted stock units had been issued, of which 70,890 had vested and 2,500 had been canceled.

The following table summarizes restricted stock and restricted stock units activity during the six months ended June 30, 2012:

	Number of Restricted
	Stock Awards / Units
Non-Vested at December 31, 2011	525,889
Granted	-
Vested	(290,105)
Forfeited	(11,496)
Non-Vested at March 31, 2012	224,288
Granted	50,000
Vested	(54,415)
Forfeited	(6,750)
Non-Vested at June 30, 2012	213,123

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 three months ended June 30, 2012 and 2011 was $178,592 and $266,019, respectively. The total intrinsic value of restricted stock for which the restrictions lapsed during the six months ended June 30, 2012 and 2011 was $1,038,739 and $1,635,512, respectively.

Options granted to officers, employees and directors during fiscal 2012 and 2011 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.

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 (benefit) 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 period, is as follows:

	Three months ended June 30,
	2012	2011
Non-qualified stock options	$       (25,262)	$          17,286
Restricted stock awards	-	19,290
	$       (25,262)	$          36,576

	Six months ended June 30,
	2012	2011
Non-qualified stock options	$         29,930	$        104,189
Restricted stock awards	-	21,882
	$         29,930	$        126,071

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 June 30, 2012, there was approximately $6,958,152 of total unrecognized compensation cost related to the Company’s unvested options, restricted shares and restricted stock units granted under the Company’s equity plans.