(2) Share-Based Payment Arrangements

9 Months Ended

Sep. 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 September 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		12,224,133		1,928,878		7,758,484	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, as amended, on July 1st 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 September 30, 2012:

	Shares Available		Shares
Name of Plan	for Grant		Outstanding
FalconStor Software, Inc., 2000 Stock Option Plan		--		3,142,612
1994 Outside Directors Stock Option Plan		--		40,000
2004 Outside Directors Stock Option Plan		--		190,000
FalconStor Software, Inc., 2007 Outside Directors Equity		--		170,000
Compensation Plan
Stand-Alone Stock Option Agreement between		--		1,220,000
the Company and James P. McNiel

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

The following table summarizes stock option activity during the nine months ended September 30, 2012:

						Weighted
				Weighted		Average
				Average		Remaining		Aggregate
	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
Granted		1,093,500		$	1.94
Exercised		-		$	0.00
Canceled		(8,250	)	$	4.12
Forfeited		(822,029	)	$	4.63
Options Outstanding at September 30, 2012		12,427,323		$	4.65		6.39	$	567,339
Options Exercisable at September 30, 2012		7,713,914		$	5.64		4.92	$	116,094

Stock option exercises are fulfilled with new shares of common stock. During the three months ended September 30, 2012, there were no stock option exercises. During the three months ended September 30, 2011, the total cash received from stock option exercises was $307,940. The total cash received from stock option exercises for the nine months ended September 30, 2012 and 2011 was $624,155 and $860,714, respectively. The total intrinsic value of stock options exercised during the three months ended September 30, 2011 was $91,139. The total intrinsic value of stock options exercised during the nine months ended September 30, 2012 and 2011 was $266,862 and $405,961, 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 September 30,
	2012		2011
Cost of revenues - Product	$	113	$	1,169
Cost of revenues - Support and Service		53,314		111,830
Research and development costs		127,982		235,782
Selling and marketing		388,167		585,814
General and administrative		486,202		501,983
	$	1,055,778	$	1,436,578
	Nine months ended September 30,
		2012		2011
Cost of revenues - Product	$	212	$	2,641
Cost of revenues - Support and Service		103,158		385,032
Research and development costs		572,170		1,044,193
Selling and marketing		1,272,823		1,471,093
General and administrative		1,645,793		1,188,919
	$	3,594,156	$	4,091,878

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 September 30,
	2012		2011
Directors, officers and employees	$	82,284	$	384,578
Non-employee consultants		13,488		-
	$	95,772	$	384,578
	Nine months ended September 30,
		2012		2011
Directors, officers and employees	$	489,864	$	1,106,076
Non-employee consultants		13,488		21,882
	$	503,352	$	1,127,958

As of September 30, 2012, an aggregate of 2,876,068 shares of restricted stock had been issued, of which, 2,219,456 had vested and 472,539 had been canceled. As of September 30, 2011, an aggregate of 2,821,054 shares of restricted stock had been issued, of which, 1,836,769 had vested and 444,645 had been canceled.

As of September 30, 2012, an aggregate of 90,412 restricted stock units had been issued, of which 79,065 had vested and 11,347 had been canceled. As of September 30, 2011, an aggregate of 90,412 restricted stock units had been issued, of which 73,580 had vested and 2,500 had been canceled.

The following table summarizes restricted stock and restricted stock units activity during the nine months ended September 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
Granted		5,014
Vested		(26,414	)
Forfeited		(7,650	)
Non-Vested at September 30, 2012		184,073

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 September 30, 2012 and 2011 was $53,312 and $254,335, respectively. The total intrinsic value of restricted stock for which the restrictions lapsed during the nine months ended September 30, 2012 and 2011 was $1,092,051 and $1,889,847, 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 September 30,
	2012			2011
Non-qualified stock options	$	(15,527	)	$	(93,836	)
Restricted stock awards		13,488			-
	$	(2,039	)	$	(93,836	)
	Nine months ended September 30,
		2012			2011
Non-qualified stock options	$	14,403		$	10,353
Restricted stock awards		13,488			21,882
	$	27,891		$	32,235

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 September 30, 2012, there was approximately $6,620,671 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.