NOTE 7. STOCK-BASED COMPENSATION

Arrowhead has two plans that provide for equity-based compensation. Under the 2004 Equity Incentive Plan and 2013 Incentive Plan, 2,657,352 and 4,000,000 shares, respectively, of Arrowhead’s Common Stock are reserved for the grant of stock options, stock appreciation rights, restricted stock awards and performance unit/share awards by the Board of Directors to employees, consultants and others. As of December 31, 2014, there were options granted and outstanding to purchase 2,561,018 and 1,686,000 shares of Common Stock under the 2004 Equity Incentive Plan and the 2013 Incentive Plan, respectively, and there were 470,000 restricted stock units granted and outstanding under the 2013 Incentive Plan. Also, as of December 31, 2014, there were 617,322 shares reserved for options and restricted stock units issued as inducement grants to new employees outside of equity compensation plans. During the three months ended December 31, 2014, no options were granted under the 2004 Equity Incentive Plan, 864,000 options were granted under the 2013 Incentive Plan, and 120,000 options and 30,000 restricted stock units were granted as inducement awards to new employees outside of equity incentive plans. Additionally, the Company’s 2000 Stock Option Plan and the 38,000 stock options that were outstanding under the 2000 Stock Option Plan expired during the three months ended December 31, 2014.

The following tables summarize information about stock options:

	Number of Options Outstanding		Weighted- Average Exercise Price Per Share		Weighted- Average Remaining Contractual Term		Aggregate Intrinsic Value
Balance At September 30, 2013		3,419,285	$	4.68
Granted		1,039,000		14.05
Cancelled		(152,582)		6.05
Exercised		(454,863)		6.00
Balance At September 30, 2014		3,850,840		6.99
Granted		984,000		5.45
Cancelled		(38,000)		18.46
Exercised		(2,500)		5.19
Balance At December 31, 2014		4,794,340	$	6.59		8.4 years	$	11,479,110
Exercisable At December 31, 2014		1,860,703	$	5.80		7.3 years	$	5,106,714

Stock-based compensation expense related to stock options for the three months ended December 31, 2014 and 2013 was $981,399 and $521,138, respectively. The Company does not recognize an income tax benefit as the Company is currently operating at a loss and an actual income tax benefit may not be realized. For non-qualified stock options, the loss creates a timing difference, resulting in a deferred tax asset, which is fully reserved by a valuation allowance.

The fair value of the options granted by Arrowhead for the three months ended December 31, 2014 and 2013 is estimated at $3,596,618 and $531,510, respectively.

The intrinsic value of the options exercised during the three months ended December 31, 2014 and 2013 was $23,774 and $314,858, respectively.

As of December 31, 2014, the pre-tax compensation expense for all outstanding unvested stock options in the amount of approximately $13,093,446 will be recognized in our results of operations over a weighted average period of 3.1 years.

The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which do not have vesting restrictions and are fully transferable. The determination of the fair value of each stock option is affected by our stock price on the date of grant, as well as assumptions regarding a number of highly complex and subjective variables. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

The assumptions used to value stock options are as follows:

	Three months ended December 31,
	2014	2013
Dividend yield	—	—
Risk-free interest rate	1.61 – 1.85%	1.90%
Volatility	75%	69%
Expected life (in years)	6.25	6.25
Weighted average grant date fair value per share of options granted	$3.66	$5.06

The dividend yield is zero as the Company currently does not pay a dividend.

The risk-free interest rate is based on the U.S. Treasury bond.

Volatility is estimated based on volatility average of the Company’s Common Stock price.

Restricted Stock Units

Restricted Stock Units (RSUs) were granted under the Company’s 2013 Incentive Plan and inducement grants granted outside of the Plan. During the three months ended December 31, 2014 and 2013, the Company issued 30,000 and 0 restricted stock units, respectively, to certain members of management. Of the restricted stock units granted during the three months ended December 31, 2014, 30,000 were granted outside of the Plan as an inducement grant to a new employee. At vesting each RSU will be exchanged for one share of the Company’s Common Stock. The RSUs issued during the three months ended December 31, 2014 vest in equal annual installments over three years from the date of grant.

The following table summarizes the activity of the Company’s Restricted Stock Units:

	Number of RSUs		Weighted- Average Grant Date Fair Value
Unvested at September 30, 2013		—	$	—
Granted		510,000		14.58
Vested		—		—
Forfeited		—		—
Unvested at September 30, 2014		510,000	$	14.58
Granted		30,000		5.22
Vested		—		—
Forfeited		—		—
Unvested at December 31, 2014		540,000	$	14.06

The Company recorded $1,033,457 and $0 of expense relating to restricted stock units during the three months ended December 31, 2014 and 2013, respectively, and such expense is included in stock-based compensation expense in the Company’s Consolidated Statement of Operations.

As of December 31, 2014, the pre-tax compensation expense for all unvested restricted stock units in the amount of approximately $4,036,658 will be recognized in the Company’s results of operations over a weighted average period of 1.4 years.