Stock-Based Compensation

The Halyard Health, Inc. Equity Participation Plan and the Halyard Health, Inc. Outside Directors’ Compensation Plan (together, the “Equity Plans”) provide for awards of stock options, stock appreciation rights, restricted stock (and in certain limited cases, unrestricted stock), restricted stock units, performance units and cash awards to eligible employees (including officers who are employees), directors, advisors and consultants of Halyard or its subsidiaries. A maximum of 4.9 million shares of Halyard common stock may be issued under the Equity Plans, and there are 1.9 million shares remaining available for issuance as of December 31, 2017.

Aggregate stock-based compensation expense under the Equity Plans was $13 million, $15 million and $14 million for the years ended December 31, 2017, 2016 and 2015, respectively, which includes amounts allocated to discontinued operations. Stock-based compensation expense included in continuing operations totals $12 million, $14 million and $13 million in the years ended December 31, 2017, 2016 and 2015, respectively. Stock-based compensation expense described by award type below refers to expense in continuing operations only. Stock-based compensation expense is included in cost of sales, research and development expenses and selling and general expenses.

Stock Options

Stock options are granted at an exercise price equal to the fair market value of Halyard’s common stock on the date of grant. Stock options are generally subject to graded vesting whereby options vest 30% at the end of each of the first two 12-month periods following the grant and 40% at the end of the third 12-month period and have a term of 10 years.

The fair value of stock option awards was determined using a Black-Scholes option-pricing model utilizing a range of assumptions related to volatility, risk-free interest rate, expected term and dividend yield. Expected volatility was based on historical weekly closing stock price volatility for a peer group of companies. The risk-free interest rate was based on the U.S. Treasury yield curve in effect at the time of grant. The expected term was based on historical observed settlement behavior. The dividend yield was based on the expectation that no dividends are expected to be paid on our common stock.

The weighted-average fair value of options granted in the years ended December 31, 2017, 2016 and 2015 was $9.07, $7.70 and $15.15, respectively, based on the following assumptions:



	Year Ended December 31,
	2017	2016(a)	2015
Volatility	24% to 25%	26%	25% to 34%
Risk-free rate	1.7% to 1.8%	1.2%	0.7% to 1.9%
Expected term (Years)	5	5	2 to 7
Dividend Yield	0%	0%	0%

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(a)	In the year ended December 31, 2016, all stock options granted had uniform terms and were awarded on the same grant date.

Stock-based compensation expense related to stock options was $3 million, $5 million and $6 million for the years ended December 31, 2017, 2016 and 2015, respectively.

A summary of stock option activity is presented below:



	Shares (in thousands)		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value (in millions)
Outstanding at December 31, 2016	1,526		$	37.42
Granted	558		37.59
Exercises	(136	)	34.80
Forfeitures	(278	)	40.38
Outstanding at December 31, 2017	1,670		$	37.20	6.9	$	15.0
Vested and exercisable at December 31, 2017	949		$	36.23	5.7	$	9.4

The following table summarizes information about options outstanding as of December 31, 2017:



			Options Outstanding		Options Exercisable
Range of Exercise Prices			Shares (in thousands)	Weighted-Average Remaining Contractual Term (Years)	Shares (in thousands)	Weighted-Average Exercise Price
$25.00	to	$35.00	530	6.3	380	$	30.29
$35.00	to	$45.00	724	7.5	366	37.24
$45.00+			416	6.6	203	45.53
			1,670	6.9	949	$	36.23

In the year ended December 31, 2017, options with an aggregate intrinsic value of $1 million were exercised resulting in an excess tax benefit of $0.4 million. In the years ended December 31, 2016 and 2015, the intrinsic value of exercised options and the resulting excess tax benefit were not material. For stock options outstanding at December 31, 2017, we expect to recognize an additional $4 million of expense over the remaining average service period of one year.

Restricted Share Units

Restricted shares, time-vested restricted share units and performance-based restricted share units granted to employees and directors are valued at the closing market price of our common stock on the grant date with vesting conditions determined upon approval of the award.

Stock-based compensation expense related to restricted stock units was $4 million, $5 million and $8 million for the years ended December 31, 2017, 2016 and 2015, respectively. A summary of restricted share unit activity is presented below:



	Shares (in thousands)		Weighted Average Fair Value
Outstanding at December 31, 2016	528		$	39.12
Granted	123		38.16
Vested	(166	)	37.99
Forfeited	(56	)	40.51
Outstanding at December 31, 2017	429		$	39.10

For restricted share units outstanding at December 31, 2017, we expect to recognize an additional $4 million of expense over the remaining average service period of one year.

We also issue restricted share units for which vesting is conditioned on meeting a defined measure of total shareholder return (“TSR units”) over a restricted period of three years. Total shareholder return is measured as our stock price performance over the restricted period compared to defined group of peer companies. The expense recognition for TSR units differs from awards with service or performance conditions in that the expense is recognized over the restricted period regardless of whether the total shareholder return target is met or not, while expense for awards with service and performance conditions is recognized based on the number of awards expected to vest. The fair value of TSR units is determined using a Monte Carlo simulation with a volatility assumption based on the average stock-price volatility for a peer group of companies over the restricted period. For awards granted in the years ended December 31, 2017 and 2016, the assumed volatility was 25% in each of the years and the weighted average fair value per TSR unit was $42.24 and $38.64, respectively. For the years ended December 31, 2017 and 2016, stock-based compensation expense related to TSR units was $5 million and $4 million, respectively. There were no TSR units awarded before 2016.

A summary of TSR unit activity is presented below.



	Shares (in thousands)		Weighted Average Fair Value
Outstanding at December 31, 2016	224		$	38.60
Granted	231		42.24
Forfeited	(57	)	42.02
Outstanding at December 31, 2017	398		$	40.22

For TSR units outstanding at December 31, 2017, we expect to recognize an additional $6 million of expense over the weighted average remaining restricted period of two years.