Note 3 – Stock-Based Compensation

Stock Incentive Program Descriptions

On January 23, 2006, the Board of Directors adopted the ADTRAN, Inc. 2006 Employee Stock Incentive Plan (2006 Plan), which authorized 13.0 million shares of common stock for issuance to certain employees and officers through incentive stock options and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units (RSUs). The 2006 Plan was adopted by stockholder approval at our annual meeting of stockholders held on May 9, 2006. Options granted under the 2006 Plan typically become exercisable beginning after one year of continued employment, normally pursuant to a four-year vesting schedule beginning on the first anniversary of the grant date, and have a ten-year contractual term. The 2006 Plan was replaced on May 13, 2015 by the ADTRAN, Inc. 2015 Employee Stock Incentive Plan (2015 Plan). Expiration dates of options outstanding at December 31, 2016 under the 2006 Plan range from 2017 to 2024.

Our stockholders approved the 2010 Directors Stock Plan (2010 Directors Plan) on May 5, 2010, under which 0.5 million shares of common stock have been reserved. This plan replaces the 2005 Directors Stock Option Plan. Under the 2010 Directors Plan, the Company may issue stock options, restricted stock and RSUs to our non-employee directors. Stock awards issued under the 2010 Directors Plan normally become vested in full on the first anniversary of the grant date. Options issued under the 2010 Directors Plan have a ten-year contractual term. Expiration dates of options outstanding at December 31, 2016 under the 2010 Directors Plan range from 2017 to 2019.

On January 20, 2015, the Board of Directors adopted the ADTRAN, Inc. 2015 Employee Stock Incentive Plan (2015 Plan), which authorizes 7.7 million shares of common stock for issuance to certain employees and officers through incentive stock options and non-qualified stock options, stock appreciation rights, performance stock units (PSUs), restricted stock and RSUs. The 2015 Plan was adopted by stockholder approval at our annual meeting of stockholders held on May 13, 2015. PSUs, restricted stock and RSUs granted under the 2015 Plan reduce the shares authorized for issuance under the 2015 Plan by 2.5 shares of common stock for each share underlying the award. Options granted under the 2015 Plan typically become exercisable beginning after one year of continued employment, normally pursuant to a four-year vesting schedule beginning on the first anniversary of the grant date, and have a ten-year contractual term. Expiration dates of options outstanding at December 31, 2015 under the 2015 Plan range from 2025 to 2026.

The following table summarizes stock-based compensation expense related to stock options, PSUs, restricted stock and RSUs for the years ended December 31, 2016, 2015 and 2014, which was recognized as follows:

(In thousands)	2016			2015			2014
Stock-based compensation expense included in cost of sales	$	389		$	280		$	479
Selling, general and administrative expense		3,341			3,261			4,185
Research and development expense		2,965			3,171			3,899
Stock-based compensation expense included in operating expenses		6,306			6,432			8,084
Total stock-based compensation expense		6,695			6,712			8,563
Tax benefit for expense associated with non-qualified options		(963	)		(862	)		(1,157	)
Total stock-based compensation expense, net of tax	$	5,732		$	5,850		$	7,406

Stock-based compensation expense recognized in our Consolidated Statements of Income for the years ended December 31, 2016, 2015 and 2014 is based on stock options, PSUs, restricted stock and RSUs ultimately expected to vest, and has been reduced for estimated forfeitures. Estimates for forfeiture rates are based upon historical experience and are evaluated quarterly. We expect our forfeiture rate for stock options and RSUs to be approximately 3.7% annually. We estimated a 0% forfeiture rate for our PSUs and restricted stock due to the limited number of recipients and historical experience for these awards.

Stock Options

The following table is a summary of our stock options outstanding as of December 31, 2015 and 2016 and the changes that occurred during 2016:

(In thousands, except per share amounts)	Number of Options			Weighted Average Exercise Price		Weighted Avg. Remaining Contractual Life in Years		Aggregate Intrinsic Value
Options outstanding, December 31, 2015		7,108		$	21.97		6.42	$	3,284
Options granted		19		$	18.24
Options exercised		(283	)	$	16.66
Options forfeited		(93	)	$	17.90
Options expired		(413	)	$	23.96
Options outstanding, December 31, 2016		6,338		$	22.14		5.63	$	16,972
Options vested and expected to vest, December 31, 2016		6,276		$	22.20		5.60	$	16,606
Options exercisable, December 31, 2016		4,757		$	23.67		4.73	$	9,137

At December 31, 2016, total compensation cost related to non-vested stock options not yet recognized was approximately $7.5 million, which is expected to be recognized over an average remaining recognition period of 2.1 years.

All of the options above were issued at exercise prices that approximated fair market value at the date of grant. At December 31, 2016, 5.6 million options were available for grant under the shareholder approved plans.

The aggregate intrinsic values in the table above represent the total pre-tax intrinsic value (the difference between ADTRAN’s closing stock price on the last trading day of 2016 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2016. The amount of aggregate intrinsic value will change based on the fair market value of ADTRAN’s stock.

The total pre-tax intrinsic value of options exercised during 2016, 2015 and 2014 was $1.1 million, $0.1 million and $0.7 million, respectively. The fair value of options fully vesting during 2016, 2015 and 2014 was $5.7 million, $6.6 million and $7.7 million, respectively.

The following table further describes our stock options outstanding as of December 31, 2016:

	Options Outstanding						Options Exercisable
Range of Exercise Prices	Options Outstanding at 12/31/16 (In thousands)		Weighted Avg. Remaining Contractual Life in Years		Weighted Average Exercise Price		Options Exercisable at 12/31/16 (In thousands)		Weighted Average Exercise Price
$14.88 – 18.96		2,101		6.78	$	15.82		1,217	$	16.14
$18.97 – 23.45		1,380		5.79	$	20.17		881	$	20.84
$23.46 – 30.35		1,491		5.08	$	23.89		1,293	$	23.92
$30.36 – 41.92		1,366		4.29	$	31.94		1,366	$	31.94
		6,338						4,757

PSUs, restricted stock and RSUs

Under the 2015 Plan, awards other than stock options, including PSUs, restricted stock and RSUs, may be granted to certain employees and officers. Under our PSU program, the number of shares of common stock earned by a recipient pursuant to the PSUs is subject to a market condition based on ADTRAN’s relative total shareholder return against all companies in the NASDAQ Telecommunications Index at the end of a three-year performance period. Depending on the relative total shareholder return over the performance period, the recipient may earn from 0% to 150% of the shares underlying the PSUs, with the shares earned distributed upon the vesting of the PSUs at the end of the three-year performance period. The fair value of the award is based on the market price of our common stock on the date of grant, adjusted for the expected outcome of the impact of market conditions using a Monte Carlo Simulation valuation method. A portion of the granted PSUs also vest and the underlying shares become deliverable upon the death or disability of the recipient or upon a change of control of ADTRAN, as defined by the 2015 Plan. The recipients of the PSUs receive dividend credits based on the shares of common stock underlying the PSUs. The dividend credits are vested and earned in the same manner as the PSUs and are paid in cash upon the issuance of common stock for the PSUs. The fair value of restricted stock and RSUs is equal to the closing price of our stock on the business day immediately preceding the grant date. Restricted stock and RSUs vest ratably over one year and four year periods, respectively.

The following table is a summary of our PSUs, restricted stock and RSUs outstanding as of December 31, 2015 and 2016 and the changes that occurred during 2016:

(In thousands, except per share amounts)	Number of shares			Weighted Average Grant Date Fair Value
Unvested PSUs, restricted stock and RSUs outstanding, December 31, 2015		106		$	21.09
PSUs, restricted stock and RSUs granted		460		$	20.63
PSUs, restricted stock and RSUs vested		(46	)	$	22.50
PSUs, restricted stock and RSUs forfeited		(1	)	$	20.00
Unvested RSUs and restricted stock outstanding, December 31, 2016		519		$	20.51

At December 31, 2016, total compensation cost related to the non-vested portion of PSUs, restricted stock and RSUs not yet recognized was approximately $8.9 million, which is expected to be recognized over an average remaining recognition period of 3.6 years.

Valuation and Expense Information

We use the Black-Scholes option pricing model (Black-Scholes Model) for the purpose of determining the estimated fair value of stock option awards on the date of grant. The Black-Scholes Model requires the input of certain assumptions that involve judgment. Because our stock options have characteristics significantly different from those of traded options, and because changes in the input assumptions can materially affect the fair value estimate, existing models may not provide reliable measures of fair value of our stock options. We use a Monte Carlo Simulation valuation method to value our performance-based PSUs. The fair value of RSUs and restricted stock issued is equal to the closing price of our stock on the date of grant. We will continue to assess the assumptions and methodologies used to calculate the estimated fair value of stock-based compensation. If circumstances change, and additional data becomes available over time, we may change our assumptions and methodologies, which may materially impact our fair value determination.

The stock option pricing model requires the use of several assumptions that impact the fair value estimate. These variables include, but are not limited to, the volatility of our stock price and employee exercise behaviors. There were no changes made during 2016 to the methodology used to determine our assumptions.

The weighted-average estimated fair value of stock options granted to employees during the years ended December 31, 2016, 2015 and 2014 was $5.22 per share, $4.28 per share and $6.31 per share, respectively, with the following weighted-average assumptions:

	2016			2015			2014
Expected volatility		34.79	%		34.57	%		39.05	%
Risk-free interest rate		1.36	%		1.81	%		1.79	%
Expected dividend yield		1.98	%		2.35	%		1.90	%
Expected life (in years)		6.25			6.23			6.33

We based our estimate of expected volatility for the years ended December 31, 2016, 2015 and 2014 on the sequential historical daily trading data of our common stock for a period equal to the expected life of the options granted. The selection of the historical volatility method was based on available data indicating our historical volatility is as equally representative of our future stock price trends as is our implied volatility. We have no reason to believe the future volatility of our stock price is likely to differ from its past volatility. The risk-free interest rate assumption is based upon implied yields of U.S. Treasury zero-coupon bonds on the date of grant having a remaining term equal to the expected life of the options granted. The dividend yield is based on our historical and expected dividend payouts. The expected life of our stock options is based upon historical exercise and forfeiture activity of our previous stock-based grants with a ten-year contractual term.

The PSU pricing model also requires the use of several significant assumptions that impact the fair value estimate. The estimated fair value of the PSUs granted to employees during the years ended December 31, 2016, 2015 and 2014 was $23.50 per share, $17.64 per share and $22.11 per share, respectively, with the following assumptions:

	2016			2015			2014
Expected volatility		29.79	%		31.34	%		36.40	%
Risk-free interest rate		1.17	%		1.20	%		0.96	%
Expected dividend yield		1.80	%		2.35	%		1.89	%