14.

STOCK-BASED COMPENSATION

The majority of the Company’s stock-based compensation arrangements vest over either a four or five year vesting schedule and the Company’s stock options have a ten-year term. The Company recognizes stock-based compensation using the ratable method, which treats each vesting tranche as if it were an individual grant.

The Company periodically grants stock options and restricted stock units (“RSUs”) for a fixed number of shares to employees and non-employee Directors. The exercise price for stock options is greater than or equal to the fair market value of the shares at the grant date. RSUs deliver to the recipient a right to receive a specified number of shares of the Company’s common stock upon vesting. Unlike stock options, there is no cost to the employee at share issuance. The Company values its RSUs at the fair value of its common stock on the grant date, which is the closing price of its common stock on the grant date, less the present value of expected dividends, as the employee is not entitled to dividends during the requisite service period. Upon vesting of the RSUs, the Company withholds shares of common stock in an amount sufficient to cover the minimum statutory tax withholding obligations and issues shares of its common stock for the remaining amount.

Employees may elect to receive 50% of their target incentive compensation under the Company’s Corporate Incentive Compensation Plan (the “CICP”) in the form of RSUs instead of cash. If elected by an employee, the equity amount is equal in value on the date of grant to 50% of his or her target incentive opportunity, based on the employee’s base salary. The number of RSUs granted is determined by dividing 50% of the employee’s target incentive opportunity by the fair value of a RSU on the grant date. If elected, the award vests 100% on the CICP payout date of the following year for all participants. Vesting is conditioned upon the performance conditions of the CICP and on continued employment; if threshold funding does not occur, the equity grant will be cancelled. The Company considers vesting to be probable on the grant date and recognizes the associated stock-based compensation expense over the requisite service period beginning on the grant date and ending on the vest date.

The Company grants options that allow for the settlement of vested stock options on a net share basis (“net settled stock options”), instead of settlement with a cash payment (“cash settled stock options”). With net settled stock options, the employee does not surrender any cash or shares upon exercise. Rather, the Company withholds the number of shares to cover the option exercise price and the minimum statutory tax withholding obligations from the shares that would otherwise be issued upon exercise. The settlement of vested stock options on a net share basis results in fewer shares issued by the Company.

Share-Based Compensation Plans:

(a) 1994 Long-term Incentive Plan

In 1994, the Company adopted a 1994 Long-Term Incentive Plan (as amended in 2003, the “1994 Plan”) to provide employees, Directors and consultants with opportunities to purchase stock through incentive stock options and non-qualified stock options. In addition to options, participants under the 1994 Plan were eligible to receive stock appreciation rights, restricted stock and long-term performance awards. As of December 31, 2012, options to purchase an aggregate of approximately 80,000 shares of common stock were outstanding under the 1994 Plan. The Company does not intend to issue any additional options or make any other awards under the 1994 Plan in the future.

(b) 1996 Non-Employee Director Stock Option Plan

In 1996, the Company adopted a 1996 Non-Employee Director Stock Option Plan (the “Director Plan”), which provided for the grant to non-employee Directors of the Company of options to purchase shares of its common stock. All shares authorized for issue under this plan have been awarded. Beginning in July 2006, in lieu of granting fully vested options, the Company grants shares of its common stock to its non-employee directors under the 2004 Long-term Incentive Plan, as described below. As of December 31, 2012, options to purchase an aggregate of approximately 50,000 shares of common stock were outstanding under the Director Plan.

(c) Amended and Restated 2004 Long-Term Incentive Plan

In 2004, the Company adopted a 2004 Long-Term Incentive Plan (the “2004 Plan”) to provide employees, non-employee Directors and consultants with opportunities to purchase stock through incentive stock options and non-qualified stock options. In addition to options, eligible participants under the 2004 Plan may be granted stock purchase rights and other stock-based awards. In July 2011, the Company’s stockholders approved the Pegasystems Inc. Amended and Restated 2004 Long-term Incentive Plan (the “Restated 2004 Plan”), which provided for an additional 5,000,000 authorized shares available for grant under the plan and extended the term of the plan to 2021. Beginning in June 2006, each member of the Company’s Board of Directors (except the Company’s Chairman and Chief Executive Officer) is entitled to receive on an annual basis a number of shares of common stock, which as of March 2010 was equal to $70,000, divided by the fair market value of its common stock on the grant date. As of December 31, 2012, approximately 4,333,000 shares were subject to outstanding options and stock-based awards under the Restated 2004 Plan.

(d) 2006 Employee Stock Purchase Plan

In 2006, the Company adopted a 2006 Employee Stock Purchase Plan (the “2006 ESPP”) pursuant to which the Company’s employees are entitled to purchase up to an aggregate of 500,000 shares of common stock at a price equal to at least 85% of the fair market value of the Company’s common stock on either the commencement date or completion date for offerings under the plan, whichever is less, or such higher price as the Company’s Board of Directors may establish from time to time. Until the Company’s Board of Directors determines otherwise, the Board has set the purchase price at 95% of the fair market value on the completion date of the offering period. As a result, the 2006 ESPP is non-compensatory and is tax qualified. Therefore, as of December 31, 2012, no compensation expense related to shares issued under the plan had been recognized. In October 2012, the Company’s Board of Directors amended the term of the 2006 ESPP such that it will continue until there are no shares remaining to be issued under the plan or until the plan is terminated by the Board of Directors, whichever occurs first. As of December 31, 2012, approximately 119,000 shares had been issued thereunder.

Shares reserved

As of December 31, 2012, there were approximately 4,118,000 shares remaining for issuance for future equity grants under the Company’s stock plans, consisting of approximately 3,736,000 shares under the Restated 2004 Plan and approximately 382,000 shares under the 2006 ESPP. There were no shares available for future equity grants under the 1994 Plan or the Director Plan.

Equity grants, assumptions and activity

During 2012, the Company issued approximately 384,000 shares to its employees under the Company’s share-based compensation plans and approximately 12,000 shares to the non-employee members of its Board of Directors.

The following table presents the stock-based compensation expense included in the Company’s consolidated statements of operations for the years ended December 31:


(in thousands)	2012			2011			2010
Stock-based compensation expense:
Cost of services	$	3,655		$	2,737		$	1,825
Operating expenses		7,851			6,291			4,920

Total stock-based compensation before tax		11,506			9,028			6,745
Income tax benefit		(3,699	)		(2,854	)		(2,185	)

Stock Options

The Company estimates the fair value of stock options using a Black-Scholes option valuation model. Key inputs used to estimate the fair value of stock options include the exercise price of the award, the expected term of the option, the expected volatility of the Company’s common stock over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. The amount of stock-based compensation recognized during a period is based on the value of the awards that are ultimately expected to vest. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Ultimately, the Company recognizes the actual expense over the vesting period only for the shares that vest. The weighted-average grant-date fair value for stock options granted in 2012, 2011, and 2010, was $9.43, $11.91, and $12.22, respectively.

The weighted-average assumptions used in the Black-Scholes option valuation model are as follows for the years ended December 31:


	2012			2011			2010
Expected volatility (1)		54	%		45	%		41	%
Expected term in years (2)		4.3			5.1			5.1
Risk-free interest rate (3)		0.63	%		1.18	%		1.65	%
Expected annual dividend yield (4)		0.52	%		0.58	%		0.71	%

(1)	The expected volatility for each grant is determined based on the average of historical weekly price changes of the Company’s common stock over a period of time which approximates the expected option term.

(2)	The expected option term for each grant is determined based on the historical exercise behavior of employees and post-vesting employment termination behavior.

(3)	The risk-free interest rate is based on the yield of zero-coupon U.S. Treasury securities for a period that is commensurate with the expected option term at the time of grant.

(4)

The expected annual dividend yield is based on the weighted-average of the dividend yield assumptions used for options granted during the applicable period. The expected annual dividend is based on the expected dividend of $0.12 per share, per year ($0.03 per share, per quarter times 4 quarters) divided by the average stock price.

The Company elected to adopt the alternative transition method (“short cut method”) in calculating their historical pool of windfall tax benefits in regards to its share-based compensation.

The following table summarizes the combined stock option activity under the Company’s stock option plans for the year ended December 31, 2012:


	Shares (in thousands)			Weighted-average exercise price		Weighted- average remaining contractual term (in years)		Aggregate intrinsic value (in thousands)
Options outstanding as of January 1, 2012		2,532		$	15.46
Granted		1,818			22.87
Exercised		(371	)		8.64
Forfeited/Cancelled		(82	)		27.19

Options outstanding as of December 31, 2012		3,897		$	19.32


Vested and expected to vest as December 31, 2012		3,300		$	18.44		6.7	$	19,728


Exercisable as of December 31, 2012		1,639		$	12.78		3.9	$	18,605

The aggregate intrinsic value of stock options exercised (i.e., the difference between the market price at exercise and the price paid by the employee at exercise) in 2012, 2011, and 2010 was $8.5 million, $19.4 million, and $23.8 million, respectively. The aggregate intrinsic value of stock options outstanding and exercisable as of December 31, 2012 is based on the difference between the closing price of the Company’s stock of $22.68 on December 31, 2012 and the exercise price of the applicable stock options.

As of December 31, 2012, the Company had unrecognized stock-based compensation expense related to the unvested portion of stock options of approximately $13.3 million that is expected to be recognized as expense over a weighted-average period of approximately 2.6 years.

RSUs

The weighted-average grant-date fair value for RSUs granted in 2012, 2011, and 2010 was $32.35, $30.87, and $33.90, respectively. The following table summarizes the combined RSU activity for periodic grants and the CICP under the Restated 2004 Plan for the year ended December 31, 2012:


	Shares (in thousands)			Weighted- Average Grant-Date Fair Value		Aggregate Intrinsic Value (in thousands)
Nonvested as of January 1, 2012		690		$	28.82
Granted		177			32.35
Vested		(236	)		26.91
Forfeited		(64	)		30.88

Nonvested as of December 31, 2012		567		$	31.19	$	12,856

Expected to vest as of December 31, 2012		407		$	31.42	$	9,235

The RSUs associated with periodic grants vest over five years with 20% vesting after one year and the remaining 80% vesting in equal quarterly installments over the remaining four years. Approximately 52,000 RSUs granted in connection with the 2012 CICP are expected to vest 100% in March 2013.

The fair value of RSUs vested in 2012, 2011, and 2010 was $7.1 million, $6.4 million, and $4.5 million, respectively. The aggregate intrinsic value of RSUs outstanding and expected to vest as of December 31, 2012 is based on the closing price of the Company’s stock of $22.68 on December 31, 2012.

As of December 31, 2012, the Company had approximately $5.9 million of unrecognized stock-based compensation expense related to all unvested RSUs that is expected to be recognized as expense over a weighted-average period of approximately 2.03 years.