NOTE 3. Stock-Based Compensation

Stock Plan Activity

Under our 1996 Equity Incentive Plan, or the 1996 Plan, we granted stock options, stock bonuses and other awards to our employees, directors and consultants as deemed appropriate by the Board. Options granted were subject to different vesting terms as determined by the Board and the maximum term of options granted was 10 years. On June 14, 2006, the 1996 Plan expired and was replaced with the 2006 Equity Incentive Plan, or the 2006 Plan. Upon the expiration of the 1996 Plan, no shares had been granted to consultants and 732,456 shares out of an aggregate of 18,300,000 shares of common stock were authorized and available for grant.

Under our 2006 Plan, we granted stock options, stock bonuses and other awards to our employees, directors and consultants as deemed appropriate by the Board. Options granted were subject to different vesting terms as determined by the Board and the maximum term of options granted was 10 years. On June 5, 2012, the 2006 Plan was terminated and replaced with the 2012 Equity Incentive Plan, or the 2012 Plan. The 2012 Plan was approved by the Board on March 16, 2012 and by our shareholders on June 5, 2012. There were 942,602 shares out of an aggregate of 3,082,456 shares of common stock authorized and available for grant upon the termination of the 2006 Plan.

The 2012 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards and other forms of equity compensation to our employees, consultants and directors as deemed appropriate by the Board. Both incentive and non-statutory stock options granted by us under the 2012 Plan must carry an exercise price of at least 100% of the fair market value of our common stock on the date of grant. Incentive stock options must carry an exercise price of at least 110% of the fair market value of our common stock on the date of grant for persons possessing 10% or more of the total combined voting power of all classes of stock. Options granted may be subject to different vesting terms as determined by the Board and the maximum term of options granted is 8 years. In addition, the maximum number of shares of common stock available for future issuance may not exceed the sum of (a) 942,602 and 34,976 shares of common stock remaining available for issuance under the 2006 Plan and the 1996 Non-Employee Directors’ Stock Option Plan, or the 1996 NEDSOP, respectively, as of June 5, 2012, (b) an additional 3,100,000 shares and (c) the number of shares subject to stock awards as of June 5, 2012 under the 2006 Plan and the 1996 NEDSOP pursuant to the terms of the 2006 Plan and the 1996 NEDSOP. As of the end of the third quarter of fiscal 2012, 3,976,103 shares were available for future grants under the 2012 Plan. All awards to date under the 2012 Plan have been granted to our employees and directors, and none have been granted to consultants.

Under the 1996 NEDSOP, we granted stock options to non-employee directors. Options granted were subject to different vesting terms as determined by the Board and the maximum term of options granted was 10 years. On June 5, 2012, the 1996 NEDSOP was terminated. Upon the termination of the 1996 NEDSOP, no shares had been granted to anyone for their role as a consultant to the company and 34,976 shares out of an aggregate of 720,000 shares of common stock were authorized and available for grant.

In June 1996, the Board adopted the Employee Stock Purchase Plan, or the Stock Purchase Plan. The Stock Purchase Plan provides for the issuance of up to 1,350,000 shares of common stock to our employees. All eligible employees are granted identical rights to purchase common stock for each Board authorized offering under the Stock Purchase Plan. Rights granted pursuant to any offering under the Stock Purchase Plan terminate immediately upon cessation of an employee’s employment for any reason. In general, an employee may reduce their contribution or withdraw from participation in an offering at any time during the purchase period for such offering. Employees receive a 15% discount on shares purchased under the Stock Purchase Plan. Rights granted under the Stock Purchase Plan are not transferable and may be exercised only by the person to whom such rights are granted. The initial offering under the Stock Purchase Plan commenced October 24, 1996 and terminated December 31, 1996. Subsequent offerings have occurred every six months commencing January 1, 1997. As of the end of the third quarter of fiscal 2012, 692,372 shares could still be sold to employees under the Stock Purchase Plan. Compensation expense for the third quarter of fiscal 2012 and 2011 was $66,000 and $45,000, respectively, related to the fair value of the rights granted to participants under the plan. During fiscal year-to-date 2012 and 2011, $150,000 and $123,000, respectively, was expensed.

In June 2012, we granted non-employee directors an aggregate of 21,008 shares of restricted common stock under the 2012 Plan. In March 2012 and June 2011, we granted non-employee directors an aggregate of 515 and 25,387 shares of restricted common stock, respectively, under the 2006 Plan. Restricted shares generally vest in one installment in the year subsequent to the grant year. All awarded common shares remain restricted (i.e., not transferable by the holders) until such time as the recipient is no longer a member of our Board. The value of these grants is expensed over the vesting period. During the third quarter of fiscal 2012 and 2011, $50,000 and $45,000, respectively, was expensed. During the fiscal year-to-date 2012 and 2011, $149,000 and $144,000, respectively, was expensed.

In April 2012, we granted an independent consultant 2,525 shares of restricted common stock under the 2006 Plan. This grant was substantially similar to the restricted common stock granted to non-employee directors described above except that vesting occurred in full after providing six months of continuous service to the company. A charge of $8,000 and $25,000 was expensed for this grant during the third quarter of fiscal 2012 and fiscal year-to-date 2012, respectively. As of the end of the third quarter of fiscal 2012, we had recorded all charges related to this grant.

In March 2012, we granted Lisa Harper an option to purchase 100,000 shares of our common stock under the 2006 Plan. This 100,000 share option is subject to a service condition as well as a performance condition that the company achieves a defined earnings target in fiscal year 2012, which will be certified by the Compensation Committee of the Board during the first quarter of fiscal 2013.

In March 2011, in connection with her appointment as Chief Executive Officer, we granted Lisa Harper an option to purchase 500,000 shares of our common stock under the 2006 Plan. This 500,000 share option vests only upon a vesting determination by the Compensation Committee of the Board. The option will terminate on the day following the third anniversary of the date of grant if the vesting determination has not been made. The vesting determination shall be made at any time on or before the third anniversary of the date of grant when the Compensation Committee of the Board certifies that the weighted average per share closing price of the company’s common stock for any trailing 90 trading days equals or exceeds twice the closing price per share on the date of grant.

In March 2011, we granted certain employees the option to purchase an aggregate of 415,000 shares of our common stock, net of forfeitures, under the 2006 Plan. These share options are subject to four-year vesting, but vesting will occur in full upon the occurrence of the vesting determination described above.

In February 2011, prior to her appointment as Chief Executive Officer, we granted Lisa Harper, in her capacity as an independent consultant, 17,568 shares of restricted common stock under the 2006 Plan. This grant was substantially similar to the restricted common stock granted to non-employee directors described above. The total charge of $98,000 was expensed for this grant during the first quarter of fiscal 2011.

In March 2009, we granted performance stock awards under the 2006 plan to certain members of our management. These 2009 awards provided for the issuance of up to 100,000 shares of our common stock, net of forfeitures, with vesting and issuance contingent upon achieving a performance goal for fiscal 2011, based upon our operating income for that fiscal year; and prior to vesting (or termination without vesting), the awards constituted an agreement by us to issue shares to the extent this performance goal was ultimately met. The market value of our common stock as of the 2009 grant date of these performance stock awards was $9.56. Compensation expense for these awards was required to be recorded over the three-year terms of the awards, based on the market values as of the grant dates, with actual amounts expensed dependent upon the likelihood from period to period of vesting of these awards at the end of fiscal 2011. In March 2012, the Board confirmed that the target performance goal for fiscal 2011 had not been met, and therefore all such awards terminated without vesting or issuance of the underlying shares. We did not recognize any compensation expense for these 2009 awards.

The following table summarizes stock options outstanding under all of our plans as of the end of the third quarter of fiscal 2012, as well as activity during fiscal year-to-date 2012:

	Options			Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (in years)		Aggregate Intrinsic Value (in thousands)
Outstanding at January 28, 2012		5,890,439		$	9.29

Granted		1,708,354		$	9.68
Exercised		(177,463	)	$	5.62
Forfeited or expired		(535,614	)	$	13.00

Outstanding at October 27, 2012		6,885,716		$	9.19		7.05	$	8,685

Exercisable at October 27, 2012		3,253,320		$	10.62		5.31	$	4,245

The total fair value of shares vested during the third quarter of fiscal 2012 and 2011 is $0.9 million and $0.7 million, respectively. The total fair value of shares vested during fiscal-year-to-date 2012 and 2011 was $2.4 and $3.0 million, respectively.

Cash proceeds, tax benefits and intrinsic values related to total stock options exercised during the third quarter of fiscal 2012 and 2011 and during fiscal year-to-date 2012 and 2011 are provided in the following table (in thousands):

	Three Months Ended				Nine Months Ended
	October 27, 2012		October 29, 2011		October 27, 2012		October 29, 2011
Proceeds from stock options exercised	$	140	$	1,733	$	997	$	2,675
Tax benefit related to stock options exercised	$	41	$	394	$	306	$	482
Intrinsic value of stock options exercised	$	103	$	986	$	766	$	1,206

Accounting for Stock-Based Compensation Expense We account for stock-based compensation expense by estimating the fair value of stock options granted, except for certain stock options granted in March 2011 that are subject to the vesting determination described above, using the Black-Scholes option-pricing formula and a single option award approach. The fair value is then amortized over the requisite vesting periods of the awards. As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures.

We estimate the fair values of the share options granted in March 2011, that are subject to the vesting determination, using a Monte Carlo simulation valuation model. The fair values of the options to purchase the aggregate of 415,000 shares, net of forfeitures, are amortized over the vesting period determined by this model. The entire fair value of the 500,000 share option was recognized as compensation expense during fiscal 2011.

The effect of recording stock-based compensation for the third quarter of fiscal 2012 and 2011 and for fiscal year-to-date 2012 and 2011 was as follows (in thousands):

	Three Months Ended						Nine Months Ended
	October 27, 2012			October 29, 2011			October 27, 2012			October 29, 2011
Stock-based compensation by type of award:
Employee and director stock options and awards	$	1,010		$	626		$	2,977		$	3,370
Non-employee stock award		8			-			25			-
Employee stock purchase plan		66			45			150			123
Total stock-based compensation expense		1,084			671			3,152			3,493
Tax effect on stock-based compensation expense		(384	)		(278	)		(1,131	)		(1,296	)
Net effect on net income or loss	$	700		$	393		$	2,021		$	2,197

For the third quarter of fiscal 2012 and 2011, $127,000 and $118,000, respectively, of stock-based compensation expense was recorded as a component of cost of goods sold and the remainder, $1.0 million and $0.6 million, respectively, was charged to selling, general and administrative expense.

For fiscal year-to-date 2012 and 2011, $460,000 and $336,000, respectively, of stock-based compensation expense was recorded as a component of cost of goods sold and the remainder, $2.7 million and $3.2 million, respectively, was charged to selling, general and administrative expense.

As of the end of the third quarter of fiscal 2012 and 2011, we had $7.0 million and $5.7 million, respectively, of unrecognized expense related to non-vested stock option grants (with the exception of Lisa Harper’s 100,000 stock options granted in March 2012 that are subject to the performance condition, and the aggregate of 415,000 stock options granted in March 2011 that are subject to the vesting determination), which are expected to be recognized over weighted average periods of 2.68 years and 2.79 years, respectively.

As of the end of the third quarter of fiscal 2012, we had $0.2 million of unrecognized expense related to Lisa Harper’s option to purchase 100,000 shares of our common stock granted in March 2012 that are subject to the performance condition, which is expected to be recognized over a weighted average period of 3.42 years. This option to purchase 100,000 shares has a $3.44 weighted average fair value at grant date.

As of the end of the third quarter of fiscal 2012 and 2011, we had $0.3 million and $0.7 million, respectively, of unrecognized expense related to the options to purchase an aggregate of 415,000 shares of our common stock granted in March 2011 that are subject to the vesting determination, which is expected to be recognized over weighted average periods of 2.42 years and 3.42 years, respectively.

As of the end of the third quarter of fiscal 2012 and 2011, we had $117,000 and $105,000, respectively, of unrecognized expense related to restricted stock grants, which is expected to be recognized over weighted average periods of 0.61 and 0.48 years, respectively.

Calculation of Fair Value of Options The Black-Scholes option valuation model used to determine the fair value of stock-based compensation for all options, except for those granted in March 2011 that are subject to the vesting determination, incorporates various assumptions including the expected term of awards, volatility of stock price, risk-free rates of return and dividend yield. The expected term of an award is generally no less than the option vesting period and is based on our historical experience. Expected volatility is based upon the historical volatility of our stock price. The risk-free interest rate is approximated using rates available on U.S. Treasury securities with a remaining term equal to the option’s expected life. The dividend yield is based on the expected dividend yield as of the date of option grant.

The following weighted average assumptions were used in the Black-Scholes option valuation model for stock options granted:

	Three Months Ended						Nine Months Ended
	October 27, 2012			October 29, 2011			October 27, 2012			October 29, 2011
Risk free interest rate		1	%		2	%		1	%		2	%
Expected life	5 years			5 years			5 years			5 years
Expected volatility		58	%		58	%		57	%		58	%
Expected dividend yield		3	%		4	%		4	%		4	%

Weighted average fair value at grant date (with the exception of Lisa Harper’s 100,000 stock options granted in March 2012 that are subject to the performance condition)	$	3.55		$	3.01		$	3.50		$	2.42

A Monte Carlo simulation was used to determine the fair value of stock-based compensation for the stock options granted in March 2011 that are subject to the vesting determination. This risk neutral model is based on projections of stock price paths and incorporates various assumptions including the early exercise behavior, volatility of stock price, risk-free rates of return and dividend yield. Expected volatility is based upon the historical volatility of our stock price. The risk-free interest rate is approximated using rates available on U.S. Treasury securities with a remaining term equal to the option’s contractual life. The dividend yield is based on the expected dividend yield as of the date of option grant.

The following weighted average assumptions were used in the Monte Carlo simulation valuation model for the stock options granted in March 2011 that are subject to the vesting determination:

Risk free interest rate	4%
Contractual life	10 years
Expected volatility	58%
Expected dividend yield	5%

Weighted average fair value at grant date	$2.06