4. Stock-Based Compensation

Stock Options

The Company accounts for stock option grants to employees and non-employee directors under the provisions of ASC 718, Stock Compensation. ASC 718 requires the recognition of the fair value of stock-based compensation in the statement of operations. In addition, the Company accounts for stock option grants to consultants under the provisions of ASC 505-50, Equity-Based Payments to Non-Employees, and as such, these stock options are revalued at each reporting period through the vesting period.

Gerald J. Kochanski, Chief Financial Officer, Treasurer and Corporate Secretary of Nephros, Inc., resigned effective June 15, 2013. The Company agreed, in consideration of Mr. Kochanski providing certain consulting services to the Company, to extend the exercise period of his outstanding vested stock options from September 15, 2013 to March 14, 2014. This modification did not result in any additional compensation expense.

The fair value of stock option awards is estimated using a Black-Scholes option pricing model. The fair value of stock-based awards is amortized over the vesting period of the award using the straight-line method.

The Company granted 176,875 stock options during the nine months ended September 30, 2013 to employees, non-employees, directors and consultants. These stock options vest over a three-year or four-year period and will be expensed over the applicable vesting period. The fair value of all stock-based awards granted during the nine months ended September 30, 2013, excluding those forfeited below, was approximately $96,000.

As a result of Mr. Kochanski’s resignation, 90,945 stock options that were granted to him were forfeited on June 15, 2013. Of these 90,945 stock options, 25,000 were granted during the nine month period ended September 30, 2013.

The following assumptions were used for options granted for the nine months ended September 30, 2013:

	Nine Months Ended September 30, 2013
Risk-free interest rate		1.09-1.22	%
Volatility		127.46 - 131.79	%
Expected dividend yield		0	%
Expected term		5.75 - 6.25 yrs

The Company calculates expected volatility for a stock-based grant based on historic monthly stock price observations of common stock during the period immediately preceding the grant that is equal in length to the expected term of the grant. The Company also estimates future forfeitures, using historical employee behaviors related to forfeitures, as a part of the estimate of expense as of the grant date. With respect to grants of options, the risk free rate of interest is based on the U.S. Treasury rates appropriate for the expected term of the grant.

Stock-based compensation expense was approximately $300,000 and $335,000 for the nine months ended September 30, 2013 and 2012, respectively. For the nine months ended September 30, 2013, approximately $275,000 and approximately $25,000 are included in Selling, General and Administrative expenses and Research and Development expenses, respectively, on the accompanying condensed consolidated statement of operations. For the nine months ended September 30, 2012, approximately $314,000 and approximately $21,000 are included in Selling, General and Administrative expenses and Research and Development expenses, respectively, on the accompanying condensed consolidated statement of operations.

There was no tax benefit related to expense recognized in the nine months ended September 30, 2013 and 2012, as the Company is in a net operating loss position. As of September 30, 2013, there was approximately $832,000 of total unrecognized compensation cost related to unvested share-based compensation awards granted under the equity compensation plans which will be amortized over the weighted average remaining requisite service period of 2.5 years. The unrecognized compensation disclosed above does not include the effect of future grants of equity compensation, if any. Of the total $832,000, the Company expects to recognize approximately 11% in the remaining interim periods of 2013, approximately 40% in 2014, approximately 38% in 2015, approximately 10% in 2016 and approximately 1% in 2017.

Restricted Stock

On August 20, 2013, the Company issued 28,329 shares of restricted stock as compensation for the services of non-employee directors. The grant date fair value of the restricted stock award was approximately $43,000 and was based on the fair value of the common stock on the date of grant, and compensation expense is recognized ratably over a six month period.

For the nine months ended September 30, 2013, including those restricted shares issued on August 20, 2013, 339,028 shares of restricted stock were granted to certain employees and non-employee directors. As a result of Mr. Kochanski’s resignation, 45,929 of those shares of were forfeited on June 15, 2013.

Total stock-based compensation expense for the restricted stock grant was approximately $217,000 for the nine months ended September 30, 2013. For the nine months ended September 30, 2013, approximately $53,000 and approximately $48,000 are included in Selling, General and Administrative expenses and Research and Development expenses, respectively, on the accompanying condensed consolidated statement of operations. The remaining expense related to the restricted stock awards issued to non-employee directors of approximately $116,000 was recorded to offset accrued director’s fees that were incurred prior to September 30, 2013. Any additional stock-based compensation related to non-employee directors will be recorded to stock-based compensation expense. As of September 30, 2013, there was approximately $14,000 of unrecognized compensation expense related to the restricted stock awards, which is expected to be recognized over the next five months.