Share-Based Payments

In January 2013, the Zoetis 2013 Equity and Incentive Plan (Equity Plan) became effective, in order to provide long-term incentives to, and facilitate the retention of, our employees. The principal types of stock-based awards available under the Equity Plan may include, but are not limited to, stock options, restricted stock and restricted stock units (RSUs), deferred stock unit awards (DSUs), performance-vesting restricted stock unit awards (PSUs), and other equity-based or cash-based awards.

Twenty-five million shares of stock were approved and registered with the SEC for grants to participants under the Equity Plan. The shares reserved may be used for any type of award under the Equity Plan. At December 31, 2015, the aggregate number of remaining shares available for future grant under the Equity Plan was approximately 16 million shares.


A.	Share-Based Compensation Expense

The components of share-based compensation expense follow:



	Year Ended December 31,
(MILLIONS OF DOLLARS)	2015			2014			2013
Stock options / stock appreciation rights	$	20		$	18		$	9
RSUs / DSUs	21			14			9
PSUs	2			—			—
Pfizer stock benefit plans—direct	—			—			25
Share-based compensation expense—total^(a)	$	43		$	32		$	43
Tax benefit for share-based compensation expense	(8		)	(8		)	(6		)
Share-based compensation expense, net of tax	$	35		$	24		$	37


^(a)	For the year ended December 31, 2015, we capitalized $1 million of share-based compensation expense to inventory.


B.	Stock Options

Stock options represent the right to purchase shares of our common stock within a specified period of time at a specified price. The exercise price for a stock option will be not less than 100% of the fair market value of the common stock on the date of grant. Stock options granted may include those intended to be “incentive stock options” within the meaning of Section 422 of the U.S. Internal Revenue Code of 1986 (the Code).

Stock options are accounted for using a fair-value-based method at the date of grant in the consolidated statement of income. The values determined through this fair-value-based method generally are amortized on a straight-line basis over the vesting term into Cost of sales, Selling, general and administrative expenses, or Research and development expenses, as appropriate.

Eligible employees may receive Zoetis stock option awards. Zoetis stock option awards generally vest after three years of continuous service from the date of grant and have a contractual term of 10 years.

The fair-value-based method for valuing each Zoetis stock option grant on the grant date uses the Black-Scholes option-pricing model, which incorporates a number of valuation assumptions noted in the following table, shown at their weighted-average values:



	Year Ended December 31,
	2015		2014
Expected dividend yield^(a)	0.72	%	0.93	%
Risk-free interest rate^(b)	1.79	%	2.01	%
Expected stock price volatility^(c)	23.92	%	24.72	%
Expected term^(d) (years)	6.5		6.5


^(a)	Determined using a constant dividend yield during the expected term of the Zoetis stock option.


^(b)	Determined using the interpolated yield on U.S. Treasury zero-coupon issues.


^(c)	For 2015, determined using a 2-year historical volatility of the Zoetis stock price and weighting it equally against the implied volatility. The selection of the blended historical and implied volatility approach was based on our assessment that this calculation of expected volatility is more representative of future stock price trends.

For 2014, determined using implied volatility.


^(d)	Determined using expected exercise and post-vesting termination patterns.

The following table provides an analysis of stock option activity for the year ended December 31, 2015:



					Weighted-Average
			Weighted-Average		Remaining	Aggregate
			Exercise Price		Contractual Term	Intrinsic Value^(a)
	Shares		Per Share		(Years)	(MILLIONS)
Outstanding, December 31, 2014	5,541,313		$	28.56
Granted	862,403		46.01
Exercised	(293,355	)	28.99
Forfeited	(162,642	)	29.68
Outstanding, December 31, 2015	5,947,719		$	31.03	7.5	$	100
Exercisable, December 31, 2015	369,306		$	31.68	1.9	$	6


^(a)	Market price of underlying Zoetis common stock less exercise price.

The following table summarizes data related to stock option activity:



	Year Ended/As of December 31,
(MILLIONS OF DOLLARS, EXCEPT PER STOCK OPTION AMOUNTS)	2015		2014
Weighted-average grant date fair value per stock option	$	11.70	$	8.01
Aggregate intrinsic value on exercise	5		1
Cash received upon exercise	9		2
Tax benefits realized related to exercise	2		1
Total compensation cost related to nonvested stock options not yet recognized, pre-tax	10		17
Weighted-average period over which stock option compensation is expected to be recognized (years)	0.8		1.8


C.	Restricted Stock Units (RSUs)

Restricted stock units represent the right to receive a share of our common stock that is subject to a risk of forfeiture until the restrictions lapse at the end of the vesting period subject to the recipient's continued employment. RSUs accrue dividend equivalent units and are paid in shares of our common stock upon vesting (or cash determined by reference to the value of our common stock).

RSUs are accounted for using a fair-value-based method that utilizes the closing price of Zoetis common stock on the date of grant. Zoetis RSU awards generally vest after three years of continuous service from the grant date and the values are amortized on a straight-line basis over the vesting term into Cost of sales, Selling, general and administrative expenses, or Research and development expenses, as appropriate.

The following table provides an analysis of RSU activity for the year ended December 31, 2015:



			Weighted-Average
			Grant Date Fair Value
	Shares		Per Share
Nonvested, December 31, 2014	1,622,974		$	28.85
Granted	716,551		46.02
Vested	(221,731	)	29.70
Reinvested dividend equivalents	14,672		33.14
Forfeited	(176,488	)	35.98
Nonvested, December 31, 2015	1,955,978		$	34.44

The following table provides data related to RSU activity:



	Year Ended/As of December 31,
(MILLIONS OF DOLLARS)	2015		2014
Total compensation cost related to nonvested RSU awards not yet recognized, pre-tax	$	32	$	24
Weighted-average period over which RSU cost is expected to be recognized (years)	1.2		1.8


D.	Deferred Stock Units (DSUs)

Deferred stock units, which are granted to non-employee compensated Directors, represent the right to receive shares of our common stock at a future date. The DSU awards will be automatically settled and paid in shares (including fractional shares) within sixty days following the Director’s separation of service on the Board of Directors.

DSUs are accounted for using a fair-value-based method that utilizes the closing price of Zoetis common stock on the date of grant. DSUs vest immediately as of the grant date and the values are expensed at the time of grant into Selling, general and administrative expenses.

For the year ended December 31, 2015, there were no DSUs granted. For the year ended December 31, 2014, Zoetis granted 36,256 DSUs at a grant date weighted-average fair value of $30.89 per stock unit. As of December 31, 2015 and 2014, there were 72,246 and 71,727 DSUs outstanding, respectively, including dividend equivalents.

E. Performance-Vesting Restricted Stock Units (PSUs)

Performance-vesting restricted stock units, which are granted to eligible senior management, represent the right to receive a share of our common stock that is subject to a risk of forfeiture until the restrictions lapse, which include continued employment through the end of the vesting period and the attainment of performance goals. PSUs represent the right to receive shares of our common stock in the future (or cash determined by reference to the value of our common stock).

PSUs are accounted for using a Monte Carlo simulation model. The units underlying the PSUs will be earned and vested over a three-year performance period, based upon the total shareholder return of the company in comparison to the total shareholder return of the companies comprising the S&P 500 index at the start of the performance period, excluding companies that during the performance period are acquired or are no longer publicly traded (Relative TSR). The weighted-average fair value was estimated based on volatility assumptions of Zoetis common stock and an average of peer companies, which were 21.8% and 23.5%, respectively. Depending on the company’s Relative TSR performance at the end of the performance period, the recipient may earn between 0% and 200% of the target number of units. Vested units, including dividend equivalent units, are paid in shares of the company’s common stock. PSU values are amortized on a straight-line basis over the vesting term into Cost of sales, Selling, general and administrative expenses, or Research and development expenses, as appropriate.

The following table provides an analysis of PSU activity for the year ended December 31, 2015:



			Weighted-Average
			Grant Date Fair Value
	Shares		Per Share
Nonvested, December 31, 2014	—		$	—
Granted	157,130		63.14
Vested	(421	)	63.14
Reinvested dividend equivalents	816		63.14
Forfeited	(15,092	)	63.14
Nonvested, December 31, 2015	142,433		$	63.14

The following table provides data related to PSU activity:



	Year Ended/As of December 31,
(MILLIONS OF DOLLARS)	2015		2014
Total compensation cost related to nonvested PSU awards not yet recognized, pre-tax	$	7	$	—
Weighted-average period over which PSU cost is expected to be recognized (years)	2.1		—


F.	Other Equity-Based or Cash-Based Awards.

Our Compensation Committee is authorized to grant awards in the form of other equity-based awards or other cash-based awards, as deemed to be consistent with the purposes of the Equity Plan.


G.	Accelerated Vesting of Outstanding Equity Awards

As a result of our operational efficiency initiative and supply network strategy, the company accelerated the vesting, and in some cases the settlement on a pro-rata basis, of outstanding RSUs of terminated employees, subject, in each case, to the requirements of Section 409A of the U.S. Internal Revenue Code, the terms of the Equity Plan and the applicable award agreements, and any outstanding deferral elections. Generally, unvested stock options previously granted to terminated employees accelerated in full, and employees generally have the ability to exercise the stock options for three months after termination. Zoetis employees who held stock options and were retirement eligible as of their termination date generally have the full term of the stock option to exercise. In addition, outstanding PSUs of terminated employees vested on a pro-rata basis will be settled on or after the third anniversary of the grant date, subject to the achievement of performance goals. The unvested portion of RSUs and PSUs were forfeited.

The accelerated vesting of the outstanding stock options and the settlement, on a pro-rata basis, of other equity awards resulted in the recognition of additional stock-based compensation expense for the year ended December 31, 2015, of approximately $2 million, which is included in Restructuring charges and certain acquisition-related costs.


H.	Treatment of Outstanding Pfizer Equity Awards

Following the IPO, the equity awards previously granted to our employees by Pfizer continued to vest, and service with Zoetis counted as service with Pfizer for equity award purposes. On June 24, 2013, Pfizer completed the Exchange Offer whereby Pfizer disposed of all of its shares of Zoetis common stock owned by Pfizer. Pfizer accelerated the vesting of, and in some cases the settlement of, on a pro-rata basis, outstanding Pfizer RSUs, Total Shareholder Return Units (TSRUs) and Performance Share Awards (PSAs) previously granted to our employees, subject, in each case, to the requirements of Section 409A of the U.S. Internal Revenue Code, the terms of the 2004 Pfizer Stock Plan and the applicable award agreements and any outstanding deferral elections. In addition, unvested Pfizer stock options previously granted to our employees accelerated in full, and our employees generally have the ability to exercise the stock options until the earlier of (i) June 23, 2016 (three years from Pfizer's completion of the Exchange Offer), (ii) termination of employment from Zoetis or (iii) the expiration date of the stock option. Zoetis employees who held Pfizer stock options and were retirement eligible as of June 24, 2013, will have the full term of the stock option to exercise.

The accelerated vesting of the outstanding Pfizer stock options, and the settlement, on a pro-rata basis, of other Pfizer equity awards, resulted in the recognition of additional expense for the year ended December 31, 2013, of $9 million, which is included in stock-based compensation. The unvested portion of Pfizer RSUs, TSRUs and PSAs were forfeited as of the completion of the Exchange Offer. In the third quarter of 2013, Zoetis made a cash payment of approximately $20 million to certain non-executive Zoetis employees, based on the value of the employees' forfeited Pfizer RSUs, TSRUs and PSAs (as applicable). This amount is included in the consolidated statement of income as additional compensation expense for the year ended December 31, 2013. Members of the Zoetis Executive Team did not receive a cash payment for any forfeited Pfizer RSUs, TSRUs and PSAs, but instead, in the third quarter of 2013, they were granted Zoetis RSUs which were equivalent in value and vest on the same date as their forfeited Pfizer RSUs, TSRUs and PSAs.