8. Equity-Based Compensation

The Tellabs, Inc. Amended and Restated 2004 Incentive Compensation Plan (2004 Plan) provides for the grant of short-term and long-term incentives, including stock options, stock appreciation rights (SARs), restricted stock and performance stock units (PSUs). Equity-based grants vest over one to four years, with the majority vesting over a three-year period. We recognize compensation expense for stock options and restricted stock on a straight-line basis over the service period based on the fair value on the grant date. Stock options and SARs granted but unexercised expire 10 years from the grant date. Stockholders previously approved 53,889,977 shares for grant under the 2004 Plan, of which 18,872,031 remain available for grant at July 1, 2011.

Stock Options

We estimate the fair value of stock options using the Black-Scholes option-pricing model. This model requires the use of assumptions that will have a significant impact on the fair value estimate. The following table summarizes the assumptions used to compute the weighted average fair value of stock option grants:


	7/1/11			7/2/10
Expected volatility		46.4	%		42.0	%
Risk-free interest rate		2.2	%		2.3	%
Expected term (in years)		5.3			5.3
Expected dividend yield		1.5	%		1.0	%

We based our calculation of expected volatility on a combination of historical and implied volatility for options granted. We based the risk-free interest rate on the U.S. Treasury yield curve in effect at the date of grant. We estimated the expected term of the options using their vesting period, post-vesting employment termination behavior and historical exercise patterns. We based the expected dividend yield on the option's exercise price and annualized dividend rate at the date of grant.

The following is a summary of stock option activity during 2011 as of July 1, 2011:


	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (in years)		Aggregate Intrinsic Value (in millions)
Outstanding – beginning of year		26,851,964		$	11.18
Granted		2,073,278		$	5.37
Exercised		(263,821	)	$	1.80
Forfeited/expired		(2,703,169	)	$	29.32

Outstanding – end of period		25,958,252		$	8.92		4.0	$	1.5


Exercisable – end of period		21,841,803		$	9.46		3.0	$	1.1
Shares expected to vest		25,635,340		$	8.96		3.9	$	1.5

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on our closing stock price as of July 1, 2011, that the option holders would have received had all holders exercised their options as of that date. The aggregate intrinsic value of exercised stock options during the second quarter of 2011 was $0.3 million.

The weighted average fair value of stock options granted during the first six months of 2011 was $2.07.

Cash-Settled Stock Appreciation Rights

The 2004 Plan provides for the granting of cash-settled SARs in conjunction with, or independent of, the stock options under the 2004 Plan. These SARs allow the holder to receive in cash the difference between the cash-settled SARs' grant price (the market value of our stock on the grant date) and the market value of our stock on the date the holder exercises the SAR. These cash payments were negligible in the first half of 2011 and 2010.

The following is a summary of cash-settled SARs activity during 2011 as of July 1, 2011:


	Shares			Weighted Average Exercise Price
Outstanding – beginning of year		445,233		$	7.73
Granted		41,700		$	5.38
Forfeited/expired		(31,036	)	$	7.76

Outstanding – end of period		455,897		$	7.51

Restricted Stock

The fair market value of restricted stock vested was $10.9 million in the first half of 2011. The weighted average grant date fair value of restricted stock was $5.37 per share in the first six months of 2011 and $8.78 per share in the first six months of 2010.

The following is a summary of restricted stock activity during 2011 as of July 1, 2011:


	Shares			Weighted Average Grant Date Fair Value
Non-vested – beginning of year		5,372,417		$	7.19
Granted		2,793,050		$	5.37
Vested		(2,279,895	)	$	6.80
Forfeited		(391,299	)	$	6.38

Non-vested – end of period		5,494,273		$	6.48

Performance Stock Units

The 2004 Plan provides for the granting of PSUs. We granted 1,640,832 PSUs in the first six months of 2011 and 1,132,220 PSUs in the first six months of 2010. The PSUs granted in the first six months of 2011 entitle the recipients to receive shares of our common stock commencing in March 2012, contingent on the achievement of strategic goals for the 2011 fiscal year. Following achievement of these measures and subject to continued employment, one-third of such shares will be issued in annual installments in February 2012, February 2013 and February 2014. At maximum target performance, we will issue two shares for each PSU granted. The weighted average price of PSUs granted in the first six months of 2011 was $5.40 per share and the weighted average price of PSUs granted in the first six months of 2010 was $7.73 per share.

The PSUs granted in 2010 entitle the recipients to receive shares of our common stock commencing in March 2011, contingent on the achievement of operating earnings targets for the 2010 fiscal year. Based upon above-target operating earnings of $237.0 million and market share and market penetration gains in some of the identified product areas, 125% of the PSUs were earned and 1.25 shares for each PSU (183,737 additional shares) granted will be paid out, subject to continued employment. We issued one-third (306,155 shares) of the total shares in the first quarter of 2011 and generally, one-third of such shares will be issued in annual installments in March 2012 and March 2013.

The following is a summary of PSU activity during 2011 as of July 1, 2011:


	Shares			Weighted Average Grant Date Fair Value
Non-vested – beginning of year		2,127,318		$	5.86
Granted¹		1,824,569		$	5.58
Vested		(798,241	)	$	5.07
Forfeited		(525,762	)	$	7.82

Non-vested – end of period		2,627,884		$	5.51

¹	This includes the additional 183,737 shares from the 2010 grant that were earned based on 2010 operating earnings and strategic goals.

Equity-Based Compensation Expense

The following table sets forth the total equity-based compensation expense resulting from stock options, SARs, restricted stock, and PSUs by line item on the statement of operations:


	Second Quarter						Six Months
	7/1/11			7/2/10			7/1/11			7/2/10
Cost of revenue – products	$	0.5		$	0.6		$	1.0		$	1.0
Cost of revenue – services		0.6			0.6			1.2			1.1
Research and development		3.1			2.4			5.6			4.2
Sales and marketing		1.3			1.3			2.6			2.5
General and administrative		2.5			2.5			5.2			4.4

Equity-based compensation expense before income taxes		8.0			7.4			15.6			13.2
Income tax benefit		(1.2	)		(2.5	)		(2.6	)		(4.3	)

Total equity-based compensation expense after income taxes	$	6.8		$	4.9		$	13.0		$	8.9

The following table sets forth the total equity-based compensation expense by type:


	Second Quarter						Six Months
	7/1/11			7/2/10			7/1/11			7/2/10
Stock options	$	1.3		$	1.4		$	2.6		$	2.7
Cash-Settled SARs		(0.1	)		(0.1	)		(0.2	)		0.1
Restricted Stock		5.4			4.0			9.8			7.5
Performance stock units		1.4			2.1			3.4			2.9

Total	$	8.0		$	7.4		$	15.6		$	13.2

As of July 1, 2011, we had $43.0 million of unrecognized equity-based compensation cost that we expect to recognize over a weighted average period of 1.9 years.