Share-based Compensation

On December 5, 2013, the Company’s stockholders approved the Farmer Bros. Co. Amended and Restated 2007 Long-Term Incentive Plan (the “Amended Equity Plan”). The Amended Equity Plan is an amendment and restatement of, and successor to, the Farmer Bros. Co. 2007 Omnibus Plan (the "Omnibus Plan"), and, among other things, increases the number of shares of the Company’s common stock, par value $1.00 per share, authorized for issuance under the plan by 250,000 from 1,125,000 to 1,375,000. In addition, the Amended Equity Plan provides for the following material changes: limits the types of equity awards available to be granted under the Amended Equity Plan to performance-based options and restricted stock; limits participants in the Amended Equity Plan to directors, officers and other employees of the Company; limits the performance criteria that will be used to establish performance goals under the plan to (i) net sales or revenue; (ii) net income before tax and excluding gain or loss on sale of property, plant and equipment; and/or (iii) cash flow (including, but not limited to, operating cash flow and free cash flow); reduces the maximum number of shares of stock with respect to one or more awards that may be granted to any one participant during any calendar year from 250,000 to 75,000; requires that all options issued to employees include performance criteria or performance goals, unless issued in connection with the commencement of employment as an executive of the Company; provides for forfeiture of unvested awards upon termination of employment or termination of directorship, except as otherwise determined by the plan administrator; prohibits awards of restricted stock to employees except in connection with the commencement of employment as an executive of the Company; limits the value of restricted stock awards granted to any non-employee director to an amount not more than $30,000 annually; and prohibits delegation of administration of the plan to another committee or subcommittee of the Board, or authority to grant or amend awards to participants to a committee of one or more members of the Board or one or more officers of the Company.

Stock Options

Compensation expense is recognized on a straight-line basis over the service period based on the estimated fair value of the stock options. The Company estimates the fair value of option awards using the Black-Scholes option valuation model, which requires management to make certain assumptions for estimating the fair value of stock options at the date of grant. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimates, in management’s opinion the existing models may not necessarily provide a reliable single measure of the fair value of the Company’s stock options. Although the fair value of stock options is determined using an option valuation model that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

Non-qualified stock options with time-based vesting ("NQOs")

In the nine months ended March 31, 2014, the Company granted 1,927 shares issuable upon the exercise of NQOs with an exercise price of $18.68 per share to an eligible employee under the Omnibus Plan prior to its amendment and restatement which vest ratably over a three-year period. There were no NQOs granted during the three months ended March 31, 2014 or 2013.

Following are the weighted average assumptions used in the Black-Scholes valuation model for NQOs granted during the nine months ended March 31, 2014 and 2013:



	Nine Months Ended March 31,
	2014			2013
Weighted average fair value of NQOs	$	9.17		$	5.56
Risk-free interest rate	1.7		%	0.8		%
Dividend yield	—		%	—		%
Average expected term	6.0 years			6.0 years
Expected stock price volatility	50.4		%	49.5		%

The Company’s assumption regarding expected stock price volatility is based on the historical volatility of the Company’s stock price. The risk-free interest rate is based on U.S. Treasury zero-coupon issues at the date of grant with a remaining term equal to the expected life of the stock options. The average expected term is based on the midpoint between the vesting date and the end of the contractual term of the award. Currently, management estimates an annual forfeiture rate of 6.5% based on actual forfeiture experience. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The following table summarizes NQO activity for the nine months ended March 31, 2014:



Outstanding NQOs:	Number of NQOs		Weighted Average Exercise Price ($)	Weighted Average Grant Date Fair Value ($)	Weighted Average Remaining Life (Years)	Aggregate Intrinsic Value (Dollars in thousands)(1)
Outstanding at June 30, 2013	557,427		12.81	5.44	5.1	1,620
Granted	1,927		18.68	9.17	6.6	2
Exercised	(109,192	)	13.20	5.84	—	—
Cancelled/Forfeited	(23,797	)	15.59	5.89	—	—
Outstanding at March 31, 2014	426,365		12.58	5.33	4.6	3,153
Vested and exercisable, March 31, 2014	214,613		14.79	5.72	3.7	1,172
Vested and expected to vest, March 31, 2014	413,073		12.63	5.33	4.6	3,038

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(1) Aggregate intrinsic value represents the total pretax intrinsic value, based on the Company’s closing stock price of $19.70 at March 31, 2014, representing the last trading day of the fiscal quarter ended March 31, 2014, which would have been received by NQO holders had all award holders exercised their NQOs that were in-the-money as of that date.

The fair value of NQOs that vested during the nine months ended March 31, 2014 was $0.5 million. During the nine months ended March 31, 2014, the Company received $1.4 million in proceeds from exercises of vested NQOs.

As of March 31, 2014 and 2013, there was $0.8 million and $1.3 million, respectively, of unrecognized compensation cost related to NQOs. Total compensation expense for NQOs recognized in operating expenses in the three months ended March 31, 2014 and 2013 was $0.1 million and $0.2 million, respectively. Total compensation expense for NQOs recognized in the nine months ended March 31, 2014 and 2013 was $0.5 million and $0.7 million, respectively.

Non-qualified stock options with performance-based and time-based vesting ("PNQs")

In the nine months ended March 31, 2014, the Company granted a total of 109,448 shares issuable upon the exercise of PNQs with a weighted average exercise price of $21.32 per share to eligible employees under the Amended Equity Plan. These PNQs vest over a three-year period with one-third of the total number of shares subject to each such PNQ vesting on the first anniversary of the grant date based on the Company’s achievement of a modified net income target for the first fiscal year of the performance period as approved by the Compensation Committee, and the remaining two-thirds of the total number of shares subject to each PNQ vesting on the third anniversary of the grant date based on the Company’s achievement of a cumulative modified net income target for all three years during the performance period as approved by the Compensation Committee, in each case, subject to the participant’s employment by the Company or service on the Board of Directors of the Company on the applicable vesting date.

Following are the weighted average assumptions used in the Black-Scholes valuation model for PNQs granted during the nine months ended March 31, 2014:



	Nine Months Ended March 31, 2014
Weighted average fair value of PNQs	$	10.51
Risk-free interest rate	1.8		%
Dividend yield	—		%
Average expected term	6.0 years
Expected stock price volatility	50.5		%

The following table summarizes PNQ activity for the nine months ended March 31, 2014:



Outstanding PNQs:	Number of PNQs	Weighted Average Exercise Price ($)	Weighted Average Grant Date Fair Value ($)	Weighted Average Remaining Life (Years)	Aggregate Intrinsic Value (Dollars in thousands) (1)
Outstanding at June 30, 2013	—	—	—	—	—
Granted	109,448	21.32	10.51	6.7	—
Exercised	—	—	—	—	—
Cancelled/Forfeited	—	—	—	—	—
Outstanding at March 31, 2014	109,448	21.32	10.51	6.7	—
Vested and exercisable, March 31, 2014	—	—	—	—	—
Vested and expected to vest, March 31, 2014	95,600	21.32	10.51	6.7	—

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(1) Aggregate intrinsic value represents the total pretax intrinsic value, based on the Company’s closing stock price of $19.70 at March 31, 2014, representing the last trading day of the fiscal quarter ended March 31, 2014, which would have been received by PNQ holders had all award holders exercised their PNQs that were in-the-money as of that date.

The Company has recorded compensation expense for the PNQs based on its expectation that achievement of the targets for the PNQs is probable. Compensation expense for PNQs recognized in operating expenses in the three and nine months ended March 31, 2014 was $0.1 million and $0.2 million, respectively, and as of March 31, 2014 there was $1.0 million in unrecognized compensation cost related to PNQs. No comparable compensation expense was recognized in operating expenses in the three and nine months ended March 31, 2013 and there was no unrecognized compensation cost related to PNQs at March 31, 2013.

Restricted Stock

In the nine months ended March 31, 2014, the Company granted 9,200 shares of restricted stock, with a weighted average grant date fair value of $20.48 per share. In the nine months ended March 31, 2013, the Company granted 45,230 shares of restricted stock with a weighted average grant date fair value of $11.42 per share. Shares of restricted stock generally vest at the end of three years for eligible employees. Shares of restricted stock generally vest ratably over a period of three years for directors.

Compensation expense is recognized on a straight-line basis over the service period based on the estimated fair value of the restricted stock. Total compensation expense recognized in each of the three months ended March 31, 2014 and 2013 was $0.1 million. Total compensation expense recognized in the nine months ended March 31, 2014 and 2013 was $0.4 million and $0.5 million, respectively. As of March 31, 2014 and 2013, there was approximately $0.7 million and $1.0 million, respectively, of unrecognized compensation cost related to restricted stock.

The following table summarizes restricted stock activity for the nine months ended March 31, 2014:



Outstanding and Nonvested Restricted Stock Awards:	Shares Awarded		Weighted Average Grant Date Fair Value ($)	Weighted Average Remaining Life (Years)	Aggregate Intrinsic Value (1) (Dollars in thousands)
Outstanding at June 30, 2013	139,360		9.87	1.9	1,959
Granted	9,200		20.48	1.7	188
Exercised/Released	(27,651	)	13.36	—	604
Cancelled/Forfeited	(12,822	)	9.05	—	—
Outstanding at March 31, 2014	108,087		9.97	1.9	2,129
Expected to vest, March 31, 2014	94,318		9.93	1.9	1,786

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(1) Aggregate intrinsic value of outstanding shares represents the total pretax intrinsic value, based on the Company’s closing stock price of $19.70 at March 31, 2014, representing the last trading day of the fiscal quarter ended March 31, 2014.