Note 4 — Stock-Based Compensation

Equity Incentive Plans

2003 Equity Incentive Plan (“2003 Plan”):

Under the 2003 Plan, the Company may grant stock options and stock appreciation rights with an exercise price that is no less than the fair market value of the stock on the date of grant. Under the 2003 Plan, the Company may also grant restricted stock and restricted stock unit awards. The Company typically grants restricted stock units (“RSUs”). No participant may be granted stock options covering more than four million shares of stock or more than an aggregate of one million shares of restricted stock and RSUs in any fiscal year. The term of each option or RSU is determined by the board of directors or its delegate and, for option grants on or after February 12, 2004, is generally seven years. Options generally vest in equal annual installments over a four-year period.

On May 9, 2012, the 2003 Plan was amended to increase the number of shares available for new awards to 25 million shares, of which 15 million shares were available for restricted stock and/or RSUs. In addition, the period during which incentive stock options can be granted was extended to February 9, 2022, and the maximum number of shares that may be issued upon exercise of incentive stock options was set at 25 million.

On May 12, 2010, the 2003 Plan was amended to increase the shares available for new awards to 45 million shares, with 30 million shares for restricted stock and RSUs, and to update the performance measures that can be used to determine the vesting of awards intended to qualify for deductibility under Section 162(m) of the Internal Revenue Code to better match the metrics the Company uses to manage its business.

As of December 31, 2012, the 2003 Plan had approximately 23.8 million common shares available for future grants. A total of approximately 79.3 million shares of common stock were reserved for issuance upon exercise of outstanding options and upon vesting of outstanding RSUs as of December 31, 2012.

Employee Stock Purchase Plan (“ESPP”):

Under the ESPP, rights are granted to LSI employees to purchase shares of common stock at 85% of the lesser of the fair market value of such shares at the beginning of a 12-month offering period or the end of each six-month purchase period within such an offering period.

On May 12, 2010, the ESPP was amended to increase the shares available for issuance under the plan to a total of 30 million shares and to extend the term of the ESPP through May 12, 2020. As of December 31, 2012, the ESPP had approximately 14.7 million shares available for future purchase.

Stock-Based Compensation Expense

Stock-based compensation expense included in continuing operations, net of estimated forfeitures, related to the Company’s stock options, ESPP and RSU awards by expense category was as follows:


	Year Ended December 31,
	2012		2011		2010
	(In thousands)
Cost of revenues	$	11,946	$	6,921	$	7,044
Research and development		47,064		23,646		23,471
Selling, general and administrative		49,290		20,343		23,487

Total stock-based compensation expense	$	108,300	$	50,910	$	54,002

In connection with the SandForce acquisition, the Company assumed unvested stock options and RSUs originally granted by SandForce. Stock-based compensation expense for 2012 included $4.5 million related to accelerated vesting and $11.6 million for amortization of assumed stock options and RSUs for former SandForce employees.

The Company has issued RSUs that will not vest unless specified performance criteria are met. In the first quarter of 2012, the compensation committee of the board of directors authorized additional vesting of performance-based RSUs where the Company’s performance had been adversely affected as a result of the flooding that occurred in Thailand in the fourth quarter of 2011 and as a result, vesting levels would have been lower. The Company recognized $7.8 million of stock-based compensation expense related to the additional vesting. No executive officers were included in the group of employees that received additional vesting.

The income tax benefit that the Company realized for the tax deduction from option exercises and other awards was not material for any period presented.

Stock Options:

The fair value of each option grant is estimated as of the date of grant using a reduced-form calibrated binomial lattice model (“lattice model”). The following table summarizes the weighted-average assumptions that the Company applied in the lattice model:


	Year Ended December 31,
	2012			2011			2010
Estimated grant date fair value per share	$	2.83		$	2.14		$	1.95
Expected life (years)		4.46			4.51			4.30
Risk-free interest rate		0.72	%		1.83	%		1.91	%
Volatility		47	%		47	%		51	%

The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is a derived output of the lattice model. The expected life of employee stock options is affected by all of the underlying assumptions and calibration of the Company’s model.

The risk-free interest rate assumption is based upon observed interest rates of constant maturity U.S. Treasury securities appropriate for the term of the Company’s employee stock options.

The Company uses an equally weighted combination of historical and implied volatilities as of the grant date. The historical volatility is the standard deviation of the daily stock returns for LSI from the date of the initial public offering of its common stock in 1983. For the implied volatilities, the Company uses near-the-money exchange-traded call options, as stock options are call options that are granted at-the-money. The historical and implied volatilities are annualized and equally weighted to determine the volatilities as of the grant date. Management believes that the equally weighted combination of historical and implied volatilities is more representative of future stock price trends than sole use of historical or implied volatilities. The lattice model assumes that employees’ exercise behavior is a function of the option’s remaining vested life and the extent to which the option is in-the-money. The lattice model estimates the probability of exercise as a function of these two variables based on the entire history of exercises and cancellations for all past option grants made by the Company since its initial public offering.

Because stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.

The Company’s determination of the fair value of stock-option awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well a number of highly complex and subjective assumptions. The Company uses third-party consultants to assist in developing the assumptions used in, as well as calibrating, the lattice model. The Company is responsible for determining the assumptions used in estimating the fair value of its stock-option awards.

The following table summarizes changes in stock options outstanding:


	Number of Shares			Weighted-Average Exercise Price per Share		Weighted-Average Remaining Contractual Term		Aggregate Intrinsic Value
	(In thousands)					(In years)		(In thousands)
Options outstanding at January 1, 2012		64,245		$	6.19
Assumed in SandForce acquisition		7,542		$	0.75
Granted		5,479		$	8.37
Exercised		(15,679	)	$	5.15
Canceled		(5,545	)	$	8.34

Options outstanding at December 31, 2012		56,042		$	5.75		3.67	$	102,589

Options exercisable at December 31, 2012		34,742		$	6.08		2.56	$	55,534

As of December 31, 2012, the total unrecognized compensation expense related to unvested stock options, net of estimated forfeitures, was $35.2 million and is expected to be recognized over the next 1.9 years on a weighted-average basis. The options assumed in the SandForce acquisition vest over periods up to four years from the date of the grant and have ten year terms. The total intrinsic value of options exercised during the years ended December 31, 2012, 2011 and 2010 was $45.1 million, $22.9 million and $4.2 million, respectively. Cash received from stock option exercises was $80.8 million in 2012.

Restricted Stock Units:

The cost of service-based and performance-based RSUs is determined using the fair value of the Company’s common stock on the date of grant. For performance-based RSU expense, the Company also considers the probability that those RSUs will vest.

Service-based:

The vesting of service-based RSUs requires that the employee remain employed by the Company for a specified period of time.

The following table summarizes changes in service-based RSUs outstanding:


	Number of Units			Weighted-Average Grant Date Fair Value per Share
	(In thousands)
Unvested service-based RSUs outstanding at January 1, 2012		12,085		$	5.94
Assumed in SandForce acquisition		1,576		$	6.17
Granted		8,579		$	8.11
Vested		(3,642	)	$	5.87
Forfeited		(943	)	$	6.60

Unvested service-based RSUs outstanding at December 31, 2012		17,655		$	6.99

As of December 31, 2012, the total unrecognized compensation expense related to the service-based RSUs, net of estimated forfeitures, was $88.8 million and will be recognized over the next 2.6 years on a weighted-average basis. The total weighted-average grant date fair value of service-based RSUs granted was $69.6 million, $55.7 million and $40.8 million for the years ended December 31, 2012, 2011 and 2010, respectively. The total fair value of the shares vested was $29.6 million, $14.6 million and $8.9 million for the years ended December 31, 2012, 2011 and 2010, respectively.

Performance-based:

Since 2010, the Company has also granted performance-based RSUs. The vesting of these RSUs is contingent upon the Company meeting specified performance criteria and requires that the employee remain employed by the Company for a specified period of time.

The following table summarizes changes in performance-based RSUs outstanding:


	Number of Units			Weighted-Average Grant Date Fair Value per Share
	(In thousands)
Unvested performance-based RSUs outstanding at January 1, 2012		4,729		$	5.98
Granted		2,986		$	8.52
Vested		(1,446	)	$	5.85
Forfeited		(635	)	$	6.60

Unvested performance-based RSUs outstanding at December 31, 2012		5,634		$	7.29

As of December 31, 2012, the total unrecognized compensation expense related to the performance-based RSUs, net of estimated forfeitures, was $12.7 million and, if the performance conditions are fully met, will be recognized over the next 3 years. The total weighted-average grant date fair value of performance-based RSUs granted was $25.4 million, $26.1 million and $16.8 million for the years ended December 31, 2012, 2011 and 2010, respectively. The total fair value of the shares vested was $12.3 million, $6.3 million for the years ended December 31, 2012 and 2011, respectively. No shares vested during the year ended December 31, 2010.

Employee Stock Purchase Plan:

Compensation expense for the ESPP is calculated using the fair value of the employees’ purchase rights under the Black-Scholes model. The following table summarizes the weighted-average assumptions that the Company applied in the calculation of the fair value of ESPP grants:


	Year Ended December 31,
	2012			2011			2010
Estimated grant date fair value per share	$	1.94		$	1.81		$	1.49
Expected life (years)		0.8			0.8			0.8
Risk-free interest rate		0.2	%		0.1	%		0.2	%
Volatility		43	%		45	%		36	%

In 2012, 2011 and 2010, 6.1 million, 5.8 million and 6.7 million shares of common stock were issued under the ESPP at a weighted-average price of $5.09, $4.64 and $4.72 per share, respectively. Cash received from ESPP issuances was $30.8 million in 2012.