Stock-Based Compensation

The Company measured and recognized compensation expense for all share-based payment awards made to employees and directors including employee stock options, restricted stock units and employee stock purchases related to the Employee Stock Purchase Plan (collectively “Employee Stock Purchases”) based on estimated fair values. The fair value of share-based payment awards is estimated on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations.

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. As stock-based compensation expense recognized in the consolidated statement of operations for the years ended December 31, 2011, January 1, 2011 and January 2, 2010 is based on awards expected to vest, it has been reduced for estimated forfeitures. ASC 740 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company’s estimated forfeiture rate in 2011, 2010 and 2009 of 6.3% 8.6%, and 19.5%, respectively, was based on historical forfeiture experience, which the Company believes is the best available information to estimate the future forfeiture rate. Tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are required to be classified as financing cash flows. The Company recognized $3.9 million and $0.8 million of excess tax benefit in fiscal years 2011 and 2010, respectively. There were no such tax benefits during fiscal 2009.

Valuation and Expense Information

The fair value of stock-based awards to employees is calculated using the Black-Scholes option pricing model, which requires subjective assumptions, including future stock price volatility and expected time to exercise. The expected term of options granted was calculated using the simplified method allowed by the SAB 107. The risk-free rate is based on the U.S Treasury rates in effect during the corresponding period of grant. The expected volatility is based on the historical volatility of Nanometrics’ stock price. These factors could change in the future, which would affect the stock-based compensation expense in future periods.

The weighted-average fair value of stock-based compensation to employees is based on the single option valuation approach. Forfeitures are estimated and it is assumed no dividends will be declared. The estimated fair value of stock-based compensation awards to employees is amortized over the vesting period of the options. The weighted-average fair value calculations are based on the following average assumptions:



	Fiscal Year 2011	Fiscal Year 2010	Fiscal Year 2009
Stock Options:
Expected life	4.5 years	4.5 years	4.1 years
Volatility	77.0%	74.2%	67.6%
Risk free interest rate	1.82%	2.04%	2.08%
Dividends	—	—	—
Employee Stock Purchase Plan:
Expected life	0.5 years	0.5 years	0.5 years
Volatility	73.4%	80.3%	99.1%
Risk free interest rate	0.19%	0.20%	0.33%
Dividends	—	—	—

Stock Options and Restricted Stock Units ("RSUs")

Prior to December 2008, the majority of options granted by the Compensation Committee vested at a rate of 33¹/3 percent over the first three years of the seven-year option term on each of the first, second and third anniversary of such grants. Starting in December 2008, the majority of the options granted to employees employed for less than one year vest one-third ( ¹/3^rd ) of the shares subject to the option on the first anniversary of the grant date, and vest one thirty sixth (¹/36^th ) each month for the following two years, for a total three year vesting period with a seven-year option term. Starting in November 2008, the majority of the options granted for employees employed for more than one year vest one thirty-sixth (¹/36^th ) of the shares subject to the options in equal monthly installments starting on the monthly anniversary of the date of grant with a seven-year option term. On February 22, 2010, the Compensation Committee reviewed best practice with regard to stock option vesting and made the following changes; existing employees generally receive vesting terms of monthly ratable vesting for a total period of four years. New employees, in general, receive vesting terms that are equivalent to 25% vesting on the one year anniversary of the grant with monthly vesting thereafter for a total of four years. All other terms remain the same. Grant of each Restricted Stock Unit (“RSU”) counts against our available for grant pool at a ratio of 2:1 against the 2005 Equity Incentive Plan as depicted below under “RSUs granted”. The number of RSUs granted during the fiscal year 2011 was 315,472 which counted as 630,944 against the stock option plan. Each RSU represents an amount equal to the fair value of one share of the Company's common stock.

A summary of activity under the Company’s stock option plans including options and RSUs during fiscal year 2011, and shares available for grant at December 31, 2011 is as follows:



	Shares Available for Grant (Options and RSUs)
Options and RSUs
Outstanding at January 2, 2011	537,991
Options granted	(683,047	)
Options canceled	155,252
Shares added	2,000,000
RSUs granted	(630,944	)
RSUs canceled	46,000
Plan shares expired	(33,322	)
Shares available for grant at December 31, 2011	1,391,930

Options

The weighted average fair value per share of the stock options awarded in fiscal years 2011, 2010 and 2009 is $9.98, $6.42, and $2.84, respectively. A summary of activity of stock options in 2011 is as follows:



	Number of Shares Outstanding (Options)		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (in Years)		Aggregate Intrinsic Value (in Thousands)
Options
Outstanding at January 2, 2011	2,763,686		$	7.43
Exercised	(943,319	)	6.07
Granted	683,047		16.51
Canceled	(155,252	)	8.83
Outstanding at December 31, 2011	2,348,162		$	10.53	$	4.86	$	18,556
Exercisable at December 31, 2011	1,210,299		$	7.77	$	3.98	$	12,886

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Company’s closing stock price of $18.42 as of December 31, 2011, which would have been received by the option holders had all option holders exercised their options as of that date. The total intrinsic value of options exercised during 2011, 2010 and 2009 was $11.6 million, $6.2 million and $2.2 million, respectively. The fair value of options vested during 2011, 2010 and 2009 was $2.9 million, $2.8 million, $3.4 million, respectively.

The following table summarizes significant ranges of outstanding and exercisable options as of December 31, 2011.



Exercise Prices	Options Outstanding				Options Exercisable
Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life (Years)	Weighted Average Exercise Price		Number Exercisable	Weighted Average Exercise Price
$0.93–$0.98	240,795	3.78	$	0.94	240,795	$	0.94
$1.13–$6.65	246,093	2.60	$	4.33	211,827	$	4.44
$6.83–$7.50	280,165	4.75	$	7.42	211,669	$	7.40
$7.78–$10.21	216,963	3.53	$	9.25	155,439	$	9.12
$10.46–$10.46	256,590	5.30	$	10.46	74,856	$	10.46
$10.83–$11.77	235,519	5.60	$	11.33	91,017	$	11.23
$12.03–$15.74	242,847	5.44	$	14.46	70,955	$	13.33
$15.88–$16.59	178,742	5.23	$	16.10	84,942	$	15.98
$16.70–$16.70	389,748	6.22	$	16.70	68,799	$	16.70
$17.23–$19.84	60,700	6.71	$	18.02	—	$	—
$0.93–$19.84	2,348,162	4.86	$	10.53	1,210,299	$	7.77

As of December 31, 2011 the total unrecognized compensation costs related to unvested stock options was $7.6 million which is expected to be recognized as an expense over a weighted average remaining amortization period of 2.7 years.

In August 2011, the Company added an additional 2 million shares of common stock to the Company's 2005 Equity Incentive Plan available for grant.

In September 2009, the Company completed an offer to exchange certain employee stock options under Nanometrics’ Option Exchange Program (the “Option Exchange Program”). Under the Option Exchange Program, certain previously granted options were exchanged by eligible option holders for new options with a lower exercise price using the following exchange ratios: a) 2 replacement options were provided for every 3 options surrendered with an original exercise price less than or equal to $10.00, and b) 1 replacement option was provided for every 2 options surrendered with an original exercise price greater than $10.00.

As a result of the Option Exchange Program, a total of 448,945 options to purchase shares of common stock were tendered for exchange, and 237,838 options to purchase shares of common stock were issued. A total of 103 employees participated in the Option Exchange Program. Options granted pursuant to the Option Exchange Program have an exercise price of $7.50 based on the NASDAQ closing price of the Company’s common stock on September 3, 2009. For options granted pursuant to the Option Exchange Program, one third vested immediately on the re-grant date, and the remaining two thirds vest on a monthly basis beginning on the 13th month anniversary through the 36th month anniversary provided that the individual remains employed by the Company during that period. The incremental stock based compensation from the Option Exchange Program was $0.2 million which is being recorded ratably over the requisite service period of three years.

Restricted Stock Units ("RSUs")

Each RSU counts against our “2005 Equity Incentive Plan” at a ratio of two shares for each unit granted but represents an amount equal to the fair value of one share of the Company's common stock. The Company granted 315,472 and 73,232 RSUs during the years ended December 31, 2011 and January 1, 2011, respectively, to key employees with vesting periods spanning from one to three years. The Company granted 286,180 RSUs on November 21, 2011 as part of employment agreements with personnel hired by the Company subsequent to the acquisition of Nanda. The RSU's granted to these newly hired employees generally vest as follows: 10% on date of grant; the remaining vest one-third per year over each of the three years from date of grant, to the extent the participant continues to be employed at Nanometrics.

A summary of activity for RSUs is as follows:



RSU	Number of RSU		Weighted Average Fair Value
Outstanding RSU as of January 1, 2011	83,307		$	9.98
Granted	315,472		$	16.44
Released	(75,721	)	$	15.65
Cancelled	(23,000	)	$	10.55
Outstanding RSU as of December 31, 2011	300,058		$	15.30

As of December 31, 2011 the total unrecognized compensation costs related to unvested RSU's was $4.0 million which is expected to be recognized as an expense over a weighted average remaining amortization period of 2.7 years.

Stock-based Compensation Expense

The following table summarizes stock-based compensation expense for all share-based payment awards made to the Company’s employees and directors pursuant to the Employee Stock Purchases as follows (in thousands):



	Fiscal Year 2011		Fiscal Year 2010		Fiscal Year 2009
Cost of products	$	176	$	126	$	34
Cost of service	218		206		180
Research and development	984		514		495
Selling	1,366		596		472
General and administrative	1,729		1,508		873
Total stock-based compensation expense related to employee stock options and employee stock purchases	$	4,473	$	2,950	$	2,054