NOTE 5 — STOCK BASED COMPENSATION

The Company recognizes stock-based compensation in accordance with ASC 718, “Compensation—Stock Compensation.” Stock-based compensation expense recognized in the unaudited condensed consolidated statement of comprehensive loss related to stock options and ESPP was $0.9 million and $2.1 million for the three and nine months ended September 30, 2012, respectively, and was $0.3 million and $0.7 million for the three and nine months ended September 30, 2011, respectively.

Valuation Assumptions

The Company estimated the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This fair value is being amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. The fair value of employee stock options and employee purchase rights under the Company’s ESPP was estimated using the following weighted-average assumptions for the three and nine months ended September 30, 2012 and 2011:

To determine the expected term of the Company’s employee stock options granted, the Company utilized the simplified approach as defined by SEC Staff Accounting Bulletin No. 107, “Share-Based Payment”. To determine the risk-free interest rate, the Company utilized an average interest rate based on U.S. Treasury instruments with a term consistent with the expected term of the Company’s stock based awards. To determine the expected stock price volatility for the Company’s stock based awards, the Company examined historical volatilities for industry peers as well as the Company and utilized a blend of the historical volatilities of the Company and its industry peers. The fair value of all the Company’s stock based awards assumes no dividends as the Company does not anticipate paying cash dividends on its common stock.

Employee Stock-based Compensation Expense

As required by ASC 718, the Company recognized $0.8 million and $1.9 million of stock-based compensation expense related to stock options and purchase rights granted after the Company’s initial public offering in February 2005, under the Company’s stock option plans and ESPP, for the three and nine months ended September 30, 2012, respectively and $0.3 million and $0.7 million of stock based compensation for the three and nine months ended September 30, 2011, respectively. As of September 30, 2012, the total unrecognized compensation cost related to unvested stock-based awards granted to employees under the Company’s stock option plans was approximately $9.4 million before forfeitures. This cost will be recorded as compensation expense on a straight-line basis over the remaining weighted average requisite service period of approximately 2.8 years.

Non-employee Stock-based Compensation Expense

The Company accounts for equity instruments issued to non-employees in accordance with ASC 505, “Equity.” The equity instruments consisting of stock options are valued using the Black-Scholes option pricing model. The values attributable to these options are amortized over the service period and the unvested portion of these options is remeasured at each vesting date. In connection with the grant of stock options to non-employees, the Company recorded stock-based compensation of approximately $0.1 million and $0.2 million for the three and nine months ended September 30, 2012, respectively, and $20,000 and $51,000 for the three and nine months ended September 30, 2011, respectively.

Stock-based compensation expense, which consists of the compensation cost for employee stock options and ESPP, and the value of options issued to non-employees for services rendered, was allocated to research and development and general and administrative as follows (in thousands):

Equity Incentive Plans

2004 Equity Incentive Plan On January 1, 2012, an additional 1,250,000 shares was authorized for issuance under the 2004 Equity Incentive Plan (“2004 Incentive Plan”), pursuant to the annual automatic increase to the authorized shares under the 2004 Incentive Plan. At September 30, 2012, 540,784 shares were authorized and available for issuance under the 2004 Equity Incentive Plan.

The following table summarizes stock option activity under the Company’s 2004 Equity Incentive Plan:

The total intrinsic value of stock options exercised during the nine months ended September 30, 2012 and 2011 were $1.4 million and $6,000, respectively, as determined at the date of the option exercise. Cash received from stock option exercises was $0.4 million and $14,000 for each of the nine months ended September 30, 2012 and 2011, respectively. The Company issues new shares of common stock upon exercise of options. In connection with these exercises, there was no tax benefit realized by the Company due to the Company’s current loss position.

2004 Employee Stock Purchase Plan On January 1, 2012, an additional 100,000 shares was authorized for issuance under the 2004 Employee Stock Purchase Plan (“2004 Purchase Plan”) pursuant to the annual automatic increase to the authorized shares under the 2004 Purchase Plan. For the nine months ended September 30, 2012, plan participants had purchased 150,677 shares at an average purchase price of $1.18. At September 30, 2012, plan participants had $0.1 million withheld to purchase stock on February 14, 2013, which is included in accrued liabilities on the accompanying unaudited condensed consolidated balance sheet. At September 30, 2012, 303,141 shares were authorized and available for issuance under the ESPP.