It is common for publicly-traded corporations to provide more than just regular salary compensation to their management and key personnel. Often, corporate boards will decide to provide special compensation to key personnel, in order to attract and retain top talent and to help align management's interests with those of shareholders.

Such compensation commonly takes the form of stock option grants, in which a specified allotment of option contracts, with an exercise date set for some point in the future, is provided to selected employees. Selected employees can also be issued new shares by the corporation. Both forms of compensation can be very lucrative and, as the value of both common shares and stock options increases as the company's share price rises, both have the effect of aligning the economic interests of management and shareholders. In other words, if management's wealth rises and falls along with the company's stock price, managers have a real incentive to make sure they do what is needed to keep the company's share price climbing. If a company's managers were instead strictly paid a fixed annual salary with no equity compensation, they would not have as much of an economic motive to maximize shareholder wealth - at least, this is one of the primary arguments supporting the use of equity compensation for management and key personnel.

For shares or options to be legally issued to employees, a corporation's board must first approve the maximum allotment and specify the terms of the allotment. Such decisions are made at periodic board meetings, but rather than go through the process of approving allotments every year, a company can adopt what is known as an evergreen option provision, which provides for an automatic allotment of equity compensation every year.

The amount of the evergreen provision is usually based on the number of shares outstanding at the beginning of each year. For example, if XYZ Corp. had 50 million shares outstanding and an evergreen provision for equity compensation up to 5% of outstanding shares, XYZ would be able to issue 2.5 million shares' worth of compensation in the first year. Assuming the shares outstanding at the beginning of Year 2 are 52.5 million, the firm would then be able to issue 2.625 million shares (5% of the current shares outstanding) of equity compensation in the second year.

From the investor's perspective, there are both positive and negative aspects to an evergreen provision. On the positive side, this provision ensures that your company will continue to issue equity compensation to key personnel, and hopefully keep their efforts focused on maximizing the value of your shares. On the negative side, an evergreen provision represents an automatic dilution of your shares every year. In our example, since only the executives receiving the stock options get the new shares, the share issuance ends up increasing the total number of shares outstanding, but it does not increase the share holdings of current investors. Thus, current investors end up owning a smaller proportion of the company than they used to - this is called dilution. (For further reading, see The "True" Cost Of Stock Options and What is dilutive stock?)

If the benefits of equity compensation outweigh the cost of share dilution, then it is to the net benefit of shareholders to continue with the compensation system. However, evergreen provisions, unless otherwise specified, allow for equity compensation even in years when the company performs poorly, and thus can end up diluting shareholder value without providing any benefits.

To learn more, check out Lifting The Lid On CEO Compensation and

A New Approach To Equity Compensation.

  1. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  2. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  3. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
  4. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  5. What is the difference between derivatives and options?

    Options are one category of derivatives. Other types of derivatives include futures contracts, swaps and forward contracts. ... Read Full Answer >>
  6. How are rights distributed in a rights offering?

    In a rights offering, rights are distributed to shareholders based on the number of shares they already own. What Is a Rights ... Read Full Answer >>
Related Articles
  1. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  2. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  3. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  4. Investing

    The Best Strategies to Manage Your Stock Options

    We look at strategies to help manage taxes and the exercise of incentive and non-qualified stock options.
  5. Investing Basics

    Retirement Planning Using Long-Dated Options

    Retirement planning using high-risk options? It is possible, and studies confirm better yields than conventional methods. Here’s how.
  6. Investing Basics

    Understanding Vega

    In options trading, vega represents the amount option prices are expected to change in response to a change in the underlying asset’s implied volatility.
  7. Investing Basics

    What Does a Transfer Agent Do?

    Transfer agents maintain the records and documents related to shareholder accounts.
  8. Options & Futures

    Introduction to Options Types

    Options are often the bread and butter of day traders. Here are some of the more common types of options.
  9. Taxes

    6 Reasons to Donate Your Car to Charity

    It's no longer a free ride, but there are still tax benefits to doing so.
  10. Economics

    What Does Vesting Mean?

    Vesting is the process of accruing non-forfeitable rights.
  1. Put-Call Parity

    A principle that defines the relationship between the price of ...
  2. Maturity

    The period of time for which a financial instrument remains outstanding. ...
  3. Employee Stock Option - ESO

    A stock option granted to specified employees of a company. ESOs ...
  4. Corporate Culture

    The beliefs and behaviors that determine how a company's employees ...
  5. Sticky Wage Theory

    An economic hypothesis theorizing that pay of employees tends ...
  6. Earnings Before Interest & Tax - EBIT

    An indicator of a company's profitability, calculated as revenue ...

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!