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. What do states do with unclaimed property?

    Unclaimed property refers to personal accounts in financial institutions or companies that have had no activity and whose ... Read Full Answer >>
  2. How do financial advisors execute trades?

    Today, almost every investor invests through online brokerage accounts. Investors often believe that their trades are directly ... Read Full Answer >>
  3. What are ComputerShare's escheatment services?

    Escheatment is the process by which ownership of abandoned property is transferred to the state. Escheated property can include ... Read Full Answer >>
  4. How does escheatment affect a company's shareholders?

    Escheated property in the United States is a designation for personal property such as bank accounts, shares, insurance proceeds, ... Read Full Answer >>
  5. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  6. 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 >>
Related Articles
  1. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  4. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  5. Investing Basics

    What are the fiduciary responsibilities of board members?

    Find out what fiduciary duties a board of directors owes to the company and its shareholders, including the duties of care, good faith and loyalty.
  6. Options & Futures

    Understanding The Escrow Process

    Learn the 10 steps that lead up to closing the deal on your new home and taking possession.
  7. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  8. Mutual Funds & ETFs

    Scared By ETF Risks? Try Hegding With ETF Options

    With more ETFs to trade, the risks associated with these investments have grown. To mitigate these risks, ETF options are a hedging strategy for traders.
  9. Mutual Funds & ETFs

    ETF Options Vs Index Options

    Investors have much to consider when they’re deciding between ETF and index options. Here's help in making the decision.
  10. Economics

    What's a Horizontal Merger?

    A horizontal merger occurs when companies within the same industry merge.
  1. Crude Oil

    Crude oil is a naturally occurring, unrefined petroleum product ...
  2. Leg

    A leg is one component of a derivatives trading strategy, in ...
  3. Grant

    The issuance of an award, such as a stock option, to key employees ...
  4. Put-Call Parity

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

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

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

You May Also Like

Hot Definitions
  1. Take A Flier

    The slang term for a decision to invest in highly speculative investments.
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center