A:

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.

RELATED FAQS
  1. I've noticed executives buy a lot of stock below market value, and then they sell ...

    On October 30, 2006, a Google executive officer purchased 2,541 shares of Google at $9 per share and sold these same shares ... Read Answer >>
  2. Why would I need to know how many outstanding shares the shareholders have?

    Find out why shareholders should know how many outstanding shares have been issued by a corporation, and learn what happens ... Read Answer >>
  3. What is evergreen funding?

    Evergreen funding is a term used to describe the incremental addition of money into a business. Before a business is started ... Read Answer >>
  4. Why do companies release financial figures in terms of fully diluted shares outstanding?

    Learn why companies release their financial figures in terms of fully diluted shares outstanding so as to give a true picture ... Read Answer >>
  5. Why is the value of capital stock important to public shareholders?

    Understand what capital stock is and how it's issued and authorized. Learn why the value of capital stock important to public ... Read Answer >>
  6. Why are corporations so concerned about their stock price?

    When the share price of a company is high or increasing, generally corporations, or more specifically their management teams, ... Read Answer >>
Related Articles
  1. Investing

    Who's Most Likely to Get Wall Street Bonuses?

    See what areas of finance were most likely to get you a bonus last year.
  2. Managing Wealth

    A New Approach To Equity Compensation

    The new financial accounting standard known as FAS 123R could take a bite out of your portfolio. Find out why here.
  3. Trading

    The Benefits And Value Of Stock Options

    The pros and cons of corporate stock options have been debated since the incentive was created. Learn more about stock option basics and the cost of stock options.
  4. Managing Wealth

    A Guide To CEO Compensation

    Make sure you assess whether a CEO has a stake in doing a good job for you, the shareholder.
  5. Trading

    Should Employees Be Compensated With Stock Options?

    Learn the good, the bad and the ugly sides of this type of payout.
  6. Retirement

    How Non-Qualified Deferred Compensation Plans Work

    These tax-advantaged retirement savings plans have their pros and cons, and employers and employees must follow strict guidelines.
  7. Investing

    How Does Dilution Work?

    Dilution refers to the reduction in the percentage equity ownership of a company due to additional equity being issued to other owners.
  8. Managing Wealth

    Benefits of Deferred Compensation Plans

    Understand the difference between a qualifying or nonqualifying deferred compensation plan. Learn about the benefits of a deferred compensation plan.
  9. Investing

    The Dangers Of Share Dilution

    Investors need to be aware of the existence of dilutive securities and how they can affect existing shareholders.
  10. Investing

    Evaluating A Company's Management

    Financial statements don't tell you everything about a company's health. Investigate the management behind the numbers!
RELATED TERMS
  1. Evergreen Option

    A type of employee stock option plan in which additional shares ...
  2. Equity Compensation

    This is one way to attract and retain employees to a startup ...
  3. Evergreen

    A contract provision that automatically renews the length of ...
  4. Camouflage Compensation

    Compensation that is granted to upper echelon employees, directors, ...
  5. Performance Shares

    In the case of stock compensation, shares of company stock given ...
  6. Evergreen Loan

    A loan that does not require the principal amount to be paid ...
Hot Definitions
  1. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  2. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  3. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  4. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
  5. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  6. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
Trading Center