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 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 >>
  3. Why do share prices fall after a company has a secondary offering?

    The best way to answer this question is to provide a simple illustration of what happens when a company increases the number ... Read Answer >>
  4. In what situations does it benefit a company to buy back outstanding shares?

    Learn about the reasons a company may choose to buy back its outstanding shares, such as reducing the cost of capital and ... Read Answer >>
  5. How do restricted stocks, treasury stocks and stock appreciation rights benefit employees?

    Restricted stock represents any equity that is conditionally given or sold to an insider as compensation or as part of an ... Read Answer >>
  6. Why is an increase in capital stock on a company's balance sheet a bad sign for stockholders?

    Understand what capital stock represents for a company and understand the significance for investors when a company initiates ... Read Answer >>
Related Articles
  1. 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.
  2. Trading

    Evaluating Executive Compensation

    Find out how to determine whether a CEO is being overpaid.
  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. Investing

    What are Issued Shares?

    Issued shares are the amount of authorized stocks a company’s shareholders buy and own. The annual report shows the number of outstanding shares.
  5. 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.
  6. 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.
  7. Personal Finance

    Equity Vs. Salary: What You Need To Know (FB, GOOG)

    Equity payments are common at startup companies. Equity offers potential for a big payout but is also much riskier than a salary payment.
  8. Investing

    Assess Shareholder Wealth With EPS

    Find out if management is doing its job of creating profit for investors.
  9. Investing

    The Dangers Of Share Dilution

    Share dilution reduces the value of an individual investment and can drastically impact a portfolio.
  10. Managing Wealth

    Calculating Basic Earnings Per Share

    Basics earnings per share measures the amount of net income earned per share of outstanding stock.
RELATED TERMS
  1. Highly Compensated Employee

    For employer-sponsored, tax-advantaged retirement plan purposes, ...
  2. Equity Compensation

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

    Compensation that is granted to upper echelon employees, directors, ...
  4. Evergreen Loan

    A loan that does not require the principal amount to be paid ...
  5. Allotment

    During an IPO, this is the number of shares granted to each participating ...
  6. Issued Shares

    The number of authorized shares that is sold to and held by the ...
Hot Definitions
  1. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  2. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  3. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  4. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  5. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center