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. 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 >>
  4. Why should investors consider the fully diluted share amount?

    Learn about the importance of considering the fully diluted shares, how it could affect a stock's share price and how dilution ... Read Answer >>
Related Articles
  1. Trading

    Evaluating Executive Compensation

    Find out how to determine whether a CEO is being overpaid.
  2. Personal Finance

    5 Tech Companies With High Stock-Based Compensation (GOOGL, AMZN)

    Examine stock-based compensation among large tech firms to determine which factors are driving equity compensation and how executive grants are determined.
  3. 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.
  4. 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.
  5. Personal Finance

    3 Factors That Impact Your Stock Compensation

    Complexity, volatility and greed can each play a part in managing stock compensation.
  6. Trading

    Should Employees Be Compensated With Stock Options?

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

    Deferred Compensation Plans Vs. 401(k)s

    Discover the major advantages and disadvantages offered by deferred compensation plans for retirement as compared to a 401(k) plan.
  8. 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.
  9. 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.
  10. Personal Finance

    Make the Most of Your Equity Compensation

    Make sure you and your financial planner know how to get the most out of your equity compensation.
RELATED TERMS
  1. Evergreen Funding

    Evergreen funding is the gradual infusion of capital into a new ...
  2. Performance-Based Compensation

    An incentive-based form of compensation that is reserved for ...
  3. Key Employee

    An employee with a major ownership and/or decision-making role ...
  4. Overhang

    A measure of the potential dilution to which a common stock's ...
  5. Workers' Compensation Coverage A

    Insurance that protects employees under state laws, and provides ...
  6. Highly Compensated Employee

    A highly compensated employee (HCE) is anyone who owns at least ...
Hot Definitions
  1. Short Covering

    Short covering is buying back borrowed securities in order to close an open short position.
  2. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  3. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  4. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  5. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  6. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
Trading Center