What is an Evergreen Option
An evergreen option is a type of employee stock option plan in which additional shares are automatically granted to the plan every year. An evergreen option may also be called an "evergreen provision" or "evergreen plan."
BREAKING DOWN Evergreen Option
An evergreen plan uses a percentage of the company's common shares outstanding to determine how many options to grant. For example, if a company has 75 million outstanding shares and a 5% evergreen option provision, the company could issue 3.750 million shares worth of compensation in the first year. In the second year, the company would have 78.750 million shares outstanding and could, therefore, issue up to 3.937 million shares worth of compensation.
Evergreen option plans don't usually have an expiration date and do not require shareholder approval. However, the board of directors must approve how many shares are automatically allotted to the plan each year. Evergreen options typically get issued as incentive stock options (ISOs), which are options strictly reserved for employees, usually company executives.
Advantages of Evergreen Options
An evergreen option gives a publicly traded company a way to attract and retain top managers and employees by providing them with additional compensation above and beyond a salary. Evergreen options help align managers' and employees’ interests with those of shareholders because their options increase in value if the company performs well.
Limitations of Evergreen Options
The downside of evergreen provisions for shareholders is that the annual issuance of additional shares dilutes the company’s share base. Current shareholders who do not receive evergreen options have a smaller ownership in the company because the total number of shares outstanding has increased, but their shareholding has remained the same. For example, Tom has a 1% interest in a company that has 20 million shares outstanding (200,000 shares / 20,000,000 share base). After senior executives receive their annual evergreen options, the company has 22 million shares outstanding. Tom’s interest in the company has decreased to 0.9% (200,000 shares / 22,000,000 share base). If a company is performing poorly, the dilution of its shares may outweigh the benefits of issuing evergreen options.
Taxation of Evergreen Options
Providing evergreen options are issued as incentive stock options, the grant is a non-taxable transaction. The first tax event occurs when the shares are sold, not exercised. If the shares are immediately sold after they get exercised, any realized gains are treated as ordinary income. However, if the shares are held for 12 months after they have been exercised, and not sold until two years after the grant date, gains are treated as a long-term capital gain. For example, suppose David’s evergreen options are granted December 15, 2017, and he exercises them December 15, 2018. If David wants to report a long-term capital gain, he cannot sell his shares until December 15, 2019.