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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.
Key Takeaways
- Evergreen provisions allow companies to automatically issue a set amount of equity, such as stock options or shares, to key employees annually without requiring repeated board approvals.
- By tying management compensation to the company’s stock performance, evergreen provisions help align the interests of management and shareholders, providing an incentive for executives to boost the company’s stock price.
- While evergreen provisions can motivate management, they can also lead to dilution, reducing existing shareholders’ percentage of ownership unless the new shares increase overall company value.
- Evergreen provisions may continue to issue equity compensation even if the company performs poorly, potentially eroding shareholder value without yielding benefits.
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.
Understanding Automatic Equity Allotments
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. has 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.
The Risks of Share Dilution in Evergreen Provisions
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.
(See also: Stock Option Definition and What Is Stock Dilution?)
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.
(See also: A Guide to CEO Compensation and FAS 123R.)
