Jennifer has just been granted at-the-money company options on 300,000 shares. These options expire in 5 years and are exercisable after 3 years. The options are valued at $1.2 million. It is normal for her to receive annual option grants such as this. She also receives a current salary of $550,000. Why might Jennifer prefer to receive a straight annual salary of $1.5 million rather than this salary and option combination?
What will be an ideal response?
Jennifer most likely has a large portion of her wealth tied up in company stock. If this is true, she has a very undiversified position and is highly dependent on the firm's stock doing well to make the options pay off. Thus, she is exposed to a large amount of risk as there is no guarantee on the stock price. She must also wait for the 3-year freeze-out period to lapse before exercising her options. Thus, she may prefer a lower fixed amount now rather than accept the risks associated with the options.
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