What is an Option to Buy Agreement?
An option to buy agreement, also known as a purchase option or option to purchase, is a legally binding contract that grants the option holder (usually the potential purchaser) the right, but not the obligation, to purchase or lease a specified property or asset at a predetermined price, within a specified time frame. This type of agreement creates the legal right to buy the property or asset under the agreed-upon conditions, without making a formal offer at the outset. It essentially establishes an agreement with a particular party to purchase an asset on the terms specified in the option agreement within a certain time period. Typically an option to buy agreement is commonly associated with real estate transactions, it can also be used in business transactions, such as mergers and acquisitions, to purchase a company at a future date under an agreed upon price and terms . In business law, an option to buy agreement is a powerful tool for protecting both the buyer and the seller from price fluctuations. Additionally, an option to buy agreement can help mitigate the risk of loss if the asset is misrepresented or fails to meet certain required conditions. Given that it represents a legal right to purchase property or assets at a certain date and price, an option to purchase agreement is often more advantageous than a letter of intent, a non-binding agreement that allows the parties to negotiate an agreement prior to entering into a contract. It’s important to note that when you are entering into an option to buy agreement, you may need to ensure that any option fees comply with your municipality or province’s Restrictive Trade Practices legislation.
How an Option to Buy Agreement Operates
Once the buyer and seller have agreed to the option, and they sign the document, that effectively means that a $150 is considered payment for the option. That $150 then serves as consideration for the contract – which makes it a legally binding agreement. And because there’s an exchange of money, there is a sale.
The option agreement can come in multiple forms. One of the most common forms of an option agreement is a right of first refusal, which is when the buyer has the opportunity prior to the sale to buy the property for a specified price. And the key there is that the buyer cannot press the sale unless the seller is ready to sell it. Otherwise, it’s just the right to purchase the property.
The buyer and seller in the agreement can be in the same document or two different documents. It can be a standalone agreement that includes the price for the option, and a legal description. Or it can include the option agreement itself in the sales contract. So, as you can see, the mechanics of it can be different, but the goal is the same.
The buyer has the option to purchase the property at a future date under specified terms, and the seller is promising that the property will be sold to the buyer – if the buyer chooses to exercise the option.
The reason the buyer pays money for the option is, for the most part, to make sure that neither party can back out of the deal if the deal is not overall beneficial to the buyer. In other words, the buyer doesn’t want it too cheap and the seller doesn’t want it too long.
That means that once the option agreement is signed, the parties are bound by the terms of the option agreement because it is a legally binding contract. Going through with the closing on the property then becomes a required obligation if the buyer decides to exercise its option to purchase. And because it is a valuable right, we always recommend to our clients that they pay something for the option since it is in fact valuable as an asset.
Advantages of a Option to Buy Agreement
The option to buy agreement offers a variety of benefits for both the buyer and the seller.
Flexibility
An option to buy agreement provides time flexibility. It allows the buyer time to conduct the necessary due diligence and provides the seller time to make arrangements for the sale of the property. Buyers are not subjected to the same time frames as in a traditional purchase and sale agreement, as the buyer does not have to obtain financing or conduct inspections until the option is exercised. There are also no penalties if the buyer decides to walk away from the agreement.
Risk Management
An advantage of an option to buy is that the buyer can identify potential problems with the property before purchasing. The buyer is not obligated to purchase the property if issues that raise the risk of the transaction become apparent. The buyer will not incur unwarranted costs, and the seller will be aware that the option agreement does not obligate the buyer to make the purchase. An option to buy permits the parties time to make an informed decision.
Investment
An option to buy agreement is frequently used to give investors time to arrange for financing. The buyer will usually arrange for financing prior to exercising the option. Having an option to buy agreement in place allows the buyer to lock in not only the price but also the other terms of the agreement. If the options are favorable, the buyer can exercise the option to buy and finalize the transaction under the original terms. The investment opportunity allows the buyer to commit to financing the property knowing that the terms and conditions of the agreement are protected.
Typical Features of an Option to Buy Agreement
Although the details of an option to buy agreement will vary, some common elements can be found in most agreements. In particular, such agreements will typically outline the following:
Strike Price
The "strike price" is a critical element in an option to buy agreement. In short, the strike price is the price of the underlying shares that is used for purposes of determining whether a particular option is in or out of the money. It is the price at which the option holder may purchase the underlying shares upon the exercise of the option.
Expiration Date
An option to buy will also generally set forth an expiration date. As the name implies, this is the date at which a particular option is no longer able to be exercised. By default, any unexercised options automatically terminate on the day immediately preceding the two-year anniversary of the date of grant; however, sometimes an option to buy will provide for an extended exercise period. In such instances, relevant state law is of particular import.
Conditions to Exercise
Lastly, an option to buy will often include a list of conditions to the exercise of the option, including the satisfaction of vesting criteria, the delivery of specific documentation to the issuer, the payment of specific amounts and the satisfaction of regulatory or legal requirements.
Legal Implications and Risks
An option to buy is a legally binding agreement that grants a purchaser a right to buy a property within a specified time period. Where there are a number of interested parties in relation to the one property (such as other prospective purchasers or existing tenants) an option to buy can be a useful device to contain the market while not binding the vendor to sell unless a prior approved situation has been satisfied.
Option to buy agreements must be carefully drafted to ensure they do not inadvertently result in a binding contract of sale being formed when left in those hands of a purchaser who is perhaps not as conscious of its contents as it should be. There are a number of statutory requirements that must be complied with if an option is to be enforceable. Section 23B of the Conveyancing Act 1919 (NSW) provides that an option in relation to land is not binding on either party unless the option or a memorandum or note in relation to the option is in writing signed by the person to be charged by the option (or in the case of the vendor, signed on his behalf by a person authorised).
Further , section 23G of the Conveyancing Act 1919 (NSW) requires that the vendor provide to the purchaser: (i) a property sales statement relating to the property being sold; and (ii) a cooling-off notice if the contracts for sale of land are not exchanged at the same time as the option.
In addition to the statutory requirements, careful consideration should be given to the scope of the matters to be included in an option to buy. Option to buy agreements are often simply worded without clauses that seek to protect the vendor from potential liabilities when the option is exercised. For example, it is common for vendors to provide a property sales statement in accordance with any relevant legislation at the time the contract is entered into. If the property is then improved by the purchaser as contemplated by the agreement there may be a resulting claim against the vendor alleging that the information in the statement is incorrect and damaging as it would result in the property no longer being suitable for the intended use or the property no longer being fit for its intended purpose which may give rise to a claim in damages for economic loss. The right to purchase should normally also be held subject to the vendor being able to comply with any statutory obligations relating to ownership, possession, occupation or use of the property from time to time so as to avoid the risk of a breach of statutory obligations.
Real-World Examples of an Option to Buy Agreement
Option to Buy Agreements are utilized in a variety of ways to facilitate business transactions. While the first example deals with a real estate option, the second example deals with the option to purchase the business of another.
Example 1:
Joanne owns a market farm and wants to sell her farm to her cousin Kyle. However, her cousin Kyle doesn’t have any money, and doesn’t know how to operate a farm. She does however have a friend Mark who has access to funds and experience running a market farm successfully. Mark would like to own a market farm. Joanne agrees to sell the farm to him for $10 million, but wants to keep the land in her family. Mark wants to run the farm for a year before he decides if he wants to buy the land. He agrees to rent the land from Joanne for $2 million per year with an option for him (or someone he designates in trust) to buy the land at the end of the 10 year term (and as long as he pays the $2 million per year to keep the lease in force). He pays Joanne a lease option premium of $4 million. If he exercises the option at the end of the 10 year term, the $2 million he paid each year is applied to the price. Mark operates the market farm profitably for 7 years and then sells the option (and assigns his lease) to another farmer for $6 million. The new farmer assumes Mark’s obligations under the lease and can exercise the option at any point in the remaining 3 years. Joanne has a guaranteed $2 million each year plus a possible $10 million at the end of the 10 year term. Kyle is relieved that he doesn’t have to pay $10 million now and saves $10 million in interest charges. He can allow the $2 million each year to come out of the market farm operations. He is also liberated from having to learn something completely foreign to him and yet can keep the land in the family.
Example 2:
Bill owns an auto body shop. His daughter Jennifer is already working there and she is very good at it. She expects to take it over one day but she is not quite ready yet. He has a great opportunity to sell the business to another shop for $2 million. Samantha, their best technician is ready to become a partner. If he sells to another shop he knows he will lose her. However, he is a little unsure of the buyer too, and it may take time to finalize a deal. He will also need to train Samantha, and he has no idea how many months or years that may take. He decides to retain the business but give Jennifer and Samantha the right to expand their roles as she becomes less involved. He studies up on how to do a buy-sell agreement. He negotiates a 10 year lease at $1 million per year, however he agrees that his children can buy the business back for $2 million if they exercise the option by the end of the 10 year lease. He sets aside $2 million in a separate bank account and takes interest on it at prime +2. This money will come from the $1 million per month lease payments. He then discusses this with Jennifer and Samantha and they are all in agreement. They now have a plan that will make them all happy. The buyer finds a competitor to buy him out a few months later at $1.1 million for 5 years and Bill closes the deal. Bill is grateful he had alternatives. He also leases a smaller space to him. At the end of the 3 years, the competitor is ready to increase his business elsewhere and is willing to close the lease deal. He is happy to have enjoyed 3 years at $1.1 million annual rate.
Writing an Effective Option to Buy Agreement
When drafting an option to buy agreement, it is essential to clearly define the subject of the option: what is being sold (real estate, shares in a company, etc.), who the parties to the agreement are and how the price will be calculated. A legal professional can also ensure that any restrictions or conditions on selling the property will be clearly stated and agreed to in the option to buy agreement.
Both the optionor (the party granting the right to purchase) and the optionee (the party requiring the option) should have their legal counsel review the option to buy agreement prior to execution to ensure that their rights are protected and that obligations are clearly delineated. When negotiating an option to buy agreement , outline the minimum terms that must be included as well as the preferred terms so that bargaining does not result in misunderstanding or gaps in the document.
The purpose of an option to buy agreement is to both protect the optionee and give the optionor a degree of certainty that the property will be purchased at the conclusion of the option period. As the result of negotiating the terms of that agreement, each party should have full confidence that the option to purchase is legally binding and that it meets their needs and requirements.