What is an Option Purchase Agreement?
An option purchase agreement or an option agreement is the document that creates an option to purchase a contract for the future sale of real property. Specifically, an option is a contract that gives a buyer the right to purchase property at a specified price within a certain period of time. The seller is bound to sell the property to the buyer if the buyer exercises the option and the buyer is not bound to buy the property. In any option, the option fee is issued for consideration for the option and is often non-refundable. Because the option creates the right for the buyer to purchase the property, regardless of whether the right is actually exercised, the option typically gives the buyer an opportunity to inspect and survey the property in order to determine if the buyer desires to purchase the property. This is true for either residential or commercial properties. For example, a developer may wish to see the layout of a potential commercial establishment before it decides to purchase the property. In that case, an option would be appropriate because it will allow the developer to have a survey of the property and the right to purchase the property if it is deemed suitable. While options are more frequently used in commercial transactions, we see them in residential contexts as well . For instance, a buyer may want to fence in a lot prior to purchasing a home to determine exactly how the dimensions will impact the development of the home. In that case, if the buyer finds there is not sufficient room for the home, then the buyer would not be obligated to purchase the property. However, the seller would be bound to sell the property if an option is executed. Because an option binds the seller, it is generally recommended that the option agreement contain language allowing the option to be assignable by the buyer. This will not only allow the buyer to assign the option, but also provide rights to the assignee in case the buyer defaults on the option agreement prior to its expiration. Thus, the assignment should set forth the rights that would otherwise exist in the event of a default by the buyer. Our attorneys are experienced with option purchase agreements in both real estate and business contexts. Mike McNeely, who regularly assists clients with real estate options, recommends including the name of the document in the option itself. By including the name of the contract, if the buyer is uncertain as to what that may be, the buyer will be unable to exercise the option to purchase because it will not be bound by clear terms. As you can see, an option is a great way to close the deal – but only if done correctly for the right reasons.
Essential Elements of an Option Purchase Agreement
An option purchase agreement is a binding contract for the sale of real property subject to significant contingencies that if not waived do not obligate a purchaser to buy the property. The significant contingencies or post-execution conditions are: (1) an option period during which the purchaser has the right to inspect the property, normally during which time the purchaser’s due diligence is conducted; (2) the right to terminate the agreement during the option period if the purchaser determines for any reason satisfactory to it that the property or its environmental conditions are not suitable for the purchaser’s purposes; and (3) satisfaction of the purchaser’s due diligence in regard to property conditions, including environmental conditions.
The agreement also has many provisions that are common in real estate purchase agreements, including, but not limited to, provisions regarding earnest money deposits and the manner in which the earnest money may be disbursed, proposed date of closing, record title, possession of the property (e.g., post-closing occupancy by seller under a lease), and proration and adjustment of operating expenses.
A critical component to the option purchase agreement is the strike price. The strike price is the price that the purchaser must pay for the property upon satisfaction of the applicable conditions.
Another component is the consideration. Consideration is the price that is paid to the seller for the rights under the option period. While the consideration is typically nominal, it is important in that the buyer does not have to materially perform under the contract unless the contract is accepted by the seller. Absent consideration, a seller would have no obligation to actually perform under the option agreement.
Advantages of Option Purchase Agreements
Both buyers and sellers find that option purchase agreements have certain benefits as compared to other types of agreements. These benefits include the following:
Less Materiality Risk to the Buyer
A buyer generally has less risk if a DPA is entered into rather than a standard purchase agreement because any materiality "bump" to the representations brings the purchase price down. For example, if a seller representation of $100,000 is bumped to $120,000 due to materiality, the purchase price goes down commensurately.
Less Post-Closing Indemnity Disputes
Disputes over post-closing indemnity claims are common in purchase agreements. With the DPA, there is no such post-closing indemnity.
Less Closing Cost Risk to the Buyer
Buyers usually fund HR pre-close, but the seller pays the HR costs under the DPA. The ability to avoid a breach of a pre-closing or post-closing HR obligation insulates the buyer from needing to handle various attendance, disciplinary and discharge issues with current employees.
Less Third-Party Approval Risk
The less negotiations with the third party, the more leeway you have in acquiring the company. A DPA provides more protection against a third party or lender denying an approval or consent. Also, an execution-only closing will avoid any delays or legal fees associated with obtaining consent from lenders of third parties.
Lower Transaction Costs to Both Parties
The DPA is a leaner transaction document. It is generally much shorter and less complex than a typical purchase agreement. This means less cost and effort in getting the deal closed.
Less Stress for Seller’s Management (and Board)
Management tends to prefer to be able to focus on running the business. They may not want to be dragged into transaction details that aren’t approved by the board of directors. Once the DPA is signed by the buyer and the seller’s authorized management, the seller is committed and the buyer has given notice.
Typical Provisions in Option Purchase Agreements
Option purchase agreements typically contain several common and provisions:
(a) – The purchase price (typically an amount per share);
(b) – The period of exercisability of the option warrants (i.e., when the option can be exercised);
(c) – Any contingencies or conditions precedent;
(d) – The conditions to exercise.
The following is a short description of these provisions:
Purchase price –
The purchase price is the price per share set forth in the option purchase agreement. The purchase price can also be determined based on the terms of the option (e.g. the number of shares times the a multiple of net income, etc.). The formula for the determination of the purchase price should be set forth and clear and unambiguous language. For example, if stock is bought based on a multiple of net income, the formula would provide, "the islands, subject to a purchase price not to be less than U.S.$10,000,000, will pay the purchasers a purchase price of 3 times the net income of the islands as reflected in the financial statements provided pursuant to Section (______) of the agreement for the fiscal year immediately preceding the fiscal year in which the definitive agreement is signed."
Period of exercisability –
The period of exercisability is a time period spelled out in the option contract which allows the option to be exercised. It is very likely that a right of first refusal will be included in the agreement to allow the option holder to sell or transfer its right prior to exercising the option. For example, the clause may provide as follows:
"The right provided hereunder (the "Option") will be exercisable by each of the purchasers during the period commencing on the date hereof and extending until (______). Hereinafter, the period of exercisability will be referred to as the "Exercise Period."
If alternative transactions (Alternative Transactions) and/or the right of first refusal (ROFR) are included in the option purchase agreement, the terms of the alternative transaction and ROFR should be expounded upon in a separate section of the option purchase agreement.
Contingencies or Conditions Precedent
The exercise of the option may be subject to contingencies or conditions and precedents. The agreement would clearly state that the agreement is does not bind the parties until certain conditions are met. For example:
"This agreement and the sale of the shares provided for herein is subject to and conditional upon the satisfaction of the following conditions being fulfilled, prior to the date that is six months following the date of this agreement. If the conditions are not so satisfied within such period, then this agreement and the sale and purchase shall be terminated at the end of such period."
This section would list the conditions. For example:
Conditions Precedent to Shares
Notwithstanding anything to the contrary contained herein, the parties acknowledge (1) that the sale and purchase of the shares are subject to and conditional upon (a) the obtaining of all governmental, regulatory and other third party consents and approvals, and (b) all approvals and consents of the shareholders of the corporation required in connection with the execution, delivery and performance, of this agreement, and the sale and purchase arriving at closing and (2) that if any of the foregoing conditions are not satisfied, the purchaser shall not be obligated to consummate the purchase and sale of the shares hereunder.
Condition Precedent to Payment of Purchase Price
The obligation of the purchaser to pay the purchase price to the vendors shall be subject to and conditional upon:
(a) all legal, corporate, regulatory, governmental and third party approvals and consents being obtained prior to the Closing and the making of any payment of the purchase price being made by the purchaser; and
(b) all dividends accruing and paid in respect of the shares from (_____ date) being paid to the purchaser on or prior to the Closing Date.
Other conditions precedent may be allowed if the parties to the option purchase agreement so desire.
Legal Implications and Risk Factors
The option purchase agreement is a legally complex document. It has to meet legal requirements in order for it to be enforceable and binding on all parties. It sets deadlines by which performance must be met, transfer of title must occur, and payment of the transition of the transaction must be paid. Often, these deadlines are set out under the requirements of the state’s law where the business is registered and incorporated. It is important to ensure that the deadlines that are set match those statutory obligations and requirements, to ensure that the parties are not open to legal proceedings.
Potential risks involved — a fallback to partnership. If the documents are not filed, the transaction may not go through. A business and an investor both enter into an agreement in which there are conditions to closing, in order for the transaction to go through. If those conditions are not met, they can fall back on the option to reject the agreement. But, if there are certain conditions that are met, and the parties have begun to behave as if they are now transacting business together , the business transacting with the investor may be seen as stating that the two parties are now partners. As a result, they financially and legally become bound to one another in a business relationship, in which they may not have made plans for, or set up, should they have filed the paperwork and it had gone through.
Speak with a legal professional as soon as possible. It is in a business’s best interest to consult with a legal professional, from the outset and throughout the process, when it comes to the drafting and entering into an option purchase agreement. Everything that is entered into a sale, along with the deadlines that have been set or are anticipated, the transfer of title, and the terms and conditions the two parties are agreeing to, has to be filed with the state where the business is incorporated, as well as with the IRS. Neither party is going to benefit from a poorly written or overly complex agreement. They are Leaving themselves open to legal issues, lack of engagement with one another, and a potential for a false sale.
How to Prepare an Option Purchase Agreement
Our guide has a number of useful options agreements. How you go about drafting the same is up to you, but below are a number of general guidelines.
A. Title—the option purchase agreement should be entitled "Option Purchase Agreement" at the top and should contain the date on which it was executed, which can be useful if any litigation arises regarding the validity of the option.
B. Recitals—should contain a statement that the issuer is willing to grant options to the optionee and that the optionee wishes to have such a grant so that the optionee may buy shares from the issuer upon the terms and conditions of the option purchase agreement.
C. Option; option term—should contain a statement granting the option and the number of shares of common stock of the issuer to which the option pertains. It should state the date on which the option can be exercised and the date (or event) on which the right to exercise the option will terminate. It should contain a statement that the right to exercise the option terminates if the optionee is not an employee of or associated with the issuer at that time. However, a statement should be included that the right to exercise the option shall continue unless terminated for cause. An appropriate definition of "cause" should be included.
D. Purchase price—the price per share to be paid for the exercised options should be stated in the agreement.
E. Method of payment—the method by which payment is to be made, i.e. check.
F. Restrictions on transfer—the agreement should include statements that the option is not transferable and may not be assigned by the optionee and that the option is personal to the optionee.
G. Adjustment for stock split and dividend—should include a statement that if the issuer at any time subdivides or combines the outstanding shares of common stock of the issuer, the number of shares of common stock subject to the option and the price per share shall be appropriately adjusted.
H. Binding on heirs, etc.—the agreement should provide that it shall be binding upon the heirs, executors, administrators, successors, and assigns of the parties to the agreement.
I. Governing law—the agreement should contain a statement that its validity, construction, and enforcement shall be governed by the laws of the issuer’s state of incorporation.
Option Purchase Agreements in Action
To further illustrate how option purchase agreements can be used in practice, below are a few examples of how they are used in the real world. These examples can aid in analyzing the various forms of option purchase agreements discussed above: Examples: Option Agreements and Nonqualified Deferred Compensation; Cross Purchase; Redemption; and C-Corporation Buy-Sell. C Corp and LLC – Mr. Buyer, a 5% owner of a 50% LLC called B’s Barbecue Bootstrapping Business wanted to purchase the remaining 45% ownership interest in B’s from Mr. Exiting, a 45% owner. Mr. Exiting has been increasingly less active in B’s management and therefore, Mr. Buyer offered to Mr. Exiting to purchase his one-half of the interest in B’s for $225,000. Mr. Exiting was nearing retirement age and did not know what his future plans involved. Mr. Exiting felt compelled to accept Mr. Buyer’s offer but agreed to an option agreement with Mr. Buyer to delay the transfer of his interest until Mr. Exiting’s actual retirement date in three years. After three years had passed, Mr. Exiting retired and Mr. Buyer completed the transfer of Mr. Exiting’s interest to himself as provided in the option purchase agreement. Due to Mr. Buyer’s strategic planning, he gained the use of the 45% interest in the LLC without having to pay for that interest until Mr. Exiting left employment with the LLC. The delay in the transfer also minimized any astronomical increase in value and savings in related tax liabilities. Mr. Buyer didn’t have to share profits with Mr. Exiting during the three-year delay, but Mr. Exiting’s value for his interest was increased. Mr. Exiting likely avoided capital gains taxes due to the peak in capital gain rates occurring a few years before he sold his interest. Additionally, since B’s is an S Corporation, Mr. Buyer was able to continue B’s as an S Corporation but he did not have to sell any of the company’s stock. Not only did all parties to the transaction win, there was minimal additional work and no negative tax consequences! C Corp and LLC – 40% owner, Mr. Exiting, of international restaurant chain Big Sam’s Tasty Tacos, a C Corporation (Big Sam’s) desires to sell his interest in Big Sam’s to his manager of 10 years, Mr. Insider. Mr. Insider has over $300,000 in unrecognized compensation deferred to him as non-qualified deferred compensation. As part of the option purchase agreement between Mr. Insider and Big Sam’s, both Big Sam’s and Mr. Insider would agree to lifetime payouts of the deferred compensation due to Mr. Insider’s early retirement. On advice of counsel, Mr. Insider has set aside over 20% of the stock price to pay deferred compensation to himself following his retirement of Mr. Exiting’s interest in the company. Mr. Insider will receive periodic payments of this deferred compensation over a period of 5 years. Without the option agreement, the money due to Mr. Insider would have been paid in full as soon as his interest was purchased by him. Instead, the deferred compensation will be paid as planned which will safeguard Mr. Insider’s nest egg. Big Sam’s also benefitted from the transaction as Big Sam’s is administratively a partnership, and would have been responsible for all of the deferred compensation accrued and vested to the former employee. Because Mr. Insider purchased the stock, he is responsible for paying all tax on the deferred compensation, not his employer. This deferred compensation arrangement allowed Mr. Insider to buy a large block of stock, but defer the purchase price payments to his retirement plan which could be fully paid and taxed within 5 years of his retirement. LLC- 25% Owner , Mr. Deep Pockets, of multi-state limited Liability company, Little Daves’ Perfectly Pickled Pickles (Little Daves) wishes to redeem his interest in Little Daves for $32 million. The LLC was formed by Mr. and Mrs. Diva Dillers to sell pickles to the public at farmer’s markets, fairs and county fairs across the country. Mr. Deep Pockets only invested $250,000 when Little Daves was organized. After 10 years of market development, regional expansion and positive publicity Little Daves was ready to expand into large, national, grocery chains. The Diva Dillers’ knew however, if Little Daves’ became a publicly traded company, then Little Daves would have annual reporting requirements and the Diva Dillers’ would become accountable to a shareholder board. The Diva Dillers’ wanted to keep the LLC manageable when it was time to grow and expand and therefore, decided not to go public. The Diva Dillers’ would have to buy out Mr. Deep Pockets’ interest and the Diva Dillers’ talked with their attorneys about the best way to accomplish their goal. Little Daves was legally bound to buy back Mr. Deep Pockets’ interest because accordingly to the company’s operating agreement; if a member wished to sell his stock, Little Daves was required to purchase the stock. So while Mr. Deep Pockets considers himself very lucky, the Diva Dillers’ have lost their ability to make decisions without Mr. Deep Pockets’ input. LLC- 25% Owner, Mr. Wealthy, of multi-state limited Liability company, Little Daves’ Perfectly Pickled Pickles (Little Daves) wishes to redeem his interest in Little Daves for $32 million. The LLC was formed by the Diva Dillers to sell pickles to the public at farmer’s markets, fairs and county fairs across the country. Mr. Wealthy only invested $350,000 when Little Daves was organized. However, after 10 years of market development, regional expansion and positive publicity Little Daves was ready to expand into large, national, grocery chains. The Diva Dillers knew they would have to bring on additional investors to finance the company’s growth and expansion or take Little Daves public. While not an accountant or a business savvy investor, Mr. Wealthy was supportive of the Diva Dillers’ decisions. Mr. Wealthy had been getting dividends from Little Daves for 10 years totaling $2.1 million and all he wanted was for the Diva Dillers to give him priority in subsequent rounds of funding so he could maintain his pro-rata share before bringing in additional shareholders. At the same time, the Diva Dillers’ did not want to continue to give away their company at a fire sale price. The Diva Dillers’ joint attorneys drafted an option purchase agreement giving Mr. Wealthy the option to buy 25% from each of the Diva Dillers’ for $8 million apiece. Mr. Wealthy would have to exercise his option in the next round of funding, whenever that may occur, or lose his ability to buy the Diva Dillers’ shares. By entering into the option purchase agreement, the Diva Dillers were not tied into purchasing Mr. Wealthy’s interest at the negotiated price, but Mr. Wealthy did not have to worry that his shares would diminish in value. If the market did not give Little Daves the reaction anticipated, then both the Diva Dillers and Mr. Wealthy would have the incentive to negotiate a lower price, either to have an outside party come into buy the shares or Mr. Deep Pockets would still have to buy Mr. Wealthy’s shares. This transaction allows for a negotiation and not a mandatory purchase of Little Daves’ shares at a higher valuation.