What is an option contract ?
An option contract is a financial contract that offers the owner of the contract the choice to purchase a certain asset, for a determined price before a determined expiry date. The right awarded by the option contract does not impose an obligation on the owner of the contract to purchase the respective asset. Options contracts are used a lot in businesses because they can play a very beneficial role in commercial transactions.
The key component of an option contract are :
- The asset(s) must be clearly stated and identified.
- The price of which the asset(s) are being offered for must be stated.
- The duration in which the contract is valid (as the contract will expire).
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Applications of option contracts in business
Real Estate :
In the real estate sector option contracts are commonly used, as they can prove to be beneficial for both the buyer and the seller.
An example would be :
Khutso has a block of flats that she wishes to sell for R15 million and Jessica is very interested in purchasing the block of flats. However, Jessica does not have all the money to complete the transaction , but she is confident that she can raise the money in 6 months. She approaches Khutso and asks Khutso to issue her an option contract on the property , for the price of R1.5 million and that the contract be valid for 6 months.
This would be to the benefit of Jessica because it would mean that for the 6 months that the contract is valid ,Khutso cannot sell the block of flats to another buyer. A further benefit to Jessica would be that if there is a spike in the property market during the 6 month duration , the block of flats will have to be sold to her for the agreed R15 million and not the new market price. This contract could also be beneficial to Khutso. If Khutso does not agree to issue an option contract , and for the next 6 months no one purchases the block of flats , she will earn nothing. On the other hand if she issues the contract she earns R1.5 million regardless to if she sells the block of flats.
The option can also be to the disadvantage of Khutso. If another buyer offers Khutso a higher offer than R15 million during the 6 month period she cannot accept that offer, in addition to that she can renegotiate her deal with Jessica. The block of flats cannot be sold to Jessica for any other amount than the R15 million as stated in the option contract.
Selling your company
When selling off portions of your company , or on the other hand when purchasing parts of a company you may wish to integrate an option contract into the transaction.
When you are the owner of a business and the buyer only wants to purchase a significant portion of the business, but not the whole business, having an option contract could be to your benefit. Lets explore an example. Samantha owns a chain of saloons called Sassy S, and Rebeca is interested in buying 50% of her business (which included the chains of saloons). With this ownership in the business Rebecca insists that she will be able to make management decisions and the authority to hire and fire employees within the business. This worries Samantha as she is worried that Rebeca’s influence in the business may cause the value of the business to depreciate. Concerned she seeks advise. In getting advise she is told that she should issue a selling option to Rebecca. This contract should state a fixed amount in which she would be willing to sell the remaining 50% to Rebecca and state the duration for which the contract would be valid.
Samantha takes the advise and issues a selling option to Rebecca. The contract stipulates she has the right to sell the 50% of the business exclusively to Rebecca for R300 000, and this contract will be valid for 10 years. Thus because it is an option contract Samantha is not obliged to execute her right (she does not have to sell the remaining 50%) .However, if she does choose to exercise this right, Rebecca will have to pay for the 50% remaining for R300 000 (as long as it occurs during the duration of the contract).
The benefit of this option contract for Samantha is that if the value of the business depreciates as a result of Rebecca’s input or different management decisions , she can sell the remaining 50% of the business to Rebecca for an already determined amount, that is not subject to the new decline in the value of the business. Rebecca will be bound by the agreement and will have to pay for the remaining 50% if Samantha exercises her right to sell. So you may be asking why would Rebecca consider entering into such an agreement?
Let’s assume that the business flourishes and does very well, and as a result the value of the business increases. If Samantha wishes to sell the remaining 50% of the business, she cannot sell it to other investors , or for a higher amount (market value). She can only sell the remaining 50% to Rebecca for R300 000, she is bound to this agreement for the next 10 years.
These examples show case what the potential benefits and limitations are of option contracts. They can help you secure certain asset prices and help you hedge against certain risk, uncertainties and volatility in commercial transactions.