Option agreements and conditional contracts - Part 1
This article is concerned mostly with dealings in land (real property). At the end of Part 2 is a note about options to buy other items.
An option is a device which enables a buyer, usually of land or property, to buy an “opportunity” to buy the land itself later. A buyer of land may seek an option when he wants to tie the seller to his proposed deal, but dare not buy immediately, in case his plans do not materialise.
An option buys time. That time can be used in any way. The optioner may need time to raise purchase money. He may need to ask consent of others to join in the transaction. He may want to make enquiries before committing himself.
The commonest reason to take an option on land is to try to secure planning permission before buying. A field may be worth £10,000 as agricultural land, but worth £2 million with consent for residential development. Someone skilled in obtaining planning consent may think he is “in with a chance” even though he may have to spend £50,000 on architects and other fees, to achieve anything.
When considering the mathematics of an option, there are several variables:
The price of the option;
The time until the last date by which the option must be exercised, or lapse;
The exercise price (the cost of the land or item if the option is exercised);
Expenses (like professional fees) of achieving the target reason for seeking the option;
The statistical chance of achieving the target reason (like obtaining planning permission).
Because some of these are subjective, the calculation of a “deal” to offer to the other party is difficult. In this article, we assume that the reader and instigator of the option is the optioner, not the owner of the land or property, but similar considerations apply to an owner - in reverse.
It is often difficult to calculate the “best” sum of money to ask or offer for an option. If any reader is prepared to send us a paragraph explaining the perfect mathematical formula, we should be delighted, but here is a mere lawyer’s view:
Let us consider a planning consent situation. Start by balancing the benefit of achieving the planning consent you want against the cost of getting it, then assess whether there is enough “profit” (after tax) to pay for your work and provide a profit to the land owner.
Start with what you know. What is the land worth now? What could it be worth to you, if your condition is satisfied? Suppose the land has a current use as tacky old sheds. For that use it is worth £100,000 an acre. But remember that it may be worth more than current actual use value simply by re-building or renovating what is there already. So your potential current use value may be £150,000 an acre, even after taking into account the cost of your work. Now let us say it is worth £1.5m an acre for residential flats, or £1.2 m as a site for detached houses.
It will cost you £20,000 in architects fees to prepare the scheme and submission. You assess your chances of achieving consent on application as 20%, but increasing to 40% on appeal, which will cost you another £50k
The whole exercise will take two years. What should you offer to the land owner?
Well, he probably has no chance of obtaining consent on his own, but he may try other developers. You decide to take a risk on that and assume yours is the only offer. If he has the chance to increase the land value at no cost to himself, he will “take a view”. But the land is his already. He does not have to do anything. If you make it sound too easy, he may decide to have a go himself. Realistically, you are going to have to give him “an offer he cannot refuse”. But that is no reason to go in with your best offer. You have to spend £20k as pure risk money, just for the chance. You want a good return on that too.
So perhaps you decide on a deal as follows:
If costs are £20k and chances 20%, you only have to make £100k in theory. But you have to cover the downside - and you are cautious anyway!
An exercise price of £800,000 will give you a minimum of £400k profit;
What about the price of the option? Well, the land owner may be pretty determined to have cash. He will see you as an opportunity and he will have to tie up his land for two years. He may want £20k, maybe more. But it is common when the optioner has to put out cash in expenses, to grant the option for a nominal £1.
So there is your deal. As auctioneers remind us “It’s not where you start that matters. It’s where you finish.”
A word now about the “legals” of an option: an option to buy anything except land or financial instruments is a transaction you can negotiate without interference from the law. You can buy an option to buy a domain name, a patent, or a car under any terms you like. To protect yourself however, you must have a water tight written agreement. This is particularly important for an option contract because so often, the optioner takes some action to either commit to the purchase or enhance the value of the subject matter. Either way, the seller would be tempted to change the terms if you had not tied him down!
Financial instruments are outside the scope of this article. I refer now to land. A contract to enter into a contract is void. A contract to buy and sell land needs only:
To be in writing;
Describe the land;
Specify the price;
Be signed by the parties and dated.
After exchange of contracts, the parties must sign a document which actually transfers the property. The time between exchange and completion is usually taken by various enquiries and checks by the buyers solicitor, but those can actually be made earlier. When push comes to shove any land transaction can be compressed into 24 hours. So you do not need a solicitor to actually enter into a contract - if you know what you are doing. In practice, there are many matters which you need to get right. The contract is by far the most complicated document in the conveyancing process.
Most of the terms to be included in a contract for the sale of land have been fine tuned by solicitors over the years and are standardised in the small print of a contract document form. Often, the other matters take few words. But in some commercial contracts, the “extra” stuff may run to many pages
Now an option agreement is a type of contract to buy land. But it is binding only on the seller - because the optioner may choose not to exercise it. If he does not exercise it by the last date for exercise, it lapses and is dead. So it follows that it is very important to use an option contract which is as thorough as possible. When you agree with someone to buy his land, he expects the lawyers to produce reams of papers. But when you call one evening with an option agreement under your arm, he may well be put off if your agreement is six pages long and needs a lawyer to explain it. So, if you are dealing with a sophisticated owner, by all means take no risks and get it right with a full document. But if your other party is likely to be worried, you might be better off with a simpler document, even if that throws up possible delays or other problems later.
If by chance you find some error of law or fact in any Net Lawman information page, do please tell us. We should also welcome your suggestions for new subjects for information pages. These notes:
Do not provide a complete or authoritative statement of the law;
Do not constitute legal advice by Net Lawman;
Do not create a contractual relationship;
Do not form part of any other advice, whether paid or free.
