An ‘option’ means the right of the option purchaser to make a deferred transaction involving an asset in respect of which a relevant option agreement has been made. Importantly, it is a right, and not an obligation. Assets, such as shares, participation interests, real property, equipment, primary products etc. as well as transaction terms, including price and option exercise period, and formal requirements for an agreement may vary greatly. Exercise of an option is frequently linked to occurrence of a certain event. For instance, participation interests or shares in the charter capital of a company can be sold or purchased once such company’s assets achieve a threshold determined in the option agreement, or an option to make a land lease agreement can be exercised on the condition that the land is free of any encumbrance.
Below we will focus on option agreements for shares or participation interests in the charter capital of companies, which are made as part of investment projects or M&As.
What are most frequent mistakes in making option agreements
To avoid a boring discussion of formal legal requirements, let us concentrate on the key issues we are encountering now and then when handling relevant deals. An enormous amount of effort and time is spent for discussions with the client’s work team and for negotiations with the counterparty.
The issues are, first of all, clarity and enforceability of financial arrangements. It happens very often that the parties reach top-level commercial agreements which they believe will be sufficient for making an option agreement because the exercise of an option is deferred for a long time and sometimes is also conditional upon occurrence of a certain event. However that is not true. All the parameters of a deal should be thought over, agreed upon and described appropriately beforehand. Otherwise, when the ‘Zero Hour’ occurs, the party believing it holds an option (i.e. the right) may face the other party’s unwillingness to satisfy its claim (to sell or buy something). Then the option holder asks lawyers to go to court, however they tell him that the chance of winning a lawsuit is low. Here is an example of a common mistake: an option agreement provides that the purchaser has the right to buy an interest fraction in an amount up to a certain threshold percentage, say “in an amount up to 3.36%”. If however the agreement provides no formula to accurately determine the amount and the price of the interest to be purchased in the circumstances, such option is not exercisable in fact.
Taking into account all these nuances, the first thing necessary to do is to agree on the financial parameters of a future transaction. Usually, if transaction lawyers join the negotiation process at an early stage, this can be done when signing a letter of intent or memorandum of understanding. Although this document is not legally binding on the parties, it contains all the key parameters of the transaction. In such case most of issues are already covered and the lawyers have just to develop a clear and accurate text of an agreement.
If the parties fail to determine transaction parameters at the stage of negotiating a letter of intent or memorandum of understanding or omit this stage, which is not an infrequent practice in Russia, this will have to be done in the process of drafting an option agreement. Of course, experienced transaction lawyers will identify all precarious points, check formulas and discuss all the requisite parameters with the client and contracting party to get their mutual approval. However, the lack of clear commercial and financial background information from the client or timely feedback on such issues will make this process complicated, lengthy and costly. In such case, the discussion and approval process takes double or triple the usual amount of time and costs are several times greater than usual.
What should be agreed upon to make an option clear and exercisable
Below is a short list of most obvious parameters that are inherent in any transaction:
1. Price. This should be either a fixed amount or a clear formula for computation of the price. In the latter case, parameters to be used in the formula should be available to both parties from a single source and easy to verify.
2. Timeline. There are clear rules of defining the timeline, and the most simple way to define it is to set a calendar date. Transaction terms do not always allow setting a calendar date, but if such option is available one should better use it. Another option is to refer the timeline to an event that will inevitably occur. For example, participation interests (or shares) can be sold or purchased once business financial results reach the agreed thresholds, or once a party to the transaction takes or refrains from taking a certain action. In such cases it is also necessary to properly define the total option exercise period according to the rules set in the Russian Civil Code.
3. Conditions. If there is a condition (or, often, a whole number of conditions) to which the existence of the right to make a transaction is linked, this is the point where serious differences between the parties may arise. They will eventually result in a substantial delay in implementation of the transaction or even collapse thereof, especially in case of an unfair contracting party who has changed its decision to exercise the option. Such party may ‘pick out’ a vague language of the parties’ understandings to claim that the condition has not occurred. It is therefore critical to agree on how to verify the occurrence thereof. As a rule, for this purpose the parties clearly define the documents which should be accepted as evidence that the condition has occurred. If, for example the condition is termination of encumbrance on an asset, such asset and the documents to evidence the encumbrance termination should be clearly described. Such documents may include an agreement on termination of a pledge or an excerpt from the public register with no record on pledges, or an equivalent document.
The above list is by no means an exhaustive one, and, depending on transaction parameters, other, not less important issues may arise, such as method of payments or terms and procedure for amendment of initial agreements, such as application of an alternative formula to calculate the price upon occurrence of certain events or extension of the initial agreed timelines. To avoid omission of any important point, it is advisable that businesses entering into option agreements as part of investment projects of M&As should think through financial and commercial parameters of their deals and engage transaction lawyers to develop proper formal grounds for them.