The Option Contract: A Primer
Can you contract for the option to contract?
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Basic contract law is just that: Basic. To enter into a contract, you only need three things: (1) One party makes an offer; (2) the other party accepts the offer; and (3) something is exchanged – better known as consideration. For prospective law school students, this may be the first law you learn on your first day of law school.
The concept is very simple in application, as well. I offer to sell you my widget and you say OK. You then pay me for the widget and the contract is complete. This contract negotiation happens every morning at the convenience store for me personally when I buy my bottle of water.
Let us assume, however, that the widget is not a bottle of water. Rather, the widget is a customized single-series classic automobile that costs a lot of money. Let us further assume that you want more time to inspect the vehicle but you do not want the seller to consider any other buyers? The answer is the very powerful and practical “Option Contract.”
An Option Contract is an agreement to hold a contract negotiation open in the future. For example, when you look at my car, you say that you really want to buy it, but you want to run it by your spouse (smart move!). However, I tell you that I have another buyer coming in later in the afternoon. You agree to pay me $100 so you can think about the transaction for two days. We have now entered into an option contract. In essence, you are saying, “I want the opportunity to accept your offer, but not for two days.”
If you come back in two days and decide to purchase the vehicle, then we enter into a new contract and the sale is complete. However, under traditional Option Contracts, if you decide not to purchase the vehicle, I get to keep your $100.
Most option contracts are substantially more complicated. Most option contracts come in the form of a “Purchase Agreement” for real estate. Hopefully regular reader Kathy C. will give some practical, day-to-day advice on what to expect.
The Purchase Agreement works something like this: I want to purchase your house but I want to make sure there are not any problems. I place a certain amount of money in escrow and I am then given a due diligence period to do further inspections. In most contracts, I have the right to retrieve my escrow money back if I find unacceptable problems or I cancel the agreement within a certain amount of time. However, if you meet your obligations, and the house passes inspection and I then decide I simply do not like the property, I lose my escrow payment.
The other common scenario that I see in my practice deals with tenants and landlords. The tenant loves the property but does not have all of the money necessary to finalize the lease agreement. The tenant will pay a portion of the upfront money such as the first month rent so the landlord will not find another tenant. The tenant then decides that he or she does not want the property.
Now the tenant wants the option payment back. The tenant is under the impression that the final contract was not completed and the landlord just lost a month worth of rent. Who gets the money? The question depends on whether an option contract was entered into.
So now that you know what an Option Contract is, what should you consider to protect yourself?
Regardless of whether you are selling a widget or buying a widget, write down the terms of your option contract. One former Florida Circuit Judge out of Miami that may or may not be on television right now (who is it?) always says, as she yells at the litigants, “You couldn’t find a napkin and a crayon to write down your agreement?”
Even the following language on a napkin is more effective than an oral contract: “I agree not to sell my widget for 48 hours in exchange for $100, and if you don’t buy my widget, I keep your $100.” I timed myself and it took me 15 seconds to type that. This would be very effective if you are buying a clock, want to have a dealership hold onto a car, or want a day to determine whether you want to rent property.
For more complicated purchases or agreements such as houses, commercial property, or other items where you need to inspect the widget for whatever reason, you need to take it a step further. Make sure that the terms are clear to determine when you either get your money back or when you as the seller get to keep the money.
An Option Contract is a great tool to use to contemplate very serious transactions. Done correctly, everyone knows their rights, obligations, and responsibilities. Done incorrectly, one can get involved in conflicts that are worth more than the actual widget that was up for sale.