Options and Rights of First Refusal

Whether I am dealing with business partners or parties to a real estate transaction (whether a purchase or lease), one main concern that pops up is what will happen to the asset in the future.  In particular, one or more of the parties will want to have some kind of obligation that the other must deal with them when it comes to the future ownership of the asset.  This is where options and rights of first refusals come in.  While they are very similar types of agreements, they have some important differences.  In fact, poor drafting can lead to a misunderstanding between the parties as to what kind of right they are dealing with.  This is especially the case if a single agreement couples an option with a right of first refusal.  Unless extreme care is taken to distinguish between the two rights, especially if applied to the same property or asset, you may find yourself in a messy lawsuit later.

What follows is a quick snapshot of these and related rights and agreements.

Options:

Options are most commonly found with relation to real property, and not personal property or business assets.  An option gives the option holder (called an Optionee) the right to purchase the subject real property and the right to compel the owner of the property to make the sale.  The Optionee has the discretion of determining when to agree to purchase the property (called “exercising the option”) so long as the option is exercised within the time specific in the agreement.  For instance, the agreement may give an Optionee five years in which to exercise the option.  If the Optionee attempts to do so after that time, the option will have expired, along with any rights it may have conferred.

Options can exist on their own or be made part of a lease or real estate purchase deal.  In a lease transaction, the landlord would grant the tenant a right to compel the landlord to sell the property at the tenant’s discretion.

Of all the rights I will discuss in this posting, option rights are the strongest.  The Optionee has the ability to acquire the property regardless of whether the owner wants to sell.  So long as the Optionee exercises the option in the appropriate time and pays the appropriate purchase price (which may be agreed-to later), the owner must sell.  For this reason, options ordinarily require payment, or consideration, in exchange for granting the right.  This is because the owner is giving up a significant right itself: the free alienability of the property.  The owner cannot freely sell the property once an option is attached.  To make up for this burden, the Optionee has to compensate the owner.  This compensation is over and above the price paid for the property, if the option is exercised.

Due to the fact this right costs the Optionee money out of pocket and because it significantly limits the owner, the parties may wish to pursue one of the following rights.

Rights of First Refusal:

Rights of First Refusal (ROFR) are common in both real estate and business law transactions.  A ROFR gives a party the right to purchase the subject asset IF the other party wishes or attempts to transfer the asset to a third party.

Applied to business law, rights of first refusal are critical if you have business partners.  Whether a true partnership, a corporation, or a limited liability company, the owners of those entities should square away what happens when any of them leaves, sells, or dies.  If the other owners want first crack at buying away the ownership from a third party, a ROFR is a vital solution.

Applied to real estate transactions, this gives the ROFR a weaker right than an option.  Unlike an option, an ROFR holder does not have the right to compel a sale.  The holder only has the right to buy the asset on the same terms as the third party is proposing to buy the asset.  Although this is weaker than an option, it still creates some barriers to the free alienability of the land.  If that is still a major concern for the property owner, the owner can avail itself of two other, less-commonly used rights, discussed below.

Rights of First Offer:

Even weaker than the ROFR is the Right of First Offer (ROFO).  A ROFO gives the right holder the right to present the owner of the property with the first offer price for the property prior to taking any other third party offers.  The trick is that the terms of the agreement restrict the owner from accepting any later third party offers that are the same price or cheaper than what the holder offered (the exact terms of which can be subject to negotiation).  The major limitation from the holder’s perspective is that the holder has to make an offer blindly, without knowing what third parties will be offering.  With the ROFR, the third party has already made an offer, and now the holder must match it.  The ROFO is obviously more advantageous to the property owner than the right holder.

Rights of First Negotiation:

Arguably the weakest of these rights is the Right of First Negotiation (ROFN).  The ROFN gives the holder the exclusively right to negotiate with the owner of the property for a set period of time if and when the owner decides to sell the property.  Although such an agreement would contain obligations to deal with each other in good faith, there is no affirmative obligation on the part of the owner to sell to the holder.  Obviously, this would be a disfavored right by any truly interested purchaser.

The outline above was intended to give you a small outline of some of the possibilities that are available in this area of law.  Each of these rights must be drafted with particularity and to avoid any ambiguity.  Chances are the holder will have these rights for years to come, so it is importantly it is done correctly at the beginning.  If you need any assistance with this complicated area of the law, contact our law offices.