In a business situation, particularly in cases involving the sale or purchase, or partial sale or purchase, of an asset, a party may seek to secure future rights to acquire something which still vests in the other party. In such cases the rights may come in the form of an option or a right of first refusal and it is accordingly important to know the principal differences between the two so that the most appropriate mechanism can be used.
An option and a right of first refusal have certain common characteristics, yet there are fundamental differences between the two.
Both entail:
It is who has the choice to invoke that right where the fundamental difference lies.
In an option the party in whose favour the option is granted decides if and when to exercise the option. A practical example would be a party ("Party A") granting to another party ("Party B") a right to purchase something which belongs to him, for example his shares in a particular company. In this case the choice whether to purchase the shares, by exercising the option, vests in Party B. Once the option is granted, it is solely up to Party B to choose whether to purchase the shares or not. The right to effectively control the sale of the shares is lost at the time Party A grants the option to Party B.
A right of first refusal on the other hand is essentially an undertaking by a party that if he decides to dispose of something, the other party will first be offered the right to acquire it.
Using the same example above and applying it to a right of first refusal, Party B does not automatically have the right to purchase the shares once the right of first refusal is granted. The right of Party B to do so only arises if Party A decides he wants to sell his shares. The right to purchase therefore only transfers to Party B if Party A decides he wants to sell, not at the time the right of first refusal is actually granted. The choice on the sale therefore remains with Party A until such time as he decides he wishes to sell.
The power to effect transfer of the shares in an option accordingly vests in Party B, and in the case of a right of first refusal this power vests in Party A.
So, given the fact that these rights most usually occur in a sale and purchase situation, it is fair to say that generally in an option the purchaser is in the controlling position and in a right of first refusal it is the seller.
In any situation where rights to acquire something are being considered, whether an option or right of first refusal is the correct contractual instrument will very much depend on the circumstances of the particular case and whether you are the seller or purchaser.
It should be borne in mind that an option is a more definitive arrangement as the terms on which the asset will be sold and the essential terms of the sale are generally recorded at the time of the granting of the option. For example, the price (or mechanism in terms of which the price will be calculated) is inserted into the option as is the manner in which it is to be invoked, and the timeframe in which it can be exercised. On occasion the party who is given the option may even pay a fee or give some other form of consideration for receiving the option in his favour.
Generally speaking, although not always strictly applicable, a right of first refusal:
- is for an unlimited time;
- does not contain a purchase price or mechanism in terms of which this is calculated; and
- is not paid for by the person in whose favour it is granted.
Although these two rights are similar in nature and can often be confused, the differences can have a significant impact and when agreeing to grant, or be the recipient of, either an option or a right of first refusal, legal advice should be obtained to ensure that the rights granted (or received) are the most appropriate in the circumstances.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
