Publication

In the business world, as well as in everyday life, there are options and opportunities. If in life options and choices are dependent on various coincidences and they coincide with human actions, then in the business world options to choose can also be strengthened contractually by closing options contracts.

Options and option contracts have been known for a long time in the business world, although they have been utilised in a somewhat of a narrow scope of transactions; most frequently – in shareholder and member of the board agreements, real estate deals and trade of financial instruments.

Options have become more popular as a tool to motivate and reward employees. Since the amendments to the Commercial Law and the Law On Personal Income Tax came into force at the beginning of 2021, the granting of stock options has also been facilitated for employees, management and supervisory board members of limited liability companies (“LLCs”) by providing tax exemptions.

Taking into account that more and more employees are becoming minority shareholders in companies, it is important to note options and option contracts can also be used in other situations, applying practices from the financial and real estate sectors.

Options contract

Due to the fact that options contracts involve an “option” rather than an obligation, they are useful in contractual relationships that focus on future possibilities or events. Given that both parties to the contract are free to choose the settlement of their relationship, option contracts offer the possibility of adjusting the events, sequence, timing and price to the subject matter of the transaction.

Under the Law of Obligations, an option is the contractual right and ability of one party to choose the manner and extent of performance of an obligation, creating corresponding obligations for the other party to the contract, or to refuse to perform it, subject to pre-agreed conditions.

Option types

Option contract types partly derived from financial derivatives futures, which involve two types of options contracts or options:

1) “Call options” provide the buyer with the right to buy a specific asset at a specific price; and

2) “Put options” provide the buyer with the right to sell a specific asset at a specific price.

Note, these options can also be sold – the seller of a call option commits to sell a certain asset at a certain price, while the seller of a put option commits to buy a certain asset at a certain price.

In real estate, an option contract has some similarities with a pre-agreement or a contract of repurchase, where the owner of real estate may grant the buyer an option to buy a certain property (or even a property that does not yet exist in nature) at a certain price, at a certain time, with the owner being obliged to sell and the buyer having an option, rather than an obligation to buy or a subsequent option to sell the property back, at a certain time.

Options are also used in board members’ and shareholders’ agreements where it is necessary to provide that members or shareholders may acquire or dispose of their shares between themselves when certain events occur or are reasonably likely to occur.

Call and Put options in board members’ agreements

Call and Put options in board members’ and shareholders’ agreements are used in situations where, for example, the owner agrees to sell part of the company to a new buyer while agreeing to remain a shareholder of the company for a fixed period and on agreed terms. The main reason for such terms is to give the buyer comfort and assurance that there will be an opportunity to learn from the existing shareholder and gain experience in managing the company.

There are also situations where the minority shareholder is also the CEO of the company who wants to stay in his or her position, but the company is sold and the possibility for the minority shareholder to acquire additional shares in the company is agreed with the new buyer if favorable financial or other conditions arise.

Such an agreement shall be documented in the members’ (shareholders’) agreement, which shall set out the following transitional provisions. In order to provide the participants with a guaranteed exit strategy, the agreement may contain provisions allowing the buyer to “call” the seller to sell their shares and allowing the seller to “put” his shares to the buyer after an agreed period that provides certainty for both parties.

A call option allows the buyer to “call” for the shares to be sold at a future date agreed by the buyer. This can sometimes be set in the event of a significant event (new markets, authorisation, sales volumes, etc.) rather than at a fixed date.

Alongside that, the buyer can also include the “nomination” in their call options contract to set forward a third-party as a buyer.

A Put option allows the seller to encourage the buyer to buy the remaining shares at a certain price on a certain future date.

To avoid potential disputes, it is advised to consider the following:

• A circumstance triggers the moment when the option is exercised (trigger);
• When the option expires or is no longer exercisable;
• Tax risks;
• Whether the option is exercisable all at once or can be divided into tranches;
• Whether the option competes with pre-emption rights or other prohibitions in the company’s articles of association; and
• Whether there must be a mandatory waiver of pre-emption or other rights of other participants.

Other options

Similarly, there are also the following options contracts:

1) “Cross option” – when the buyer acquires a call option in one company and the seller in return acquires a put option in another company. Such an option is exercisable when there are two companies that are financially or strategically linked to each other. A mutual option can be used to ensure the succession of a company if one of the participants passes away. Heirs may be granted call and put options in cooperation with another specified participant;

2) “Reverse option” – more often applied in real estate transactions whereby the buyer is to receive a share of the resale value of the property. A reverse option ensures the seller would have the right to buy back the property when the buyer is unable to develop the property and sell it at a higher price;

3) “Reverse vesting option” – typically used to motivate start-ups when attracting an investor. As with employee stock options, the criteria are set for the acquisition of shares, but in a buyback option, the founder of a new company receives shares in the company immediately, with the condition that the investor can buy them back within a certain period of time if the criteria are not met. The investor’s repurchase options decrease in percentage with the passage of time or the fulfilment of the criteria.

Conclusions

Option contracts provide flexible solutions in a changing business environment, additional options for sellers and buyers, opportunities to maximise financial benefits for investors and minority shareholders, and opportunities to incentivise counterparties. Options can also be useful in transactions where the expected outcome may not materialise. By exercising options effectively, corporate participants can achieve strategic objectives and plan for different exit scenarios.

For more information on options and strategies on how to implement them, please contact Reinis Sokolovs, Partner and Head of Corporate Practice at VILGERTS ([email protected] ).