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Abandonment Option – Meaning, Importance, and More

Abandonment or termination option is an optional clause in a contract or an agreement. This option allows either party to cease or abandon the project any time before the maturity. Or, we can say it gives all parties in a contract the right to end or leave the agreement, without fulfilling their obligations.

We can also say that it is an option that management has when deciding on the future of a project. They can either abandon it or take it forward with more investment.

Parties to a contract need to explicitly agree to include such a clause in terms of the contract. Also, the clause must specify that the party leaving the contract won’t need to pay a fine or penalty on termination.

It is one of the “real” options or an outcome that is real and may occur depending upon the circumstances. We can also say it is one of the several options that may occur during a project’s life cycle. For instance, depending upon future circumstances, a firm can expand, wait, or exit a project.

Abandonment Option – Where applicable?

Such a clause could be added to any type of contract, be it a business contract, employment contract, and more. Also, the termination clause is more common in bilateral agreements, i.e. involving two parties. Usually, there is no set time frame within which a party can exercise this clause. But, the party needs to exercise this option before maturity.

One can also find such a clause in the contracts between the financial planners and their clients. In case, the return or profit that the planner gives is less than the expectations. Or what the two sides agree on, then the client could terminate the agreement.

Abandonment options are also popular in a lease contract. The owner of a high-rent commercial property may offer such a clause to attract tenants. They usually offer this to avoid giving a discount, in order, to attract tenants on rents since they own high-rent property.  

Such a clause is also common for contracts related to tangible assets. For example, investments in projects like heavy equipment, gold mines, and more.

Abandonment Option

Are Abandonment Options With or Without Penalty?

In case, the contract that the two sides agree on is silent about the penalty, then one party may leave the contract without incurring any penalty if the salvage value of the project completed is more than the present value of the project’s remaining life cash flows.

Thus, the termination clause must clearly specify whether or not the party abandoning the contract needs to pay any fine or incur any penalty at the time of leaving.

For example, if an employee withdraws from an employment contract, which includes this termination option, then the management can’t object to it. Also, if the contract specifies, the employee doesn’t need to pay any penalty for leaving the company as well.

Importance of Abandonment Option

For the parties in a contract, the abandonment option provides them with protection. Basically, it secures their financial interest in case the project fails to go as per the expectations. However, for the other party (or parties), the decision of one party leaving could create havoc and can have some serious consequences.

Similarly, such a clause gives the management the ability to take a decision on whether or not to carry forward with the project. For instance, the management may decide to terminate the contract if the cash flows from the project are less than the project’s expenses. In such a case, the management may terminate the contract to avoid losing more money.

Final Words

There is no doubt that an abandonment option protects the parties if the project fails to work as per the expectations. However, an exit of one party from the agreement could have serious repercussions for the other party. Thus, the party leaving the contract, on commercial grounds, should make efforts to ensure the other party does not incur big losses as well. If the parties foresee losses ahead, then an early withdrawal would help to minimize the losses for both. Moreover, such a clause also provides compensation and penalty to protect the other party. It may partially take care of the anticipated losses or to disincentivize the other party to leave at will.

References
https://thebusinessprofessor.com/lesson/abandonment-option-definition/ https://www.investopedia.com/terms/a/abandonmentoption.asp https://investinganswers.com/dictionary/a/abandonment-option
Last updated on : November 11th, 2020
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