a clause in an agreement that allows any participating party to leave the contract before all obligations are fulfilled.
Abandonment Option Details
When creating a contract, you would list an abandonment option within the terms and conditions section. It is a clause that allows anybody involved in the contract to withdraw from (or abandon) the agreement before fulfilling the obligations required. Contracts that include abandonment clauses include project agreements, employment contracts, leases, and financial investments. When an abandonment option exists in a contract, nobody involved will receive penalties for leaving, especially if the clause specifies this.
An abandonment option can also indicate the options management has when deciding how to move forward with a project. They can abandon it or continue with more investments. In this instance, it is considered one of the options that can occur during a project's life cycle. There are ways companies can calculate cash flow vs. expenses to make decisions on whether to abandon a project.
You can also refer to abandonment options as termination options. However, you will more commonly see the term termination in clauses for bilateral agreements.
Examples Of Abandonment Options
Abandonment options can be an attractive component of business, lease, and financial agreements and usually exist in contracts without a set expiration. For example, most employment contracts will contain an abandonment option clause that allows them to resign. In this situation, if an employee leaves a company before their contract is up, the employer can't contest the decision because of the abandonment option.
Property owners can also include an abandonment option clause in a lease contract to attract renters to high-rent property. Providing this option allows property owners to avoid giving discounts or other perks.
In the finance industry, agreements between financial planners and their clients often have an abandonment option. This clause allows the client to withdraw from their financial planner's services if the returns on their investments aren't as profitable as initially expected.
Significance Of Abandonment Option
Abandonment options can reduce the risk of committing to a contract and being stuck in it even when the situation becomes less favorable. For example, if a contracted employee finds they cannot do the work required or dislike the work environment, they have the option to leave if they wish.
In a financial situation, the abandonment option provides flexibility and can serve as a way to protect someone's financial interest if a project or investment fails. For example, if a company invests in a project, but the cash flow proves to be less than the project costs, it may decide to abandon the project and terminate contracts related to the project. Abandoning a project could potentially minimize losses for everyone involved in the long-term if the situation appears just to be getting worse.
However, it is important to note that when one person or entity exits a contract, this can negatively affect others involved. For the examples above, the employer will have to rehire and retrain a new employee sooner than expected. With the abandoned project, suppliers or contractors may have cash flow issues because the project from which they expected earnings was terminated.
Abandonment Option vs. Real Option
An abandonment option is a type of real option. A real option is a choice managers can make regarding projects and business investment opportunities.
Real option decisions are associated with options on tangible assets such as gold mines, cargo ships, and heavy equipment that you can add to investing projects. It is considered a "real" and tangible investment as opposed to financially related ones.
There are generally four types of real options. These are:
- Expanding with more investments
- Waiting and investing later
- Abandoning or shrinking projects
- Varying the mix of output or production methods