What is an expansion option?

In finance, an option typically refers to a derivative financial instrument. Options, such as a call or put option, derive their values from an underlying asset and give the option holder a right to buy or sell the underlying asset. However, expansion options are a subset of real options, which reflect opportunities or options that a business may or may not choose to realise depending upon the surrounding circumstances.

An expansion option means a flexible arrangement for the company’s management to choose whether to further its operations in the future, if it feels business is picking up at a cost lower than the existing market rate. However, considering an expansion option doesn’t need to be exercised, it can be left to expire if the economic situation isn’t favourable for expanding. Expansion options belong to the domain of real options, because they relate to real, tangible assets such as equipment and land.

Example of an expansion option

Let’s say a company is set to launch a new product. While a lot of research and development goes into making the product, its ultimate success will be dependent on how the market perceives its utility. 

The company has plans to manufacture 500 units of the new product over the next year, but if demand picks up and it needs to suddenly cater to more than the anticipated production – an expansion option can be utilised. By exercising an expansion option, the company can secure equipment, additional workshop space, etc., to meet the growing demand at prices below the market value. If the opposite were to happen, and the new product isn’t readily accepted in the market – the company can choose to not exercise or activate the expansion option.

A real estate perspective

In commercial real estate and within a tenant-landlord relationship, the expansion option establishes certain ground rules to limit the scope of expansions that can be made by tenants. If the initial contract between the parties has an expansion option, it will typically lay out the time frame and other conditions within which certain permissible expansions can be carried out.

For example, if a company has leased out its office premises from another party, the former can choose to exercise the expansion option over time, if and when it has a larger workforce to accommodate. However, the expansion option in the initial lease contract will contain a specific timeline within which the company can carry out its expansion programme within the office premises. In this case, exercising the expansion option could potentially increase the rent payable. Specifics regarding this increase would ideally be stated in the expansion clause within the initial contract.  

Is an expansion option worth it?

While it may seem tempting to include the option in a contract to have flexibility, there are certain disadvantages to an expansion option. In commercial leases, from a landlord’s perspective, an expansion option can seem wasteful. With an expansion clause embedded in the initial contract, the landlord would be forced to leave a portion of their property vacant. 

If the tenant chooses not to exercise the expansion option, the landlord would have to bear the opportunity cost. To cover this, the landlord could potentially negotiate a higher rent to include the expansion clause in the lease agreement. 

There are also advantages to having an expansion option. For companies that have just started operations, an expansion option gives them the flexibility to quickly scale up their existing business if required. Without an expansion option, if the company has to grow its business to meet increased consumer demand, it would require higher cash flow.