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This Guide focuses on Heads of Terms as used for acquisitions (buying company shares or buying business assets as a going concern).
What are Heads of Terms?
A Heads of Terms is a document used to set out the key principles and terms of a proposed deal. This produces a framework on which the lengthier and more detailed legal documentation (eg share purchase agreement) can be drafted.
What else can they be called?
For those who like abbreviations, Heads of Terms are often shortened to HoTs. Or they can be called LoIs (letters of intent), MoUs (memoranda of understanding), term sheets, or frankly anything else you choose. In this Guide, let’s call them ‘Heads’.
What’s the point of them?
- They help parties to reach a position where they can confirm a strong level of commitment to move forward seriously with a deal, so they can put the time, cost and effort into due diligence work and more detailed negotiations.
- They help to focus people’s minds. They help parties focus on and address the key issues they each want to address. They can help to bring out any misunderstandings, identify potential ‘deal-breakers’, at an early stage. This can save time and cost, particularly if these issues can’t be resolved and the deal falls through – better to discover this sooner rather than later.
- They are useful as a deal crib sheet – a document that all parties and solicitors can refer back to when putting together and progressing the legal deal documentation.
- They can occasionally be useful for regulatory or other reasons, eg as an accompanying document for a tax clearance application. Or for producing to potential funders.
- They can be particularly useful for more complex transactions.
What’s the point of NOT having them?
- They can add time and cost. Sometimes the key terms of a deal are so straightforward, and the deal is of such a value, that it can be more cost-effective just to go straight into drafting the formal legal documentation.
- They can be risky if not done with legal advice. There could be future ambiguity or uncertainty which can be tricky to untangle. Or there could be issues which one party or other should have addressed in the Heads which can be embarrassing to raise after they have been signed.
Who prepares them?
Anyone can produce them. The legal work for acquisitions is usually driven by the buyer, so the first draft of the Heads will usually be drawn up by the buyer, its accountants or lawyers, and then sent to the seller for review.
What format do they take?
Whatever you want. Anything from a simple letter or email exchange done by the parties themselves, to a carefully crafted legal looking document (with clauses, definitions etc) prepared by accountants or (preferably of course) solicitors.
Do you need solicitors, and if so at what stage?
Of course you need to use solicitors. Silly question.
If you want to get best value from your professional advisors, get them involved sooner rather than later. We can draft things. More importantly, we can ask questions and can highlight issues which may not have been considered or addressed clearly. This can end up saving time and money, or even the deal itself, by helping to set things off on the right tracks. It makes life difficult for a lawyer when we are presented with a signed fait accompli to which we could have made useful contributions.
It’s usually sensible to involve a professional advisor (appropriately specialist accountant or solicitor) from the beginning, to help produce the first drafts.
However, because of their importance in setting out the framework of a deal, and the difficulty in backtracking on anything contained in signed Heads, I would say it is very important not to sign off on any Heads without accountants and solicitors for both parties having been involved in finalising them. You’re going to have to involve us in producing the formal deal documentation anyway so why put us in a position where we have to do this with our hands behind our backs? Many’s the time I’ve come into a deal only after the Heads have been signed by the parties (sometimes with accountants’ input) and it has taken considerable time and effort and embarrassment to point out and help to put right errors and inconsistencies, crossed wires and key unaddressed issues.
Are they legally binding?
It depends what they say. They can be binding, non-binding, or a bit of each.
Most acquisitions of shares or businesses are relatively straightforward, in that there is one basic contract whereby a seller is simply selling something and a buyer is paying for it. Most Heads used for acquisitions are not intended to be legally binding, save for a few clauses at the back end (eg confidentiality, exclusivity (or lock-out); non-circumvention; non-solicitation and other restrictive covenants; provisions about one party covering some of the other party’s costs if it pulls out of the deal for no good reason (easier to say than to provide for…); and governing law and jurisdiction.)
More complex long-term commercial arrangements or joint ventures can involve different contractual arrangements over different stages, and you often have to be much more careful to set out at a Heads of Terms stage which bits are meant to be legally binding or not.
If you don’t make clear whether or not some or all of the Heads are to be legally binding, then you fall back on standard legal tests as to whether a contract has come into existence – eg is there evidence of a clear intention to create binding legal relations? And are the key commercial terms needed to establish a binding contract set out sufficiently completely and clearly? Or is there just an ‘agreement to agree’ (which is not generally enforceable)? These things are never very clear, so you want to make clear in the Heads themselves whether you want any part of them to be binding, otherwise you might have to take the risk of what a court might decide some time and expense down the road.
There is a general presumption in UK law that parties intend to create legal relations, so if you later want to argue that your Heads weren’t intended to do so the onus of showing this will fall on you. If you don’t want your Heads to be binding you need to say so and use the magic (in the UK) ‘subject to contract’ words. (For more on this have a look at this Legal Update: https://www.onhandcounsel.co.uk/legal-update-favourites/subject-to-contract-its-a-moneything/)
Are they morally binding?
It depends on your morals.
Most Heads are meant to be legally non-binding, but are meant to provide moral commitment so that parties don’t back away from what they have previously agreed in the Heads when it comes to negotiating the final legal agreement. Parties should lose face and trust if they do this (which might put the other party off from proceeding with any deal).
How should you approach drafting them?
You are just trying to set out the key principles and commercial and legal terms of a deal which the parties have shaken hands on, and the approach the parties agree to take towards putting together and agreeing final legal deal documents.
As a rule, you’re trying to save time and money and to be more efficient, so you should try to avoid getting sucked in to detailed legal drafting and secondary legal issues and fine print.
Here are some guidelines (with examples):
State the principle and defer the detail
For example, many share deals will involve a net assets- or working capital-based price adjustment based on accounts to be produced at completion. The share purchase agreement can get quite detailed in firming up on the detail, eg how the completion accounts should be prepared, particular things they should or shouldn’t take into account, and how any price adjustment should be made. But the Heads should ideally just set out the principles behind the completion accounts adjustment clearly enough to enable the parties and their advisors to work on the detail later. Obviously if there is anything unusual which parties think might be worth mentioning at this stage then they should do so.
State the exception and defer the rule
For example, it is standard for the final purchase agreement in most deals to contain extensive warranties. These might be 40 pages long and take a while to negotiate. But you don’t want to be doing this at the Heads stage. The Heads just need to say that ‘usual and proportionate’ warranties will be given. However, if there are issues that the buyer is particularly concerned about it can be worth saying so, and even saying that the buyer wants indemnity protection against risks it already knows about.
Also for example, it’s normal for all sellers to give the warranties, and usually jointly and severally. The Heads do not therefore need to state this. But if there is an exception, eg a particular seller won’t give warranties or wants different treatment, then the Heads should ideally say so.
Consider carefully, and take professional advice, before agreeing anything (I can’t remember if I’ve said this yet…)
Don’t agree to sign off on any Heads until you have had advice from your accountant on the tax consequences. And don’t agree a deal unless you have fully considered the commercial and legal implications. For example, I’ve lost count of the number of deals where sellers have come to me saying they have agreed to take deferred payments (earn-out based or otherwise), but they haven’t thought about asking for security or other protections to cover the risk of the buyer failing to pay (or how to protect their ability to achieve their earn-out targets).
So what kinds of things might a standard Heads of Terms include?
A. Assumptions made by the buyer on which it is relying when coming up with the proposed purchase price and purchase terms. If the Heads set out key assumptions then it leaves the door more easily open to renegotiate aspects of the deal if those assumptions turn out to have been wrong.
B. Key conditions which need to be satisfied for the deal to get to completion. eg:
• What due diligence will the buyer still need to do?
• Are any third party consents, regulatory approvals or tax clearances needed?
• Are there any issues to be addressed as a result of how the buyer is financing the deal?
• No major changes in the business from the date the Heads are signed
C. Key commercial terms. eg:
• Price. How is it to be worked out? Eg on a share sale, will there be an adjustment based on completion accounts? If so, briefly set out details of how they will be prepared and key assumptions and adjustments that might be needed. Possibly include a few worked examples.
• When will payment be made? Any deferred payments? Any conditional payments, eg an earn-out’ basis’? If so, how will this actually work? What if any security will the buyer provide?
• How will payment be made? eg will any of it be paid by way of loan notes, or shares in the buyer?
• If it’s an asset sale, details of the assets which are to be included in the sale, or excluded from the sale; or of any liabilities that the buyer will agree to take on.
D. Summaries of standard provisions that the parties expect to be covered in the final purchase agreement. eg:
• A statement that there will be ‘usual’ warranties (and, from the sellers’ point of view, ‘usual’ caps and other limitations on liability and seller protection provisions) appropriate to a deal of this size and nature. (Your solicitors can tell you what this means, for example in terms of how warranties and disclosure letters work.)
• Whether there will be a ‘usual’ tax indemnity (ie the seller broadly indemnifying the buyer against any tax which the target company’s accounts didn’t provide for or any unusual tax liability that might have arisen since that accounts date). The actual tax indemnity in the share purchase agreement will cover several pages and be far more complicated.
• A brief summary of any restrictive covenants that the parties have agreed.
E. Specific additional provisions or protections the parties might want to include. eg:
• Possibly agree and set out caps and other limits on liability under warranties, and other key ‘vendor protection’ terms, to save arguing over these later.
• If the buyer knows of a potential liability it wants covered, the Heads could say that the sellers must give the buyer an indemnity against it.
• If some of the consideration is deferred, the sellers might want appropriate guarantees or other security to be provided.
F. Deal structure. eg will exchange of contracts and completion be simultaneous? (If they are not, quite a few knock on issues need to be addressed to cover the ‘gap’ between exchange and completion.)
G. Key terms covering any ancillary agreements. eg a new consultancy agreement with a seller; or any transitional services agreement.
H. Deal timeframe. When are the parties hoping to exchange contracts/complete. Is there a timetable leading up to this? eg for particular due diligence to be done, or for the first draft purchase agreement to be circulated?
I. Deal housekeeping, and key transaction documents. eg who will draft the main agreement (generally the buyer); how will the disclosure process be managed?
J. Acknowledgement that the Heads are not exhaustive. The parties want to be reasonably comfortable that they have agreed enough to justify going full steam ahead on putting the formal deal together. But they don’t want to feel that signing the Heads means they have their hands tied behind their backs if they come up with something later that they want to address. Rather than letting any worry about this kind of thing hold up the signing of the Heads it can be helpful to make clear that each party reserves the right to raise new issues later.
K. Exclusivity or lock-out. ie preventing the sellers from negotiating with anyone else for a period of time.
L. Confidentiality. Particularly in relation to information which the buyer learns during its due diligence. The parties will usually already have signed a confidentiality agreement at an earlier stage in their discussions.
M. Break fees. Broadly, agreement that one or other party will pay the other’s costs if the deal doesn’t end up going ahead for various reasons. Can be quite tricky to firm up on.
N. Governing law
O. Which clauses if any are intended to be legally binding.