Call it a term sheet, a letter of intent, or a memorandum of understanding: the label shifts depending on the deal and the jurisdiction, but the job stays the same. Heads of Terms record the key commercial terms the parties have agreed in principle, to get everyone pulling in the same direction early on, and head off the costly disputes and renegotiations that tend to crop up if nothing was ever written down.
This article looks at why Heads of Terms are key to a transaction, what belongs in them, what is better left out, and how best to prepare a functional document that guides and shapes the transaction that follows.
Think of a set of Heads of Terms as a roadmap rather than a long-form contract. It’s not meant to spell out every transaction arrangement in extensive detail – that comes later. Its purpose is to record the commercial arrangements the parties have provisionally agreed, most of which touch on the legal side of the deal, along with a handful of other related components.
Heads of Terms should also set the pace of the transaction and the negotiating parameters for the long-form documents that follow. Whilst it’s always difficult to pin down an exact timetable at the outset, agreeing at least an indicative one, and a target completion date, gives everyone something to aim for and keeps the deal from drifting.
Heads of Terms documents are usually expressed as not legally binding. However, as an acquisition process involves swapping sensitive information, a handful of provisions almost always are, and are stated as such. More on those specific provisions below.
If possible, deal structure should be decided early in the negotiations, and ideally before the Heads of Terms are even signed. Whether the transaction will be structured as a share sale, an asset sale, or something else (such as a hive-down or a joint venture) will typically depend on the tax analysis, which is usually conducted after the Heads of Terms are signed. Building in some flexibility into the Heads of Terms is helpful: even though the structure informs the key transaction documents, it may not actually be known until after the Heads of Terms are put in place. That’s not to say it is not worth considering the structure up front – having an idea about the nature of the transaction, even in outline, avoids having to fundamentally restructure the deal midway through legal drafting.
Obvious but necessary: it’s also worth naming the specific parties to the transaction where possible. Whilst the exact entities involved may only be finalised following the tax and structuring analysis, having this clarity upfront helps advisers with their early-stage analysis and reduces time spent updating or re-drafting documents to account for changes to company details later on.
The price a buyer pays is rarely just one number: it’s often built from several components, cash and non-cash alike, so the Heads of Terms should set out, as clearly as possible, how this is expected to work.
The headline price should be stated clearly, as well as details about how and when it will be paid. Will the transaction incorporate a locked box mechanism, or a completion accounts adjustment? Typically, the deal will be on a cash-free, debt-free basis with a normalised level of working capital (and a post-close adjustment to the extent the target company has excess cash, indebtedness or a higher or lower level of working capital).
Is any part of the price deferred or subject to an earn-out? Identifying, negotiating and agreeing these points before entering into Heads of Terms, even at a high level, can significantly reduce time spent on negotiation and drafting later in the transaction.
Not all of the consideration mechanics may be known at Heads of Terms stage, though. Depending on what is found in due diligence, a buyer may insist on a proportion of the purchase price being held back to cover any indemnity or warranty claims.
Transactions frequently come with conditions that must be satisfied before the deal closes. The Heads of Terms should identify each condition considered necessary, rather than relying on a generic reference to ‘usual conditions’ or similar wording.
Conditions such as confirmatory due diligence and, where relevant, third-party financing and regulatory or other third-party approvals (competition clearance, sector-specific regulatory consents, landlord consents, or key customer or supplier consents) should be identified and included where applicable.
A realistic timetable should be included, running from the signing of the Heads of Terms through to an anticipated completion date for the definitive agreement. Key milestones such as the completion of due diligence, tax clearance, or receipt of any regulatory approvals should also be flagged.
Exclusivity, sometimes called a ‘lock-out’ or ‘no-shop’ provision, is one of a handful of elements in Heads of Terms that is nearly always intended to be legally binding, and the Heads of Terms should say so expressly.
Sellers are usually asked to grant the buyer a period of exclusivity, during which the seller will not solicit, negotiate with, or accept an approach from any other prospective buyer. This keeps competing buyers off the table for an agreed period while the deal is worked through.
The default position in an English law transaction is that each party bears its own costs regardless of whether the deal completes, and the Heads of Terms should say this expressly to avoid any later disagreement.
To the extent the parties wish to agree a different arrangement, this should be set out clearly in the Heads of Terms, including any caps on fees, or contributions to be made from one party to another in connection with transaction costs.
Heads of Terms discussions inevitably involve the exchange of sensitive commercial information between the parties – customer lists, financial projections, management structures, and often the very fact that a sale is being contemplated at all.
The confidentiality provisions in Heads of Terms are almost always intended to survive regardless of whether the deal proceeds, and the document should say so expressly. If a standalone non-disclosure agreement was entered into earlier in the negotiation process, the Heads of Terms should confirm how the two documents interact, rather than leaving two potentially inconsistent confidentiality arrangements running in parallel.
Even a short, largely non-binding document such as Heads of Terms benefits from an express and binding governing law and jurisdiction clause. A governing law provision sets out clearly which country’s courts would resolve a dispute over the binding provisions, and becomes considerably more important once either party, or any element of the target’s business, has a cross-border dimension.
We would always encourage parties to include a good level of detail in any Heads of Terms. But there are some aspects that do not need to be settled before a transaction gets underway, and which are better left until later in the negotiation process.
Provisions such as detailed tax covenants, precise completion mechanics, particular warranty wording, and specific restrictive covenant wording can be negotiated and included in the long-form agreement, and are commonly best negotiated with the benefit of due diligence findings.
Preparing Heads of Terms gives the parties a chance to surface the hard points early, and ideally to reach agreed positions on them, before entering into costly negotiations and preparing transaction documentation for a deal that might otherwise unravel later over issues that could have been settled at the outset.
Approached properly, rather than being merely a formality, the Heads of Terms can be the foundation stone on which everything that follows is built.
If you are preparing to buy or sell a business and would like a hand putting together a set of Heads of Terms – or have any questions about the sale process more generally – we would be glad to help.
