Heads of terms in private M&A (also known as letters of intent, memoranda of understanding and heads of agreement) are generally contained in a relatively short document that outlines the main terms that the parties have agreed. Heads of terms evidence serious intent, and may have moral force, but are not automatically legally binding. This will depend on the contents of the heads of terms, the parties’ intention and whatever particular circumstances can be taken into account in accordance with the rules for contract formation.

Heads of Terms Purpose

It should not always be assumed that heads of terms will be useful in the context of negotiating a transaction and they may be of more use to one party than the other, but heads of terms can help to avoid misunderstandings and provide a useful map of the steps to be taken on the way to signing the formal agreement. If, however, negotiation of the heads of terms stalls over points of unnecessary detail (which in reality should properly be addressed at a later stage in the process) this can delay preparation of the definitive documents and increase the length and cost of the negotiations.

Heads of terms are used for a number of purposes:

  • As written confirmation of the main terms agreed in principle.
  • To outline the timetable and obligations of the parties during the negotiations.
  • As a framework for certain preliminary legally binding clauses, such as an exclusivity (or lock-out) agreement.

Heads of terms are commonly entered into at the beginning of a transaction, once preliminary terms have been agreed and before commencement of detailed due diligence and the drafting of definitive agreements (which is where the parties will begin to incur significant legal costs). The parties may enter into a series of heads of terms throughout the negotiations, particularly when negotiations are prolonged.

What goes in Heads of Terms?

As a general rule, the heads of terms should cover the commercial deal points, rather than legal drafting ones, and important deal points rather than routine ones. Inevitably, the distinctions blur, but it is in the interests of both sides not to turn the negotiation of the heads into a full dress rehearsal for the final agreement. Time spent negotiating the heads of terms should be confined to discussing the commercial deal in principle. Arguments over the fine print should be reserved for negotiating the final agreements.

Below are some examples of suggested principles to be applied to heads of terms:

  • State the exception and defer the rule – If it is fundamental that, for example, certain sellers will not join in the giving of warranties and indemnities, or that only very limited warranties will be given, the heads should say so. If not, it should be sufficient to indicate that the final agreement is expected to include warranties, indemnities (and limitations on them) appropriate to a transaction of this type.
  • State the principle and defer the detail – Unless an issue is very complicated or unusual, the heads of terms should state the principle underlying the issue and leave the detail for the formal agreement. For example, if there is to be a post-completion audit and balancing payment based on net asset value, that is probably all that needs to be said in the heads of terms. Timing, agreed adjustments to the accounts and accountants that prepare the initial version can be dealt with later. If, however, the parties have agreed a specific unusual formula for calculating the net asset value this may need to be set out in the heads of terms to avoid any later disagreement.
  • Consider carefully, and take professional advice, before making significant concessions – If one side wants the agreement to be governed by foreign law, the other party should understand how this may affect its rights before making this concession. Similarly, both parties should take advice on the tax consequences of the basic deal structure. Such issues highlight the importance of taking appropriate advice or at least including reservations to the extent this has not yet been possible.

Are Heads of Terms legally binding?

Heads of terms may be fully binding or partly binding or not binding at all. Typically, however, they are not legally binding apart from sections dealing with confidentiality (where the parties agree to keep their discussions confidential) and exclusivity (where the seller agrees not to talk with any other potential buyer for an agreed period while the buyer carries out due diligence and hopefully concludes the purchase). Where the heads of terms include provisions that are intended to be binding, these must be clearly identified and the legal requirements for creation of a valid contract must be satisfied. Among other things, under English law:

  • The terms must be sufficiently certain to be enforceable. An “agreement” to continue negotiations in good faith, for example, is nothing more than an “agreement to agree” and normally unenforceable (Walford v Miles). Much depends on the facts however.
  • Unless the heads of terms are executed as a deed, there must be consideration moving from the party benefiting from the agreement to the other party, either in the form of a promise in return, or a payment, action or forbearance. Where there is no actual consideration, however, and execution as a deed alone is relied upon, specific performance is unlikely to be available. For more information on the specific formalities relating to the execution of deed by a company, see section 46 Companies Act 2006.

Third parties

Regard should also be had to the implications of the Contracts (Rights of Third Parties) Act 1999. If a term expressly provides that a third party has the right to enforce that term, or if the term purports to confer a benefit on a third party, then that term may give the third party directly enforceable rights. For example, a parent company, or another group subsidiary of a party to the heads of terms may wish to benefit from the confidentiality provisions. Where there is more than one prospective buyer, the seller may intend the successful buyer to have the benefit of confidentiality undertakings given by the others. On the other hand, if there is a risk that a term may be enforceable by a third party and the parties do not wish to create any third party rights, then an express exclusion should be included to that effect.

Reasons for using Heads of Terms

Whether or not the parties draw up heads of terms is purely a matter of choice: there are both advantages and disadvantages. The perceived advantages of using heads of terms are:

  • Moral commitment. Heads of terms are usually considered to confirm a moral commitment on both sides to observe the terms agreed (which can be an advantage or disadvantage depending on the circumstances).
  • Complex transactions. Where a transaction is complex, heads of terms can help focus the negotiations, bring out any misunderstandings and, by highlighting major issues at an early stage, prevent the parties wasting time and money if those issues cannot be resolved at this stage.
  • Framework for binding commitments. Heads of terms frequently contain a binding exclusivity agreement, a confidentiality agreement and, in some cases, provide for payment of costs and break fees in the event of negotiations breaking down. Obtaining exclusivity for a limited period, and some protection against wasted costs, should enable the buyer to proceed with more confidence.
  • Third parties. Where a deal has to be explained and sold in advance to persons not directly involved in the negotiations, the heads of terms can provide a useful statement of the key terms of the proposed deal.
  • Basis for clearance submissions. Heads of terms can provide the basis of a joint submission for clearance or guidance from the relevant competition authorities and might assist in the preparation of tax clearance applications.
  • Basis for instructing advisers. Draft heads of terms can sometimes be a helpful tool for the parties to instruct their respective advisers.
  • Provide seller with a tactical advantage. Because heads of terms are normally prepared early in the transaction process, before the buyer has commenced detailed due diligence, the seller will know considerably more about the business being sold than the buyer.

Reasons against using heads of terms

  • Limit room for manoeuvre. Heads of terms carry strong force, so they can limit room for manoeuvre in the subsequent negotiations. They should therefore be approached with caution, especially on the part of a buyer, who at this stage normally has much less information than the other side. If the buyer is required to sign heads of terms, then consideration should be given to inserting into the document the key assumptions on which the buyer is relying. This was illustrated by the ill-fated acquisition of PRB by Astra Holdings PLC in 1989. PRB went into liquidation a year after the acquisition and the Department of Trade and Industry (now BEIS) launched an investigation into the matter. In their report, the inspectors mentioned the fact that Astra had, before taking legal advice, entered into heads of terms which included certain unfavourable terms (the acquisition agreement was to be drafted by the seller’s lawyers, governed by Belgian law and was to contain only limited warranties). Although it was not legally binding, it severely tied Astra’s hands in the subsequent negotiations. It was the seller’s “firm view that the [heads of terms] had set the agreed goal posts, and they did not want them moved”.
  • Create legal relations inadvertently. In some jurisdictions, heads of terms can create a legally binding agreement between the parties unless an express term is included to the effect that there is no intent to create legal relations.
  • Accelerate need for public announcement of deal. Where either party is a listed company, an AIM company or otherwise has financial instruments that bring the company within the Market Abuse Regulation (596/2014/EU) it will need to consider whether one effect of negotiating and signing heads of terms may be to precipitate an early announcement of the deal.
  • Adverse tax consequences. In the UK, the heads of terms can be evidence of an “arrangement” which restricts the ability of the parties subsequently to take advantage of certain tax reliefs.
  • Increase in workload. The time taken to agree heads of terms may be disproportionate to the benefit. Care needs to be taken to avoid effectively negotiating the main agreement twice.

Here to help

Drafting heads of terms can be an exciting moment in pursuit of a deal. It is crucial to have an insight into how best to play your hand and what the legal consequences will be of your commercial strategy. The most significant legal question will be whether or not any of the terms are binding.

A document will usually be enforceable when it is adopted into a parent contract and is subsequently agreed upon. Until that point, a heads of terms will not usually be legally binding (Fletcher Challenge Energy Ltd v Electricity Corp of New Zealand Ltd [2002]). However, such documents can be legally binding if the agreement document contains terms or language which explicitly indicates a binding intention. Equally, a letter which contains no expression of whether its terms were intended to be binding can be found to be binding due to language used. (RTS Flexible Systems Ltd v Molkerei Alois Müller GmbH & Co KG [2008]) This is also dependent on the circumstances of the transaction and includes the conduct of the parties themselves.

If you have any questions on heads of terms or need help drafting such a document please contact Neil Williamson.