Heads of Terms Agreement

When selling or buying a business or corporate entity, or entering into any other complex sales transaction, the sale process will typically involve several stages, including preparation of agreed Heads of Terms.

In this guide, we explain what a Heads of Terms Agreement is, and when and why these types of agreements are used. We also look at when these agreements are legally binding on the parties and what provisions should be included.

What is a Heads of Terms Agreement?

A Heads of Terms Agreement is a document containing the basic agreed framework and key commercial terms for a proposed sales transaction. Agreed during the course of initial negotiations, Heads of Terms are preliminary agreements that precede substantive contract negotiations. They are designed to inform the basis of a much more detailed sales document, which will include comprehensive contractual provisions covering every aspect of the sale.

Heads of Terms are used in a variety of high value and complex transactions, including private equity investments, joint ventures, and public mergers and acquisitions. They can also be used in the context of large supply chain agreements, the lease of premises or equipment, or any other commercial transaction requiring the protection of a detailed contract.

The Heads of Terms Agreement will usually run to just a couple of pages, unlike the principal sales document — often referred to as either a Sale and Purchase Agreement (SPA) or a Business Purchase Agreement (BPA) — which typically comprises a detailed main document, and various schedules or annexes containing disclosures and details of the transaction.

When are Heads of Terms Agreements used?

When a seller is selling, and a buyer is acquiring, a business or other high value asset, the parties will usually engage in a complex and protracted sales process. This process will typically require a number of key documents to be agreed by the parties. Below we look at these documents and how the Heads of Terms Agreement fits into the overall sales process:

Non-Disclosure Agreement (NDA)

An NDA should always be entered into very early on in any negotiations. The process of investigation undertaken by a buyer at the outset— commonly referred to as due diligence — necessarily involves disclosure by the seller of significant amounts of sensitive and confidential information. This is so the buyer can obtain a complete picture of the business, including any liabilities or areas of concern that may exist. A properly drafted NDA will help to prevent the buyer from taking unfair advantage of that information, using it for their own gain, while the transaction is taking place.

Heads of Terms Agreement

Once an NDA has been put in place, the parties will usually go on to agree Heads of Terms, providing the key provisions for the proposed sales transaction and the basic framework for the SPA/BPA. Although there is no legal requirement for the parties to agree Heads of Terms prior to drafting the principal sales agreement, this can then be used to facilitate more substantive negotiations, providing a timescale for entering into a formal commercial contract. Heads of Terms Agreements are also known as Heads of Terms, Heads of Agreement, Letters of Intent or a Memorandum of Understanding.

SPA or BPA

This is the principal transaction document that structures the entire deal. It will include all the contractual provisions in detail, where the operative parts are likely to be the subject of a significant amount of negotiation time. The SPA/BPA will also include certain standard provisions that are not usually negotiated heavily, but rather designed to provide certainty on a variety of general legal matters, such as confirming the governing law applicable to the contract and the mechanism for determining any disputes arising under it.

Disclosure Letter

Second only to the SPA/BPA in terms of importance, and negotiated alongside it, is the Disclosure Letter. This document is the main mechanism by which a seller protects themselves against a warranty claim. It is used to fix the buyer with knowledge about specific aspects of the business which may be inconsistent with any warranties contained within the final agreement. This means that if a warranty is breached, providing the relevant matter has been fully and fairly disclosed in the Disclosure Letter, the buyer will be prevented from bringing a claim because they had prior knowledge of the matter.

Why are Heads of Terms Agreements used?

Heads of Terms Agreements are used for a number of purposes, including:

As written confirmation of the main terms agreed in principle by the parties.
To outline the timetable and respective obligations of the parties during the course of negotiations prior to reaching a final agreement.
As a framework for certain preliminary legally binding clauses, such as an exclusivity agreement. This is an agreement that limits the seller’s ability to solicit an offer from, or negotiate with, any other party during a specified timeframe. This protects the buyer against being outbid by a third party, having already invested time and money in the sale process..

Heads of Terms are commonly entered into right at the very beginning of a sales transaction, before embarking on detailed due diligence and drafting definitive agreements, which is where the parties will begin to incur significant costs. However, it is important that the parties do not get bogged down in detail when drafting Heads of Terms, as this can lead to protracted negotiations and higher costs before the sale process has even properly begun.

Generally, the Heads of Terms Agreement is used to help focus the parties’ minds and highlight any major issues that are not agreed at an early stage, thereby reducing time and costs in the long run. In this way, the Heads of Terms simply act as a useful framework for the parties’ advisers to work from in drafting and negotiating the SPA/BPA.

Are Heads of Terms Agreements legally binding?

Unlike the SPA/BPA, Heads of Terms Agreements are not usually legally binding, but rather subject to a formal contract. This type of agreement will evidence serious intent and even have moral force, but it will not legally compel the parties to conclude the deal on those terms, or at all. Still, Heads of Terms will ensure that there is an agreement in principle on all key provisions of the sales transaction, giving the parties confidence that a deal is possible without committing themselves legally, and before significant time and money are invested.

However, certain provisions, such as a provision relating to exclusivity, can often be binding on the parties. Equally, where an NDA has not initially been put in place, the parties can instead incorporate legally binding confidentiality provisions into the Heads of Terms Agreement. Confidentiality provisions are not necessarily limited to protect the seller, but can work both ways, so that there is an obligation on either party not to disclose that they are in negotiations in connection with a possible sale, where the detail as to how, where and when announcements about the sale transaction may be made public can be decided at a later date.

Given the largely non-binding nature of Heads of Terms, it is often tempting not to secure expert assistance at this preliminary stage, either from lawyers or accountants. However, as with any agreement drafted during the course of the sales process, it is important to have professional input from the outset. In this way, the parties can ensure that the main terms that will be used to inform the final contract protect their respective interests. As the Heads of Terms set out key commercial terms, the parties will often be reluctant to move away from these, so it is important to get this agreement in principle right from the start. Equally, if not drafted with care, Heads of Terms can have legal force, even when unintended.

What should be included in a Heads of Terms Agreement?

A Heads of Terms Agreement is not intended to be an exhaustive document setting out all the terms of sale between the parties, but rather should focus on the key issues.

Below we set out what Heads of Terms would generally cover, although every agreement will need to be tailored to the proposed transaction in question:

Key commercial terms

The Heads of Terms Agreement should list the key commercial terms that the parties will be negotiating. In addition to the purchase price and payment terms, these can include provisions that deal with the respective obligations on either party, together with important protections to mitigate any risks, for example, warranties and indemnities, any interim controls pending completion and post-sale restrictive covenants.

Any pre-conditions

These are any conditions that must be met before either party can enter into a final and legally-binding agreement, for example, the buyer being satisfied with the results of its due diligence exercise, or receiving any applicable regulatory approvals or third party consents, for example, from directors and shareholders, or from key clients.

Exclusivity clause

As the buyer will be investing time and money in undertaking the due diligence exercise on the business, and instructing professional advisers to assist with the sale process, it is common for the buyer to request a period of exclusivity within the Heads of Terms Agreement. This means that the seller agrees for a specified period of time not to supply any information or enter into discussions with a third party in connection with a sale.

Confidentiality clause

Where not otherwise agreed, such as in an NDA, it is common for the parties to incorporate confidentiality provisions into the Heads of Terms Agreement.

Timescales

The Heads of Terms Agreement should include a timetable for the sale process, setting out the next steps to be taken and when completion of the transaction is anticipated. This is when the parties expect to be able to reach a formal agreement and finalise the sale.

Declaration of legal effect

As Heads of Terms are not intended to create a legally binding commitment on the parties to enter into a SPA/BPA, this should be made clear in writing. To ensure that no implied contractual relationship is created, it is important to expressly state that the terms are not intended to have legal effect. However, where it is intended that the parties are bound by certain provisions, for example, any exclusivity or confidentiality clause(s), it should be made clear in relation to these terms that in the event of a breach, the non-defaulting party could seek to take action against the party in default.

Where the Heads of Terms Agreement is not intended to have any legally binding effect whatsoever, there is no strict requirement for the parties to sign the agreement. However, in all cases, it is best practice for both parties to sign the Heads of Terms so as to demonstrate their agreement in principle and their commitment to negotiating a formal contract.

In any scenario where one party refuses or fails to sign the Heads of Terms, this might indicate a lack of intent or the possibility that they are likely to shift their position when it comes to further negotiations. In these circumstances, a cautionary approach should always be adopted, as continuing negotiations may not prove to be worth the additional time and expense.