Heads of terms (also known as letters of intent and memoranda of understanding) (Heads) set out the agreement in principle between the parties to a transaction before they proceed to the formal documentation and implementation phase.
Whether you are selling or buying a business, it is important to ensure that the main terms are agreed upfront, especially those which could impact on value, the deal timetable or the willingness of the parties to proceed with the transaction. Although the Heads are not legally binding, the points agreed form a moral commitment which is difficult for a party to row back from without clear justification (e.g. because of specific issues/risks identified in due diligence).
While the key items for inclusion will vary from deal to deal, below are examples of things to consider when preparing and negotiating the Heads.
Identify all required parties and their roles
This goes beyond simply setting out the details of the sellers and the buyer. You should consider whether it is appropriate for all sellers to stand behind the obligations/liabilities in the sale agreement equally. For example, it is not uncommon for shareholders who are not actively involved in the business (including investors) to only give title and capacity warranties and to sign-up to a more limited set of post-completion obligations (including restrictive covenants).
In respect of the buyer, it is important to consider its identity and financial strength, especially if the price mechanic includes deferred consideration. In this circumstance, you should consider what security the buyer can offer the sellers for its obligations under the sale agreement, including in respect of the deferred consideration, and it is not uncommon for a guarantor to be offered as such security. If so, the guarantor should be identified in, and a party to, the Heads.
Add the finer details to key concepts
The Heads do not usually set out in detail the key terms that will find their way into the transaction documents, such as the warranties, tax covenant, restrictive covenants and earnout provisions. These provisions require detailed and/or bespoke drafting, and nobody wants to see Heads that are 50 (or more) pages long! However, the parties should use the Heads to agree upfront some of the points that sit alongside such concepts.
The Heads should set out which sellers are liable for the warranties and the tax covenant and agree the parameters for the standard limitations on the sellers' liability under the warranties and the tax covenant. These limitations include: the sellers' aggregate and, if agreed between the parties, individual cap on liability; the small claims disregard threshold (also known as the "de minimis" threshold) and the basket threshold; and the time period after completion within which the buyer needs to give notice of general warranty claims, tax warranty claims and tax covenant claims.
The parties should use the time in their preparation of the Heads to ensure that:
- The scope of the restrictive covenants is proportionate and protects the legitimate interests of the target business.
- The restrictive covenants do not prohibit or otherwise affect any existing interests and activities of any sellers that they carry out independently of the target business.
In respect of earnout provisions (and we'd need an entirely separate article to discuss the pros and cons of earnouts!), the Heads should identify:
- Amount – will this be fixed depending on the earnout threshold(s) that is/are met or will this be calculated through a formula based on the earnout reference and threshold(s)?
- Reference – will this be the target business' revenue, EBITDA or other performance metric?
- Threshold – what level of revenue, EBITDA or other performance metric will trigger the earnout payment, and will there be a sliding scale?
- Payment date(s) and bases – if the earnout period is just for one year after completion, there may simply be a single payment date. However, if the earnout period covers a number of years after completion, will there be a single payment date at the end of the full earnout period or will there be an annual earnout calculation and, if the annual threshold has been met, an annual payment?
- Protections – what earnout protections will be included for the sellers (e.g. to prevent the buyer from running the target business after completion in a way that would artificially affect the earnout payment) and the buyer (e.g. should certain sellers need to remain involved in the target business for all or part of the earnout period)?
Practicalities after completion
The buyer should consider whether it requires certain sellers to remain involved in the target business after completion (e.g. for transitional support on a consultancy basis) and whether it expects such sellers and/or any key employees of the target business to enter into new employment contracts (e.g. to harmonise their employment terms to those of the buyer's wider group). Any such points should be discussed and, if agreed, the commercial terms should be included in the Heads.
Timings are key
It is normal to agree a period in which the bidder has the exclusive opportunity to complete the transaction. The exclusivity period should be clear in the Heads. Unless there are reasons for a short exclusivity period (e.g. because the buyer was selected in a competitive process ahead of other bidders because of its deliverability), the exclusivity period should correspond with the deal timetable and potentially allow some leeway to avoid unnecessary repeated extensions. The parties should also agree the sellers' liability for breaching exclusivity, which is often based on the buyer's costs incurred up to the point of breach, but subject to a cap to allow certainty for all parties.
Finally, the Heads should set out a desired (and realistic) exchange and/or completion date and address any factors outside of the parties' control that could affect achieving that date, e.g. the input and/or consent of certain third parties required for the transaction, such as banks, landlords, key customers and suppliers and governmental or regulatory bodies. Addressing such factors in the Heads will help manage expectations on the deal timetable and each party's role and responsibilities in respect of any such third parties.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.