Dr McDeal title Heads of agreement

“Heads of agreement” sounds like the title of a bad movie.What exactly is it?

Heads of agreement, also known as a memorandum of understanding or letter of intent, is of particular value when negotiating high-value or complex agreements and as such almost always feature when buying or selling companies. They have two main purposes: the first is to record the commercial agreement between the parties and avoid subsequent misunderstanding. They should form a core source when the legal advisers start to prepare legal documentation. Secondly, they provide a route map through to completion setting out the agreed timetable and the issues that must be satisfied for the deal to complete. It is an important document and well worth investing time and effort to get right.

What am I agreeing to in a heads of agreement?

It is important to state explicitly if the agreement, or any part of it, is legally binding. In most cases, heads of terms will include a disclaimer specifying that - with the exception of one or two specific clauses - the agreement is not intended by either party to be legally binding. In the UK, this disclaimer will generally be effective. If you are involved in a cross-border transaction, you must get specific advice, as the position may be less clear-cut. Heads of agreement should be regarded as a strong moral commitment from both parties to complete the deal on the agreed terms.

So what, if any, are the binding bits of such a document?

- Confidentiality. Neither party should tell anyone that they are in negotiations, nor should the purchaser abuse any information passed over during the sale process.
- Costs. Generally, each party will bear their own professional costs.
- Exclusivity. A purchaser will want the comfort of knowing that a seller has stopped talking to other buyers before he or she invests resources in a detailed due diligence exercise.

When drafting heads of agreement, what significant points should be included?

Heads of agreement should cover the following commercial issues:

- The parties reaching the agreement and the company, business or assets being sold should be clearly identified.
- As vendor, satisfy yourself that the purchaser has the money to complete the deal. If the transaction is dependent upon external funding, the heads should identify the providers of funds and, ideally, will have support letters from the funders attached that specifically refer to the heads of agreement.
- Specify the amount, form and timing of the consideration, along with contingent or deferred amounts and pre-completion dividends.
- The condition of the company, business or assets at the point of sale should be set out briefly. Specify the treatment of cash on the balance sheet, inter-company balances, borrowings (including preference shares and other forms of long-term funding) and the expected level of net assets.

What problems could arise if something is left out of the heads of agreement?

An important but often neglected part of the heads of agreement is the process through which the purchaser will confirm his or her decision to buy and the various conditions to the agreement. These include:

- The expected process and timetable to completion. The agreement should set out when the transaction is expected to complete and the main milestones on the way, including, for example, the expected start and completion of due diligence and the negotiation of the legal documentation.
- Conditionality. Specify the areas where the agreement is subject to further satisfaction, for example due diligence, contract, regulatory approval, financing and purchaser board approval.
- The signing of heads of agreement will generally give rise to a period of exclusivity during which the vendor should not commence or continue discussions with other potential purchasers. Vendors should assess the acceptability of the proposed purchaser’s process and timetable, and should require as short a period of exclusivity as is reasonable. Purchasers should resist too short a period as they may be exposed to exclusivity ending before their work is completed.
- A fee indemnity may be introduced. The purpose is to penalise either party if it withdraws from the transaction without cause or breaches the exclusivity agreement. The amount may be either fixed or calculated by reference to reasonable costs incurred. They tend to be difficult to draft and for this reason are often dispensed with. Both of these matters and that of exclusivity should be brought into the heads and should specifically be identified as legally binding.

Who should prepare heads of agreement?

While the commercial aspects of heads of agreement will almost certainly not be expressed in legally binding terms, they should represent the carefully considered agreement of all parties.

In the absence of factors that genuinely affect the value of the business, you should expect the final deal to reflect the deal set out in the heads. If either party attempts to renegotiate the deal post-heads without good cause, it suggests that the agreement has not been entered into in good faith. Accordingly, the heads should deal with all significant issues, leaving few if any substantive points for subsequent negotiation.

For these reasons, heads of agreement should be negotiated by your corporate finance advisers. Lawyers should always “bless” them, but not be responsible for drafting them. Heads are not intended to be a substitute for the definitive legal agreement, and a greater involvement by lawyers may well impact the length of time it takes to prepare the heads of agreement.