An Essential Guide to Heads of Terms in Business Sales

Heads of terms are documents that give you a framework for the business acquisitions deals you will eventually do. In some countries heads is known as a letter of intent, in others a memorandum of understanding, but it all boils down to the same thing.

What are Heads of Terms

The heads of terms agreement sits in the area between initial negotiations and the final sale and purchase agreement, when buying a business. You might also include a heads of terms stage when negotiating other commercial transactions, such as property transactions or joint ventures. It is a way of getting the key terms of a deal down in writing.

The two main reasons for this are to help avoid later misunderstandings or disagreements, and to make it easier for solicitors to draft the sale and purchase agreement – they can use heads of terms as a reference point of what has been commercially agreed between the parties and then turn that into a legally enforceable document.

While heads of terms is a framework, the sale and purchase agreement will record finer details of commercial terms, and include things like details of property transactions, covenants, warranties and indemnities, and details of any earn out, if appropriate.

Importance and Legal Implications of Heads of Terms

Heads of terms is a critical point in the business acquisition process, but it doesn’t commit either party to completing the deal. Signing heads of terms does not obligate you to buy, nor the seller to sell. Either can pull out right up until the last minute.

While the term sheet is important, it is not a legally binding agreement. A buyer can move to heads without worrying about ‘what ifs’, like, what if the business turns out to be something I didn’t expect it to be, meaning I don’t want to do the deal? Should that happen, you can pull out.

While signing heads doesn’t commit you to buy, there are four main terms that are legally binding. Those are jurisdiction, fees, confidentiality, and exclusivity.

Jurisdiction

This specifies which legal system governs the agreement. If you are both in the UK, then it seems fair to assert that the agreement is governed by the UK legal system.

If you’re buying from an international company, jurisdiction can be a bit trickier.

Fees

Typically, each party pays their own legal fees.’

There is generally some debate when it comes to fees attached to lease assignments. With this, there are three sets of legal fees: the buyer’s, the seller’s, and the landlord’s, and the landlord will expect to have their fees covered. You and the seller decide who pays them, or whether you split the cost.

Confidentiality

You don’t want to sign heads of terms and have the seller telling everyone they’ve sold the business. That can erode the value of the business as, all too often, the staff immediately want to leave.

The confidentiality agreement is an important clause, and we talk a little more about that below.

Exclusivity

This may well be the reason you want to get to heads of terms as quickly as possible. The exclusivity agreement clause effectively removes all the other potential buyers from the picture for a set period of time because it prevents the seller from engaging with anyone else. If they are currently in negotiation with another potential buyer, they need to stop those conversations completely.

Again, we’ll talk a little more about that shortly.

Key Elements of Heads of Terms

We’ve covered briefly the four legally binding components in the heads of terms agreement – jurisdiction, fees, confidentiality, and exclusivity – and we’ll be looking in more detail at confidentiality and exclusivity. The document also records things like the personal data relating to both parties, and shareholder information. But what key elements go into the agreement?

The price

The price you’ve agreed to pay for the business will generally be included, although this is not a legally binding element and it is subject to negotiation after due diligence has been conducted.

There is also a possibility that before due diligence is conducted there are too many unknown variables for a price to be determined. If that is the case, you might instead agree and include a mechanism for determining the price. For example, the price will be three times EBITDA as determined by due diligence.

The terms

The terms set out how the purchase price is going to be paid. This is where you state what will be paid on completion and how any deferred consideration will be paid, and over how long. Again, this is all subject to negotiation following due diligence.

Special conditions

What are special conditions? Here are some examples.

The lease

Say the seller owns and intends to keep the commercial property the business trades from and it is going to be leased to you on a 25-year lease: you want that down in writing.

Personal guarantees

You should avoid giving personal guarantees wherever possible. While this element of heads is not legally binding, by recording that directors cannot offer personal guarantees, you set a precedent and, should the seller’s solicitor seek a PG later, you can point to the agreement already made.

Family members leave

You can specify that family members will leave the company prior to completion but that their replacements will have already been hired. That way, you avoid many potential problems and also don’t have an immediate staffing shortage.

No material change

That there should be no material change in the performance of the business between signing heads of terms and completion is a key special condition.

‘Material change’ is a legal term meaning a ‘significant change’.

Say you’ve been told that the business makes £500,000 profit; you are buying the business on that basis and the price and terms are based upon that figure. If either due diligence shows that it was never £500,000 or performance of the business drops, you want to be paying less for it. If the performance drops by 25%, so should the price. You will likely change the terms as well.

Management accounts

Price and terms stated in heads are based on the financials provided by the seller. If they’ve provided management accounts, you might want to attach those to the heads of terms document and get them to sign to confirm they are the ones supplied and used. There are often multiple versions of management accounts in existence so this avoids future confusion. Also, numbers can be exaggerated to make them as impressive as possible.

Exclusivity Period in Heads of Terms

This is a key element and a good reason to get to heads as soon as possible. The exclusivity period removes competitor buyers from the picture, even if the seller is already speaking with them. Everything other than the negotiations the seller has with you stops, and that strengthens your position.

When the seller has signed heads that gives you exclusivity typically for two to four months. I make sure it goes all the way to completion target date, and can be extended afterwards.

Confidentiality in Heads of Terms

A confidentiality clause aims to prevent details of the deal from being leaked prior to it being finalised and officially announced.

There are various reasons to do this, including if word gets out people might panic, meaning staff leave and customers seek another supplier; if the potential buyer is a competitor, or linked in some way to a competitor, they will be in receipt of sensitive information and the seller needs to know that will be kept secret.

The danger is that a leak of information will cause the business to be eroded, which will damage the sale.

If confidentiality is breached, the injured party may seek redress through the courts and the defaulter could be subject to payment of damages and costs, and more, depending on the circumstances. In practice, that will depend on the perceived cost of the damage done and the cost of seeking redress. However, the defaulting party could suffer reputational damage that will cost them dearly.

Practical Tips for Negotiating Heads of Terms

Make sure, before you start negotiating heads of terms, that you know what it is you want to commit to. Even at this relatively early stage, aim to be clear on the key elements and your position on them.

Aim to lead the discussion. It’s possible the seller isn’t familiar with heads of terms, so you can position yourself as the expert here.

Keep the discussion friendly, but on track. Go through the points in turn. Make sure they understand the parts that are legally binding, the ones that are subject to renegotiation following due diligence, and that they are not committing to selling the business at this time.

Have an eye on the resulting sale and purchase agreement and aim to head off any potential issues – such as the requirement for personal guarantees – by including in heads that they won’t be provided.

Impact of Due Diligence on Heads of Terms

Due diligence will examine things including assets and liabilities, legal issues, existing commercial contracts, commercial property issues, including the lease, and the financial health of the company.

Due diligence runs in tandem with the drafting of the sale and purchase agreement. The price and terms agreed in the heads of terms are likely to change during that period because the due diligence process is going to show up all the flaws in the business that the owner didn’t tell you about.

In your discussions with the owner, their focus was on selling you the business and so they focused on the positives and didn’t mention the negatives. One of the purposes of due diligence is to root out those negative aspects so you understand what you are buying, and a consequence of that greater understanding is, where necessary, a renegotiation of price and terms.

Who is Responsible for Creating Heads of Terms?

Either the buyer or the seller can create heads of terms. Alternatively, you can get your solicitors involved to draw them up. While solicitors can be useful for bigger deals, for smaller ones they are likely to slow things down, and there will, of course, be fees involved. They are also likely to change things from the basic agreement you and the seller arrived at during your discussions.

The key to keeping things between yourself and the seller is to keep things simple. For smaller deals, you don’t need a big long document stuffed with legalese. Explain the terms of the transaction and what each section means, and make sure they understand that only four clauses are legally binding – if you remember, they are jurisdiction, fees, confidentiality, and exclusivity.

Dealmakers provides a template you can use to create heads of terms for your deals.

Of course, if the seller insists on engaging a law firm, taking legal advice or seeking consultancy guidance, they are free to do so.

Is Signing Heads of Terms Mandatory?

Heads of terms has to be signed by both parties in order to be binding, which is the same as with any other contract. But remember, only four clauses are legally binding and heads doesn’t obligate either party to complete the deal. It’s more an indication of serious intent.

Conclusion

While heads of terms doesn’t commit you to buy or the business owner to sell, and only certain elements are legally binding, it can be a useful document when it comes to drafting the sale and purchase agreement. It’s worth taking time to understand it and to get the details you record correct and in line with your ultimate goals.

Having someone with years of experience in business mergers and acquisitions on your side can be a huge advantage. Jonathan Jay has helped more than 3,000 people buy successful businesses and become acquisition entrepreneurs, and he has put together the most comprehensive FREE package of business buying resources available today. To get started on your acquisitions journey, download your FREE Business Buying Toolkit now.