Heads of Terms: An invaluable tool in M&A

Heads of Terms (HoT), also known as heads of agreement, memorandum of understanding or letter of intent, is a document utilised early in an M&A deal to outline the key terms of the acquisition.

More than simply being just another document in the lengthy M&A process, however, Heads of Terms are vital to the early stages of a deal and can be used to a buyer’s advantage in numerous ways.

While they are an early step, the core points of an acquisition will be set out in the heads of terms and most of the rest of the deal – from due diligence and later negotiations to post-acquisition integration – will flow from agreements established by the HoT.

Naturally, Heads of Terms are highly deal-specific, with the terms depending on a range of factors concerning the nature of the businesses involved in the deal and the structure of the transaction.

For Rishi Malliwal of SGM Law, who estimates he has worked on around 700 deals over a twenty-year career, Heads of Terms are one of the most important elements of any acquisition and something he would advise any prospective buyer to use as early as possible in a prospective deal. When asked if there were any drawbacks for buyers in using Heads of Terms in M&A deals, Malliwal’s answer was an unequivocal “no”.

This is perhaps especially pertinent in the current M&A environment, where economic uncertainty has bred caution among both buyers and sellers, risk is elevated for both parties and deals are fragile up to the point that they are finally closed.

In such an environment, an HoT can provide a greater sense of structure and assurance on both sides, helping to propel the deal forward from the outset. Perhaps just as importantly from a buyer’s perspective, utilising a Heads of Terms agreement can enable them to set out a deal structure and terms that benefits them and best serves their strategic interests.

What is a Heads of Terms agreement?

Speaking to BSR, Rishi Malliwal briefly summarised Heads of Terms agreements as typically being a two to four page document that sets out up to ten key terms of a deal. Heads of Terms are almost exclusively used in solvent deals, rather than in distressed acquisitions, which have shortened timeframes and in which the risks are readily apparent and balanced by the fact that the buyer is paying such a low consideration.

One of the primary functions of the HoT is to essentially ensure that buyer and seller are both on the same page and that there is a deal to be done. If the two parties cannot agree to the fundamentals of a deal, then there is likely to be little point in proceeding, as this would be a waste of time and resources for both buyer and seller.

Again, while the specific content of a Heads of Terms agreement are highly contingent on the nature of the deal itself, they are a few points that are often covered. One of the main points is an exclusivity clause or confidentiality clause, which will lock the seller into exclusive negotiations with the buyer for a predetermined period of time, preventing the deal from being hijacked by any other interested parties.

Typically, a basic price for the acquisition will already have been agreed prior to the buyer sending a heads of terms to the seller. The agreement will then flesh out the structure of this consideration.

For example, whether the payment will be an entirely up-front consideration, or whether certain amounts will be deferred or payable as earnouts contingent upon post-acquisition factors such as the target company’s performance over a 1-3 year period.

Heads of Terms will also often set out the role that the seller will play in the business once the deal has closed. For example, whether they will exit entirely immediately upon completion, or whether they will remain in place in another role, or remain for a period following the deal in order to aid integration.

The agreement will often set out a timeframe for these things, detailing when any deferred/contingent payments are to be made (as well as the conditions required for earnout payments) and the length of time that an outgoing owner may remain involved post-acquisition.

Buyers will also use heads of terms to address areas of risk. For example, if the target company has any ongoing litigation or legal issues (such as disputes over intellectual property ownership), the buyer may stipulate that these need to be settled by the time the acquisition completes.

Another area of risk that is often addressed in the Heads of Terms is the completion account. In a nutshell, a company’s completion account is its net assets on the day that the deal completes. While the company’s balance sheet and asset valuation may amount to, for example, £10 million, its net assets may run into liabilities if it has a high debt or tax burden.

In such a scenario, a buyer may insist in the Heads of Terms that a certain amount is left behind when the deal completes in order to settle this amount and ensure that the business is not in debt when the buyer takes over.

A crucial aspect of the Heads of Terms agreement is that, barring exclusivity and confidentiality clauses, it is not legally enforceable. Instead, it should be regarded as “an agreement to agree” or “a handshake” - setting out the basic terms of the deal, with the finer details to be sorted out as negotiations and due diligence progress.

According to Malliwal, rather than being legally binding, the aim of a heads of terms is moral enforceability. While this may be seen as potentially introducing a new element of risk, the moral force of the agreement in fact provides a buyer with a powerful negotiating position going forward, as well as the flexibility for both parties to agree on changes.

Drawing up Heads of Terms

When buyers are preparing a Heads of Terms document, perhaps the key thing is to engage expert advice. Working with a professional, such as a lawyer or business advisor, will ensure that the document is structured correctly and is consistent throughout.

While buyers sometimes draft agreements themselves, this can often lead to errors and inconsistencies, particularly for inexperienced buyers. In our talk with Rishi Malliwal he mentioned an instance in which a Heads of Terms drawn up by a prospective buyer stipulated, in separate points, that the owner should exit the target business immediately when the deal completes and that they should also remain with the business for a six-month post-deal transition period.

While such a major contradiction may be an extreme example, engaging with a professional who has extensive experience in Heads of Terms will ensure that any inconsistencies are ironed out and that such errors don’t end up in a final document. Something that could severely harm the buyer’s standing and potentially put the deal in jeopardy right at the outset.

Speaking to a professional can not only help to ensure that the document is consistent and written correctly, this experienced outside counsel can also help buyers to clarify in their own minds what they want out of a deal.

The typical way in which a Heads of Terms is drawn up is that the buyer will communicate their terms to a professional, who will then write these up in a consistent, structured form to be sent to the seller.

Crucially, Heads of Terms will also need to give certain assurances to sellers. This typically covers things such as the price, payment structure and timings, as well as the seller committing to promises such as not making redundancies or restructuring the business too drastically immediately after taking over.

What are the key advantages of using Heads of Terms?

Exclusivity
One of the main reasons a buyer will proceed with a Heads of Terms agreement is in order to get a seller to commit to exclusivity. As mentioned above, exclusivity clauses are generally one of the only legally enforceable elements of a Heads of Terms document and will mean that a seller can only engage with that buyer for a specific period of time.

Obviously, the key facet of this is to head off potential interest from other parties that may be interested in the target business and reduce the possibility of competing bids derailing the deal.

Perhaps just as importantly, however, this exclusivity provides buyers with the time and security to then proceed with their due diligence processes without the additional pressure that can come from trying to beat other interested parties to a deal.

In addition, getting a seller to agree to confidentiality early in the deal process can provide a buyer with further reassurance that they are a serious vendor that is committed to selling their business and ensuring that the process is as smooth and professional as possible.

Gain more favourable deal terms
One of the most common concerns among business owners selling with a deal structure that involves deferred payments is that they may not ever receive the full consideration.

Heads of Terms can help to assuage such fears, setting out timelines for payments and providing a commitment (albeit not yet legally binding) that the buyer will indeed pay the remaining balance (or commit to paying it if performance-related earnouts are met).

Buyers can subsequently use the sense of reassurance provided by heads of terms to push for more favourable deal terms for them, structuring and phrasing the document in such a way that the seller will agree to things that they may otherwise have been hesitant to.

One of the main aims of a Heads of Terms agreement is to subtly convince a seller to agree to their terms on aspects such as the payment structure, terms and timeline, completion account amount and liabilities.

Leverage in negotiations
As well as providing buyers with an opportunity to negotiate terms, pricing, deal structures and conditions that suit them, the moral force carried by a Heads of Terms agreement also offers a powerful asset in later negotiations.

This is regarded as a key advantage for buyers using Heads of Terms, with the agreement providing a reference point for buyers to cite throughout subsequent negotiations, helping to ensure a strong negotiating position.

If a seller was to agree to certain deal conditions in the Heads of Terms, then later seek to change some aspect of the agreement, then the original document puts the buyer in a position of considerable strength.

They could refuse the changes and, as a result of the Heads of Terms, would have the authority to point out that the agreement has already been made. Alternatively, they may make concessions to the seller’s requests and then use this as an opportunity to negotiate more favourable terms for themselves elsewhere.

Say, for example, that a buyer attempted to negotiate a higher overall price in an earnout deal structure that has already been established in the Heads of Terms. The buyer may agree to the increased price, but insist that the performance-related goals for activating the earnout are made more stringent, or that the timeline over which payments are made is extended.

Obviously, these are changes that would be unwelcome to the seller, but the buyer’s flexibility in being willing to agree to the seller’s requests, as well as fact that acquiescing to the seller would involve deviating from the original Heads of Terms, provides the buyer with an authoritative moral footing to insist that any changes in the seller’s favour are balanced by other alterations that suit them.

Limiting risk
As mentioned previously, the Heads of Terms can be priceless for buyers when it comes to limiting the risk they are exposed to following the acquisition. While this should always be a central concern for businesses planning acquisitions, it is perhaps especially vital in the current economic climate, where post-deal success may prove harder to achieve and the costs of an underperforming acquisition can be greater.

As well as providing buyers with an early opportunity to head off risks relating to things such as litigation, IP disputes and liabilities, the heads of terms also enables buyers to structure the deal in such a way as to limit the risks they may encounter during integration.

If, for example, a buyer wishes to smooth out the integration process by retaining the services of the current owner or management team during the post-deal period, then this can be stipulated in the heads of terms.

Similarly, if a buyer wishes to protect themselves from overpaying for an underperforming company, then the heads of terms agreement can be used to establish an earnout structure that will ensure they pay a lower total consideration if the business’ post-deal performance doesn’t meet expectations.

Again, by analysing and considering the potential pitfalls they might encounter and structuring the heads of terms correctly, buyers can limit the risk they are exposed to in making the acquisition, from the day they takeover to the day that the integration process is finally complete.

Furthermore, when using the Heads of Terms to analyse risks such as liabilities or IP disputes, this can help buyers flag up potential issues that might require further investigation, helping to provide a framework for their full due diligence process.

Time and resource management
Getting the deal structure, exclusivity and other factors in place early through a heads of terms can enable a buyer to then more effectively and accurately plan for the remainder of the process and allocate their resources accordingly.

A deal timeline is often one of the most important things to come out of a Heads of Terms. While he cautioned that these are often not stuck to (particularly in the case of a first-time acquisition), the structure it provides can be vital.
Heads of Terms can lay out the length of time required for due diligence on both sides (which may be covered by a period of exclusivity), as well as other important target dates relating to the progression of the deal.

Being able to plan the timeline of the deal, as well as gaining a clearer understanding of what the due diligence and negotiation stages will cover, means that buyers can allocate their resources more effectively, ensuring greater focus and clarity and potentially helping to deliver significant cost and time savings.

Spotting a non-starter quickly
Perhaps a less obvious benefit of utilising Heads of Terms during the early stages of an M&A deal is to test the seller’s resolve to actually exit their business. Being presented with a Heads of Terms may be the moment in a sale process that it dawns on an owner that they are, in fact, potentially exiting their business.

Even in active deals, sellers are often uncertain about actually leaving their company. This is a situation that can result in significant complications for the buyer further down the line. For example, if a buyer has spent time and money conducting a full due diligence process and is poised to complete the deal, only for the seller to suddenly get cold feet and call the whole thing off.

A Heads of Terms can therefore be useful as a means of spotting an owner who is not 100 per cent certain about selling their business. When we put it to Rishi that this was potentially a downside and that sending out a Heads of Terms early could possibly spook a hesitant seller and scupper a deal that may have been successful with a more patient approach, he replied that, in his experience, seller hesitancy is something that would just come up again later in the deal anyway.

For that reason, a Heads of Terms can be effective in flagging up an unwilling seller and showing that, if the buyer went ahead, the deal would be risky and potentially very difficult to execute. In such a scenario, a buyer would be well advised to save their own time and effort and move on to other targets.

Heads of Terms are a highly interesting and, in many ways, curious tool for M&A deals. In our conversation with Rishi Malliwal he agreed with our observation that, in certain respects (their non-binding nature, the focus on moral commitment and “handshake-style” promises made between professionals) they are somewhat old-fashioned.

But that is not to say that they are outdated. Heads of Terms remain vital and Malliwal would always advise a buyer in any solvent deal to utilise them.

Heads of Terms offer a wide-ranging array of benefits to M&A buyers, from spotting a seller that is not fully serious about exiting, to gaining exclusivity with a promising acquisition target, to negotiating favourable terms and gaining an immensely strong negotiating position.

In such a febrile dealmaking and economic environment, such things will be worth their weight in gold for buyers. They demonstrate that Heads of Terms can be an invaluable asset for buyers of all stripes, from first time acquirers seeking to extract maximum value and limit risk, to seasoned consolidators operating scaled-up, highly-efficient and process-driven M&A strategies.



Click here to download a Heads of Terms template agreement for the 100% share purchase of a target acquisition. This is for information purposes only and our advice is to always consult your lawyer before creating a Heads of Terms.

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