Written with Andy Moseby, Partner at Lee & Thompson, this article is the first in The Anatomy of a Deal, a joint series from Novistra Capital and Lee & Thompson exploring the key stages of a transaction through banking and legal perspectives.

What should, and should not, be in your Heads of Terms.

Call it a term sheet, a letter of intent or a memorandum of understanding: the label varies depending on the deal and the jurisdiction, but the purpose remains the same. Heads of Terms record the key commercial terms the parties have agreed in principle, to get everyone pulling in the same direction early on, and head off the costly disputes and renegotiations that tend to crop up if nothing was ever written down.

This article examines why Heads of Terms are key to a transaction, what they should include, what is better left out, and how best to prepare a functional document that guides and shapes the transaction that follows.

The purpose

Think of a set of Heads of Terms as a roadmap rather than a long-form contract.  It’s not intended to spell out every transaction arrangement in extensive detail – that comes later. Its purpose is to record the commercial arrangements the parties have provisionally agreed, most of which touch on the legal side of the deal, along with a handful of related components.

Heads of Terms should also set the pace of the transaction and establish the negotiating parameters for the long-form documents that follow.  Whilst it is always difficult to pin down an exact timetable at the outset, agreeing an indicative timetable and target completion date gives everyone something to work towards and helps prevent the deal from drifting.

Heads of Terms are usually expressed to be legally non-binding.  However, as an acquisition process involves exchanging sensitive information, a handful of provisions are almost always intended to be binding and should be identified as such. More on those provisions below.

Core elements of Heads of Terms

1. Parties and structure

If possible, the deal structure should be decided early in the negotiations, ideally before the Heads of Terms are signed.  Whether the transaction will be structured as a share sale, an asset sale, or something else (such as a hive-down or a joint venture) will typically depend on the tax analysis, which is usually conducted after the Heads of Terms are signed.  Building some flexibility into the Heads of Terms is helpful: although the structure informs the key transaction documents, it may not be known until after the Heads of Terms are put in place.  That’s not to say it is not worth considering the structure up front – having an idea about the nature of the transaction, even in outline, avoids having to fundamentally restructure the deal midway through legal drafting.

Obvious but necessary: it’s also worth naming the specific parties to the transaction where possible.  Whilst the exact entities involved may only be finalised following the tax and structuring analysis, clarity at this stage helps advisers with their early-stage analysis and reduces time spent updating or re-drafting documents to account for changes to company details later on.

2. Headline price and payment mechanism

The price a buyer pays is rarely just one number: it’s often built from several components, cash and non-cash alike, so the Heads of Terms should set out, as clearly as possible, how this is expected to work.

The headline price should be stated clearly, together with details of how and when it will be paid. Will the transaction incorporate a locked-box mechanism or a completion accounts adjustment? Typically, the deal will be on a cash-free, debt-free basis, with a normalised level of working capital and a post-completion adjustment to reflect any excess cash, indebtedness or higher or lower level of working capital in the target company.

Will any part of the price be deferred or subject to an earn-out? Identifying, negotiating and agreeing these points before entering into Heads of Terms, even at a high level, can significantly reduce the time spent negotiating and drafting later in the transaction.

Not all consideration mechanics will necessarily be known at the Heads of Terms stage. Depending on the findings of due diligence, a buyer may insist on a proportion of the purchase price being held back to cover potential warranty or indemnity claims.

3. Key conditions

Transactions frequently include conditions that must be satisfied before the deal closes. The Heads of Terms should identify each condition considered necessary, rather than relying on a generic reference to ‘usual conditions’ or similar wording.

Conditions such as confirmatory due diligence and, where relevant, third-party financing and regulatory or other third-party approvals (competition clearance, sector-specific regulatory consents, landlord consents, or key customer or supplier consents) should be identified and included where applicable.

4. Indicative timetable

A realistic timetable should be included, running from the signing of the Heads of Terms through to the  anticipated completion date for the definitive agreement.  Key milestones, such as completion of due diligence, tax clearance, or receipt of any regulatory approvals should also be flagged.

5. Exclusivity and lock-out period

Exclusivity, sometimes called a ‘lock-out’ or ‘no-shop’ provision, is one of a handful of elements in Heads of Terms that is nearly always intended to be legally binding, and the Heads of Terms should say so expressly.

Sellers are usually asked to grant the buyer a period of exclusivity, during which the seller will not solicit, negotiate with, or accept an approach from any other prospective buyer. This keeps competing buyers off the table for an agreed period while the deal is worked through.

6. Costs allocation

The default position in an English law transaction is that each party bears its own costs, regardless of whether the deal completes. The Heads of Terms should state this expressly to avoid any later disagreement.

To the extent the parties wish to agree a different arrangement, this should be set out clearly in the Heads of Terms, including any caps on fees or contributions to be made from one party will make towards the other’s transaction costs.

7. Confidentiality

Heads of Terms discussions inevitably involve the exchange of sensitive commercial information between the parties – customer lists, financial projections, management structures, and the very fact that a sale is being contemplated at all.

The confidentiality provisions in Heads of Terms are almost always intended to survive, regardless of whether the deal proceeds, and the document should say so expressly. If a standalone non-disclosure agreement was entered into earlier in the negotiation process, the Heads of Terms should confirm how the two documents interact, rather than leaving potentially inconsistent confidentiality arrangements running in parallel.

8. Governing law

Even a short, largely non-binding document such as Heads of Terms benefits from an express, binding governing law and jurisdiction clause. A governing law provision identifies which country’s courts would resolve a dispute over the binding provisions, and becomes considerably more important once either party, or any element of the target’s business, has a cross-border dimension.

What Heads of Terms should not include

We encourage parties to include a good level of detail in any Heads of Terms. However, some aspects do not need to be settled before a transaction gets underway and are better left until later in the negotiation process.

Provisions such as detailed tax covenants, precise completion mechanics, particular warranty wording, and specific restrictive covenant wording can be negotiated and included in the long-form agreement. These are commonly best negotiated with the benefit of due diligence findings.

The practical takeaway

Preparing Heads of Terms gives the parties a chance to surface the hard points early and, ideally, agree positions on them before entering into costly negotiations and preparing transaction documentation for a deal. This can help prevent a deal from unravelling later over issues that could have been settled at the outset.

When approached properly, Heads of Terms are more than a formality: they provide the foundation on which everything that follows is built.

If you are preparing to buy or sell a business and would like help putting together a set of Heads of Terms, or have questions about the sale process more generally, we would be glad to help.