What are heads of terms?
The phrase “heads of terms” is typically used to describe a set of proposed high level deal terms that the parties to a prospective transaction have agreed in principle.
Heads of terms essentially record and formalise the outcome of early discussions and negotiations, which often initially take place on calls, in meetings, and over email. Signing a heads of terms can help to signal that both parties are provisionally happy with the deal that has been (informally) agreed, and want to proceed on this basis.
As heads of terms only tend to cover the key high level commercial terms – and therefore are not sufficiently detailed and precise from a legal perspective to properly govern a transaction – the parties will expand upon, supplement, and caveat the terms during the main negotiation phase. In this sense, heads of terms tend to form the basis of more detailed, legally-binding documents which the parties subsequently negotiate, draft and enter into.
When are heads of terms drafted, and who drafts them?
Heads of terms are often used for a broad range of transactions, from acquisitions of companies and specific assets, to the purchase of services, entry into leases and licences, and taking of loans.
Heads of terms are typically drafted in the early stages of a transaction, once the key terms have been provisionally discussed, but before more detailed due diligence and negotiations have been carried out. Either party can prepare a heads of terms, although it is more common for a buyer to take the lead (or a lender in the context of loan agreements).
Note that a heads of terms may evolve over time. For example, if early due diligence reveals issues that impact the viability of the original heads of terms, the parties may initially agree to amend the heads of terms accordingly, before kicking off the more substantive drafting process later on.
What is included in a heads of terms?
The length of a heads of terms and the detail included can vary considerably. A heads of terms can range from a simple letter setting out a few very high level points in plain English, to a more comprehensive and specific agreement that might include some input from lawyers.
A heads of terms will often cover key aspects of a transaction, such as what is being purchased, the price (or how this will be calculated), the form of consideration, the time of payment, the main procedural responsibilities, some reference to key contractual protections and due diligence, the anticipated deal timetable, the assumptions on which the terms are based, and conditions that must be fulfilled before completion.
A heads of terms will also commonly cover the intended governing law and jurisdiction, confidentiality obligations, exclusivity provisions, responsibilities around costs (e.g. if negotiations subsequently break down), some limitations of liability, and the circumstances under which the heads of terms will expire or can be terminated.
Note that this is all a simplification; in practice, heads of terms will differ depending on the context. For example, a heads of terms relating to a commercial lease will likely include provisions relating to rent, the scope of the property, the term, key landlord/tenant obligations and restrictions, insurance, service charges, assignment, alterations, third party rights, and more. In a finance context, heads of terms will often include provisions relating to the loan value, currency, interest rate, structure of repayments and amortisations, prepayments, key covenants, events of default, transferability, security, conditions precedent, and so on.
Are heads of terms binding?
In England, heads of terms are not automatically legally binding, although the parties can explicitly agree that some (or all) of the terms will bind them. Even where it is agreed that the terms are binding, if those terms are high level and ambiguous, there may still be scope to negotiate caveats and supplemental obligations without technically departing from what was agreed in principle. Note that provisions in heads of terms regarding exclusivity and confidentiality are often stated to be binding (and confidentiality obligations will survive the termination of the heads of terms to protect both parties), as are provisions regarding the payment of costs and break fees if negotiations break down for certain reasons.
What are the benefits of heads of terms?
Early discussions around heads of terms can help to draw out significant issues at an early stage, giving the parties an opportunity to walk away from the deal without investing too heavily in due diligence and negotiations. Formalising these discussions can also help to avoid misunderstandings further down the line.
Once agreed, heads of terms provide a framework to follow when drafting the main transaction documentation, which can save time and costs through helping to focus the negotiations. Moreover, even where some or all of the provisions set out in a heads of terms are not binding, they can still have “moral” force, as it can be psychologically harder for one party to renege on earlier commitments that have been recorded in writing.
In addition, an agreed heads of terms can be used by the parties to seek guidance on potential competition issues and tax implications, and form the basis of instructions for advisers.
What are the drawbacks of heads of terms?
If heads of terms are not binding, theoretically the parties could refuse to adhere to what was agreed, meaning the time and money spent preparing the document may ultimately be wasted. Conversely, in some jurisdictions, the default position is that heads of terms are binding unless the document explicitly states otherwise, meaning parties could inadvertently find themselves subject to unanticipated legal obligations.
In addition, from a buyer’s perspective – given that heads of terms can limit room for manoeuvre during subsequent negotiations – agreeing high level deal terms before carrying out substantive due diligence can be risky. After all, the buyer won’t yet fully understand the risks and issues that could impact the obligations it is willing to take on and the protections it will want in place. However, the buyer can typically minimise this particular risk by ensuring that everything is stated to be subject to “the completion of a full due diligence exercise”. Note that in certain circumstances, heads of terms can also have unwanted implications relating to tax, competition law, and public announcements.
Key considerations when drafting heads of terms
When drafting heads of terms, best practice suggests that the document should: