Heads of Terms

March 4, 2009

In Dragons' Den, it seems to viewers that the deal is done (or not) on the basis of a cursory Q&A by investors. In fact, all that will have been agreed by the end of the show (if anything) are the heads of terms for investment. And these will inevitably be subject to contract and satisfactory due diligence.

Do I need heads of terms?

Heads of terms are used to record what has been agreed in principle between parties prior to reaching the stage of entering into formal, contractual documentation. They are often used for significant business transactions, for example, the sale of a company or business or the raising of finance. Investors or buyers of tech businesses know the importance of first mover advantage, but they need sufficient time to investigate and understand the business model. And investee companies need to understand and agree the level of control that an investor will require.

Heads of terms aim to create a clear and unambiguous starting point for drafting the transaction documents. They can also be a useful tool for identifying problem areas in the principles of the deal before the parties begin to incur significant costs, legal or otherwise. Sometimes they are also structured to apportion the costs of a failed due diligence exercise.

Non-binding (mostly)

When agreeing heads of terms, remember that they are normally largely non-binding. This is because investor or buyer will need to understand and assess all of the assets and liabilities of the target business, which may be particularly involved with tech companies. Agreeing heads of terms gives both sides breathing room while due diligence is undertaken and detailed warranty protection negotiated.

Because both sides will incur costs during such period, the parties may want certain provisions to have legal effect.  For example, parties may wish to insert an exclusivity clause which prevents either party from entering into negotiations with a third party in relation to the same deal. There may be an agreed “break fee” if either side pulls out without good reason. Where any provision is indicated to be binding, it must be capable of being enforced under English law, and you are strongly advised to seek legal advice.

Key provisions

Heads of terms will normally include the following provisions:

• Transaction – is this a share sale, asset sale or investment? If it is a share sale, is the entire shareholding being sold? If it is an asset sale, which assets are included in the sale? If an investment, how much equity is being taken? Will minority protection rights be required, such as board membership or veto rights over certain matters?
• Price – is there is a deferred element to the consideration or investment, or must certain milestones be reached to trigger payment? Is payment to be made in cash or cash and shares? Royalties and other commercial pricing terms should also be included.
• Conditions – are there are any conditions which must be satisfied pre or post sale or investment? An example would be where the consent of a third party must be obtained.
• Timetable – enough time should be given for each stage of the process. For example, if there is a complicated group structure, one week may not be long enough for a potential buyer or investor to carry out its due diligence.
• Costs undertaking – if negotiations break down, will each party bear their own costs or how else will costs be shared?

Above all, the heads of terms should simply focus on the key commercial points of the deal and the finer detail should be reserved for negotiation between the parties as the transaction progresses. In our experience, heads of terms are very useful in ensuring that the principles of the deal inform the detailed negotiations and not the other way around. This can help speed up the legal drafting process (cutting costs down the line) and more importantly avoid misunderstandings about the parameters of the deal.

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