Why heads of terms are key to a successful M&A transaction
The nineteenth century actor-philosopher Will Rogers once said that you never get a second chance to make a first impression. Heads of terms in an M&A transaction are a good example of this as they set the tone for the whole relationship between the parties.
Any individual or entity intending to engage in a corporate transaction needs to have a mutual understanding with the other party prior to bearing costs for legal due diligence, drafting, and negotiating agreements. In a private sale of shares or assets, this is normally achieved by the parties entering into a document setting out the parameters and the main terms of the transaction on which definitive agreements are to be concluded.
This document can be called the heads of terms, the term sheet, the letter of intent, the memorandum of understanding or the heads of agreement. For ease, we will use the description heads of terms (or ‘HoTs’). For the purposes of this article, we assume that an independent non-disclosure agreement has already been signed by the parties.
The parties to the HoTs will always be the purchaser on one side and on the other side either (a) the shareholders of the target company whose shares are subject of sale, or (b) the company owning the assets to be disposed under the transaction. More often than not, the first draft of the HoTs is prepared by the purchaser side.
Reasons for having heads of terms
HoTs are usually entered into to provide assurance of the seriousness of the parties prior to bearing costs and disclosing confidential information. They represent the framework of the prospective transaction, determining the core concepts that the parties would want to commit to and some protections for the parties. The purpose is to avoid material disagreements during negotiations.
Concepts commonly covered include the transaction structure, the price determination mechanism, the transaction timeline, the main conditions to complete and the nature of the transaction documents to be entered into. HoTs will usually include exclusivity for a period in favour of the purchaser, confidentiality and any certain regulatory procedures that shall be undertaken.
The legal effect of heads of terms
HoTs can either be binding in whole or in part or non-binding. The binding effect is usually determined by the matters addressed in the HoTs themselves, the parties’ intentions and whether the key elements required for the formation of a contract are fully agreed upon in the HoTs.
The most common approach is that the binding effect will be limited to things like exclusivity, confidentiality, and governing law, with all other terms being non-binding, to give the purchaser flexibility to renegotiate terms based on the due diligence findings.
The main contents of heads of terms
1. Transaction details
The HoTs should clearly specify if the transaction is an asset or a share deal.
If it is a share deal, they should specify the company name and registration number, the number of shares that constitute the share capital, the number of shares to be sold, details of the shareholders and similar information for any subsidiaries it may have.
In an asset deal, the assets being sold should be clearly identified, such as real property, machinery, contracts, copyrights, trademarks, patents, customers, and employees.
2. Price and payment details
The price structure agreed upon should be reflected in the HoTs, whether it is fixed or determinable. If determinable, this can be by a locked-box or completion accounts mechanism.
If the price is to be determined by a locked-box mechanism, the parties both agree on the final purchase price using the company’s accounts and there is no post-completion adjustment. This is often termed the ‘locked-box balance sheet’ and is based on a locked-box date. No value is permitted to leave the business between the locked-box date until completion of the transaction. The HoTs should specify the intended locked-box date.
If the price is to be determined by a completion accounts mechanism, then the parties should include in the HoTs a price and adjustment mechanism and the factors that will be adjusted based on the completion accounts to reach the final price.
The parties should set out the methodology of payment of the price, particularly if there will be any deferred amount or earn out.
3. Transaction documents
The HoTs should specify the suite of agreements that are intended to be concluded as part of the transaction.
In the case of a share sale, the main agreement will be a share purchase agreement (with its customary warranties, covenants, representations, and indemnities). It is helpful for the HoTs to set out the framework of any restrictive covenants to be imposed on the selling shareholders to avoid any material issues whilst negotiating the details.
If the share deal is not of the entire share capital of the company, then it would be wise to anticipate a new or amended shareholders’ agreement to specify the rights of the minorities, operations of the company and future exit options.
In the case of asset sale, the main agreement will be asset sale agreement and there may be other documents such as employment or consultancy contracts for those remaining with the company post deal and deed of novation for material agreements subject of transfer/sale.
Transactions usually have conditions precedents and conditions subsequent to completion. Conditions precedent are conditions that must be fulfilled post signing but pre-completion while conditions subsequent must be fulfilled post-completion.
In some industry sectors, it is necessary to obtain regulatory approvals before a transaction can proceed to completion and this should be reflected as a condition precedent to completion in the HoTs.
Likewise, where the target company has an outstanding issue of material importance that could affect the value of the target post completion, such as renewal of an expired licence or insurance policy, these should also be reflected in the HoTs.
An exclusivity clause provides a finite period for the parties to negotiate the detailed terms of the transaction and the transaction documents whilst giving the purchaser some protection that the seller is not negotiating with third parties.
Most HoTs contain an exclusivity clause, preventing the seller from speaking to and negotiating with any other interested purchasers during the exclusivity period, enabling the purchaser to invest time and money in the due diligence process and in negotiating the deal.
Exclusivity periods are open to negotiation between the parties but tend to be between 3 and 6 months from the date on which the HoTs are signed off.
One important practical tip
HoTs tend to be drafted by purchasers and negotiated by sellers. Whichever party you are, it is important to involve your financial and legal advisers early on to help you structure, negotiate and finalise them. Any upfront cost involved in doing this will be rewarded by a more streamlined deal process with fewer stumbling blocks and less confrontation.
A stitch in time saves nine, as they say.
For further information, please contact Yousra Gamgoum or call 0151 906 1000.