Heads of Agreement Explained: Tackling a Letter of Intent

A heads of agreement (HOA) (also known as a letter of intent or heads of terms) is a document that you and your counterparty might use when setting out the main commercial terms of a transaction. It means that both parties know what you’ve agreed to before you start negotiating the details of the main agreement and perhaps before significant due diligence has been conducted. Essentially, you’re making sure you’re on the same page from the beginning.

In this article, we cover the essentials of a Heads of Agreement, from the pros, and cons, to when to make it legally binding.

We cover,

• What is a letter of intent?
• Pros of a Letter of Intent
• Cons of a Letter of Intent
• Heads of Agreement FAQs
• Negotiating a Letter of Intent
• Is a letter of intent legally binding?
• Tax implications for Heads of Terms
• Note: Product recalls
• Legal support for a Heads of Agreement

What is a letter of intent

You may also know HOAs as letters of intent, term sheets, or memoranda of understanding. Either you or your counterparty can prepare the letter of intent and there is no standard form. They can range from super detailed to just the bare bones. Outside counsel will usually have some draft heads of agreement templates that could be used. 

A letter of intent can be used in many different types of transactions, for example, mergers and acquisitions, joint ventures, project financing, and private equity transactions. It’s up to you. 

Pros of a Letter of Intent

There are lots of advantages to using a Heads of Agreement, for example:

Getting on the same page

You, your counterparty, your advisers and any other third parties who want to know what you’re doing, like shareholders and lenders, will understand the framework and key terms of the transaction, and more importantly, if there are any major commercial issues from the beginning.

Clarifies negotiations

Because you are only considering the key terms when negotiating the term sheets, neither party will get distracted by minor points, so you’ll be more efficient and focused.

Secures commitment

If you agree to be legally bound, both parties will be committed to the transaction and the terms you’ve set out in the Heads of Agreement before you’ve even started negotiating the main agreement. See discussion below.

Regulation

You may be able to provide a Heads Of Aagreement for any clearance, consent or approvals you’re seeking from regulatory bodies, including the UK Takeover Code, Australian Competition and Consumer Commission (ACCC), the Foreign Investment Review Board (FIRB), the Australian Securities Exchange (ASX), or the Australian Tax Office.

For the seller: Tactics

Usually the HOA is agreed before the detailed due diligence is complete so you may be able to agree some terms with the buyer that they would not have agreed to following completion of the due diligence. Buyer beware.

However, there are some reasons not to use a Letter of Intent.

Cons of a Letter of Intent

Time and money

Obviously, it means more expense from the outset because you’ll be incurring time and costs to produce a term sheet and then more time and costs to produce the main agreement. You may not have enough time (or money) to do both.

Not always necessary

If you will only be entering into a simple transaction agreement, then there is probably not much point in agreeing to a slightly more basic Heads Of Agreement beforehand.

Limitations and less flexibility

If you enter into a legally binding term sheet, you will have less flexibility to change your mind once you get around to negotiating the main agreement.

Regulation

There is a risk that a term sheet can breach competition law so you may need ACCC clearances before you agree to the HOA.

For the buyer: Risks

Where a Letter of Intent can be a pro for a seller, it can be a con for the buyer. You may be putting yourself at risk by agreeing to key terms before you know exactly what you’re buying.

Heads of Agreement FAQs

You should include the key transaction terms in the term sheet. While these will differ depending on the type of transaction, there are a few generic questions you may want to answer in the HOA.

• What is the transaction? Articulate what the transaction is.

• What amount is being paid and in what form? The price may change after due diligence and closer to completion. However, generally parties include a price, perhaps a method of price adjustment, and how the price will be paid – do you want cash, shares, or debentures? – in the Heads Of Agreement.

• Are there any conditions? There are frequently some hurdles you and your counterparty will need to overcome before you can complete the transaction. These could include shareholder approval or regulatory approvals / clearance from ACCC, ASX or FIRB. Work out what they are and then put them in the term sheet.

• What’s the timeline? You may have an idea of when you want to enter into the main agreement and then complete the transaction, but make sure your counterparty is thinking the same. Putting it in the HOA will give you some comfort and keep you both on track.

• What are we promising each other? Warranties and indemnities are often given by parties to a transaction. You could either outline the key ones or note the level of protection that will be given, for example, providing ‘full’ or ‘light touch’ warranties and indemnities.

• How do we want to approach future negotiations? It is common to include an express term that the parties agree to negotiate the main agreement ‘in good faith’. However, unless you are quite specific in this term, it can be too vague to be legally enforceable. Such specifics could include referring to the timetable for negotiations, stating expressly who is negotiating, and noting that the parties may still act in their own commercial interests.

Negotiating a Letter of Intent

The top three things to keep in mind when you’re negotiating a Heads Of Agreement:

1. Be commercial –  Focus on the key terms from a commercial and business perspective, not a legal perspective. You’ll get to all the legal detail and standard clauses in the main agreement. 
2. Be careful – Don’t rely on being able to change your mind later. Think about the terms to which you’re agreeing. 
3. Be clear – Have you made any assumptions? Are there any procedural matters that need to be completed? Are the terms exhaustive? If that is the case, record this in the HOA. Use clear language and don’t be afraid to use examples if they might help. 

Is a letter of intent legally binding?

Before it is signed, you need to decide whether you want you and your counterparty to be legally bound by the terms of the HOA or you only want the HOA to be a step to further discussions (an ‘agreement to agree’).

Why make a Heads of Agreement legally binding?

If you are certain you are and will be happy with the key terms in the HOA (which can be conditional), propose that is binding. This will ensure commitment from the other party to those terms, including the timetable, and provide you with certainty. It will also generate a bit of commercial goodwill.

When should you not make a Heads of Agreement legally binding?

If you want some flexibility, perhaps to change the terms or walk away from the transaction altogether, only agree to a non-binding HOA. This will also mean you’ll have less regulatory hurdles at this initial stage. You can still include some terms that are legally binding, which could concern exclusivity, confidentiality or the costs both parties have incurred in negotiations.

Once you and your counterparty have made a decision, your intention to be legally bound (or not be legally bound) must be expressly and clearly stated in the HOA, either for the whole agreement or just in respect of specific terms. 

If there is no clear statement of intention in the HOA and a court needs to decide whether you and your counterparty intended to be legally bound, they may look more broadly at the HOA and the surrounding circumstances. This results in uncertainty for both parties and is something you want to avoid. 

However, you can help support your intention by: 

• If you want a binding HOA – When drafting, fill in the gaps. Make it as complete and certain as possible. It is also advisable to include a dispute resolution / arbitration clause so you know what to do if there is any future dispute. 

• If you want a non-binding HOA – Be non-committal in your words and actions. Show in the HOA and in your conduct that you don’t believe that you are bound. Avoid performing your obligations in the terms of the HOA until you are bound under the main agreement. 

A final note: The main transaction agreement should contain an ‘entire agreement’ clause, so that it supersedes the HOA and it becomes the only binding document once executed. 

Tax implications for Heads of Terms

Remember, there are always potential tax implications. Think about those of the proposed transaction in advance so you can address them in the HOA and avoid expensive amendments to the agreed HOA down the track. This is something to consider outsourcing as it can be quite complicated. 

It is also a good idea to expressly state the commercial reasons for the transaction in the term sheet so both you, and the tax authorities in the future, know why you entered into the transaction (and that it wasn’t solely for tax avoidance purposes).

Seeking legal advice about tax and the drafting of a Heads of Agreement will ensure that the above has all been properly considered.

Note: Product recalls

It is important that you have a product recall plan in place for your tech startup that complies with the relevant laws. Recalls can be damaging to your brand and profits and having a plan in case you are faced with this, will minimise the effects on your business.

Legaly support for a Heads of Agreement

In need of corporate law support? Biztech Lawyers is a multi-award-winning law firm, known for fuelling and protecting tech innovation worldwide. Get in touch now to see how we can help.