Understanding Heads of Terms in an M&A | Hilton Smythe

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Understanding Heads of Terms in an Merger and Acquisitions

Heads of Terms documents are essential for defining the scope of a business transaction and ensuring everyone is on the same page. This guide explains how HoTs work and why you should have one.

Are you considering buying or selling a business?

Businesses in the UK are actively examining making strategic transactions in the next twelve months. According to an Ernst & Young survey, 68% of CEOs surveyed were planning an M&A transaction during this period.

If you are already pursuing a strategic acquisition or merger, drafting Heads of Terms (HoT) is one of the most crucial steps. These documents are essential for defining the scope of a business transaction and ensuring everyone is on the same page.

This guide explains how HoTs work and why you should have one.

The UK M&A market remains stagnant, but global M&A deals have seen a cautious rebound at the end of 2023. If your business is part of the revival in the M&A market, you already know that these deals are complicated and expensive.

HoT agreements are no silver bullet but are vital for avoiding potential pitfalls. These documents are designed to set the scope of the transaction using broad terms. Typically, they are very short and will include:

·  Summaries of the main terms of the deal.

·  The transaction’s timeline.

·  Necessary conditions which must be satisfied before the transaction can proceed.

Ultimately, these are not purchasing agreements, and they will not dive into the nuts and bolts of the deal. Instead, they serve as a foundation that defines how processes like due diligence will proceed.

The simplest way to view HoT agreements in the UK is to view them as an Agreement in Principle (AIP) when purchasing a house with a mortgage. The AIP isn’t legally binding, but it does outline the lender’s intention to approve your mortgage, assuming there are no unforeseen problems.

HoTs act similarly. They function as an agreement to complete the transaction later. Solicitors would say that while they have no legal power, they provide moral weight to complete the transaction.Of course, M&A transactions can still fall through after this stage. Roughly 70% of M&A deals will fail for one reason or another. Naturally, few would sign a legally binding agreement before the due diligence stage, so they don’t carry that legal weight.

Despite HoT agreements not having any legal power, certain provisions within the agreement could result in legal obligations.

It’s standard practice to include some of these provisions to protect themselves. For example, if a business claims to want to purchase a rival company and then performs due diligence only to back out, this impacts the seller adversely. Not participating in good faith could mean the company has divulged its internal workings and secrets for nothing.

This is why certain legally binding provisions will exist in your agreement, but what are the most common provisions?

Lock-Outs – Sellers may include this provision to establish exclusivity. An exclusivity clause prevents both buyers and sellers from negotiating with third parties. It facilitates communication and trust and ensures that deals cannot be stolen from either side.

Confidentiality – Due diligence provides highly sensitive information to potential buyers. The risks are obvious, which is why confidentiality agreements are common practice.

Break Fees – Sometimes, HoT agreements may include break fees. This provision commits one party to pay a specific sum if they terminate the agreement outside of select pre-agreed reasons. Break fees of 3% are the most common.

Anyone entering M&A negotiations in good faith shouldn’t see these additional terms signalling a lack of trust. Instead, they are there to protect the interests of both sides should something go wrong.

HoT documents are there to outline the intentions of both parties when embarking upon their respective M&A journeys.

For example, a HoT agreement may outline that the seller will sell all their shares to the buyer. In exchange, they might receive £20 for every share. But it’s also possible to be more specific about your intentions.

Extra information could include:

·  When will the buyer pay for said shares?

·  In which circumstances may the stated share price change due to due diligence findings?

Buyers can also include provisions that protect themselves. These are usually outlined as conditions whereby compensation may change or circumstances that may curtail the deal.

Here’s an example of some provisions you may choose to include in your own HoT:

·  Assuming that the company has no outstanding litigation against it.

·  Certain conditions must be met before the agreement can proceed.

·  Detailed timelines, such as when the due diligence process will begin.

·  Listed financial and legal advisors from each side.

Naturally, every deal is unique. Depending on your circumstances, the nature of the deal, or the industry, HoT agreements can be moulded accordingly. Above all, it’s vital to consult a solicitor to create an agreement that both sides are satisfied with.

Why should you take the time to draft these types of agreements?

HoTs can technically form part of any commercial transaction, not only mergers and acquisitions. However, they are usually only deployed for high-value, complex and important transactions.

The primary advantage is to focus the minds of both sides. That’s why the term “meeting of the minds” is often associated with this document type. Successfully bringing everybody together via written documentation before due diligence includes:

Form a Clear Picture – Preliminary negotiations and exploratory processes can quickly get bogged down in a mass of emails and phone calls. HoT agreements summarise everything so that nothing is forgotten. This clear picture is why HoTs carry so-called “moral weight.”

Speed Up Your Deal – HoTs are a convenient way to accelerate the M&A process because they offer both parties a quick and easy reference. You may also use it as a pre-legal checklist before and after due diligence.

Set Down Legal Provisions – The HoT has no legal weight, but some of its provisions may create legal obligations. Establishing these offers security for both parties before they embark upon the complex and resource-intensive due diligence process.

Decrease Renegotiation Risk – Drafting HoTs reduces the risk of radical renegotiation further down the line. Since they include a rough idea of price and deal structure, a written HoT reduces the chances of either side attempting to flip the table later.

In short, while there’s no requirement to have HoT agreements, it simply makes sense to protect your deal’s integrity and streamline the process.

At Hilton Smythe, our M&A experts have extensive experience in drafting and reviewing HoTs on behalf of our clients. If you need a professional to support you in this crucial step, speak to the team today.

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