Heads of Agreement: Binding Terms, Due Diligence and Deal Risk

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You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

Heads of agreement are often treated as an informal stepping stone towards a deal.

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In practice, they can shape negotiations, create binding obligations, and materially affect positions long before the final contract is signed.

This episode examines what a heads of agreement is, when they're appropriate, whether they're legally binding, and the strategic and legal risks businesses should understand before signing one.

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Today, I'm joined by Lauren Gross, who's the Senior Associate within our Commercial Law team, to discuss heads of agreement.

Welcome to the show, Lauren.

Thanks for having me.

Lauren, I'll start with an easy one.

What are we talking about? What is a heads of agreement?

So it's essentially a summary of the key terms before you go into the fulsome agreement.

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The heads of agreement, well, it can be several different things.

It can be called a heads of agreement, a term sheet, memorandum of understanding, so an MOU, or a non-binding indicative offer.

So NBIO, lots of different names, lots of different acronyms or shortening of the names, but they're essentially the same.

1:13
It's an agreement to agree, right?

An agreement to agree, and that's how it should be expressed in the document to make clear that, you know, this is the preliminary agreement, but it's subject to that fulsome contract being entered into.

And normally that fulsome contract, you know, a share sale agreement or a business sale agreement, might be 50 pages, 100 pages long.

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Whereas the first one, the heads of agreement should be, you know, a few pages or 10 pages or something like that.

So a lot shorter, and it has the key kind of points in it.

So the key deal mechanics.

So what would you expect to be, I guess, in a heads of agreement, just very broadly?

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So it should be those kind of key terms or things that are really, really critical.

And that's kind of where the value comes in of having that preliminary agreement, because if you can't agree on those critical things, then the deal isn't going to go ahead.

So it's basically like, well, if you can't agree at this point, there's no point going any further.

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And it's things like the purchase price, you know, that's a key one, right?

How much are you willing to pay? Is that acceptable to the vendor, or is that what they're willing to sell for?

If you can't get agreement on that, you're obviously not going anywhere.

It's things like any kind of conditions precedent.

So things that, okay, we agree to go ahead with the purchase or the sale, but only if these things happen.

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If they don't, we don't want to be bound.

So there's really common ones like landlord consent is a big one.

Finance is another one, due diligence.

But then there can be things that are specific to that deal.

And it might be things like if there's some kind of regulatory overlay for that business, getting approval first.

2:55
Maybe there's a key employee who's really, really critical to the business.

And if we're purchasing, we say, well, if that person doesn't agree to stick around, we don't want to go ahead.

So maybe it's subject to that person signing an employment agreement, or maybe it's a key kind of client who makes up a huge chunk of the revenue of the business.

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And as the purchaser, we might say, okay, we want to purchase, but only if that key client signs up, you know, maybe for a longer-term contract or exclusivity or something like that.

So conditions precedent is another kind of key one to put in there.

But essentially, no two deals are the same and it's sitting down with the client and saying, okay, what's critically important for you to get this deal across the line?

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Because it can even be really personal things, like it might be the vendor not wanting to be bound by restraints of trade because they want to start a new business after that that's in a similar kind of industry, all the same.

Or maybe they have existing businesses and that should be carved out from the restraint.

3:56
So those really critical things should be in that heads of agreement.

I wanted to talk about, I guess, from a legal perspective, we've talked about sort of the practical benefit of setting out what the deal is.

But from a legal perspective, what are the benefits?

4:14
What is the importance of having heads of agreement? Which parts of the documents are typically binding?

Yeah, what’s the benefit from a legal, a strictly legal perspective?

So from a legal perspective, I mean, if you don't clearly express what's in the agreement, they can actually make things worse.

4:31
So you mentioned if it's binding or not.

Usually in M&A it will be non-binding, but there will be binding confidentiality and potentially exclusivity provisions in there.

And then the key terms themselves will be non-binding.

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Usually it's done that way because the purchaser and the vendor will agree to this and then the purchaser will go and do their due diligence into the business.

And if they do those investigations and they decide, okay, I don't like what I've found and they don't want to go ahead, they don't have to if the agreement's not binding.

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But there have been lots of cases where people have kind of got it wrong or fallen into traps and the deal has fallen over, and one person has said, that's fine, it was non-binding.

And the other person has said, wait, hang on, actually it was binding, and then there's been a fight for it.

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So it's really important to avoid that fight before it's happened by clearly drafting the agreement in the way that the parties intend.

So it's really sitting down with the client at the beginning and saying, are you prepared to commit to this transaction on these terms, or is it subject to you doing these other things first?

5:40
There was a case in the Victorian Court of Appeal, it's Delaney and Delaney.

So it was two brothers and they had a construction company, so worth a lot of money.

One brother agreed to leave and he would sell his interest in the group to the remaining brother and it was $10 million.

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They agreed on that key term, the purchase price, in the heads of agreement that they signed.

The heads of agreement said that there were other kind of non-essential terms that were yet to be agreed, including things like tax implications, how they would be dealt with.

But the critical thing was that the heads of agreement expressly said that it would prevail if a fulsome agreement hadn't been entered into by a certain date.

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So that's the problem.

Because that date came and went, a fulsome agreement wasn't entered into.

One party purported to terminate that heads of agreement and said, look, negotiations have failed. We haven't agreed on these things. I'm walking away and it doesn't matter because it's non-binding.

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The other party said no, it is binding and you need to sell me your interest, and went to the court.

The court agreed that it was a binding document, and the clear kind of critical bit was the wording in the agreement.

And that term was really what undid the whole thing, that it would prevail if that formal agreement hadn't been entered into.

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So you've got to be really careful in the way that you word it.

And then even if a heads of agreement is legally binding, it also has to be enforceable as a contract.

So that's another kind of pitfall that people can fall into.

And a contract isn't binding if it's not complete enough to be enforceable.

7:20
And that was another argument that was raised.

Well, because these other terms hadn't been agreed yet, it wasn't a complete contract.

But the court said no, the key kind of things that you need for a contract to be binding had been agreed.

These other things are outstanding, sure, but they're non-essential.

So it was binding.

7:36
That's really interesting.

It's a learning lesson on, you know, being very clear in the contract.

As you said, if there's those provisions around, well, if we can't agree, then this is going to prevail.

Then that's sort of, yeah, I think that's pretty clear language that they're going to go ahead.

7:54
I think one thing that's probably interesting from that is that in this Delaney case, it's two parties who are already in a business.

And I suspect, I don't know, but I suspect that each party could be presumed to sort of have full knowledge of what's going on within the entity.

8:13
Whereas in your, you know, non-related party transactions, the person coming in, the buyer, doesn't have full visibility.

They maybe haven't done due diligence yet.

The question I wanted to ask was around that due diligence.

8:32
Do you see that as sort of a, how much due diligence do you see being done before heads of agreements versus afterwards?

And does that affect, I guess, the drafting of those agreements as well?

Yeah, I think it really varies deal by deal and it depends on the side of the party.

8:50
So sometimes you'll find a vendor who is really protective over their business information.

And obviously it's commercially sensitive information, so that's understandable.

But sometimes they won't provide anything to the purchaser until they have something in writing.

And that's also when heads of agreement can be valuable because it sends a message to the vendor that the purchaser is a legitimate person, you know, and they're not just sniffing around for no reason.

9:13
They've kind of got some skin in the game because they've incurred legal costs of having that document prepared.

And sometimes that can really help get across the line.

And then the vendor is more willing to be really kind of transparent and provide all of their DD information because they have some comfort with that document.

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It provides a bit of kind of transaction certainty, whereas some vendors are like, yeah, no problem, you know, I'll hand over some information before that's been agreed.

So it really depends.

But I think if the purchaser hasn't done any DD or it's been really limited, then you have to be careful with what you're agreeing in the heads of agreement.

9:48
It's really hard to quantify risk at that time, right?

Yeah.

Exactly, because you're kind of going in blind.

You have no idea what's kind of lurking behind the exterior of that business because you haven't seen anything.

And if you're agreeing to a purchase price without that information, you need to be really careful in how that's been drafted because even if it's non-binding legally, there's a practical kind of consideration of it anchors negotiations.

10:16
So if you put $10 million in the heads of agreement, the other party is thinking that they're getting $10 million.

If you then do your DD and you think, oh, I only want to pay $7 million, that's pretty hard to move all the way down.

So you have to be careful practically of how it's being expressed.

10:33
And maybe sometimes as well, you don't have to have that figure in the heads of agreement.

It can be, you know, we're looking at a formula like this, but it's dependent on what the DD investigations are, and the accountant can really help with that as well.

Because profit multiple or something?

10:48
Yeah, something else like that.

Something like that.

And that way the other party can't use it against you because they will, if you try and move away, they'll say, well, we went through these negotiations and we agreed on all of these things and you didn't mention that at the time.

So practically it can be difficult, even if legally you can do it.

11:06
Yeah.

I wanted to ask about deal fatigue, where, you know, contract negotiations of the contract being drafted is back and forward, back and forward.

How often and how pivotal is the heads of agreement when we're getting to the later stages of, you know, the lawyers going back and forward?

11:27
You know, are there lots of references back?

I get that it's deal specific, but is there a lot of reference back to the heads?

You made the point that, you know, it's hard to move from it.

What's your experience there and those sort of late deal fatigue type stages of a contractual negotiation?

11:43
Yeah, I think it can really go either way.

Sometimes the heads of agreement can make people more annoyed because, like you said, it's fatigue.

It's been going for such a long time, they're so over it by that point.

But it can also help sometimes because sometimes at the very beginning the parties might not be able to get over a hurdle.

12:01
You know, we're on different ends of the spectrum and we can't agree.

Whereas when it's been going on for weeks or months, people are kind of more willing to move, usually because they've invested so much time, money, effort that you can get over things that you couldn't at the very, very beginning.

12:19
I think the heads of agreement usually makes the process more streamlined because you have agreed on the most critical things.

And I think if it's been done properly the way it's intended to be, it does make entering that fulsome contract a lot smoother and easier because those key things aren't in dispute.

12:35
And then really the fulsome agreement, it's usually going back and forth, are the things like warranties and limitations of liability, which usually aren't addressed in full in the heads of agreement, which is how it should be because it's kind of, I think it's too difficult to do that in the short form document.

12:51
The short form document should really be the key kind of commercial terms rather than the nitty gritty legal.

Yeah, which is really part of the fulsome agreement.

Lauren, you mentioned earlier that two of the typically legally binding provisions in heads of agreement are exclusivity and confidentiality.

13:10
What should an adviser be looking for in those provisions and having that discussion around the heads of agreement?

So it really depends who we're acting for, of what terms we want in there and how robust they need to be.

So if we're acting for the vendor, we always want binding confidentiality provisions because the vendor during DD will hand over a whole heap of commercially sensitive and valuable information to the purchaser.

13:35
And it's obviously really problematic if that information can be used against them, particularly if it's a competitor that's looking at acquiring the business.

If the deal falls over, they have all of this information, right?

So we want to make sure that there's really robust terms around how they can use that information, who they can provide it to.

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What happens if the deal falls over?

Do they have to destroy it and return everything to us?

And when do they have to do it?

We want an indemnity if they fail to do those things that we can rely on.

There can be really practical kind of logistic challenges in enforcing confidentiality breaches.

14:10
So having really robust terms is really important.

I think if it's a more complex deal, ideally we would want a separate confidentiality agreement in place that has all of those robust provisions in there.

And that's if we're acting for the vendor.

If we're acting for the purchaser, we kind of don't mind as much because we're not the party that's at risk there.

14:31
So if they've got some kind of wishy washy confidentiality provisions in the heads of agreement, we're like sure, no problem.

But then on the flip side, with the exclusivity provisions, that's something that stops the vendor from going and selling their business to some other person or even having kind of conversations around selling.

14:51
Essentially locked into sort of good faith negotiations with a view to sell, right?

Yeah, to that specific purchaser, yeah, which is what we want as the purchaser.

And because, you know, usually we'll need time to go away and do our DD, and it can take quite a bit of time depending on how complicated the business is, how much information we need to sort through and whatnot.

15:11
We want to lock that person in, you know, for the two months or whatever it is, that they can't start getting ready to sell to someone else.

They're kind of committed to us in the deal and that should be legally binding so that if they breach that, we have a right of action against them.

15:27
I wanted to ask the question, you did say two months, but in terms of, I guess, what's typical, and I accept that there's going to be all sorts of variants.

What do you typically see as exclusivity periods?

Is it one month, two months, three months?

15:43
Yeah.

I think somewhere in that range is most common, like one month being the shortest, three months, four months kind of being the absolute longest, but it depends on the deal.

You know, the complexity.

Right, yeah, how much information there is.

It depends how much preliminary DD has been done before this point.

16:02
If the purchaser has gotten access to some kind of preliminary information beforehand and if that process has already been going on for a while, then if they're asking for something like four months, you would be saying, hang on, why do you need that long because you have done this already.

And we do kind of push back against that in practice a lot of the time.

16:21
I think, you know, the DD process, hopefully once the heads of agreement is signed, if it hasn't been already, would be streamlined a lot more.

We'd have a separate data room set up, access for the accountants to look at all the platforms, that kind of thing, which should make it an efficient process and then you wouldn't need as long as maybe they requested originally.

16:41
Let's say the heads of agreement is signed.

What comes next?

Who makes the next move from there?

So that should be documented in the heads of agreement as well, and that's another thing that we can put in there.

So in addition to having all the key commercial terms and then the legal bits, which is confidentiality, exclusivity, there should also be general terms including, you know, each party being responsible for their own costs is one that should be in there and counterparts provisions, all of those kind of boilerplate clauses.

17:12
And it should also say in that document, who is going to prepare the fulsome agreement.

It's customary for the vendor's side to do that, but it doesn't have to be. It can be the purchaser as well.

So that's something that should be put in there so all the parties are on the same page from the beginning.

17:28
Who's going to go away and do it?

You can also have an indicative time frame in the heads of agreement and say, look, we're aiming to sign this on this date, complete DD by this date, have the first cut of the fulsome agreement by this and then signing it, blah, blah, blah.

17:44
And that can kind of help parties be a bit more accountable and be working towards the same goal and stop kind of stuffing around sometimes, you know?

Yeah.

But it also has to be realistic.

You know, a lot of the time people will say, oh, you know, we'll do this and we'll completely.

The lawyers will do it within one day, yeah.

17:59
No problem, we don't have anything else to do.

And then DD within a week, and then we'll settle a week later.

A week later is just not going to happen.

Particularly if you have conditions precedent that need to be completed.

Like landlords are notoriously slow and their lawyers, they're not going to respond within a week and have consent provided and have the document drawn up, the, you know, assignment of lease or the consent to change in control within a week.

18:24
And everyone sign.

It's just like pigs are going to be flying before that's ever going to happen.

So it should be a realistic time frame, but that can be helpful as well.

And then in terms of who's preparing the contract, like I said, it's customary for the vendor, but there can be strategic advantages in being the one to prepare the first draft because again, it goes back to that anchoring point.

18:45
Yeah, you know, it anchors the tone of the negotiations.

And sometimes it can be really hard to move away from something that's completely one-sided in the beginning.

So if you prepare it really one-sided, maybe it can end up a bit more on your side, but then there's a balance as well.

You don't want to also, you know, be sort of.

19:03
Completely commercially unreasonable.

Yeah, yeah, yeah, yeah, yeah.

I wanted to ask.

So let's say we sign the heads of agreement.

And in a perfect world, you know, you do the DD and you sign the contract and, you know, happy days.

But what if things don't go as planned?

19:18
And particularly, you know, if it becomes clear that you're just at loggerheads and maybe you're the seller and someone else is starting to, you know, say, hey, you know, I'm interested, what do you do from there?

19:35
So firstly, make sure you're not breaching the exclusivity provisions that you have in there.

Yeah.

I think, let's say that those have exhausted, yeah.

Yeah.

And I think that goes to that point of setting realistic timeframes because if you are the vendor, you shouldn't be agreeing to an unrealistic exclusivity provision for that exact reason.

19:51
If we can't get past negotiations, if we're at a stalemate, I think as well kind of taking a step back, a heads of agreement isn't necessary for every deal, and sometimes it's not appropriate for every deal.

And sometimes it can just duplicate cost and time and effort if there isn't a whole heap of DD to be done or if the key commercial terms are not that contentious.

20:18
It can be more efficient for everyone if you go straight to a fulsome contract.

And also if you're the vendor, you can get the deal done faster rather than kind of letting the purchaser stuff around a little bit.

So sometimes we shouldn't have the heads of agreement in the first place.

And it really depends on the specifics of the deal.

20:35
If you are negotiating and things aren't moving, then exclusivity, if it's expired, yeah, then we can walk away from the deal.

Would you terminate formally, sort of terminate in those type of situations?

So ideally the heads of agreement should be drafted with clear termination provisions in there.

20:52
So sometimes it might be, you know, if the fulsome contract isn't entered into by this date, it's at an end or either party can terminate at that date.

Usually it's, you know, tied to kind of the exclusivity period or the DD expiring.

So have a look at the termination provisions as a first step and see if you can terminate properly.

21:12
I think as well, on the flip side, if everything is agreed and we're ready to go to the fulsome contract, it's important to make sure in that fulsome contract that it's clear the heads of agreement has been superseded by that fulsome contract, which you can do with an entire agreement clause.

21:29
Otherwise, you potentially have two agreements that are still in existence and often the terms of the heads will change into the fulsome one, you know.

So you have your heads, the DD which kind of changes the deal a bit, and then the fulsome agreement records the final deal and it should be clear that that heads of agreement doesn't exist anymore.

21:48
Lauren, I want to put you on the spot with my last question and make it difficult because I know there's a lot of important things here.

But if listeners could just take away one point around a heads of agreement and considering entering into one, what would you say that point is?

22:07
I'm going to be greedy and have two.

But two really short, I'll allow it.

And it's being careful around if it's legally binding or not, or if some clauses are and some aren't, being clear about the extent to which it's legally binding because people come unstuck with that all of the time.

22:23
And the other critical thing, particularly if you're buying, is making clear the purchase price.

If the purchase price is subject to DD investigations, making that clear in the heads of agreement, so you're not committing to a price that after you do your DD you actually don't want to pay.

22:39
I think they're two great summaries.

Is it legally binding and is the price going to get watered down or not?

Lauren, I wanted to thank you so much for being part of this episode and I encourage listeners to reach out to Lauren if they have any questions regarding heads of agreement, letter of intent, non-binding indicative offers or any other name you want to put on those documents.

22:58
MOU.

MOU. Thanks once again, Lauren.