Heads of Terms, Letters of Intent: they refer to the same thing.
They can abbreviated to “HOTs” and “LOIs”.
In business, they also go by the names of "term sheets", "memorandum of understanding", "letters of understanding", "heads of agreement", "letters of interest" and "term sheets". In the construction industry, heads of terms are often wrapped up and packaged as letters of intent or “LOIs” for short.
They’re usually exchanged by the 2 businesses in draft form before they’re finalised – to reach what businesses call “commercial agreement” - to distinguish from the sort of agreement which is legally binding.
Once you have commercial agreement on the Heads of Terms, businesses prepare the formal contract documentation, which will be legally binding when it's signed.
What are Heads of Terms?
They’re a document:
- to reduce a preliminary agreement to writing
- without being legally binding
- before the formal legal documentation is prepared.
- which supports the pre-contract negotiation process.
Formal, legally binding agreements are intended to follow agreement to the heads of terms.
That’s when the legally binding relationship is usually intended to start.
It’s when the intending contracting parties change their relationship intentionally or unintentionally that heads of terms and letters of intent become binding.
And it’s the same with letters of intent.
Letters of Intent
They’re the same thing as heads of terms, presented in a different format: as a letter.
They’re the same thing from a legal perspective. That's because the law prefers the substance of things over form or presentation.
The form of the document and what it's titled is far less important that what it does from a legal perspective.
So like a document entitled "Heads of Terms" which isn't a contract (or hasn't become a contract since it was signed), a letter of intent isn't - usually - intended to be legally binding.
More on that below.
When are they used?
LOIs/Heads of Terms can be used:
- in the run up to set up the framework for a joint venture
- to progress negotiations for settlement agreements in employer / employee disputes
- set up the commercial agreement which will lead to settlement of contractual disputes
- to preface exclusivity arrangements for intellectual property rights
- flesh out the structure of a merger, acquisition of shares and sales of businesses
- to lay the groundwork for what will be expected in the contractual terms for supply of materials for construction work
Really, they can used as a lead-in to any business agreement.
If they’re used, and negotiations break down and the parties are no worse off, because you don’t have a legally binding contract.
That's theory. But often businesses go further and use them for purposes beyond that. Which can create problems.
How are Heads of Terms and Letters of Intent used?
They’re a means to agree in a written form a non-legally binding agreement.
Here’s a process on how heads of terms might be used in your business:
- negotiate with your counterpart - in calls, by email and meetings
- prepare draft heads of terms to send to your counterpart, once you’ve the basics are in place
- send the draft to your counterpart to ask if it a fair reflection of the discussions
- If they’re not, invite them amend them and send them back
- If negotiations continue the heads of terms can be updated and changed to reflect the commercial agreement.
In this way, the document will reduce the main terms of an intended contract to written form. The exchange between the negotiating parties is a way to reach the “commercial agreement" referred to above.
It’s meant to be a short, succinct, structured summary of the fundamental terms of the contract. Most of the time, they’re not meant to include every last detail, like this. But that depends on a number of factors.
What are the benefits of Heads of Terms?
Negotiations and discussions can get quite complicated. Negotiating the final terms of a contract can get even more complicated.
When they do, the situation ripens for misunderstandings. If misunderstandings mature at the time the contractual documentation is exchanged, it can waste your time, and obviously money.
That’s that Heads of Terms and LOIs serve a real purpose: they minimise the chances that misunderstandings mature at a late stage.
You’re trying to reduce complexity at an early stage to reach a commercial agreement. The final terms of contract follow in turn.
When you use Heads of Terms or an LOI, they can:
- make you focus on the really important parts of the deal being negotiated
- show up gaps in other matters that should be discussed.
The sort that get in the way when the formal contracts are prepared – for example, limitations of liability or indemnities
- make it harder to renege on something which has already been agreed in Heads of Terms.
- serve as an agreed guide for what is needed in the formal documentation if you're going to ask a lawyer to prepare the documentation
- help others that come into the negotiations late. They have document to read to know the status of the negotiations and the points of difference
- speed up the contractual drafting. They save time and money
You can also run it by your lawyer to make sure you haven’t dealt with something that you should, during the negotiations. Saves you from going back to your counterpart at a later date after commercial agreement has been reached.
Finally, commercial agreements may not be straightforward from a legal perspective as they sound from a commercial perspective.
Heads of terms draw that out. And you can address that at an early stage.
If you're trying to fit your commercial agreement into a legal framework, the deal might be re-structured from a legal perspective to make the formal documentation more straightforward to prepare.
Checklist of Tips: Heads of Terms
- In most industries and sectors, LOIs and Heads of Terms should be not be complicated. They’re meant to move the transaction along. Not bog parties down into excessive detail. In the construction industry, heads of terms can get extensive with high value work.
- Think twice if you want them to be drafted formally: is it really necessary? Is the transaction of sufficient size or importance to justify it? Is your counterpart expecting it?
- They should serve your purpose, whether that’s to:
- speed up negotiations
- clarify complexity to reach a common understanding
- fully reflect the contractual relationship.
- Make sure the Heads of Terms do want you think they will do for your business venture.
Clauses 3 to 5 of the precedent here seems to be the sort of obligations that in the ordinary course, you’d want to be legally binding. They wouldn't have any legal effect, because they're expressly stated not to be legally binding.
We’ve included some templates to download below.
So are Heads of Terms legally binding?
Heads of Terms (and LOIs) can provide that:
- none of the terms of legally binding
- some terms are legally binding, but others aren’t.
There’s nothing wrong with having legally binding Heads of Terms, provided the terms that you don’t want to be tied to are stated not to be legally binding. Clearly and unambiguously.
Because of the way the law works, after parties have signed the non-binding or even legally binding type, they can by their words and actions make the non-legally binding parts .... legally binding.
Non-Legally Binding Heads of Terms
When all of the elements to form a contract are present, a contract is formed.
There are limited things which prevent a document agreed by two or more parties with a business relationship which would be a contract, becoming a legally binding contract.
Usually, Heads of Terms prevent a contract being formed, by using:
- the words “Subject to Contract”
- the words “Agreement in Principle”
- a contractual precondition.
If and while the precondition hasn’t been satisfied, the condition prevents the contract from being formed.
What does “Subject to Contact” mean?
To form a legally binding contract, the parties must have an intention to create a legally binding agreement.
“Subject to contract” communicates that the parties don’t have the required intention to be legally bound.
Assuming that there is no trading relationship between the parties or anything else that would impute a legally binding relationship - those words "Subject to Contract" remove the intention to create legal relationship.
What’s the meaning of “Agreement in Principle”?
The words “agreement in principle” communicates that:
- one party believes that it’s only an agreement which has been reached on a broad level
- there is more detail to be agreed before a legally binding contract arises
- the agreement – comprised by an offer and an acceptance – has not been reached, and therefore
- you don't have a final binding contract.
But it could become binding at a later date.
When do non-binding Heads of Terms become legally binding?
Whether or not a contract has been formed depends on the facts of particular case. It's highly fact sensitive: a small change in the facts can change the outcome.
Commercial negotiations are free flowing exchanges. Proposals and counter-proposals are passed with counterparts.
They can be recorded in Heads of Terms (or not).
But let's say they are, and the Heads of Terms aren't intended to be legally binding.
Is there “no contract”?
Businesses frequently think that “there is no contract”, because:
- nothing (or little) has been written down and/or
- nothing has been signed.
But the law operates differently. When work has been carried out by one business for another, the situation changes.
The commercial character of the relationship changes. Work has been carried out by one side. Odds on, it's a contract of supply.
And if money (or some other consideration) has been paid, the odds lower.
- when businesses are involved, it's a commercial relationship.
- there's a presumption that they intend to create legal relationships (ie contracts) when they do business with one another.
The Supreme Court says that these commercial relationships (as opposed to just negotiating):
will often make it unrealistic to argue that there was no intention to enter into legal relations...
Businesses are seen to have intended to enter into a legally binding relationship. Whether they thought they were or not.
There will almost certainly be a legally binding contracts created on some terms or another.
When it comes to forming contracts, law works on an objective standard: personal intentions aren't a significant factor in the equation when deciding whether a legal relationship has been formed.
In this way, the law of contract deems a contract has been formed when all of the elements of a legally binding contract are satisfied - and the parties' behaviour bear all the hallmarks of a contractual relationship.
When Heads of Terms become binding
So, if Heads of Terms or an LOI has been signed, and the parties to the Heads of Terms have stared working together, the binding contract might be:
- the heads of terms
- the Heads of Terms + some other terms.
When parties start working with one another after the heads of terms have been agreed, but before the formal terms of contract have been signed off, there could well be other events (in the real world, rather than just on paper) which form part of the legal relationship: that you weren’t intending.
- some of the terms of the Heads of the Heads of Terms, and some other terms
- nothing like what was recorded in the Heads of Terms or in the process of being agreed in the Heads of Terms.
It depends on what has happened in terms of the conduct of the parties, and the communications passing between the parties.
That’s not to say that businesses can’t use heads of terms intentionally to negotiate and enter legally binding arrangements. It a matter of knowing when they do, and what the legal consequences are.
Here are examples of the some of the different forms of heads of terms and letters of intent.
- Template: Non-binding (and informal) Heads of Terms
- Template: Heads of Terms: Contract Form. Once signed, this will be a contract. Parts are not legally binding. You can see how it's split into the binding and non-binding parts
- Letter of Intent: Template LOI: A sample of Letter of Intent for a business venture or proposal.
These are heads of terms restructured as a Letter of Intent. Includes some suggestions for what might want to cover, for a joint venture, intellectual property licence (software or data), a share purchase or settlement agreement
It’s not a false economy to run your situation by a qualified and experienced solicitor to help you avoid pitfalls and traps in negotiating a contract at an early stage.
Will it work out the way that you hope it will?
If you have concerns that your Heads of Terms or Letter of Intent won't work as you want it to, our specialist contract lawyers give legal advice that helps you minimise your exposure to legal risk. And avoid disappointment. Or recover from an undesirable position.
We can also help you prepare your contracts to help you do what you need to do to finalise your deal.
Avoid pitfalls and traps with where you’re headed, and sidestep problems and difficult conversations altogether. You can avoid having to revisit negotiations at a later stage because something has been missed at an early stage.