Preparing Heads of Terms Agreements: Joint Ventures, Business Purchases and Software Agreements (and when legally binding)

Heads of Terms, Heads of Agreement, Letters of Intent: they all refer to and mean the same sort of thing.

They serve the same purpose.

In business, they also go by the names of "term sheets", "memorandum of understanding", "MOU", "letters of understanding", "heads of agreement", "heads of terms agreement" and "letters of interest".

They're all different expressions that means the same thing: preliminary agreements or pre-contract agreements.

In the construction industry, heads of terms are often wrapped up and packaged as letters of intent or “LOIs” for short. Different terminology with the same meaning.

Heads of Terms are precursor to a legally binding agreement. The process involves:

• Two businesses exchange heads of terms to reach what businesses sometimes call the “commercial agreement”.
  It's not usually intended to be legally binding:
  • it's a document used to negotiate what the final contract will contain.
  • This "commercial agreement" distinguishes it from the sort of agreement which is legally binding.
  • It's not legally binding because the parties lack contractual intention.
• The businesses go on to prepare the formal contract document when they reach commercial agreement on the Heads of Terms.
• The final document will be the legally binding contract, when it's signed by both parties.

 

What are Heads of Terms?

Heads of Terms is a document:

1. used to reduce a preliminary, commercial agreement to writing
2. without being legally binding
3. before the formal legal document is prepared,
4. which supports pre-contractual negotiations.

Formal, legally binding contracts are intended to follow agreement to the heads of terms. 

That’s when the legally binding relationship is intended to start.

And so it is with heads of agreement, term sheets, memorandum of understanding, letters of understanding.

It’s when the intending contracting parties change their relationship intentionally or unintentionally that heads of terms and letters of intent become legally binding.  

 

What about Letters of Intent?

They’re the same thing as heads of terms and heads of agreement: a document 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.

 

Uses of Heads of Agreement

Letters of Intent and Heads of Terms can be used: 

1. in the run up to set up the framework for a joint venture
2. to progress negotiations for settlement agreements in employer / employee disputes
3. set up the commercial agreement which will lead to settlement of contractual disputes
4. to preface:
   1. sale of intellectual property rights 
   2. agreement to exclusivity arrangements for use of intellectual property rights
5. to flesh out the structure of a merger, acquisition of shares and sales of businesses
6. to lay the groundwork for what will be expected in the contractual terms for supply of materials for construction work
7. in property transactions, such as leases and commercial premises

Really, they can be used as a lead-in to any business agreement.

If they’re used, and negotiations break down, you're no worse off, because you don’t make a legally binding contract by implication - ie by mistake. 

But often businesses go further and use heads of agreement for purposes beyond their primary purpose.

Which can create problems.

They can become legally binding, even if they weren't when the commercial agreement was reached, and even if you don't intend it to happen.

 

How are Heads of Terms 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:

1. negotiate with your counterpart - in calls, email and meetings
2. prepare draft heads of terms to send to your counterpart, once you’ve the basics are in place
3. send the draft to your counterpart to ask if it's a fair reflection of the discussions.
   If they’re not, invite them to change them and send them back.
   If negotiations continue, the heads of terms can be updated and changed to reflect the commercial agreement.

Heads of Terms documents 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. 

Do you sign Heads of Terms?

If parts of the heads of terms aren't meant to be legally binding, there is no need to sign heads of terms. It's about reaching commercial - non-legally binding agreement after-all.

If however parts of the heads of terms are meant to be legally binding, then they should be signed or some other method used to form the contract, so that it is legally binding. 

 

Contents of Heads of Terms

It’s an agreement in principle.

There’s some subtlety in that last sentence. Heads of terms serve to consolidate understandings.

They’re not as informal as a conversation or as a pre-contract meeting to negotiate (talk is cheap) and they’re not as formal as a contract (they don’t impose legal commitments).

They’re somewhere in-between.

It’s a step in between to move in a semi-structured fashion to move towards a legal binding relationship.

It commits the "pre-agreement" to writing. 

They're not meant to include every last detail.

The level of detail you go into will probably be dictated by the complexity which will be necessary in the final agreement.

Different Purposes

They set out the structure the basics of the transaction to:

1. list preconditions or events that must take place before agreement is reached
2. confirm the understanding of what the final terms of contract will contain
3. set up a process and timetable to reach legally binding agreement, and/or
4. list the basics of a sale, licence, acquisition of property, or whatever the final agreement is meant to be.

It’s what’s important to you, and what’s important to your counterpart to get the deal done, and keep it moving in that direction.

It's the fundamentals of the transaction without descending into nauseating detail which will probably stall discussions and negotiations.

Fundamentals

You might include:

• Parties to the intended transaction
• What is to be done by each party
• Payments:
  • price to be paid
  • pricing structure or cost structure
  • expenses to be reimbursed
• Timetable for completion

When you use Heads of Terms, Heads of Agreement or a Letter of Intent (whichever term your industry  prefers), 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 Agreement
• 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 you time and money

There's more on what is included further below.

Negotiating Strategy

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. 

It's that Heads of Terms and letters of intent serve a real purpose: they minimise the chances that misunderstandings mature at a late stage. You probably want problems identified early so that they can be addressed. If they can't be solved early, you can move on to the next opportunity.

You’re trying to reduce complexity at an early stage to reach a commercial agreement. The final terms of contract follow, in turn.

 

Raising Touchy Subjects Early

There’s no point kicking something critically important to you down the line. 

It can be useful to include matters that are likely to cause friction later in the negotiations, to draw out the conversation in the terms, early on.

If you don't, it just delays the matters and raises the question, “Well, if it was that important to you, why didn’t you raise it earlier?”.

Raising prickly issues late in the day might cause proposal to disintegrate for reasons which might have been revealed earlier, and waste your time.

Trust

You might even test and prod for a reaction: you might get better terms than what you expected because your counterpart doesn’t have the reaction that you expect that they might. Even then you want a business partner who will react maturely.

They can also be a test of trust.

If your counterpart agrees to the non-binding Heads of Terms but then reneges on what was commercially agreed late in the day - before contracts are signed - you have something tangible to raise with them at a later date for an explanation... and why they didn't tell you about the change of position earlier.

And if your counterpart flies off the handle easily - even before a contract has been signed - what will they be like after it has been signed? 

You can reassess whether you should be contracting with them at all.

Business is hard enough, without having high maintenance contracting partners.

But the deal might be worth it. Obviously, it's your call.

 

Examples: Heads of Terms Agreements

Here's some of the sorts of matters which might be covered when you're looking to reach agreement on heads of terms for different sorts of contracts.

Partnerships and Joint Ventures:

A letter of intent for a business proposal, heads of terms for a partnership agreement, or a joint venture company might mention:

• Background to set the context
• If a joint venture company is to be formed
  • name (“NewCo” or “JVC” if not decided)
  • ownership of shares in what quantities; types of shares
  • internal control of company: appointment of directors, management structure, limitations on incurring expenditure
• Roles & responsibilities of participants: operations / admin / software development / product supplier / service provider / distribution rights 
• Resources to be contributed: money, staff, intellectual property licensed, services to be supplied
• Exclusivity of services, software, business activities
• Ownership of intellectual property: Contributions of IP assets: owners retain ownership? What sort of licence or software licence is granted?
• revenue/profit sharing provisions, payment of expenses by the JVC or the parties
• areas where the businesses will not compete with one another, ie non competition
• Exit conditions

 

Intellectual Property Licences: Software & Data

• SaaS services to be supplied, and:
  • a synopsis of service levels
  • limits and exclusions to the services. There always are: such as interference with the services, user load, disk space, bandwidth.
• Terms of licences to be granted:
  • What sort of licence is on the table? Is it exclusive, non-exclusive, sole, worldwide or smaller territory, royalty-free, revocable, perpetual
  • Does the term of licence = the term of contract? (they don't necessarily need to be the same) 
  • is an additional period required for wind down?
• When there's artificial intelligence involved, what are the performance metrics?
• If or when the licence can be terminated: under what conditions can licences be revoked?
• Source code to be contributed
• Are any deliberate consequences of termination to apply?
• Are any quality standards to apply to the data licences, or conditions to use or re-use?
• Do limitations apply to open source licences for software?
• Associated services to be provided:
  • help desk / code support
  • data fixes
  • help desk hours,
  • proposed response times and resolution times

 

Sales of Business / Business Purchases

It's pretty obvious that money is usually paid for a business. 

What's not so obvious is to specify exactly what is being purchased.

Warranties and indemnities obtained by the purchaser from the vendor should support and maximise the chances that the value of the money paid by the purchaser is transferred to the purchaser with the sale. 

Even a basic letter of intent or heads of terms for the sale of a business should include:

• whether it's a sale of shares or the assets owned by the business (they're fundamentally different types of purchases)
• fundamental assumptions of the purchaser underlying the value of the transaction.
  These find form in warranties and indemnities given by the vendor to the purchaser
• contracts between the target acquisition and customers to be novated
• assets included:
  • real property, ie land and buildings
  • tangible property such as equipment, plant and machinery included
  • intellectual property assets, which might include:
    • customer lists and customer information such as purchasing data and patterns 
    • databases 
    • software source code
    • design masters
    • websites and domain names
    • any repository of intellectual capital
• assets not included (if any)
• for a sale of shares, the liabilities of the company
• transfer of employees and named employees (or not)
• post-sale/acquisition commitments of the vendor
• restrictive covenants, aka non-competition clauses to protect the goodwill purchased, and
• price to be paid, and when.
• importantly for the purchaser, circumstances where the purchase price can be clawed back.
  For instance, what if all of the customers or a large percentage of them don't stay with the business after it's sold?

 

Settling Disputes: Settlement Agreements: 

There are a whole host of considerations for agreements to settle disputes. For a settlement agreement to manage the exit of a person who owns shares in a company might include:

• Price to be paid for shares / Structure of payments (assuming shares are to be paid for)
• Procedure up to completion
  • handover of assets and property
  • documents required to be signed as preconditions to completion
  • procedure and time commitments
• Statements of service of individuals
• Full and final settlement
• Planned date of completion
• Mutual releases from historical claims
• Restrictive Covenants to apply post-settlement

 

Checklist of Tips: Heads of Terms

• In most industries and sectors, letters of intent and heads of terms shouldn't 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? Will formality or hyper-detail just get in the way?

• They should serve your purpose, whether that’s to:
  • speed up negotiations
  • clarify or reduce 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 template here seem 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
• Keep it simple

We’ve included some templates for you to start with below.

 

Are Heads of Agreement and Heads of Terms legally binding?

Heads of Terms (and LOIs) can provide that:

1. none of the terms of legally binding
2. 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.

How's that?

 

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:

1. the words “Subject to Contract”
2. the words “Agreement in Principle”
3. a condition precedent, which is a condition which must be satisfied before the contract comes into force.
   If and while the precondition hasn’t been satisfied, the condition prevents the contract from being formed.

 

What does “Subject to Contract” 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.

 

Meaning of “Agreement in Principle”

Is an agreement in principle legally binding? 

The words “agreement in principle” communicate a meaning 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.

And here's the trap with the words.

You might see words in a letter or email that say something like, "We're all agreed in principle".

Looks like you're agreed, doesn't it?  You're not, for the reasons above.

New players read those words (or something similar to it) and think they have a ... legally binding commitment.

Well, odds on, it's not. Something further needs to be done to conclude the contract to reach a legally binding contract.

 

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:

1. nothing (or little) has been written down and/or
2. 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 has been paid, (or some other consideration has been provided) the odds lower. 

In summary:

1. when businesses are involved, it's a commercial relationship, and
2. there's a presumption that the 2 businesses 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 contract 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 (ie a contract) 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. 

 

Consequences: When Heads of Terms become binding

So, if the Heads of Terms has been signed, and the parties to the Heads of Terms have started 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 or in an email thread) which have legal consequences.
  They dictate part of the legal relationship: that you weren’t intending

• some of the terms of the heads of terms, and some other terms altogether
• nothing like what was recorded in the heads of terms or in the process of being commercially agreed

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's a matter of knowing when they do, and what the legal consequences are.

 

Specialist Contract Lawyers 

Need to structure a deal in a certain way, but can't find the words to say it?

It’s not a false economy to run your situation by a qualified and experienced solicitor to help you avoid pitfalls and traps negotiating a contract at an early stage.  

If you have concerns that your Heads of Terms won't work as you want it to, our specialist contract lawyers can help you:

• recover from an undesirable negotiating position and find the right solution for your business
• structure your transaction to make legal enforcement easy
• find the legal words to get your Heads of Agreement and contract done right the first time
• spot ominous signs that things might not work out as you expect
• minimise your exposure to legal risk, and
• avoid imminent disaster.

We've done it before for others, and can do it for you.

We can also help you prepare your contracts to help you do what you need to do to finalise your deal, so you can get on with business.

Avoid pitfalls and traps that others have fallen into in the process.

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.

Call us now on +44 20 7036 9282 to speak with one of our specialist contract lawyers for legal advice.

 

Template Downloads

Here are examples of the some of the different forms of commercial heads of terms and letters of intent in templates:

• Example Heads of Terms Template: Non-binding (and informal) Heads of Terms
• Draft Heads of Terms Template: Heads of Terms Agreement: Contract Form 
  Once signed by the parties, this heads of agreement template will be a contract.
  Parts of it would not be legally binding.
  You can see how the agreement is split into the binding and non-binding parts by the clause references
• Letter of Intent Template: LOI Template: 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.

If you begin with the end in mind, you'll be in a better position to review your contract prior to signing it once it's ready.

Legal Advice: Expert Contract Lawyers

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 later.

When you prepare heads of terms, you're able to:

• find out early on whether your proposed commercial arrangements is an optimal approach. They may not be as straightforward from a legal perspective as they sound from a commercial perspective.
  Heads of terms draw that out. And you can address it early on.
• run your draft heads of agreement by your lawyer to make sure you haven’t dealt with something that you should from a legal perspective. Each different sort of contractual relationship has its own base requirements. It's better not to miss any
• save yourself time and hassle of having to think through what you need in heads of terms by consulting a solicitor. 
  You won't waste your time, risk the relationship and the embarrassment having to go back to your counterpart at a later date after commercial agreement has been reached

You can save significant legal costs later by addressing potential problems and gaps early on. Some times, a framework agreement may be more appropriate for setting up your contracts.

For specialist legal advice on contracts, call us on +44 20 7036 9282 or email us now at contact@hallellis.co.uk.