M&A: Understanding Heads of Terms

A serious buyer for your company is likely to present you with heads of terms (also known as a letter of intent, memoranda of understanding or term sheet) covering the basic terms on which it proposes to buy your company.  The aim of these heads of terms is to set out the basic principles of the deal upfront in order to minimise the chances of disagreement over commercial issues when drafting the main contract.

This is an important document and you should seek legal advice before signing it, particularly as some of the terms may be legally binding (see below).  This note sets out some of the key areas usually covered by the heads of terms that you will need to understand before agreeing to proceed:

1. Aggregate Value: What is the aggregate purchase price payable for the company?  Will debt, other liabilities or transaction fees be deducted?  Will the consideration be paid unconditionally or subject to performance conditions, and will it be in cash and/or shares in the purchasing company?  If the consideration is to be shares, how will they be valued?  Will any consideration shares be listed and therefore freely tradeable?

2. Adjustments to the Purchase Price /Earnouts/Conditions: Will there be an adjustment to the headline purchase price based on financial indicators, such as working capital levels and/or debt/cash levels on completion or a measurement of net assets?  Is there an earnout by which the purchase price can increase based on the future performance of the company following completion?  If so, what are the terms of the earnout and what covenants will you need from the buyer following completion to help ensure potential targets can be met? Is any of the purchase price deferred or conditional upon key employees remaining in employment?

3. Payout Mechanics: How will the purchase price be allocated?  Do any preferred shareholders and the holders of any other convertible debt or equity have preferences – and how does this impact on deal mechanics?  Will you have to use a portion of the proceeds to repay debt or other liabilities?  Does the buyer require loan facilities to finance the deal?  If so are these in place?  What are the consequences if these funds are not forthcoming?

4. Warranties and Indemnities: What is the extent of the warranties being requested by the buyer?  Who is going to give these warranties and share the risk?  Is the buyer requesting any indemnities at this stage and if so who will give them?  What is the potential liability under these provisions?  Are these liabilities capped and time limited in any way?

5. Escrow and indemnity: It is common for a buyer to ask for a portion of the purchase price to be held back as security against potential breaches of representation/warranties/ indemnities (an “escrow”).  What is the size of the escrow being requested?  Is this normal for deals of this size?  Will all sellers participate in the escrow?

6. Options: How does the proposed acquisition affect existing options?  Do their terms provide for their exercise to be accelerated on a sale? Will the options be assumed by the buyer or cashed out?  How do the value of the options affect the purchase price?  Will employees be properly incentivised after completion?

7. Tax matters: What are the tax implications of the transaction?  How can it be structured to help minimise the tax payable?  Consider whether specialist advice is needed.

8. Employee issues: Are all employees to be kept on long-term or is a restructuring planned?  Will employees be asked to sign new contracts on closing?

9. Special exercises: If the business of the Company is specialist or if the buyer has any concerns early on, it may include some special requests in the heads of terms, such as for technical diligence, an environmental audit to be commissioned, an accountants’ long-form report to be drafted or specialist due diligence to be undertaken.

10. Approvals and consents: Are any third party or regulatory approvals needed to complete the deal?  Do any of these need to be conditions to completion thereby requiring a delay between exchange and completion?  If approvals/consents are required (for instance a customer change of control consent) are any third parties likely to use this influence to obstruct the transaction?

11. Completion: Who is responsible for providing what at completion?  Consider whether any of the following may be required – new employment contracts; regulatory approval; tax clearances; third party consents, competition authority approval or updated accounts.
12. Binding provisions:  Heads of terms are usually expressed to be subject to contract (i.e. not legally binding) but some provisions may be legally binding.  For example the buyer may request an exclusivity period whilst it carries out its due diligence and/or both parties may wish the transaction and any information passed between parties to be kept confidential.