A heads of agreement is a short, interim agreement that parties use before negotiating and finalising a formal agreement. They are also known as a ‘terms sheet’ or ‘memorandum of understanding’ (or ‘MOU’) and serve much the same purpose as a ‘letter of intent’.
When are they used?
The idea behind a Heads of Agreement is to give the parties comfort that the deal is likely to go through, before they commit the time and money involved in detailed negotiations and contract drafting.
They are used in a variety of commercial situations, including business sales, asset sales, property deals (such as leasing), joint venture formations, investment transactions, partnership creations, and other significant business transactions. They tend to be used for deals where the preparation or negotiation of a formal contract cannot happen instantaneously, but where the parties wish to demonstrate a mutual commitment to the transaction.
A Heads of Agreement will summarise the main commercial points that have been agreed between the parties, without getting bogged down into much of the detail that would appear in a formal contract.
Are they legally binding?
This depends on how they are written. Usually, most parts of a Heads of Agreement are expressed to be non-binding. This means that most of their provisions do not create any legal obligations and cannot be enforced in Court.
This is mainly for three reasons.
First, parties are likely to commit to non-binding obligations faster than they are likely to commit to non-binding ones. Heads of Agreements are intended to be short term agreements that the parties can prepare and sign relatively quickly.
Second, an initial commitment to non-binding obligations can lead to smoother negotiations over all. There is inevitably less friction involved in negotiating non-binding obligations than when negotiating binding ones. If there is any tension between the parties, an initial interim agreement can reduce this by demonstrating that both parties remain willing to proceed. Also, the use of non-binding obligations gives the parties more flexibility (and potential points of leverage) when negotiating the final agreement.
Third, having binding terms in an informal document could create unintended tax or legal consequences. For example, a binding commitment to transfer an asset could trigger stamp duty or CGT liabilities. Parties will often commit to a non-binding Heads of Agreement without having received the same level of advice as they would if they were signing a formal document.
Which parts are binding?
The document should specify which terms are binding, and which parts are not.
The binding parts usually include provisions relating to:
- exclusivity (to prevent the parties dealing with others while the contract is being finalised); and
- further negotiations and finalising the contract.
There may also be binding provisions relating to ownership of intellectual property, particularly where the parties intend to exchange valuable information or collaborate together to develop something new.
As part of the binding obligations, the parties usually commit to negotiating with each other on exclusive basis and using their best efforts to prepare and sign a formal contract within a specified period of time. This is to provide an incentive for both parties to attempt to resolve the deal quickly, whilst giving them the freedom to walk away if it does not.
Some heads of agreement will contain provisions requiring the payment of deposits or costs, to serve as a further disincentive for a party to walk away from the deal. This is however relatively uncommon.
Tips for preparing one
It is not uncommon for lawyers to become involved in preparing a heads of agreement, although this will depend on the size and complexity of the transaction, as well as the skills and experience of the people negotiating it.
Regardless of who is drafting the document, some basic guidelines are as follows:
- Clearly specify which parts of the document are binding, and which are not.
- Make sure the document captures all of the key points that have been agreed, without getting into unnecessary detail.
- Even though it is non-binding, the document should not contain anything that you are not prepared to agree to. Keep in mind that the document will be used as the basis for preparing the final agreement.
- Be willing to be flexible with the drafting of the document.
- Include exclusive negotiation provisions (as described above), as well as a timeframe for the parties to attempt to finalise the deal.