Founders at exit:
how to negotiate heads of terms on the sell side

Adding more (clear and cogent) detail to a heads of terms should mean there is less to negotiate in the sale and purchase agreement and other transaction documents.

Too much detail, however, may delay a deal and involve discussing and finessing language that will then need to be duplicated when it comes to draft the long form documents. This is more of an issue for the buyer (who wants exclusivity) than the sellers, perhaps.

The rule of thumb is that the heads of terms should include enough detail so that the points of legal and commercial principle are made clear. Anything further is better deferred to the long form.

On smaller deals, having all the key points of principle mapped out in the heads of terms becomes particularly important. Both sides may well have restricted budgets when it comes to incurring professional costs. Voluminous turns of re-worked long form documents will likely blow those budgets. And then it may be that there is disparity in leverage between the buyer and the sellers on a small deal (and there the sellers will want more detail in the heads of terms if they are to understand what they are signing up to).

And so – in our experience – there is a somewhat curious theme where the size of the deal often inversely correlates with the level of detail in the heads of terms.

Nevertheless, all else being equal, the professional costs and management time incurred on a deal with a crystal-clear and exhaustive set of heads of terms will be less than if on the same deal the parties skipped straight to the long form documents.

What happens quite often, however, is the opposite.

Parties will often rush into the long form documents on the back of ‘agreed’ heads of terms that are deeply confused on key points of principle. As a result, vast time and energy is needed to work out what was in fact agreed (the parties’ recollection and understanding of this may differ) and how that then maps across to the sale and purchase agreement.

Imagine building a house without any structural plans, and then finding that the roof does not fit. Yes, it’s a bit like that.

One must think about weighting and balance when holding the pen on a heads of terms.

Are some topics included whilst others of (even arguably) similar importance are excluded? If so, and if the excluded points are mainly for the benefit of the sellers, consider pushing for their inclusion. If any such issues are not included, the sell-side leaves itself open to the argument that, “if topic X was wanted it should have been in the heads of terms as evidenced by the fact that topics Y and Z (which are no more important that Topic X) were included in the heads of terms”.

Once people get into the long form documents they tend to accept, as already agreed and therefore non-negotiable, whatever is stated in the heads of terms.

And there are sometimes points, below the high-level fundamental points, which people may accept in the early stages of negotiation but will be more likely to resist later in the process (once they have had more chance to think about it or if negotiations are heated and neither side wants to concede anything).

Again then, from a sell-side perspective it is important that the points of importance are – unambiguously – in the heads of terms.

The buyer’s exclusivity usually only starts when the heads are signed. From the sellers’ perspective, it is advantageous to have more (clear and cogent) detail in the heads of terms so that, at the point they go exclusive with the buyer, the terms of the deal are known.

We say more about exclusivity below.

Are you selling the Target shares or its assets?  This is an apples or oranges question; the answer fundamentally shapes the deal structure. Before price even, it is perhaps the first threshold question for both sides to answer the same way.

The fact that the parties have a choice can often bog down negotiations at an early stage and – usually in the absence of sensible advice on both sides – Frankenstein-type heads of terms sometimes emerge that look to combine aspects of a share deal with aspects of an asset deal.  The result is sub-optimal, to say the least.

Asset deals are found primarily in circumstances where the buyer does not want to buy all of the Target assets.  Or the Target may have known (or perhaps Rumsfeldian ‘known unknown’) nasty liabilities that the buyer does not want to deal with.

If you want a deeper dive into shares vs assets, see our deep dive on the subject here.

The rest of this article assumes that the transaction in question will be structured as a share deal.

The buyer would usually look to acquire 100% of the Target. Where that is not the case, life becomes more complicated for the parties and their advisors because a separate part of the transaction will need to deal with the sellers’ equity that is left behind. Questions such as when or if that equity will (or can) be sold to the buyer (or someone else), and what the terms governing the relationship between the Target shareholders will be post-close, will need to be answered.

That will immediately make the deal more complicated and there is more to consider at heads of terms stage.

Note that we are not talking about deferred consideration here, or buyer equity being used as consideration for the transfer of the Target shares. In either case, 100% of the Target may be acquired, it is just that payment for the Target shares may not all come at completion and that payment may not be all in cash. More on types and timing of consideration below.

For the purpose of this article, we will assume that the transaction in question will see the buyer seek to acquire “the entire issued and to be issued share capital”, i.e., 100%.

You can’t do a deal without agreeing a price. And the sellers do not necessarily need to go into exclusivity before price is discussed.

It is important to clarify the specific details on price sooner rather than later. After the parties have decided what sort of deal they want to close, the next question to ask is what is the buyer willing to pay and whether the sellers would sell for that price.

If advisors are not involved in drafting a heads of terms, then invariably there will be confusing or contradictory statements made about price. Some heads of terms will skirt around the topic. Occasionally we see weird sets of heads that ignore price altogether.

A heads of terms needs a number. But a good heads of terms will explain how the parties arrived at that number, and be clear that the number is the value for the equity. And the price is a moving target.

The price will always fluctuate between signing the heads of terms and closing the deal – sometimes by quite a lot – and explaining how the parties at the figure(s) in the heads of terms will be useful for framing discussions later on about how it may or probably will need to be adjusted.

Much has been written on how to value companies and businesses, and law firms are not qualified to do the valuing.

Where a good corporate finance broker will provide value is in advising on what metric to use for valuing the Target equity. It could be a multiple of EBITDA, net asset values, annual recurring revenues (used ubiquitously for software companies), or something else.

If, for example, the heads of terms state that the proposed value is arrived at by multiplying the average of the last two financial years’ EBITDA by 10, and it turns out – following financial due diligence – that EBITDA was in fact 25% lower than was assumed in the heads of terms, then the sellers may not be surprised when the buyer floats the idea of the purchase price being 25% lower.

Some of the same principles may also apply if the present net asset value was chosen as the metric for valuation, or annual recurring revenues, or almost anything else.

A good heads of terms will have said how value is being calculated and the parties should not be then apart on how the Target is being valued, even if the value referred to in the heads of terms needs to change in the long form documents.

The price is often expressed to be on a “cash-free, debt-free basis assuming a normalised level of working capital, subject to DD”.

What does this mean?  A lot has been written by accountants and in corporate finance manuals on the subject.  In simple terms, it means that the sale will be made on the basis that:

• the Target’s accumulated profits belong to the seller;
• amounts owed by the Target to its lenders will be repaid (or refinanced by the buyer) prior to or on completion;
• there will be an agreed level of working capital – i.e. the ‘float’ needed to trade in the ordinary course – in the Target’s bank accounts at completion; and
• what all those amounts actually are will be subject to due diligence (financial, legal, commercial, etc).Which leaves a lot to figure out, but at least it gets the parties to a place where a headline value for the Target equity can be agreed in principle.

After coming to an agreement about a price, the heads of terms will then need to cover how it will be paid. The easiest structure to agree and to document is where the price is payable 100% in cash.

Cash is usually king, but non-cash consideration may also come into play when the buyer does not have the available cash to pay, or when the sellers want to have some ‘equity upside’ in the buyer group post-completion. The seller may also wish to optimise the price structure for tax, for example by limiting the extent of a taxable disposal through exchanging Target shares for shares or securities issued by the buyer. Usually all or a combination of these factors will be in play, and there may be others that are specific to a particular transaction.

The sellers, however, will want to press for the pricing structure to be made clear in the heads of terms.

If some or all of the price is payable in the form of buyer equity, then the heads of terms should set out the rights and obligations that attach to that equity.

Shares typically confer three sets of rights:

• a right to capital (on a share sale, an IPO, an asset sale or a winding up);
• a right to income (i.e., to dividends and distributions); and
• a right to vote (as a shareholder).

But thought should also be given to board or observer seats, information rights, leaver provisions, and any employment package.  And then the tax treatment of all that.

The rights that the sellers can ask for and the rights that the buyer will be willing to give will be driven by the percentage of the buyer’s fully diluted share capital on offer to the sellers, and then the relative bargaining position between the parties. A seller who will take a 25% interest in the buyer post-close will usually be in a very different position from someone taking a 0.5% interest.

If the parties know what the price is, and in what form it will be paid, then the next question is when it will be paid.

Deals where 100% of the price is paid on completion are the most simple. Where that is not the case, deals (and their documents) are more complicated.

Where transactions involve deferred consideration, the sellers will want to be comfortable that this is not ‘jam tomorrow’, perhaps never to convert into cash. This will be the case in particular where the reason for deferred payments is an inability of the buyer to raise the necessary funds for payment on completion. In such cases, sell side due diligence on the buyer will be important.

Negotiating equity terms is a major topic in and of itself and is not further discussed here.

A buyer may be prepared to pay the agreed price for the Target, but only if the sellers who have been managing the business stay on post-completion for a period of time to manage the hand-over.

This is what is known as an ‘earn out’.  If an earn out is proposed, then the heads of terms should explain how it will work.

The principal variables when structuring an earn out are:

• how much of the price is kept back;
• when and at what intervals is it paid out;
• what levels of business performance need to be met in order to trigger a pay out; and
• what control over the activities will the seller have during the earn-out period.

Earn outs can be difficult to agree or even draft clearly enough that all parties can be sure on what has actually been agreed.  There is a long and storied history of earn outs not being met on deals and the parties falling out.

In fact, according to Inc., about half of all deals result in a loss of value for the buyer, and three-quarters of all M&A deals fall short of expectations.  Sellers beware.

If the sellers are to continue working for the Target or in the buyer group post-completion, then on what terms?  The heads of terms may not be the place to hash through the details of this and the buyer may want to push the discussion to later on in the process.  But those who are staying on would ideally have an understanding of the salary, bonus, role, and so on at the point of signing the heads, even if those terms are not detailed.

Tax is also a consideration here. The parties will usually want to structure an earn out so that payments are treated as consideration for the sale of the Target shares, and not as employment income in return for the sellers’ involvement post-completion. There can be a fine line between those two types of receipts, especially where payment is conditional on the sellers staying with the business.

The seller – with the leverage in negotiations – may insist on any deferred consideration being placed into escrow with an independent third party. They would hold the funds and be obliged to pay them to the sellers if the agreed conditions for payment are met.

Making arrangements to organise an escrow account will add a further layer of cost and complexity to a transaction.  They are not as easy to organise as they used to be.  It is now difficult (if not impossible) for a firm of solicitors to act as a pure escrow agent for the parties and hold the funds in their client account.

If the buyer is a group company subsidiary – perhaps an SPV set up for the purpose of the acquisition – then the seller might consider whether to ask for a parent-company guarantee for any deferred consideration.

The sellers – if they are not staying with the Target business – should expect the heads of terms to refer to market standard restrictive covenants. These will be obligations on the sellers, or at least on any who were also managers, not to compete with the Target business (or the buyer group business including the Target business). This would extend to not poaching senior employees and not to solicit Target customers or clients following completion.

The key point for the heads of terms is, “for how long?” The sale will be an arm’s length commercial transaction and restrictions will be enforceable over a longer period than is the case in an employment agreement. The sellers should expect to see anything between 18 and 36 months written into the heads, and will want to consider whether their future plans would require them to try to negotiate the point or whether they do not care as they are walking away from the industry or retiring.

The geographical scope of the restrictions and the scope of which activities of the business they catch should also be carefully looked at as regards likely enforceability.

The buyer will usually say that even after the price in the heads of terms has been finessed, it may need to be further adjusted post-completion once the buyer has its hands on the Target business.

It will be important that the parties are on the same page as to what is being measured, and what assets and liabilities will be taken into account. Apart from affecting the amount of consideration payable to the sellers, the accounting policies agreed for the completion accounts may also affect the extent of the sellers’ liabilities under the sale and purchase agreement.

While the heads of terms may not provide details of the accounting policies to be used, they should ideally provide an indication of an agreed approach.

For example, known liabilities of the Target are often factored into the completion accounts, in which case the sellers should be protected against the buyer making a separate claim in respect of such liabilities (e.g. for a breach of warranty or under the tax covenant).

Instead of working out the price adjustment post completion with completion accounts, the buyer may wish to use what’s called a ‘locked box’ mechanism.

This involves using a pre-completion Target balance sheet (prepared by the Target accountants) as the ‘box’ that will be locked. And the date of that balance sheet should not be too far into the past, and so often a balance sheet is prepared specifically for the purpose.

What the sale and purchase agreement then says is that any ‘leakage’ from the locked box – which means payments to the sellers or their connected persons – taking place in between the locked box date and completion is to be paid by the sellers to the buyer under an indemnity, with a schedule of ‘permitted leakage’ carving out any particular payments on a case by case basis.

The buyer has then – in theory – locked in the value of the equity as at the date of the locked box balance sheet. The sellers might consider asking for a ‘ticker’ the price to apply as regards EBITDA generated in the business after the locked box date but before completion.

Occasionally we see heads of terms where attempts have been made to combine a completion accounts mechanism with a locked box. The results are usually sub-optimal to say the least.

The buyer will be acquiring the Target with its entire tax history, including any unpaid tax liabilities in respect of pre-completion periods. A standard tax covenant allows the parties to ‘draw a line in the sand’, often by reference to the completion date, for the purpose of allocating the cost of any such liabilities between the parties.

In a completion accounts deal, any tax liabilities of the Target which relate to a period or event prior to completion are normally for the account of the sellers. This includes tax on any pre-completion profits, since such profits are (directly or indirectly) factored into the completion accounts. The sellers have the benefit of them and therefore bear the tax.

In a locked box deal, the benefit of any profits arising between the locked box accounts date and completion will be for the benefit of the buyer. For that reason, any liabilities of the Target to pay tax on such profits are normally carved out from the remit of the tax covenant.

The tax covenant will normally be drafted to cover any specific tax risks in the Target that are identified during due diligence. As well as tax risks relating to any pre-completion event or period that the parties are not aware of on completion. To the extent a tax liability is covered by the tax covenant, the buyer is usually entitled to ‘pound for pound’ recovery, without being obliged to mitigate its loss.

Heads of terms often cover buyer due diligence in fairly broad terms. The scope of the due diligence carried out by the buyer will usually depend on the size of the proposed transaction. The buyer’s solicitors may be tasked to carry out ‘legal due diligence’ across a number of specific areas, which would normally include the Target’s constitution and ownership, its assets, employment arrangements, intellectual property, properties, and so on.

The buyer may also commission a separate financial and tax due diligence report, which is usually prepared by a firm of accountants instructed by the buyer. In some cases, the seller may prepare a due diligence report upfront to streamline the process. This is common in an auction process.

The heads will usually provide a timeframe within which any buyer due diligence must be completed, in line with an indicative transaction timetable.

The heads of terms will often refer to a “tax covenant and customary warranties, depending on the outcome of due diligence”.  The heads are usually prepared before the buyer has had a chance to carry out any meaningful due diligence, and the buyer’s requirements with regard to a tax covenant, warranties, and specific indemnities cannot be too prescriptive at that point.

The buyer will usually expect that any Target liabilities outside the ordinary course of business that are unearthed during due diligence will be for the sellers’ account.

The sale and purchase agreement will include provisions that limit the sellers’ liability under the warranties, tax warranties, tax covenant, and (where relevant) other specific indemnities. These will usually include financial and time limits and other customary exclusions and limitations.

The heads of terms should ideally specify the financial and time limits. Most of the detail beyond this is usually discussed and agreed at the stage of drafting the sale and purchase agreement.

The limitations in the sale and purchase agreement usually include a provision that the sellers will not be liable for a breach of a warranty (including a tax warranty), assuming the relevant matter has been disclosed.

Disclosures are normally made in the disclosure letter, which includes specific disclosures against the warranties, as well as matters that the parties agree should be treated as generally disclosed (subject to meeting the standard of ‘fair disclosure’ established by case law). For example, the parties normally agree that information available on Companies House will be treated as generally disclosed.

Whether an entire data site put together during the due diligence process should also be considered generally disclosed may be more controversial.

The heads of terms may provide some detail here, but in practice rarely do. In this case, this is a matter for negotiation when the long form documents are being prepared.

The sale of a company or group may be preceded by a reorganisation.  Maybe the business being sold is spread across various companies in a group but needs to be combined in a single entity prior to sale, or the group being sold includes assets that the buyer does not wish to acquire. There may also be tax reasons for a reorganisation to precede completion of a proposed sale.

Either way, a reorganisation needs to be properly planned and thought through, and advice on the tax implications of the reorganisation is a necessity.

To what extent a pre-completion reorganisation should be detailed in the heads of terms will vary. The buyer may not be overly concerned with the detail. As long as the sellers commit to the end result and (where appropriate) indemnify the buyer against adverse consequences – particularly tax ones.

In any event, the end result timescale of any pre-completion reorganisation should be clearly mapped out and agreed between the parties.  The same applies for any other conditions that need to be met by either party prior to completion.

Some deals can be signed and completed simultaneously. In other cases, a period of time may be needed between signing and completion; for example, if there will be a reorganisation that needs completing first.  Or perhaps there are other steps that need to happen once the parties have committed to the sale, but prior to completion.

The heads of terms should make it clear what needs to happen, and when it should happen in the transaction timetable, in sufficient detail for the parties to be clear about their respective obligations.

The sale and purchase agreement will be longer and therefore more expensive on a deal with a split exchange and completion, and it will need to legislate for the running of the Target business during the interim period.

A good heads of terms document will set out some detail on the proposed timetable to completion. In particular, it should cover what period due diligence will be carried out and when the transaction documents will be drafted.

The buyer will usually be negotiating the heads of terms with the owner-manager (i.e. shareholders and directors).  If the Target has minority shareholders who are not involved in management, then those persons will not normally be parties to the heads of terms.

These minority shareholders will not usually be giving the warranties (other than as to title to their shares and capacity to transact) and will be interested in the sale price, but perhaps not the rest of the deal structure.

Typically, however, as part of the process of negotiating the heads of terms, or perhaps as the first step after signing them, Target management will need to be sounding out the minority shareholders and understanding whether they will sell at the price proposed by the buyer.

If there are minority shareholders who refuse to sell, can no longer be contacted, or will not confirm either way, then hopefully the Target articles of association contain a ‘drag-along’ mechanic.  With this, a majority of some description can drag the minority into the sale on the same terms (and a ‘drag-along’ mechanic exists under company law where there is a sale of 90%+ of the equity).

Using a drag-along mechanic may sound easy, but the reality is that these are often difficult for a number of commercial and legal issues.  Not to mention the associated legal and professional costs.  Avoid using a drag-along mechanic unless you absolutely have to.

A good heads of terms will divide up drafting responsibilities.

The buyer’s lawyers will usually draft the sale and purchase agreement.  The Target’s lawyers will usually prepare stock transfer forms and other ancillary documents.

If there is debt to be repaid or refinanced then the heads would ideally make clear which side will manage that process and obtain deeds of release from secured lenders.

The terms referred to above will not be legally binding. They seek to agree points of legal and commercial principal that will be mapped out in full in the sale and purchase agreement and other transaction documents.

The provisions below are – usually – expressed to be legally binding.

The parties will want the heads of terms to be kept confidential.  Exceptions will be written in to allow the heads of terms to be disclosed in confidence to the parties’ advisors, regulators, and under applicable law.

The seller will often be particularly keen that the heads of terms are not leaked to the Target workforce and the Target’s competitors in the market.

News travels fast, however, and despite best efforts, news that there is a sale underway usually leaks at some point in the transaction; especially so where there is a lengthy sale process.

Note that confidentiality here should not cut across confidentiality that has been put in place under a non-disclosure agreement with the buyer.

The heads of terms will invariably contain exclusivity provisions. This requires the seller (and the Target) to break off discussions with third parties around any kind of sale or investment process, meaning they can proceed exclusively with the buyer.

Exclusivity will be stated to continue for a period of time. The buyer will want the period to be longer, and the sellers will usually seek to persuade the buyer to make the period of exclusivity no longer than is required to close the deal with a fair wind behind the transaction.

The provisions will also say that if the seller breaches exclusivity, then they will be liable to pay the costs incurred by the buyer to that point. The seller should seek to put a cap on this amount. Note that the language should refer to the wasted costs incurred by the buyer rather than as simply a penalty. Where the liability for breach of exclusivity goes beyond a genuine pre-estimate of the buyer’s loss, then the provision may be treated as a penalty clause and unenforceable on grounds of public policy.

If the sell-side has a lot of leverage, then it might be able to insist upon short periods of exclusivity so as to put the pressure on the buy side to finish due diligence and transact quickly.

A heads of terms document needs a governing law clause for the legally binding provisions. For UK deals, the binding parts of the heads of terms will invariably be governed by English law and be subject to the jurisdiction of the English courts.

On cross-border deals, thought should be given as to whether there should be a deviation from that position. An overseas buyer of a UK company will usually seek to put the governing law and jurisdiction into its home courts, which UK based sellers will usually want to resist.

Heads of terms do not have to be signed.  The non-legally binding terms by definition do not form part of a contract, and signatures are not a necessary condition to forming a contract under English law anyway.

But signatures are usually added to provide moral force to the non-binding provisions because the binding provisions outlined are contractual and it is standard practice to have contracts signed by the parties.

One error we sometimes see on heads of terms for a share deal is the addition of a signature block for the Target company.  On a share deal, the Target is not a party to the transaction per se, even though its shares are changing hands.  The selling shareholders – or at least the majority selling shareholders – should be signing the heads of terms.

On an asset deal, the Target should be signing since it is the Target selling the assets.