Letters of offer and heads of agreement: what to put in writing early

Between a buyer saying "we're interested" and both sides signing a sale contract, there is a stage that is often rushed. A short document setting out the main terms, usually called a letter of offer, a term sheet or heads of agreement, can save a great deal of time, legal cost and frustration. Leave the key points vague and they tend to surface late, when the parties have already spent money and goodwill getting there.

What these documents are

The names vary and are often used interchangeably. In general terms:

a letter of offer or expression of interest is the buyer's written proposal, setting out the price and main conditions;
heads of agreement, a term sheet or a memorandum of understanding records the main terms both parties have agreed in principle, before the full contract is drafted.

Most are intended to be largely non-binding on the commercial terms, while making a few specific clauses binding. Whether a document is binding depends on its wording and the parties' conduct, not on its title. Australian courts look at what the parties intended, and a document drafted loosely can end up more binding, or less binding, than either side expected. Have your lawyer review it before you sign.

Why put things in writing early

Getting the main terms down early:

tests whether the parties actually agree on the things that matter;
gives the lawyers a clear brief for the sale contract, reducing drafting rounds;
sets a timetable and expectations for due diligence;
protects confidential information and, if agreed, gives the buyer a period of exclusivity;
identifies early any condition, such as finance or landlord consent, that could delay or stop the deal.

The cheapest time to find out you disagree on something important is before anyone has paid for due diligence or a contract.

What to include

Parties and what is being sold

Name the buyer and seller entities. State whether the sale is of business assets or of shares, and what is included and excluded. If stock is extra, say how it will be valued. See asset sale vs share sale for why this choice matters so much.

Price and how it is paid

Set out the headline price and its components, for example goodwill, plant and equipment, and stock at valuation. Be clear about:

whether the price is inclusive or exclusive of GST, and whether the sale is intended to be a going concern;
the deposit, if any, and when it is paid;
any deferred payment, vendor finance or earn-out, and the terms that apply to it;
how any adjustments at settlement will work.

Our article on working capital and stock adjustments explains why adjustments deserve attention at this stage, not just at settlement.

Conditions

List the conditions that must be met before the deal completes. Common ones include:

satisfactory due diligence by the buyer, within a set period;
the buyer obtaining finance;
the landlord consenting to a lease assignment or granting a new lease;
consent from a franchisor or key counterparties;
transfer of licences or permits;
any required regulatory approvals.

Each condition should have a deadline and say what happens if it is not met.

Due diligence

Set out how long the buyer has, what information will be made available and how access to staff, customers or premises will be handled. Sellers often stage disclosure, releasing commercially sensitive information only later in the process.

Employees

State which employees the buyer intends to offer employment to, and how accrued leave and other entitlements will be treated. These points can have a real effect on the price. See employee entitlements when a business changes hands.

Handover and restraint

Set out how long the seller will stay on to assist, whether paid or unpaid, and in what role. Most buyers will also want the seller to agree not to compete or solicit customers and staff for a period and within a geographic area. Restraints need to be reasonable to be enforceable, so their scope is a matter for your lawyer.

Warranties

Outline the main promises the seller will give about the business, particularly in a share sale. The detail goes in the contract, but agreeing the general approach early avoids a late argument.

Timetable

Include target dates for due diligence, contract signing and settlement.

Which clauses should be binding

Even where the commercial terms are non-binding, some clauses are commonly made binding from signature:

Confidentiality. The buyer must keep information it receives confidential and use it only to assess the purchase.
Exclusivity. The seller agrees not to negotiate with other buyers for a set period. Sellers should keep this short and tied to the buyer making progress.
Costs. Each party pays its own costs, unless agreed otherwise.
Non-binding effect. A clear statement that the rest of the document does not create a binding agreement to buy or sell.
Governing law. Which state's or territory's law applies.

The document should say plainly which clauses bind and which do not.

Common mistakes

Leaving the price formula vague. "Price plus stock" without a valuation method is an argument waiting to happen.
Open-ended exclusivity. A seller can lose months and other buyers to a buyer who stalls.
No deadlines on conditions. Conditions without dates let a deal drift.
Ignoring tax and GST. Structure and GST treatment affect what each party really pays or receives.
Signing without legal review. Wording can make a document binding when it was not meant to be.

How we can help

Kainos helps buyers and sellers work out the commercial terms that matter, models the effect of price structures, adjustments and deferred payments, and makes sure the key points are captured before the contract is drafted. We advise and represent clients through negotiation, working alongside their lawyer, who prepares and reviews the documents. To talk about a deal you are negotiating, contact us or read about our business sales and purchases service.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.