Helping small business owners navigate the complexities of contract negotiations, Grid Law founder David Walker explains both the benefits and dangers of using heads of agreement.
Heads of agreement (also known as heads of terms, a letter of intent or a memorandum of understanding) are a useful tool when negotiating complex contracts. Generally, they’re not legally binding, but instead act as an aide memoir of the headline points agreed whilst a formal contract is being prepared.
However, as helpful as they can be, they can also hinder negotiations if they’re not used properly. So, in this article we’re going to look at when you should use heads of agreement and what should or shouldn’t go into them.
What are the benefits of heads of agreement?
Contract negotiation can become complex and protracted, for example when you’re buying or selling a business. In these situations, heads of agreement are extremely useful to keep the negotiations on track.
You can use them to record key points of agreement, to help avoid misunderstandings and prevent you from going over and over points that have already been agreed.
Generally, heads of agreement are not legally binding (but see more on this below) but they are regarded as morally binding. So, whilst you may not be able to enforce any terms contained within them, they show a commitment that the parties do want to reach an agreement.
Heads of agreement can also save you time (and therefore expense) when it comes to preparing the final contract. If they contain all of the main points that have been agreed, it makes my role as a solicitor drafting the final contract much, much easier. This means I have to spend less time negotiating points on behalf of my client which then saves a considerable amount in fees in the process.
What are the dangers of entering into heads of agreement?
Sometimes, trying to finalise heads of agreement can slow down negotiations. The parties forget that they’re only meant to contain headline terms and waste a huge amount of time and effort, trying to agree every single little detail.
If they’re negotiating every point in so much detail, they might as well be negotiating the terms of the final contract!
Sometimes, heads of agreement can inadvertently become legally binding. Rather than having a non-legally binding memorandum of the main points agreed, the parties accidentally turn it into a contract which is legally binding. (Below, I explain how to avoid this happening.)
This can cause problems if there are still points to discuss and agree. So, if you’re not confident about ensuring they’re non-binding, either enter into a proper contract to start with or ask for professional help from a solicitor.
Another problem I’ve seen is that the heads of agreement get signed off and in the excitement of a new working relationship, the parties never get around to finalising the main agreement. Everything is fine until a problem arises and one party comes to see me for help resolving the dispute.
My first task is then to unravel the actual contractual position and this usually turns out to be an oral agreement based loosely on the terms contained in the heads of agreement. As I explained in a previous article (Does a handshake form a legally binding contract?), in most situations an oral agreement is legally binding, but not always.
If intellectual property rights are involved, this can cause serious problems because intellectual property can only be transferred by way of a written contract signed by the assignor. Suddenly, with no written contract, one party who thought they owned (and had often paid for) intellectual property rights find that they don’t have the rights they thought they had.
So, if you do enter into heads of agreement, make sure you finalise the terms of a formal written contract.
How do you prepare heads of agreement?
If you’re preparing heads of agreement, please try to keep them simple. They don’t need to contain huge amounts of detail as their purpose is to record the headline points.
Simple bullet points are often all that’s needed, but there’s nothing wrong with adding some further explanation if it makes it clearer what has been agreed.
As explained above, heads of agreement are not intended to be legally binding, but there’s always a risk that a legally binding contract could be formed. Therefore, the heads of agreement should contain a statement saying they are “subject to contract” or “not intended to be legally binding”.
Sometimes, you may want certain provisions to be legally binding. For example, you may want the negotiations to be kept confidential or you may want to agree an exclusive period for the negotiations where the parties are locked out of entering discussions with anyone else.
These points could be made to be legally binding and contained within the heads of agreement, but personally, I prefer to have them in a separate agreement.
There are two reasons for this. First, you will probably want these points agreed before any other terms are discussed, so the heads of agreement won’t be in existence at this point. Second, if the legally binding points are contained in a separate agreement, there can be no doubt about what is and what isn’t legally binding.
Sometimes, a client will say they want “binding heads of agreement”. This always leads to some interesting conversations as I try to get to the bottom of what they really want.
Do they want non-binding heads of agreement whilst a contract is being prepared or do they want a legally binding contract?
What they usually want a simple contract. They don’t want unnecessary legalese or complicated terms.
My response is that a contract should reflect the agreement reached between the parties. Both parties will want some safeguards to protect their position and this sometimes means it’s necessary to go into a little more detail than the client originally wanted. Other times a simple contract is all that’s needed.
Ultimately, the level of detail you go into is a balance of the risks you’re prepared to take and the need to get the deal done.
If you have any questions about negotiating or preparing contracts, please feel free to email me at firstname.lastname@example.org and I’ll happily answer them for you.
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