Heads Of Terms

Heads Of Terms For Buying A Company

When buying a company, heads of terms (also known as letters of intent, memoranda of understanding and heads of agreement) are by and large contained in a short document that sets out the principle terms of an agreement. Heads of terms constitute serious intent, and may have moral power, yet are not necessarily binding. This will rely upon the substance of the heads of terms and the goals of the parties.

Heads of Terms Purpose

Heads of terms will not always be valuable with regards to arranging an exchange and they might be of more use to one side than the other, yet heads of terms can assist with avoiding mistaken assumptions and give a helpful guide when consenting to a proper arrangement. Parties should be wary that an exchange of the heads of terms can slow down over marks of pointless detail, which in actuality ought to appropriately be tended to at a later stage. This can postpone readiness of the full contract and increase the length and cost of dealings.

Content

Generally, the heads of terms should cover the bargain at hand and significant components as opposed to routine ones. Often the two parties treat the heads of terms as a practice of the real agreement. Time spent arranging the heads of terms ought to be limited to talking about the bargain on a basic level. Contentions over the fine print ought to be left for the final arrangements.

Below are some examples of suggested principles to be applied to heads of terms:

  • State the exception and defer the rule - If it is fundamental that, for example, certain sellers will not join in the giving of warranties and indemnities, or that only very limited warranties will be given, the heads should say so. If not, it should be sufficient to indicate that the final agreement is expected to include warranties, indemnities (and limitations on them) appropriate to a transaction of this type.
  • State the principle and defer the detail - Unless an issue is very complicated or unusual, the heads of terms should state the principle underlying the issue and leave the detail for the formal agreement. For example, if there is to be a post-completion audit and balancing payment based on net asset value, that is probably all that needs to be said in the heads of terms. Timing, agreed adjustments to the accounts and accountants that prepare the initial version can be dealt with later. If, however, the parties have agreed a specific unusual formula for calculating the net asset value this may need to be set out in the heads of terms to avoid any later disagreement.
  • Consider carefully, and take professional advice, before making significant concessions - If one side wants the agreement to be governed by foreign law, the other party should understand how this may affect its rights before making this concession. Similarly, both parties should take advice on the tax consequences of the basic deal structure. Such issues highlight the importance of taking appropriate advice or at least including reservations to the extent this has not yet been possible.

Are Heads of Terms legally binding?

Heads of terms may be fully binding or partly binding or not binding at all. Typically, however, they are not legally binding apart from sections dealing with confidentiality (where the parties agree to keep their discussions confidential) and exclusivity (where the seller agrees not to talk with any other potential buyer for an agreed period while the buyer carries out due diligence and hopefully concludes the purchase). Where the heads of terms include provisions that are intended to be binding, these must be clearly identified and the legal requirements for creation of a valid contract must be satisfied. Among other things, under English law:

  • The terms must be sufficiently certain to be enforceable. An "agreement" to continue negotiations in good faith, for example, is nothing more than an "agreement to agree" and normally unenforceable (Walford v Miles). Much depends on the facts however.
  • Unless the heads of terms are executed as a deed, there must be consideration moving from the party benefiting from the agreement to the other party, either in the form of a promise in return, or a payment, action or forbearance. Where there is no actual consideration, however, and execution as a deed alone is relied upon, specific performance is unlikely to be available. For more information on the specific formalities relating to the execution of deed by a company, see section 46 Companies Act 2006.

Third parties

Regard should also be had to the implications of the Contracts (Rights of Third Parties) Act 1999. If a term expressly provides that a third party has the right to enforce that term, or if the term purports to confer a benefit on a third party, then that term may give the third party directly enforceable rights. For example, a parent company, or another group subsidiary of a party to the heads of terms may wish to benefit from the confidentiality provisions. Where there is more than one prospective buyer, the seller may intend the successful buyer to have the benefit of confidentiality undertakings given by the others. On the other hand, if there is a risk that a term may be enforceable by a third party and the parties do not wish to create any third party rights, then an express exclusion should be included to that effect.

Reasons for using Heads of Terms

Whether or not the parties draw up heads of terms is purely a matter of choice: there are both advantages and disadvantages. The perceived advantages of using heads of terms are:

  • Moral commitment. Heads of terms are usually considered to confirm a moral commitment on both sides to observe the terms agreed (which can be an advantage or disadvantage depending on the circumstances).
  • Complex transactions. Where a transaction is complex, heads of terms can help focus the negotiations, bring out any misunderstandings and, by highlighting major issues at an early stage, prevent the parties wasting time and money if those issues cannot be resolved at this stage.
  • Framework for binding commitments. Heads of terms frequently contain a binding exclusivity agreement, a confidentiality agreement and, in some cases, provide for payment of costs and break fees in the event of negotiations breaking down. Obtaining exclusivity for a limited period, and some protection against wasted costs, should enable the buyer to proceed with more confidence.
  • Third parties. Where a deal has to be explained and sold in advance to persons not directly involved in the negotiations, the heads of terms can provide a useful statement of the key terms of the proposed deal.
  • Basis for clearance submissions. Heads of terms can provide the basis of a joint submission for clearance or guidance from the relevant competition authorities and might assist in the preparation of tax clearance applications.
  • Basis for instructing advisers. Draft heads of terms can sometimes be a helpful tool for the parties to instruct their respective advisers.
  • Provide seller with a tactical advantage. Because heads of terms are normally prepared early in the transaction process, before the buyer has commenced detailed due diligence, the seller will know considerably more about the business being sold than the buyer.

Reasons against using heads of terms

  • Limit room for manoeuvre. Heads of terms carry strong force, so they can limit room for manoeuvre in the subsequent negotiations. They should therefore be approached with caution, especially on the part of a buyer, who at this stage normally has much less information than the other side. If the buyer is required to sign heads of terms, then consideration should be given to inserting into the document the key assumptions on which the buyer is relying. This was illustrated by the ill-fated acquisition of PRB by Astra Holdings PLC in 1989. PRB went into liquidation a year after the acquisition and the Department of Trade and Industry (now BEIS) launched an investigation into the matter. In their report, the inspectors mentioned the fact that Astra had, before taking legal advice, entered into heads of terms which included certain unfavourable terms (the acquisition agreement was to be drafted by the seller's lawyers, governed by Belgian law and was to contain only limited warranties). Although it was not legally binding, it severely tied Astra's hands in the subsequent negotiations. It was the seller's "firm view that the [heads of terms] had set the agreed goal posts, and they did not want them moved".
  • Create legal relations inadvertently. In some jurisdictions, heads of terms can create a legally binding agreement between the parties unless an express term is included to the effect that there is no intent to create legal relations.
  • Accelerate need for public announcement of deal. Where either party is a listed company, an AIM company or otherwise has financial instruments that bring the company within the Market Abuse Regulation (596/2014/EU) it will need to consider whether one effect of negotiating and signing heads of terms may be to precipitate an early announcement of the deal.
  • Adverse tax consequences. In the UK, the heads of terms can be evidence of an "arrangement" which restricts the ability of the parties subsequently to take advantage of certain tax reliefs.
  • Increase in workload. The time taken to agree heads of terms may be disproportionate to the benefit. Care needs to be taken to avoid effectively negotiating the main agreement twice.

Here to help

Drafting heads of terms can be an exciting moment in pursuit of a deal. It is crucial to have an insight into how best to play your hand and what the legal consequences will be of your commercial strategy. The most significant legal question will be whether or not any of the terms are binding.

A document will usually be enforceable when it is adopted into a parent contract and is subsequently agreed upon. Until that point, a heads of terms will not usually be legally binding (Fletcher Challenge Energy Ltd v Electricity Corp of New Zealand Ltd [2002]). However, such documents can be legally binding if the agreement document contains terms or language which explicitly indicates a binding intention. Equally, a letter which contains no expression of whether its terms were intended to be binding can be found to be binding due to language used. (RTS Flexible Systems Ltd v Molkerei Alois Müller GmbH & Co KG [2008]) This is also dependent on the circumstances of the transaction and includes the conduct of the parties themselves.

If you have any questions on heads of terms or need help drafting such a document please contact Neil Williamson.


Due Diligence When Buying A Business

Due Diligence When Buying A Business

This blog considers the purpose, scope and practical aspects of due diligence when buying a business. In the past, studies have shown that, for a number of reasons, a large number of acquisitions fail to meet expected targets and some high-profile disasters have brought the question of acquisition planning and management sharply into focus. It is therefore crucial that there is good management of the acquisition process and, in particular, the due diligence exercise.

Purpose of due diligence when buying a business

On any significant acquisition, the prospective buyer will want to be sure that the seller and (in the case of a share purchase) the target company have good title to the assets being bought and to know the full extent of any liabilities it will assume. For acquisitions subject to English law, the principle of caveat emptor, or buyer beware, will apply. It is therefore essential that the buyer carries out its own investigation of the target business at the negotiating stage through a due diligence review.

The primary purpose of carrying out due diligence when buying a business is to obtain sufficient information about the target's business to enable the buyer (or other parties with an interest in the transaction) to decide whether the proposed acquisition represents a sound commercial investment. Due diligence is effectively an audit of the target's affairs - legal, business and financial. It is therefore a crucial bargaining tool for the buyer.

Business due diligence when buying a business

Business due diligence looks at broader issues such as the market in which the business operates, competitors, the business' strengths and weaknesses, production, sales and marketing, and research and development. Obviously, some of the results of this part of the due diligence review will be relevant to the legal investigation which focuses on the full extent of any liabilities the buyer will assume.

Financial due diligence when buying a business

As part of the due diligence process, the buyer may instruct accountants to prepare a report on the financial aspects of the target business. This financial due diligence is not the equivalent of an audit, and accountants' reports will usually make this clear. However, financial due diligence should focus on those areas of the target's financial affairs that are material to the buyer's decision so that the buyer can assess the financial risks and opportunities of the deal and whether, given these risks and opportunities, the target business will fit well into the buyer's strategy.

Legal due diligence when buying a business

The legal due diligence exercise will focus on a number of core areas mainly to establish the ownership structure in the target, the target’s position under its key customer and supplier contracts, whether any litigation is ongoing and the extent to which the target is behaving in a legally compliant way.

On the basis of this information, the buyer can determine whether it is appropriate to:

  • Proceed with the transaction on terms that have been negotiated.
  • Seek to renegotiate the terms of the acquisition to reflect any issues or liabilities identified during the due diligence process.
  • Withdraw from the transaction.

In addition to identifying any issues that may affect the buyer's decision to enter into the transaction (or the terms on which it is prepared to proceed), the information revealed during the legal due diligence exercise will assist the buyer and its solicitors in:

  • Determining the scope of the warranties that should be included in the share purchase agreement (SPA).
  • Identifying any areas of risk that should be subject to specific indemnities.

Who carries out due diligence when buying a business?

It is essential that the acquisition team is made up of appropriate people under clear leadership and with good reporting structures. The team carrying out the due diligence must involve the buyer's own personnel as well as its legal and financial advisers and accountants. Only the buyer's own personnel will be able to make effective judgements as to the commercial importance and potential risk brought to light by the information uncovered.

Due Diligence Questionnaire

The cornerstone of any due diligence exercise is the questionnaire or information request which sets out the areas of investigation and a list of questions and enquiries to be put to the seller. These questions will usually be supplemented by further requests as the negotiations proceed and as the buyer learns more about the target.

Confidentiality and data protection

Although a seller will typically require prospective buyers to enter into a confidentiality agreement, these are difficult to enforce in practice. Where the buyer is a competitor or potential competitor, a seller may be particularly reluctant to disclose sensitive information about the target business until it can be sure that the sale will go through. The knowledge that a business is for sale can also be unsettling for employees, customers and suppliers. At worst, it can lead to a permanent loss of customers; even at best it may involve loss of sales and possibly key staff during the course of the sale process. In some cases, the seller will wish to keep confidential from all but the most senior management its intention to sell the target. Of necessity, this will limit the scope of the information available for a full due diligence enquiry.

The seller will want to ensure that no approaches are made to its customers, suppliers, management or employees either with a view to poaching them or obtaining more information. On an auction sale particularly, although confidentiality undertakings are required as a matter of practice, it is more difficult to maintain confidentiality because of the number of parties involved. The seller may be reluctant to risk the consequences of a breach of security during the information-gathering process or may be concerned that the only purpose of obtaining more information is to renegotiate the price. Bridging the gap in expectations between the seller, who is concerned to restrict the release of information, and the buyer, who will want to gather as much information as possible, is a crucial element of the initial stages of any transaction.

The due diligence report

Once the enquiry is complete, the information will be summarised in the due diligence report, which should cover the business, financial, legal and other specialist areas of the investigation. For certain transactions, this may be a fairly informal report focusing only on matters material to the transaction. For others, it will comprise a complete audit of the target's business including an in-depth summary of the target's material contracts. Some clients may wish to have a board presentation in addition to a written report. In any event, the due diligence report should be easy to read and have an index. It should be written in a clear and concise manner and should be free of legal jargon, bearing in mind that it will be read by non-lawyers. The executive summary - the part of the report that everyone will read - should summarise all of the key findings of the due diligence review

International transactions

International transactions, by their very nature, throw up a number of added risks and challenges. These fall broadly into three categories:

  • On a practical level, there may be difficulties relating to language, the added number of people involved, time differences, and so on.
  • Buyers should carefully assess the impact of a foreign country's law on a transaction.
  • In some jurisdictions, investigations of the level which have now become invariable practice in the UK or US may be seen as damaging the spirit of mutual trust between seller and buyer or even as a sign of mistrust or bad faith on the part of the buyer.

Here to help

This blog is only an introduction to due diligence when buying a business. If you have any questions about due diligence more specifically or if you need help undertaking such an investigation please contact our specialist corporate lawyers.


Software Licences

Software Licences – Different Legal Structures

Software licences come in many shapes and sizes. The range of legal solutions available to software companies is forever morphing and increasing. A significant shift has occurred with the existence of software available via cloud computing (read our blog). This gives suppliers the option of making their software available via the cloud rather than a user being required to upload the licenced software to their own server. Software licences need to maintain a balancing act between protecting the software in question and being attractive to consumers.

Monetising software

Organisations in the technology sector monetise software in various ways, including:

  • Developing software from scratch, or configuring or adapting an existing core package software, to meet a user's specific needs.
  • Software licences that licence (either standard or bespoke) directly to end-users (for them to run on their systems, locally).
  • Providing software-as-a-service. Read our blog.
  • Selling software outright, either as a standalone asset, or as part of a wider share or asset sale of a technology business.
  • Offering other software consultancy services, such as maintenance and support or escrow deposit services.
  • Software licences that licence to an intermediary, such as a software reseller or retailer, who will on-licence the software, either by itself or as part of wider bundle of products
  • Licencing their application programming interfaces (APIs). See section below for a further explanation.

Software licensing

Licensing is still the main method by which most businesses and individuals obtain the right to use software, and how software vendors make money. Traditionally, software has been licensed ‘on-premise’ but recently there has been a surge of organisations migrating to delivery of software as a service via the cloud.

Why does software need to be licensed?

A software licence is typically a combination of a copyright licence, giving the user permission to do something that would otherwise be an infringement of copyright law and a contract, to give the licensor (among other things) the ability to exclude or limit its liability and the right to sue the licensee in contract as well as copyright law.

Software is protected by copyright as a literary work under the Copyright, Designs and Patents Act 1988 (CDPA). The operation of software for all practical purposes always involves its copying in one form or another, for example, when the software is copied on to the hard disk of the computer on loading and later when it is copied into Random Access Memory, for use. Subsequent further transient copies may then be made during operation. This, and the fact that software is statutorily protected by copyright as a literary work, means that the owner of the intellectual property rights in software can prevent its use without permission.

Software Licences Permitted Use

Suppliers will generally only be prepared to grant licences of package software on non-exclusive terms so that they can grant licences of the software to multiple customers. A supplier will also often restrict the use of the software in certain ways, for example, by reference to:

  • The identity of the customer or a group of users associated with the customer.
  • The identity and number of machines or operating system environments on which the software is loaded.
  • The geographical location of the machines on which the software is loaded.
  • The purpose for which the software is used.
  • The number of concurrent users of the software.
  • The volume of processing handled by the software.

The type of restrictions will depend on the nature of the software (the supplier may have developed the software, for example, for use in a particular operating system or other software) and the manner in which the supplier typically licenses its software. The customer should ensure that any applicable restrictions are acceptable, taking into account its current and future business requirements, since use of the software in breach of such restrictions will constitute a breach of the licence and may entitle the supplier to damages, an injunction preventing use or termination (or all three). It is therefore important that the customer knows exactly what rights they are buying.

Technological changes can have a serious impact on licensing. For example, if software is licensed for use on a single server, one must consider the consequence if that server is included within a virtualised environment in which it can be made to function as a number of independent mini-computers or, if software is licensed for use on a specified server or at a specified location, you must consider the consequence of replacing or moving that server.

Software Licences Restricting Use

The supplier will often wish to ensure that use of the software is restricted to the company with which it is contracting. Typically, this is achieved by prohibiting sub-licensing and assignment under the licence. For the customer, this can cause problems in the case of groups of companies. Software that is licensed in the name of one group company may well be accessed by another group company, whether intended, as a result of inadvertence or as a consequence of organisational change. Such access may constitute a breach of the licence unless the licence permits use among group companies. This is a particular problem with utility software where what constitutes ‘use’ or ‘access’ may be unclear. If there is a virus protection program on a network, is it used or accessed by everyone whose PC is connected to the network? Consequently, the customer should ensure, where necessary, that the licence extends to all other companies in its group that are likely to use the software.

Similarly, if outsourcing is contemplated by the customer or the customer intends to engage other external service providers to provide services to the customer (for example configuration or support services), the software may need to be used by, or assigned to, the external service provider. If such use or assignment is not permitted by the terms of the licence, then the supplier may charge a significant fee for agreeing a change of or additional use.

Third parties

From the supplier's perspective, it is difficult to police the use of the software (to ensure, for example, that no illegal copying is taking place), and enforce the terms of the licence, against unconnected third parties. In order to ensure that the customer remains within the terms of the licence throughout its term, the licence could include an obligation on the customer to inform the supplier where there is any change in or additional use of the software and a right for the supplier to audit the use of the software remotely or by entry to all premises on which the software is used (the extent of which will be subject to negotiation and the respective bargaining strengths of the parties).

Software as a service

For typical on-premises software licences, the user will need a licence from the software owner (or from a licensee to whom the rights owner has granted rights to sub-license the software) to copy software to the extent necessary to install and use the software on their own computer. For software as a service, the method of accessing the software, or its functional outputs, may be different but a permission from the copyright owner will still likely be necessary. For example, with SaaS, the application software itself will not need to be installed on the user's machine, but a generic piece of software, such as a web browser, may, and the user's machine will still need to interface with the application software in some way. Because of this, the licence terminology used in a software-as-a-service agreement may change. For example, it may not be the application software, itself, which is licensed for use by the customer; the customer may only be permitted to remotely access certain functional outputs from the software, that is, to receive ‘a service’.

On-premise software licensing

On-premises software licences for business use (such as operating system software) are typically bundled with hardware when purchased. Sometimes a customer may ask for a trial period under which it may evaluate or ‘road test’ business software. This is typically done under an evaluation licence, which will provide a limited licence to use the software for a limited period, free of charge, with few or no warranties being provided by the software supplier during the trial period.

For on-premises software licences for consumer use it is essential that any terms and conditions for the use of software by consumers are drafted to comply with the extensive consumer protection rules that apply in the UK. Different rules apply depending on whether the trader is selling to the consumer online, ‘on-premises’ or ‘off-premises’.

Different distribution models for on-premise licensing

A software producer will sometimes distribute its software through a third party reseller, who may combine or bundle the producer's software with its own products, or offer other value-added services. In both types of agreement, in return for gaining access to this alternative (generally, additional) distribution channel, the producer usually agrees to sell licences to its software to the reseller at a lower unit price than would otherwise be paid if the software were being distributed on its own. The consequence of this is that the reseller obtains a more limited distribution right, as it is only entitled to distribute the supplier's software in combination with particular products of its own and/or on terms and conditions specified by the supplying company.

Competition aspects to Software Licences

Software licences may contain various restrictions which require consideration of UK competition law. These include exclusivity of the licence grant and grants of rights to improvements made by the customer. Software vendors should also be aware that, following the CJEU's decision in UsedSoft GmbH v Oracle International Corp, they may not be able to rely on contractual provisions in their software licences which prohibit a customer from transferring or assigning the software to a third party. This only applies under certain circumstance, such as where the vendor has purported to grant the customer a perpetual licence to use the software for a one-off fee. Along with all other EU case law, UsedSoft v Oracle has been incorporated into UK law following Brexit. UK courts will, however, be able to overrule it in the future.

Open-source software

Open-source software (OSS) (read our blog) is software provided under a licence which grants certain freedoms to the licensee to use and re-distribute the OSS. It is often used by software companies whilst they develop software. There are many different types of OSS licences which differ widely in clarity, length and legal effect. There are many advantages to organisations making use of OSS. The use of OSS is usually free of charge and free of many of the use restrictions that apply to proprietary software. Using pre-made OSS components (particularly for routine, lower-level tasks) shortens the development phase for projects and frees up internal resources to develop higher-level software that confers competitive advantage.

However, use of OSS also presents risks. The main risk is often that certain types of OSS licence, known as ‘restrictive licences’, adopt the principle of ‘copyleft’. This imposes licensing restrictions or requirements where the OSS is amended, adapted or combined with any other software to produce a derivative work. While the provisions vary, restrictive OSS licences will (to a certain extent) apply to both the original OSS and any derivative works based on it. This can be of key concern to organisations when using restrictive OSS alongside their proprietary ‘closed-source’ software, as proprietary software could unintentionally be made subject to the OSS licence. An example of a restrictive OSS licence is the General Public Licence (GPL).

Application programming interfaces (APIs)

In recent years, many technology companies have grown their revenues by licensing their application programming interfaces (APIs). An API can take different forms, but typically provides a set of tools, documents, protocols, and specifications that enable software applications to communicate and interact with each other. Licensing (or opening up) its API is a way for a software vendor to invite third parties to create applications that complement the supplier's offering. By doing so, the software vendor may get a better pool of integrated applications that enhance the user experience for the vendor's offering, without needing to hire or otherwise engage developers. APIs can be differentiated from traditional software applications, including to the extent they are protected under law.

Here to help

There is a lot to think about when putting software on the market. Being aware of the range of licencing issues is key when putting in place a legal framework that exists to the benefit of both supplier and customer. Software licences will continue to develop as technology does and so the challenges faced by lawyers in this sector are unlikely to diminish in the face of the never-ending innovation and ingenuity that defines it.

EM law specialises in technology and contract law. Get in touch if you need advice on a SaaS agreement or have any questions on the above.