Heads of terms and due diligence: why are they the foundations of a good deal?
Along with great potential, transactions such as mergers, acquisitions, joint ventures and investment carry huge risks. ‘Heads of terms’ and ‘due diligence’ are two key stages in the life cycle of a deal that minimise the risk of unpleasant surprises, and set it on the path to success.
Heads of terms
Sometimes known as letters of intent, heads of terms set out the key elements of the transaction. This is the primary negotiating document that puts in writing the expectations and obligations of all involved. It also lays a roadmap for how the deal will be done, including a timetable of key milestones.
The heads of terms are not legally binding, and may not even reflect the eventual deal that is signed. However, they present a strong starting point which may flush out misunderstanding or unanticipated problems and are an ‘agreement in principle’ that will shape the rest of the transaction. Once the heads of terms are agreed, due diligence can begin.
In law, ‘diligence’ means care and caution, and this is exactly what the process seeks to bring. Due diligence is an evaluation of the ‘target’ business that is undertaken by its purchasers, investors or future business partners. The evaluation examines a wealth of legal and accountancy information to identify the following:
Due diligence primarily sets out to prove that the claims of the target company are true. That doesn’t necessarily mean target companies deliberately lie (although it has been known to happen), but rather than an outside perspective and expert analysis may offer a different interpretation of the data.
• Additional risks and opportunities
Due diligence can also expose risks that the target company isn’t aware of, or doesn’t perceive the full extent of damage that could occur. Equally, the process is key for uncovering areas of further opportunity within the target company. This might include physical assets or intellectual property that can be exploited in different and innovative ways.
The due diligence reports will help the buyers, investors or partners decide whether to proceed. In many cases, queries and concerns prompt a further round of negotiations over the price, or key terms of the deal.
The value of getting it right
Deal making is an expensive undertaking for all sides, particularly the due diligence stage. While the buyers, investors and partners incur the cost of undertaking the due diligence itself, the target business must spend time and resources providing replies to the questions, and preparing documents in response to requests. Much of this will require the support of accountants and lawyers.
If the deal fails, all parties can be left with costs that cannot be recouped. However, bear in mind that the financial cost of the due diligence process is likely to be significantly less than the potentially catastrophic costs of an unsuccessful purchase, investment or partnership.
The best chances of success rely on the experience of your accountants and lawyers in not only being familiar with executing due diligence, but also possessing the commercial acumen to spot risks and opportunities in a venture.
SA Law’s Corporate team has worked with a huge range of companies on major transactions. Contact us if you want to learn more about the process, or want to chat about a specific deal you are working on.