Memorandum of a Transaction Foretold

In an acquisition or a joint venture transaction, the first substantive document on which the parties sign their name is the memorandum of understanding (the “MOU”). To a large extent, the MOU foretells the fate of the transaction.

The MOU (also known as heads of terms, letter of intent and term sheet) is a document that outlines the parties’ initial understanding of the terms of the transaction. It usually comprises a set of binding and non-binding provisions. Each set plays a different role. The binding provisions govern the mechanical processes while the non-binding provisions lay out the key commercial terms. The non-binding commercial provisions are the focus of this article.

The fate of the transaction is written in the non-binding provisions, but it is common for commercial parties to rush through them in order to commence due diligence and serious drafting. This article seeks to set out a systematic approach for determining the minimal commercial terms that an MOU should contain to ensure that there is a transaction within reach.

Binding Procedural Provisions

The binding provisions govern the process that leads to the execution of the definitive agreements. They define the parameters of the parties’ conduct and set out their obligations during the due diligence and negotiation stages. There is a fairly standard set of binding procedural provisions, which typically includes: 

  • an exclusivity provision (which is sometimes coupled with a deposit/earnest money provision) that is usually a precondition to the parties’ further investment of resources in the transaction;
  • a confidentiality provision that facilitates the exchange of sensitive business information;
  • a cost provision that typically specifies that each party bears its own costs; and
  • mechanical provisions such as the governing law and dispute resolution provisions. 

Since the procedural provisions set out the ground rules of the pre-execution phase, the parties usually agree that they should be binding. 

Non-Binding Commercial Provisions

The non-binding provisions lay out the substance of the deal. They are necessarily non-binding because the parties need to retain flexibility pending due diligence, financial modelling and further negotiations. Unlike the binding procedural provisions, there is no standard set of non-binding commercial provisions. They can range from the very vague to the very detailed, from being a little more than a formal way of saying “let’s make some money together” to being almost a full blown definitive agreement. The amount of commercial detail speaks volumes about how smoothly (or otherwise) the transaction will be.

How much commercial detail?

How much commercial detail should an MOU contain? Sometimes a purchaser may, for strategic reasons, favour a bare-bone MOU. This may occur where there are multiple bidders. The top priority for the bidders would be to secure an exclusivity arrangement with the seller as soon as possible, rather than to negotiate the commercial terms. 

Putting strategic reasons aside, the more key commercial issues addressed in an MOU the better. Some parties prefer to leave the hard issues to the drafting stage, because they wish to commence the transaction on a friendly note and they believe that the sunk cost would be so great at the later stage that the parties would have to compromise. 

This is a bad idea. If a hard issue is a deal breaker, saving it until last will not guarantee a solution. The parties may end up with a collapsed deal and a huge bill. Even if the issue is resolved in the end, this is not an efficient way to run a transaction. Moreover, in the case of a joint venture, the grilling negotiations may start the collaboration on the wrong foot.

So what are the key commercial issues that should be included in an MOU? Commercial issues can be categorised by their level of importance (ie, their potential to kill transactions) into (1) top priority issues; (2) high priority issues; and (3) low priority issues. An MOU should address all the known “top priority issues” and “high priority issues”.

Top Priority Issues

“Top priority issues” are the issues that go to the root of a transaction. Without agreement on these issues, there is simply no deal. 

Although the focus and concerns of the parties to each transaction differ, in the context of an acquisition, the top priority issues are usually those relating to the target and the price. Questions as to whether the target would include the seller’s entire business or only part of it, the indicative price, whether the consideration would be satisfied by cash or a combination of cash and non-cash should be agreed. 

Parties should also watch out for fundamental issues that are deal-specific. For example, in the context of a joint venture, if one party’s business imperative is to constitute the joint venture company as both parties’ sole platform for operating a certain line of business, this should be raised upfront and agreed in the MOU. Given the importance of this issue, the parties should also go into more detail of how this would work, such as:

  • Would each party transfer its current business to the joint venture company? 
  • How would the parties ensure that future opportunities are referred to the joint venture? 
  • What level of approval is required for the joint venture company to take up the opportunity?
  • If the joint venture company does not take up the opportunity, can one party pursue the opportunity either alone or with third parties? 

The precise wording and mechanisms can be left to the drafting stage, but the parties should lay out the principles at the MOU stage.

High Priority Issues

“High priority issues” are potential deal breakers and matters that may have a significant impact on the timeline or structure of the deal. At the MOU stage, it is not necessary to settle all of these issues in detail. The aim should be to agree on the principles for addressing the deal breakers and to signpost the matters which may materially affect the transaction. 

Warranty provisions are just one example of potential deal breakers. For instance, PRC sellers are, generally speaking, accustomed to a less extensive set of warranties than what is customary in Europe and the United States. Hence, there might be a discrepancy between the extent of warranties that a PRC seller is willing to provide and that which a European or American purchaser requires. It is obviously premature to set out the warranties in the MOU, but the parties should agree on the principles (ie, whether “mere title warranties” or “a full set of title and business warranties” would be included in the transaction document).

Non-compete undertakings are another example of potential deal breakers. At a minimum, the parties should agree on whether restrictive covenants are required. They should also try to agree on the scope of the restricted activities, territorial reach and duration of the restrictions. 

As mentioned, “high priority issues” also include matters that may significantly impact the timeline and deal structure. The purpose of including them in the MOU is not to find an immediate solution (which may not be available), but to identify hurdles, manage expectations and plan the next move. Time-consuming action items identified could also be taken care of at an early stage. 

Take conditions precedent for instance. If the parties have flagged out “merger clearance” as one of the conditions precedent to completion, once the MOU is signed, the parties could kick off the legal work stream to conduct a more thorough analysis and prepare the filing documents. If governmental or regulatory approvals are conditions precedent, the parties may wish to commence discussions with the government or regulators to explore, early on, whether such approvals would be forthcoming.

Low Priority Issues

“Low priority issues” are commercial issues that are unlikely to result in protracted negotiations. They are usually items that supplement the key commercial positions that have already been addressed as “top priority issues” or “high priority issues”. As such, the room for argument is limited. Examples would include the cap amount and de minimis threshold for warranty claims, pre-emption rights, drag-along rights, tag-along rights, the list of reserved matters. Unless a quick decision can be made, discussions on “low priority issues” could be left out of the MOU for negotiation at a later stage.

Conclusion

The non-binding commercial provisions in an MOU contain early signs of whether the road to completion is a smooth highway, a rough uphill track or a cul-de-sac. If circumstances permit, by advising clients on the “top priority issues” and “high priority issues” that should be addressed at the MOU stage, lawyers can help parties to ensure that there is a true meeting of minds and a transaction within reach. 

Jurisdictions: 

Mayer Brown JSM, Associate

Xin Fang holds a First-Class Honours Master’s Degree in Corporate Law from the University of Cambridge. She has worked at Mayer Brown JSM since 2010, focusing on international mergers and acquisitions, joint ventures and private equity transactions.