What is a heads of agreement?
A heads of agreement is a short document that records the key commercial terms two parties have reached during negotiations, before they sign the full formal contract. It is also called a heads of terms, a memorandum of understanding, a term sheet or a letter of intent. In Australian business these names are used interchangeably, and none of them, by itself, tells you whether the document is legally binding.
A heads of agreement is a written record of where the deal stands. It lets the parties show each other, their lenders and their advisers what has been agreed, and it gives the lawyers a roadmap for drafting the formal contracts. It is common before buying or selling a business, entering a joint venture, setting up a supply or distribution arrangement, or agreeing the terms of a funding round.
The key point to understand is that a heads of agreement can be binding, non-binding, or a mixture of both. Whether it is one or the other depends on the words used and how a court reads them.
When is a heads of agreement legally binding?
Australian courts decide whether a heads of agreement is binding by asking what the parties objectively intended, judged by the language of the document read in context. Claims made afterwards, such as "I never meant it to bind", carry little weight if the words say otherwise.
The leading authority is Masters v Cameron (1954) 91 CLR 353, a High Court decision about a sale of land agreed "subject to the preparation of a formal contract". The High Court said a preliminary agreement can fall into one of three classes:
- Class 1: the parties have settled all the essential terms and intend to be immediately bound, with a fuller formal contract to follow that restates the same terms. This is a binding contract from the start.
- Class 2: the parties have agreed all the terms and intend to be bound, but performance of some obligations is conditional on a formal document being executed. The agreement is binding, but particular obligations only take effect when the condition is met.
- Class 3: the parties do not intend to be bound at all until a formal contract is executed, usually signalled by words such as "subject to contract". There is no binding contract.
In Masters itself, the document was held not to create a binding contract, and the deposit paid had to be returned. The High Court explained that expressions like "subject to contract" or "subject to the preparation of a formal contract" prima facie create an overriding condition: what has been agreed is the basis for a future contract, not a contract in itself.
So three things drive the outcome: whether the essential terms are all agreed, whether the document shows an intention to be bound now, and whether it is left "subject to contract" or to a formal document. A clause that says this heads of agreement is not binding will normally achieve that result. A clause that says the parties agree to be bound by these terms will normally bind.
Many heads of agreement are deliberately mixed. The commercial terms are stated to be non-binding, while clauses dealing with confidentiality, exclusivity and "no shop" arrangements are expressly binding from signing. That split is legitimate and common, but it only works if the document says which clauses are which.
Courts have also had to deal with clauses where parties promise to negotiate in good faith. Historically there was real doubt about whether such promises could be enforced at all. In United Group Rail Services Ltd v Rail Corporation NSW [2009] NSWCA 177 the NSW Court of Appeal held that an obligation to undertake "genuine and good faith negotiations" can be sufficiently certain to be enforceable. A bare promise to negotiate in good faith is therefore not automatically empty wording, and it should not be treated as harmless boilerplate.
What should a heads of agreement include?
There is no statutory form, but a useful heads of agreement covers the following:
- Parties: the full legal names of everyone entering the deal, including the correct entity names of companies.
- Purpose: what the deal is, for example the purchase of a business, a joint venture or a supply arrangement.
- Key commercial terms: price, payment structure, responsibilities, timelines and milestones.
- Confidentiality: what information stays secret during negotiations and after.
- Exclusivity: whether either party is locked out of negotiating with third parties for a period.
- Conditions precedent: what must happen before the formal contract is signed, such as finance approval, due diligence or board sign-off.
- Binding and non-binding clauses: a clause stating precisely which provisions are intended to be immediately binding and which are statements of intention only.
- Next steps and timing: how and when the formal contract will be prepared, and the target completion date.
- Termination and expiry: how long the document lasts and how a party withdraws.
The binding and non-binding clause is the most important one, and it is the one most often left vague. If the document is silent, a court will infer the parties' intention from everything else, and the outcome may surprise you.
The worked example: heads of agreement at a mediation
A NSW case shows how these principles play out in practice. In Cacace v Bayside Operations Pty Ltd [2006] NSWSC 572, a couple who ran a café under a management agreement in a Port Macquarie hotel were locked out after a dispute about access to the hotel's kitchen and restaurant areas. At a mediation, a document called "Heads of Agreement" was signed. It referred to the exchange of further agreements "incorporating these Heads of Agreement", and said that obligations would take effect from the date of that exchange.
The hotel owner argued the heads of agreement was a binding compromise of the dispute and asked the court to order specific performance. The Supreme Court dismissed that claim. The document plainly contemplated that a further formal agreement would be prepared and exchanged, and that obligations would only arise from that exchange. On the Masters v Cameron framework, that made it a document where the parties had not yet committed themselves.
The lesson for a business owner is double-edged. Relying on a "formal agreement to come" clause can keep your heads of agreement non-binding, which is what the café operators needed. But the same style of clause can defeat you if you are the party who wants the deal enforced, and in a Masters class 1 case the expectation of a later formal document does not stop the agreement from binding immediately. The document has to be drafted so that its status is unmistakable.
Common misconceptions about heads of agreement
Several misconceptions recur when owners think about heads of agreement, and each one is worth correcting:
- "It's just a draft, so it can't bind me": This is the most expensive mistake. Depending on its wording, a one-page heads of agreement can be a fully enforceable contract. The label on the document does not decide the issue; the words and the completeness of the terms do.
- "If it says subject to contract, I'm safe": Usually, but not automatically. The whole document is read in context, and conduct can matter. Even where a document is not binding, statements made during the negotiations can still create exposure under s 18 of the Australian Consumer Law (Schedule 2 to the Competition and Consumer Act 2010 (Cth)), which prohibits conduct in trade or commerce that is misleading or deceptive or likely to mislead or deceive. A confident claim in a heads of agreement about a business's turnover, for example, can found a claim even if the agreement itself is never signed.
- "A free template will do": A template gives you headings, not judgment. It will not be tailored to your deal, and it may include binding language you did not notice or omit terms that matter to your transaction.
- "If we never sign the final contract, nothing can happen": Binding clauses such as confidentiality and exclusivity take effect immediately and survive. Breaching them can expose a party to a damages claim even if the main deal falls over.
Where a commercial lawyer helps
A commercial lawyer's job with a heads of agreement is to make sure the document does exactly what you want and nothing more. That means advising on whether the deal should bind now or only after the formal contract, drafting the clause that separates binding from non-binding provisions, and checking that the essential terms are complete enough that a court could enforce them if it came to that.
A lawyer will also deal with the clauses that commonly cause trouble: exclusivity arrangements and "no shop" periods, confidentiality obligations that survive the end of negotiations, conditions precedent that are clear enough to operate, and the consequences if the deal collapses. Where the transaction is a business purchase, there may be regulatory approvals, lease assignments, employee transfers and tax consequences to map out before anyone signs anything.
Even if you intend to use a template as a starting point, having a lawyer review it before it is signed is far cheaper than litigating over what it meant afterwards. The cost of the review is small against the cost of being bound to a deal you thought was only an intention.
Decide which promises must bind before you sign
Before anyone signs, decide which promises you need to be able to enforce tomorrow, and which you are happy to treat as intentions. The single most common source of loss in this area is not the deliberate breaking of a deal, it is the party who assumed their heads of agreement could not bind them, only to find a court reading it as a binding contract.
The question to put to your lawyer is simple: if this deal falls over next week, which clauses do you need to be able to enforce? Work through the document clause by clause and label each one binding, conditional or a statement of intention. Then the document's legal status is a decision you have made, not something a court decides for you later.