This article was written by Timothy R. Davis, Senior Contracts Representative with NRECA’s Vendor Management Office. Tim is a guru on US Agency-specific procurements and international procurements.
It’s a common question for many business people: what’s the difference between a letter of intent (LOI) and a formal contract? When should you use one instead of the other? Perhaps the most important difference is that although an LOI may contain legally binding language, the letter itself is not a formal commitment to the transaction being negotiated.
LOIs usually come into play during the negotiation phase of a deal—whether it’s a joint venture, a partnership, or a contract to render services. They are often used to show good faith in the negotiations process, assuring each party that the other(s) are committed to a successful outcome. In many transactions, the signing of an LOI signifies the official beginning of the negotiations process and may preclude the agreeing parties from carrying on simultaneous negotiations with others.
Contracts, on the other hand, formalize the transaction and signify a legally binding commitment to carry out the transaction as described in the LOI.
LOIs are used to clearly define the terms and conditions of the pending transaction, to ensure that everyone understands them and agrees to them. For instance, in a transaction involving a collaborative venture, it can lay out the responsibilities of each side.
Often an LOI will cover aspects such as confidentiality provisions, ownership of the final product, marketing and advertising responsibilities, and revenue splitting. This ensures that everyone knows and is satisfied with what they will be agreeing to if a formal contract is signed.
An LOI also often provides a clause (often called a “no shop” clause) that guarantees exclusivity during the negotiations phase; in other words, neither party may enter into negotiations with outside parties for the transaction in question. A no-shop clause typically covers a set period of time, often 30 to 45 days, after which the parties can decide whether to continue negotiations or back out completely.
Another common aspect of an LOI is the “Conditions to Close” section, which details the conditions that must be in place in order for the deal to go forward. This can involve anything from the sign-off by senior management, to the securing of required consents and approvals.
So, how is an LOI different from a contract? An LOI, in essence, says, “If we both agree to do this, this is what we’ll agree to,” yet it does not bind either party into actually carrying out the negotiated transaction. It does not obligate either party to undertake the transaction, but certain conditions contained within the LOI, such as exclusivity or confidentiality clauses, would be legally binding regardless.
When an LOI leads to a successful agreement, the terms and conditions are often carried over into a formal contract. The signing of a contract signals the beginning of the formal relationship, and both parties commence with the delivery of their respective responsibilities. Unlike an LOI, a contract is a legally binding document.
If you’re headed into business negotiations with another party, an LOI is an important and powerful tool for negotiating the terms of a proposed transaction if you so choose to use it.