Letter of understanding: Overview, definition, and example
What is a letter of understanding?
A letter of understanding (LOU) is a formal document that outlines the key terms and intentions of an agreement between two or more parties before a final, legally binding contract is signed. It serves as a preliminary agreement that clarifies the main points of negotiation, expectations, and responsibilities. While an LOU is not always legally binding, it can serve as evidence of the parties’ intent and provide a foundation for future contracts.
For example, two companies negotiating a joint venture may draft a letter of understanding to outline their roles, financial contributions, and intended timeline before drafting a final contract.
Why is a letter of understanding important?
A letter of understanding is important because it helps prevent misunderstandings by clearly documenting what has been discussed and agreed upon during negotiations. It provides a roadmap for formalizing an agreement, ensuring that all parties are aligned before committing to a legally binding contract. LOUs can also help streamline contract drafting, saving time and reducing the risk of disputes later.
For businesses, an LOU offers a structured way to document preliminary discussions, making negotiations more efficient and reducing uncertainty. It also serves as a reference point if disagreements arise during the final contract drafting process.
Understanding a letter of understanding through an example
Imagine a manufacturing company and a supplier discussing a long-term supply agreement. Before signing a detailed contract, they draft a letter of understanding that specifies:
- The supplier will provide raw materials for three years.
- Pricing will be determined based on quarterly market rates.
- The final contract will be signed within 60 days.
This LOU ensures that both parties have a shared understanding before committing to a legally binding agreement.
In another example, an employer and a prospective employee may sign a letter of understanding outlining job responsibilities, salary expectations, and potential start dates while awaiting final contract approval.
An example of a letter of understanding clause
Here’s how a letter of understanding clause might look in a document:
“This Letter of Understanding sets forth the principal terms agreed upon by the Parties regarding [insert subject matter]. The Parties acknowledge that this Letter is not intended to create legally binding obligations, except where explicitly stated. A final and binding agreement will be negotiated and executed by the Parties within [insert timeframe].”
Conclusion
A letter of understanding is a valuable tool for documenting key terms and intentions before a final contract is signed. It helps clarify expectations, prevent misunderstandings, and serve as a reference point during negotiations. While not always legally binding, an LOU ensures that all parties are aligned before moving forward with a formal agreement. When drafting an LOU, it is essential to specify whether the document is legally enforceable and outline the next steps for finalizing the contract.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.