Letters of intent and early works: starting before the contract without losing control

Projects rarely wait for lawyers. A long-lead machine must be ordered now to arrive in time. A fabricator needs to start shop drawings to hold its place in the workshop schedule. A contractor must mobilise before a shutdown window closes. The contract is “nearly there”, but not signed. So the buyer issues a letter of intent, a short document that lets work begin while negotiations finish.

Letters of intent are useful. They are also one of the most common sources of commercial trouble. Some are meant to be non-binding but end up creating obligations. Some are meant to authorise a small amount of early work but have no limit, and the supplier keeps working for months. Some are superseded by a signed contract; many are never superseded at all, and the parties find themselves completing a large project on the strength of two pages that never contemplated it. When a dispute arises, the parties then argue about whether there was a contract, what its terms were and how much should be paid.

This article explains, in general terms, the different kinds of letter of intent, what determines whether they bind, what a well-drafted one contains, how to manage them so they do not drift, and how suppliers can protect themselves when working under one. It is general information, not legal advice. Whether a particular letter creates binding obligations depends on its words and the circumstances, so take advice on significant arrangements.

What a letter of intent is, and is not

“Letter of intent” is a label, not a legal category. Documents with this title range from a polite statement that the buyer hopes to award a contract, with no obligations at all, to a binding contract for a defined package of early work. The label tells you very little. What matters is the content and the conduct that follows it.

In practice, letters of intent tend to fall into three broad types:

The third type is often confused with the first. A letter that “accepts your tender dated 4 March” may create a binding contract on the terms of the tender, even if it also says a formal contract will be prepared.

When an arrangement is binding

Whether a letter of intent creates a binding contract depends on ordinary contract principles: was there an agreement on essential terms, did the parties intend to be legally bound, and was there consideration?

Australian courts often approach “subject to contract” arrangements using categories described by the High Court in Masters v Cameron (1954). In broad terms, the parties may have:

1. reached final agreement and intend to be bound immediately, with a formal document simply restating the terms;
2. reached final agreement and intend to be bound, but made performance of some terms conditional on signing a formal document; or
3. not intended to be bound at all until a formal contract is signed.

Courts have also recognised a further category, where the parties intend to be bound immediately by the terms agreed so far while expecting to make a further contract with additional terms.

Phrases such as “subject to contract” or “subject to formal agreement” usually point to the third category, but not always. Conduct matters too. If the parties start performing, exchanging payments and acting as if a contract exists, a court may find that one does, even if the formal document was never signed. The when a conversation becomes a commitment article explains how informal exchanges can create obligations without anyone intending them to.

The core risks

For the buyer, the main risks of a letter of intent are:

• Open-ended cost. Without a cap, the supplier may continue working and claim payment for everything done.
• Unclear terms. If no main contract is signed, the buyer may be left without the protections it negotiated, such as liquidated damages, warranties, limitation of liability and security.
• Weaker negotiating position. Once work is well advanced, the supplier’s negotiating position on the remaining terms improves.
• Unwanted commitment. A letter intended as an expression of intent may be treated as an acceptance.

For the supplier, the risks are:

• Unpaid work. If the letter is non-binding or the scope is unclear, the supplier may struggle to be paid for work done, particularly if it exceeds what was authorised.
• Uncapped liability. Without the main contract’s limitation of liability, a supplier may be exposed to claims without the limits it would normally negotiate.
• Uncertain termination. If the buyer withdraws, the supplier needs to know what will be paid for work done and commitments made to its own suppliers.

When no contract governs, the supplier’s claim for payment may depend on recovering a reasonable sum for work requested or accepted, which is harder to prove and less predictable than a contract price.

What a well-drafted letter of intent contains

A letter of intent that authorises early work should be treated as a short contract. It should cover, at minimum:

• The parties, correctly named, with the authority of the signatory confirmed.
• The authorised scope, described precisely: which drawings, which materials, which activities. Anything not listed is not authorised.
• A financial cap, stating the maximum amount the buyer will pay under the letter, and that the supplier must not exceed it without written approval.
• The payment basis, such as rates, a lump sum for defined items or cost plus a stated margin, with invoicing and payment terms.
• The terms that apply, for example the draft contract’s conditions on insurance, quality, safety, intellectual property and liability, so the early work is not done in a vacuum.
• A time limit, after which the authorisation expires unless extended in writing.
• What happens on signing, typically that the main contract will supersede the letter and that work done under it will be treated as work under the contract, with payments credited.
• What happens if no contract is signed, including the buyer’s right to end the arrangement, what will be paid (for example, work done and committed costs up to the cap) and what the supplier must hand over.
• Ownership of materials, equipment and design work paid for under the letter.
• A statement of intention about legal effect, making clear whether the letter is binding and to what extent.

Keep letters of intent from becoming the contract

The most common failure is not a badly drafted letter but one that lasts too long. Negotiations stall, the letter is extended informally, the cap is exceeded “just for now”, and months later the project is substantially complete without a signed contract.

Good management practices include:

• A register of every active letter of intent, with scope, cap, value of work done to date, expiry date and the owner responsible for concluding the main contract.
• Monitoring against the cap. Require the supplier to report committed and incurred costs regularly, and increase the cap only by formal written variation.
• A deadline for the main contract, with escalation if it is missed.
• Treating extensions as decisions. Each extension of scope, value or time should be deliberately approved by someone with authority, not drifted into.
• Finishing the negotiation. If the parties cannot agree the main contract, it is often better to resolve the outstanding points, or end the arrangement cleanly, than to let the work run on under the letter.

The what your people can commit you to article covers delegated authority, which is often where letters of intent drift: project staff approve extra early work they do not have authority to approve.

Insurance, safety and site access during early works

Early works raise practical questions that the main contract would normally answer and a hurried letter often ignores.

Insurance. Who insures the works, the materials stored off site and any equipment delivered early? A conveyor sitting in the supplier’s yard, already paid for by the buyer, may fall into a gap between the supplier’s policy and the buyer’s. State which party insures what, and require evidence of public liability and, where relevant, professional indemnity cover before work starts.

Work health and safety. Any work on site, even a survey or a delivery, brings obligations under work health and safety legislation. Both parties may have duties at the same time. The letter should confirm site induction, permits, supervision and who is the principal contractor where that role is relevant.

Site access and interfaces. If early works involve access to an operating facility, state when and how access will be given, who coordinates with other contractors and how disruption to operations will be managed.

Approvals. Early works sometimes need planning, building or environmental approvals that are not yet in place. Make sure authorised activities do not get ahead of the approvals they depend on.

If you are the supplier

Suppliers can protect themselves with a few habits:

• Do not start on a verbal promise. Ask for a written authorisation that states the scope, cap and payment basis.
• Stay within the cap. Work beyond the authorised value may not be paid. Ask for a written increase before you exceed it.
• Clarify the terms. Ask which terms apply to the early work, especially liability, insurance and intellectual property.
• Track your commitments. Orders placed with your own suppliers may not be cancellable. Make sure the letter covers committed costs if the arrangement ends.
• Keep good records. Timesheets, orders and progress photographs support any claim for payment.
• Escalate stalled negotiations. A letter of intent running on without a contract is a risk for both parties. Raise it formally.

A worked example

This is an illustrative example. The businesses, figures and events are hypothetical.

A food manufacturer is negotiating a $1.2 million contract with a mechanical contractor to install a new processing line during a three-week shutdown in five months. A key conveyor system has a sixteen-week lead time, and the contract will not be signed in time to order it. The manufacturer issues a letter of intent authorising the contractor to:

• prepare shop drawings for the conveyor system; and
• place an order for the conveyor, with a cap of $180,000 covering both.

Payment is the supplier’s cost plus 8% for the order, and agreed hourly rates for drawings. The letter applies the draft contract’s insurance, quality and intellectual property clauses, expires in eight weeks unless extended in writing, and provides that if the main contract is not signed, the manufacturer will pay for work done and committed costs up to the cap and take ownership of the conveyor and drawings.

Six weeks later, negotiations over liquidated damages have stalled. The contractor asks to start procuring electrical components “to protect the shutdown date”. The manufacturer’s project manager agrees by phone. A month later the contractor invoices $64,000 for electrical components on top of $172,000 for the conveyor and drawings, a total of $236,000, which is $56,000 over the cap. The letter has expired, and no written extension was issued.

The manufacturer now has an awkward position. The electrical work was requested, so it may have to pay a reasonable sum for it even though it was outside the letter. Its negotiating position on the main contract has weakened. Had it tracked the register, it would have seen the expiry approaching, issued a formal written variation increasing the cap and extending the term for defined electrical items, and escalated the liquidated damages negotiation to senior decision-makers before the shutdown date added pressure.

How this applies to a small Australian business

• Use letters of intent only when they are necessary. If the contract can be signed in time, sign it.
• Treat early works letters as short contracts. Scope, cap, payment, terms, expiry and exit belong in every one.
• Be careful with the word “accept”. Accepting a tender can create a binding contract immediately.
• Keep a register and watch the cap. Most problems come from letters that run on unnoticed.
• Make extensions formal. Phone approvals and informal emails erode the cap and the record.
• As a supplier, protect your commitments. Make sure orders to your own suppliers are covered if the arrangement ends.
• The how contracts are formed article explains the elements that turn exchanges into contracts, which is the background to every letter of intent.

Common mistakes

• Relying on the title. Calling a document a “letter of intent” does not decide whether it binds.
• No cap. An uncapped authorisation is an open cheque.
• No expiry. Letters without a time limit tend to become the contract by default.
• No terms. Early work done without agreed terms on liability, insurance and intellectual property creates gaps.
• Informal extensions. Verbal approvals beyond the cap undermine the arrangement and the buyer’s negotiating position.
• Ignoring the exit. Not deciding what happens if no contract is signed leaves both parties exposed.

Questions to ask

• Is a letter of intent really necessary, or can the contract be signed in time?
• Is this letter meant to be binding, and does its wording make that clear?
• What exactly is authorised, and what is the maximum value?
• Which terms of the draft contract apply to the early work?
• When does the authorisation expire, and who is responsible for concluding the main contract before then?
• What will be paid, and what will be handed over, if no contract is signed?
• Who has authority to extend the scope, value or time, and how must extensions be recorded?

Bringing it together

A letter of intent lets work start before the contract is signed, which is sometimes essential. Its legal effect depends on its words and the parties’ conduct, not its title: it may be a non-binding expression of intent, a binding authorisation for defined early works or an acceptance that creates the contract itself. The safest approach is to treat any letter that authorises work as a short contract with a precise scope, a firm cap, a payment basis, applicable terms, an expiry date and a clear exit, and then to manage it actively so it ends when the main contract is signed, rather than quietly becoming the contract.

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Source: KEVOS editorial notes. Examples and figures in this article are illustrations. This article provides general information and does not constitute legal advice.