Before You Sign A Commercial Contract

This one of the first posts I wrote as a guide on what you need to do before you sign a commercial contract.

You can use it as a checklist for all tasks and activities you need to perform preceding the contract signature.

What is the purpose and what are the goals of a contract? When does the contract lifecycle process start? What do you need to do before submitting a proposal? How do you prepare for negotiation and what can the result of successful negotiation be? And, in the event of a successful negotiation, is a legally binding agreement always the outcome?

The focus will be on commercial contracts from the perspective of the supplier.

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The Purpose and Goals of a Contract

Let’s start with the purpose of contracts.

The main purpose of any commercial contract is to allocate the parties’ respective rights, risks, and responsibilities.

Traditionally the goals of a contract are to:

• Maximize business value over the lifetime of a contract
• Make your rights and obligations as clear as possible, and encourage correct delivery and acceptance.
• Protect you against the risk of another party suing you.
• Limit your liability in the event that a dispute came to court.
• Ensure that if a dispute comes to court, your understanding of your liability will be upheld by the court.
• Protect your intellectual property.
• Provide a clear way of dealing with changes during the term of the contract.
• Provide a mechanism for addressing disputes, to avoid getting to court.

The Collaborative Contract

Traditional contracting centers very much on solving future conflicts and penalizing each other for non-performance.

Agile contracting is a more collaborative way of contracting and focuses on:

• Close collaboration in defining the products and services you will deliver
• Working towards common goals, interests, and organizational objectives of all parties involved
• Sharing risks, skills, resources, and values.

Whatever the goals, you and your team must write the contract for multiple audiences that may include:

• The customer
• Your own lawyers or legal advisors.
• The other party’s lawyers or legal advisors.
• The executives of both your business and the other party, who need to sign off on the deal.
• The operational buyer (the person within the purchasing organization who actually wants to use the product or service).
• Your procurement professional.
• The finance departments on both sides.
• The salesperson.
• The delivery team and project manager.
• The day-to-day users of the product or service.
• Future stakeholders taking over the contract.
• A judge, if a dispute gets to court.
• Subcontractors and vendors.

You, therefore, have to write the contract in an understandable way. All users – technical, legal, and business – should be able to understand the contract long after it has been signed.

In the next chapters, I will focus on the different steps needed before you can sign a contract.

The Processes, Tasks and Documents Needed to Sign a Contract

The initiation

As I wrote in one of my other posts on the contract lifecycle, like here on CLM, the contract lifecycle starts as soon as you have identified a sales opportunity.

Often it is when you and your teams start working with the customers on defining the customer requirements.

Based on that input you need to prepare the value proposition and put everything together in a business case.

Ideally, your salespeople have a good relationship with customers. Especially if it concerns existing customers. They should therefore already be aware of any forthcoming requests for information, quotation, or proposal. If you’re surprised by a request, you need to work harder on getting to know your customer. Or you may be talking to the wrong person.

The Request for Information (RFI), Quotation (RFQ) or Proposal (RFP)

In most companies, the proposal writing process starts with a request by a third party – prospect or existing customer.

Occasionally, it can also be a request from your salespeople to create an offer. In that case you call it an ‘unsolicited offer’.

There are several types of requests prospects or customers can send you a request for:

• information (or RFI)
• budgetary quotation (RFQ or ROM)
• proposal (or RFP)
• an invitation to tender (or ITT)

The RFI

In the case of an RFI the prospect or customer is not seeking a specific contractual relationship. They only want information on capabilities and expertise to:

• obtain up-to-date technical information on available products
• get information to support decision making
• collect data to prepare for an effective RFP
• receive budgetary quotations.

In the case of replying to an RFI, you can provide the other party with the data asked for.

As long as the data requested do not contain specific cost/price information, commitments, guarantees, IP, or other terms and conditions.

Make sure that have any correspondence or data shared with prospects and/or customers first checked by your contract specialists or legal experts.

The RFQ

In the case of RFQs, you indeed share specific cost/price information that the customer can use for budgetary purposes. However, this should be drafted in such a way that it is still non-committal. If it’s written like a proposal, the customer may accept it and you’ll be bound to the quoted prices.

You can use ‘Rough Order Magnitude’ (ROM) estimates in reply to RFQs. A ROM is an estimate of costs and time that you provide in the early stages of a project. It is when the scope and requirements have not been fully defined.

It is used to reduce the uncertainty of cost outcomes for both parties when you still have to identify all details.

A typical reply to a ROM request usually looks something like this. A new aircraft will cost between a minimum of 120 and a maximum of 150 million dollars depending on which options your customers will require and which terms and conditions the parties will agree upon for the purchase of the aircraft.

In fact, it is (solely) input that your prospects or your customers need for a decision to proceed whether or not to request a formal offer (through an RFP).

You should be very careful in replying to an RFQ and not include specific prices or terms and conditions. Or you should write the replies in such a way that you define the price as an estimated range with wording making it very clear that the reply is for information only etc.

If a prospect or customer would accept such a ROM, it would be very hard (also in court) to argue it was not a real and formal offer.

So also here: please let your contract specialists or legal experts check your replies to RFQs and ROMs.

The ITT or RFP

In the case of an Invitation to Tender or Request for Proposal, your reply will be a formal business proposal.

The business proposal

The format of the business proposal

A business proposal is “a voluntary but conditional promise submitted by one party to another party for acceptance, and which becomes legally enforceable if accepted by such other party”.

In aerospace, aviation, and high-tech industries business proposals we often draft in the same format and structure as the contract that you will draft and edit as soon as negotiations start.

It is good practice to set a business proposal up in such a way that just adding a second signature of the counterparty under such offers automatically constitutes an agreement. But, to be honest, I have never seen that happen. You will always make some kind of negotiation and changes to the original wording.

It is, therefore, important not to include in the terms and conditions part of proposals any sales, marketing, or other commercial statements, let alone (performance) guarantees, or commitments that you don’t want in the contract in the theoretical event the proposal is accepted without negotiation.

The place for commercial or marketing statements can be the cover letter you may add when sending the proposal. But also there (and in all other correspondence and marketing presentations) you need to be careful with such representations.

Also check in the contract that there is an ‘Enter Agreement’ clause stating that other agreements, letters, discussions, representations, commitments made in the past, and not specifically defined in the agreement, will not be applicable and therefore superseded by the contract.

The criteria to sign a valid and legally binding agreement

In order for the law to recognize an agreement as being a legally binding contract, there are a number of criteria that need to come back in your proposal:

1. Offer

A party must have made an offer capable of acceptance.

This could be an offer to supply goods or services, or to enter into some other form of the legal relationship, or an offer to do, or refrain from doing, something of value to the other party.

2. Acceptance

To become an agreement, the other party must have accepted the offer in the form in which it was made.

If a party indicates to have accepted an offer but in a modified form, acceptance has not occurred, and instead, the party has made a counteroffer.

3. Valuable consideration

In the proposal, there must be a benefit that each party will receive as a result of the performance of the other party: Party A selling goods to Party B in exchange for the price.

In some agreements, there is no cash consideration. It may be that one party is making a promise to do or refrain from something, and the other party does not have to do or provide anything in return.

In this case, there is no obvious ‘valuable consideration’, and the contract could be considered void for lack of consideration.

4. Offer expiration date (validity)

A crucial element in the proposal I always add is the validity or expiration date.

After a certain date, the customer and you need to sign the contract. Or if certain circumstances (fees, delivery schedule, technology) changed, the proposal should no longer be applicable.

Therefore, an expiry (or ‘validity’) date is needed for the other party to know when to hold you responsible.

Not only for the fees you set but also for the delivery schedule and other conditions you promised.

The consequences of not putting an expiration date on a proposal can range from mildly annoying to downright harmful to your business.

Also, you need to think about the period. Longer periods mean higher risk.

Before and during the proposal phase preparing a negotiating strategy is fundamental to getting reasonable terms and conditions in the contract you will sign with your customers.

Setting up a negotiation strategy

Some general rules for preparing negotiation are:

1. Plan your negotiation and identify what leverage (being able to influence) through negotiation will make all the difference in the final contract; therefore already in or before the proposal phase, there must be a plan to maximize such leverage.
2. In the case of ‘third-party paper’ (terms and conditions provided by customer) the customer’s contract and terms and conditions (Ts & Cs) need to be reviewed as early as possible with input from the various functional, operational, and commercial/legal teams
3. You must make clear to the customer from the beginning that the pricing in your proposal is based upon reaching a satisfactory resolution of Ts & Cs.
4. Interim agreements (such as a Memorandum of Understanding or ‘MOU’ or an Instruction to Proceed or ‘ITP’; see later) should in general not be used instead of a contract. Use them only in those extreme circumstances where the contract is in progress and the award of business is reasonably certain. Or when work already needs to be started before you can sign the final contract to make sure the product or service is delivered on time.
5. Also, for a new product, our costs and pricing are sometimes not decided until after you do substantial engineering or research work (‘Non-Recurring Cost projects). In that case, a proposal for an interim agreement is required which allows you to recover its costs of the engineering and research work (like in the case of feasibility studies).
6. You should make good use of best practices observed in past negotiations, but you should never just copy signed agreements. They will always contain negotiated compromises that may not be beneficial to you or your company.
7. Involve your contract specialists and/or legal experts on which contract vehicle and which sets of Ts & Cs to use for (new) cases or customers.

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The pre-contractual agreement or agreement to agree

Before you and your customer sign a contract, it is possible to insert an extra step. Before reaching the final agreement parties can “agree to agree” on major topics in a memorandum of understanding (MOU), letter of intent (LOI), or heads of terms (HoT) document. Although there are some difference’s in this post I’ll further use MOU’ to describe them.

They are grouped together in this section because – generally speaking – none of them is intended as such to create a legally binding contract. They are therefore called “pre-contractual” documents.

A “memorandum of understanding” (MOU) is a document outlining certain key terms, commercial or legal, that the parties have agreed should be reflected in a binding formal contract that they have yet to conclude.

They tend to be used in the pre-contractual phase when parties are discussing a potential new relationship or deal and want some form of ‘cover’ while they invest time and potentially other resources in developing the relationship. In a complex transaction, an MOU can be useful in highlighting key issues and may help focus the negotiations. 

The difficulty with these sorts of documents is that it is common for a party to sign such a document mistakenly believing that it represents a binding agreement.

An MOU is typically an incomplete and non-exhaustive description of the commercial deal and it is, therefore, dangerous to treat an MOU as a substitute for a fully-drafted agreement, since it may contain gaps and ambiguities.

Another risk is that a party may use the agreement within its own organization as leverage to secure resources or disclose information.

Legally binding provisions in an MOU

An MOU may be used to give the ‘go ahead’ for a project to begin while you are still in negotiation and before you sign the final contract.

However, unless the document is expressly written to provide for payment for the supplier in the event that the main contract is not signed within a fixed amount of time, this can be a recipe for disaster.

What you at least would require in the event you want to start work before you and the customer sign the contract is an ‘Instruction to Proceed’ (ITP) signed by the customer in which the customer asks you to already start work and commits to paying for work performed, even if the negotiations and final agreement are not concluded anymore.

So,it is possible to state that certain provisions of the MoU are intended to be legally binding, and to establish appropriate consideration so as to make them so.

This mechanism is often used to allow the document to function as a non-disclosure agreement, or to protect a party’s intellectual property, and can be used to set out the basis for payment if the main agreement is not signed.

But you should take care to ensure that this is done clearly so that you can rely on the relevant provisions before disclosing information or starting work.

While a Letter of Intent (LOI) usually evidences serious intent, whether it legally compels the parties to conclude the deal on those terms, or even at all, will depend on the circumstances. 

To avoid any dispute, the terms of the letter should be clear as to whether or not it is legally binding or if only some parts are legally binding (for example, the confidentiality provision).

‘Subject to Contract’

The phrase “subject to contract” is commonly used in commercial negotiations to show that the parties do not intend to be legally bound unless and until they sign a formal written contract.

When used, the phrase “subject to contract” in Letters of Intent and Memorandums of Understanding (see above) strongly suggests that the parties do not intend to be legally bound until they sign a formal contract.

The parties must agree, either expressly or impliedly, that the “subject to contract” status no longer applies if they want to lift this condition.

However, you still need to be careful, because in exceptional circumstances a binding contract may come into existence even if the phrase ‘subject to contract’ is not used.

The behavior of the parties may in some circumstances supersede the “subject to contract” wording.

If the parties conduct themselves as if they are legally bound and begin to perform their obligations, a court may conclude that they intended to be bound and therefore that an implied binding contract has come into effect. 

For example, if one party effectively performs its obligations as set out in the document and the other party benefits from this, the courts are likely to find that there is a binding contract even if the phrase “subject to contract” has been used.

Conclusion

• There are different forms of requests that will start the proposal process: request for information, quotation (or ROM), proposal, or an invitation to tender
• If the request comes from one of your departments and not from the customer it will be an ‘unsolicited offer’
• The criteria that need to be addressed in a proposal to arrive at a legally binding contract are:
  • Offer
  • Acceptance
  • Valuable consideration
  • Offer expiration date (validity)
• Preparing a negotiating strategy is fundamental to obtaining reasonable terms with customers
• The result of a negotiation can be a pre-contractual agreement like a memorandum of understanding, letter of intent, or heads of terms that in principle is not legally binding
• This doesn’t mean that there never are legal consequences, since the exact legal effect of a letter of intent will depend on the circumstances
• By using the phrase “subject to contract” there will be a strong presumption that the parties do not want to be bound by its terms
• Better is to ensure that you don’t begin to perform your obligations before you and your customer sign a formal contract
• Still, ultimately a court may still, based on their perceptions of what the intentions of the parties were, conclude that a binding contract exists despite the use of the phrase.