Engagement Letter: What It Is, How It Works, Why It's Important

What Is an Engagement Letter?

An engagement letter is a written agreement that describes the business relationship to be entered into by a client and a company. The letter details the scope of the agreement, its terms, and costs. The purpose of an engagement letter is to set expectations on both sides of the agreement.

How an Engagement Letter Works

A letter of engagement serves the same purpose as a contract between two parties. However, its format is less formal than a contract and it generally avoids legal jargon.

The letter is intended to briefly but accurately describe the services to be delivered, the terms and conditions, the deadline or deadlines, and the compensation. A letter of engagement is a legal document and binding in a business deal.

An engagement letter also serves to limit the scope of the company's services. For example, when an individual or business secures the services of an attorney, the letter might describe the specific purpose or area of expertise in which their services can be used.

A contractor who hires an attorney to draw up a land purchase cannot call the attorney for advice about his divorce. The engagement letter will not state that fact as baldly, but the meaning will be clear.

Advantages of an Engagement Letter

Setting expectations is important. The client gets the reassurance of knowing when a service will be completed, and how much it will cost. The letter also makes it clear if other costs are involved that are not covered in the agreement, such as required software that must be purchased separately by the client.

The business has set boundaries on the work that is expected to be performed. This is intended to prevent "scope creep," something that every tax accountant and attorney dreads. The letter may also cite services that lie outside the current agreement but may be added in the future as needed, with an estimate of the costs of these additions.

An engagement letter may include a clause regarding mediation or binding arbitration for the relationship. This clause provides guidance for managing any disputes arising between the parties.

Special Considerations

If the relationship is long-term, many companies require their engagement letter to be updated and signed again by the client annually.

This allows for any changes in the business relationship over time and strengthens the legal standing of the document. It also reminds the client of the scope of the agreement, perhaps forestalling "scope creep."

The Bottom Line

Companies offering a service can face all sorts of problems if they don’t lay out their boundaries in a written, legally binding contract. Engagement letters essentially help protect firms from lawsuits while offering customers clarity over what services they can expect to receive and when. In short, they seek to avoid misunderstandings and basically function as a cheaper, simpler alternative to a regular contract.