Whether you are running a major international corporation with customers around the globe or are the owner of a local mom-and-pop shop, contracts are an essential part of doing business.
Companies use binding legal agreements to do everything from lease space and hire employees to deal with shippers, manufacturers, vendors, and others. Binding legal agreements help ensure that operations are smooth and provide certain protections in the event that they get off track.
For small business owners, it is crucial to have a basic understanding of how contracts work and what happens when disputes over agreements inevitably arise.
Here is what you need to know.
Why You Need a Contract
There are several reasons why any business involved in a transaction should have a clear contract in place.
Legal agreements ensure that all parties are on the same page. When properly drafted and executed, they give everyone involved a clear understanding of each other’s responsibilities and obligations.
This can save you significant time, stress, and money by preventing misunderstandings later down the road. It can also provide a sense of security and peace of mind on the front end. Each party should have a reasonable opportunity to review the contract before it is signed, discuss the terms as needed, and negotiate changes before it may be too late.
Contracts also explain what happens if one or more parties to the deal do not live up to their part of it. These provisions help parties understand what they are getting into and serve as a reminder to take their obligations seriously. Having a readily available written contract reduces the risk of litigation in the first place and can prevent court battles over agreements from dragging on more than necessary.
Is it a Contract?
The term “contract” refers to any binding legal agreement between two or more parties. They are often – and definitely should be – in writing, but verbal and other agreements can also sometimes be enforceable.
In order to be enforceable, an agreement must generally meet the following requirements:
- An offer and an acceptance: One party must offer to do something and the other party must accept. In employment contracts, for example, a company typically offers the employee pay and other benefits in exchange for adequately performing the job.
- Exchange of value: Each party to a contract must agree to provide something of value. In a contract between a business and a supplier, the supplier agrees to provide certain products or materials to the business in exchange for payment.
- Intent to be bound: This requirement is often called a “meeting of the minds.” The parties must agree to all of the material terms of the deal and express an intention to be bound by the agreement.
- Certainty: The contract’s terms must be sufficiently clear that each party knows its responsibilities and rights.
Contracts that do not include all of these necessary elements are not enforceable in court. That is true even if both sides have signed the agreement and potentially even if they have started taking steps to carry it out.
Put it in Writing
There is generally no good reason not to use written contracts. Putting the agreement in writing makes it much more likely to be enforceable and reduces the risk of confusion and disputes down the road.
Some types of contracts are required to be written under state law. In New Jersey, for instance, prenuptial agreements, certain loans, leases, real property transfers, and other contracts (based on duration or value) must be in writing.
Verbal contracts can be enforceable in certain situations, but these agreements carry significant risks. Circumstances change, memories fade, and disputes often arise about what the parties had in mind when a verbal agreement was initially made.
Binding legal agreements may also be implied based on the circumstances in some cases. These deals are implied from the parties’ conduct, along with their communications and course of dealing with one another.
The problem with implied and verbal contracts is that they leave too much up for debate. Written agreements, by contrast, give everyone involved clarity and security by putting the terms down on paper (and/or in a digital file), which can be revisited and reviewed at any time.
What Should Be in the Contract?
The devil, of course, is in the details.
Any business owner entering into a contract – and its lawyer – should make sure that all of the intended terms of the deal are expressly stated in the agreement. They should also make certain that the terms are clearly understandable, both for the parties and for a judge or jury in the event of a dispute.
Here are some of the terms commonly spelled out in a contract:
- The duration of the agreement.
- The full scope of work to be performed, including all deliverables.
- Timing and deadlines, including precise due dates for deliverables and milestones whenever possible.
- Payment: Amounts, method, timing, and late fees.
- Disputes: How they will be resolved, including through mediation and other means, what law applies, and who bears the cost.
Nothing that you discussed should be left out of the contract if you want it to be enforceable. The earlier that the parties discuss and negotiate the terms, the better. Each party’s specific needs and requirements should be made clear and discussed early in the drafting process to avoid problems when it comes time to sign the agreement.
Confidentiality and Non-Compete Provisions
Confidentiality and non-compete provisions are common aspects of contracts that offer helpful protections for businesses.
Non-disclosure terms are designed to protect trade secrets and other sensitive information. These contractual provisions often bar parties from sharing certain information related to the deal or otherwise gained while performing the contract. They also provide for penalties in the event that a party violates the disclosure restrictions.
It is important to understand that confidentiality agreements are getting more scrutiny in the employment setting and when used to prevent the disclosure of sexual harassment and related accusations. A business owner considering imposing confidentiality requirements on employees should seek the advice of an experienced lawyer.
Non-compete provisions, on the other hand, generally prevent parties from using the information gained in the process of performing the contract to then compete for business with another party. These kinds of restrictions are generally enforceable so long as they are reasonable in scope and duration, protect legitimate business interests and are not harmful to the public.
Common Contract Mistakes by Small Business Owners
Small business owners frequently have a lot on their plates.
Juggling the slew of responsibilities that come with keeping the business running can leave little time to review and negotiate contracts. Yet, when margins are thin, some business owners may be inclined to try to do it themselves without the advice of a seasoned attorney.
This is a recipe for disaster. Here are some of the most common mistakes that small business owners make when it comes to contracts.
Handshake deals are not what they used to be. Your word may be bond, but promises, assurances, and guarantees mean little if they are not legally enforceable.
A well-written contract reduces risk and provides important safeguards against the uncertainties that are simply a part of life and business. If a business partner hits the road or a vendor drops the ball, for example, you do not have to just hope and pray that things will work out. You have a binding agreement that gives you recourse.
Opting for a form or “fill in the blanks” contract is also often a bad idea. A generic contract that you find online may not even be valid in your state. That is not to mention that it will not reflect the various particular facets of the transaction that need to be laid out in the terms of the agreement.
Making Themselves Parties to the Contract
When you enter a contract as a small business owner, you are acting on behalf of the business, not in your own personal capacity. There is no reason in the world that a business owner should sign on personally as a party to the agreement, and yet people make this mistake far too regularly.
Doing so means you are putting yourself personally at risk if a dispute later happens. In other words, you can be held personally liable for breach of contract. That is true even if your business is a limited liability corporation or structured in another way to generally shield you.
It is vital to ensure that it is the company – not you – is the party in any and all agreements related to the operation of the business.
Omitting Important Terms
Anything that you agree to in the course of contract negotiations is much less likely to be enforceable if it is not expressly stated in the written document.
The problem is that essential terms can be overlooked when drafting and executing a contract, especially when done in a rush or without the advice of an experienced attorney.
Terms that are commonly overlooked include:
- Performance guidelines: These guidelines should clearly state how and when the work is to be completed. They should explain the full scope of the work and indicate how any work outside of that scope will be handled, if needed. The contract should also lay out defined deadlines for performance.
- Performance standards: The contract should specifically state the goals, objectives, and deliverables. This makes it much easier to determine whether a party has lived up to its duties under the agreement.
- Breach provisions: This is where the contract explains what happens in various worst-case scenarios. Lots of things can go wrong after a contract is signed. The agreement should have a clearly defined process for resolving these situations.
- Dispute resolution requirements: You can save significant time and money by avoiding drawn-out court battles when disputes happen. Parties should agree in advance whether to take any disputes to an arbitrator or mediator. They can also determine which state’s laws apply.
- Exit provisions: Things change. Contracts should be written to give the parties an option to opt-out by giving the other party mutually agreeable notice.
Contracts can be a valuable tool for businesses large and small, but they can also cause major headaches – or worse – if not drafted properly.
The terms of any agreement should be negotiated through the active involvement of the parties (and/or their lawyers). While the parties may come to the negotiating table in a spirit of fairness and a commitment to working together, that does not change the fact that each and every term on which they agree should be clearly and concisely stated in the contract. That is essential to avoid misunderstandings and limit the risk of disputes.
Agreeing to Indemnify Other Parties
Indemnity clauses generally state that one party to an agreement will shoulder the cost of non-performance and pick up the tab if the other party is sued while carrying out its responsibilities under the contract. That includes covering lawsuits by third parties.
Service providers should not agree to sweeping indemnity clauses. These provisions significantly increase your risk, even for losses caused through no fault of your own.
Breach of Contract
Unfortunately, not everyone always lives up to their obligations under a contract. Breaches can and do happen, regardless of the setting.
When a party to a contract does not meet its obligations, this can result in significant business interruptions that are both aggravating and costly. Fortunately, small business owners have the right to seek compensation and other legal remedies when another party to a contract does not live up to its side of the bargain.
Contracts can be breached in a variety of ways, with consequences that range from minor to major. Material breaches – those that go to the heart of the agreement and cause financial or some other injury to one or more parties – fall into these general categories:
- Failure to perform
- Doing something prohibited by the agreement
- Making it impossible for another party to perform
- Repudiating the contract or making clear that you have no plan to perform
A material breach may terminate the parties’ obligations under the agreement.
Legal Remedies for Breach of Contract
Anyone who has been victimized by a contract breach will usually tell you that they would much rather that the party had simply carried out its duties under the deal.
It is important to know, however, that you have the right to take legal action in the event of a breach. That may mean filing a lawsuit or sending a demand letter instructing the other party to perform its duties and threatening to file suit if necessary.
The type and scope of legal remedies in breach of contract cases vary based on circumstances. They are broadly designed to put that party that did not violate the agreement back in the position that it would have been in had the contract been properly performed.
Money damages are a common legal remedy for businesses in breach of contract cases. Monetary compensation is designed to make the business whole for the economic losses incurred as a result of the breach.
That includes consequential damages or certain damages caused indirectly by the breach. If you have to shut down your business for a day because a supplier did not deliver necessary products on time, for instance, the revenue that you lost out on is consequential damage.
Additionally, punitive damages may also be awarded in very limited circumstances in order to punish particularly reckless or callous behavior.
An injunction may also be helpful in some situations where money damages are not adequate. A court can order specific performance, forcing the breaching party to carry out its obligations under the contract.
Defenses to Breach of Contract
There are several legal defenses potentially available to a person or entity accused of breaching a contract. They boil down to challenging whether the contract is enforceable and arguing over the meaning of the agreement’s terms.
In addition to the basic legal elements required for a valid contract, other factors may make an otherwise binding agreement unenforceable. Every party to an agreement must have the capacity to enter into a contract, for example. People under the age of 18 and those with certain mental health conditions do not have that capacity in the eyes of the law.
A person or entity who has the capacity to enter a contract can argue that the agreement is nevertheless unenforceable because it was the product of a mistake, duress, or fraud.
The good news is that small business owners can take a lot of the guesswork out of whether a legal agreement will actually hold up in court. By taking the time to ensure that the contract is clearly and comprehensively drafted and executed in a way that satisfies the legal requirements, small business owners can help protect the companies that they have dedicated their lives to building.