Every year, the NFIB Small Business Legal Center receives dozens of calls from business owners with all sorts of questions about contracts. As such, we thought it would be helpful to provide some basic guidance about the world of contracts. So in this post we explain how to create a binding contract, and in a separate post we address common problems that arise once the parties have agreed to a contract.
At the outset we must emphasize that contracts are a very complicated area of the law. It is always advisable to seek out competent legal counsel. Having an attorney involved in the process can help avoid problems down the road. To be sure, an attorney can be instrumental in ensuring that the contract says what it needs to and that there will be fewer “surprises” during performance. And if problems should arise once a contract has been executed, it is strongly recommended that you consult with an attorney to discuss your options.
What is a Contract?
Businesses live and breathe through contracts. Contracts represent an important tool—a binding guarantee that can be enforced in a court of law. To be sure, small business owners use contracts all the time: when hiring employees, contracting with customers, contracting out projects to independent contractors, purchasing goods, entering leases, or whenever seeking out other services. But how do you know when you have a binding agreement?
To answer that question, it is helpful to think about what constitutes a contract. In the most basic sense, a contract is an agreement between two or more parties—each promising to do something in exchange for the other’s agreement. Where there is such an agreement (i.e., a “meeting of the minds”) it becomes enforceable at law. Importantly, a contract can be either a written OR oral agreement.
With that said, it’s generally best to have something in writing. For one, different states require that different sorts of contracts must be in writing to be enforceable. But even when such formalities are not required, one might be wise to memorialize the terms of a contract in writing in case questions should arise.
Without a definitive written agreement between the parties, the specifics of the contract will be hard to figure out. Writing out the terms of the contract can be helpful in setting the expectations of all parties at the outset, which can minimize the risk of problems down the road. And should problems arise, clearly written contracts can avoid expensive legal battles that may devolve into a game of ‘he said, she said.’ For all of these reasons, it is highly recommended that any contracts you wish to enter into be finalized in writing. This is especially important if you contemplate a continuing working relationship, or for a high-dollar transaction.
There must be “Consideration” for a Binding Contract
There are a few required elements in order for a contract to be enforceable. First, one party must propose a contract (i.e. “offer”). Second, the contract must be consummated, which occurs when the other party agrees to the proposed terms (i.e. “acceptance”). And finally, there must be “consideration” (i.e. an agreement to exchange something of value) in order for the agreement to be enforceable in court.
The idea of “consideration” is tricky only because it’s an arcane term that lawyers use to confuse ordinary folks. But the concept is actually rather simple. Consideration is a bargained for good or service. In other words, it is the “benefit” or “detriment” that you agree to in exchange for the “benefit” or “detriment” from the other party.
For example, suppose that Jack and Diane both own business in the town of Heartland, USA. Jack owns a construction firm, Cougar Construction, and Diane owns a cement company, Thrill of Living Cement. At some point they realize that they can make better use of their resources by working with each other.
Cougar Construction has just won the rights to build a football stadium on Thunder Road in Heartland’s town center. Previously, Jack purchased cement from Purple Rain Cement. But Purple Rain has recently gone out of business. So in order to build the stadium, Jack will need to purchase cement from someone else. And he enters into negotiations with Diane. Eventually Jack agrees to buy 1,000 units of cement at $5.00 per unit.
In this scenario Jack’s consideration would be the $5,000 he has just agreed to pay (his detriment) in order to receive the 1,000 units of cement (his benefit) from Diane. For Diane, her consideration would be the 1,000 units of cement she now needs to produce for Jack (her detriment) and the $5,000 Jack is paying her (her benefit). So as demonstrated by this example, a mutual contract will entail both a benefit and detriment to each party. They agree to these terms because they see the overall value in the arrangement.
What Do I Need to Know about Contract Negotiations?
As noted above, there must be a mutual manifestation of assent for a contract to be binding. Or as lawyers will say: there must be “offer and acceptance.” On one level this is a pretty straight-forward concept. But we’ll address some potential pitfalls that may come-up in the course of negotiations.
Negotiations: Offer
An offer is exactly what it sounds like. It is an act offering to pay money, perform a service, or sell goods to another party. The person proposing the offer is referred to as the “offeror.”
Usually the offeror can revoke the offer at any time prior to acceptance from the other party. The offeror controls how acceptance can be shown, and sets the original terms. Additionally, the offeror can state how long the offer is open for. If no amount of time is stated, courts will usually hold that an offer is open for acceptance for a “reasonable amount of time” according to the customs and standards of the situation.
Jack and Diane: Thus for example, Jack makes an offer to Diane when he calls her and says: “I will pay you $5.00 a unit for 1,000 units of cement.”
Negotiations: Acceptance
Acceptance is pretty much exactly what it sounds like. The person to whom the offer is proposed is often called the “offeree.” Acceptance is the offeree’s assent to the offer. But this “assent” concept can be a little tricky.
In many cases the offeree will accept the offer through explicit words, whether orally in writing. But in some cases the offeror will require the offeree to accept the offer in some specific way. For example, in a formal written contract, the offeree will be directed to sign and date the agreement. But, in other cases acceptance may be conveyed by the very fact that the offeree has agreed to write a check or swipe his or her credit card—as when we buy groceries at the store. And in some cases the offeree may accept an offer simply by commencing work when asked to do so.
But again the important thing to remember is that there is no binding contract until there has been a valid acceptance. And since the offeror proposes the terms of the contract, the offeror can dictate how exactly the offer should be accepted. Importantly, the offeree cannot accept an offer while conditionally insisting on a change in the proposed terms. That sort of bargaining amounts to a counter-offer, which requires acceptance from the other party.
Jack and Diane: Let’s assume this time that Jack sends a slightly different offer. This offer says: “I will pay you $5.00 per unit for 1,000 units of cement. Acceptance is valid either through an express written agreement, phone confirmation, or when I receive the first shipment of cement.”
Upon receiving the offer, Diane can do a few things. She can accept by sending Jack a letter or email, explicitly agreeing to his proposed terms. She can also call him and confirm her agreement to fulfill his order. But she can also demonstrate her acceptance by delivering the first load of cement. All of these would be valid forms of acceptance, and would make the contract enforceable.
But suppose that Diane did not agree to the exact terms of Jack’s offer in her “acceptance.” Perhaps she might say: “I accept your offer. I’m happy to provide all the cement you need, but my going-rate is $5.50 per unit.” Do they have a binding contract yet?
The answer is: “no.” There would be no contract at this point because there is a material disagreement on the price. Diane is willing to provide cement for Jack’s project, but she has made a counteroffer—which Jack can either accept or reject. And the fact that Diane said that she has accepted Jack’s offer is immaterial because—in fact—she has proposed a different contract. In this manner, Jack and Diane may continue to negotiate until they can agree to a price; however, Jack may also choose to take his business elsewhere if Diane is unwilling to agree to acceptable terms.
A Word to the Wise
In our next post, we will talk about how to resolve contractual disputes when they arise. As we stress in that piece, it is always a good idea to go back and review the original agreement when a controversy arises. But of course, you should always read and fully understand any contract that you are signing. If something seems ambiguous, seek clarification in writing. For additional best practices, you might want to check out the Federal Trade Commission’s guidance for negotiating with credit card processors: Be Careful When Dealing With Credit Card Processors!
Overview
The law of contract is often referred to as “private law” because it effectively establishes a legal relationship between two parties who would not otherwise have any obligation to do anything for each other. Private parties are to negotiate any contract that they may like—except as foreclosed by state or federal law. Thus for example, an employer cannot require an employee to work for less than minimum wage.
Yet, while state and federal regulators may meddle in many aspects of your business, there is still a presumption of freedom of contract. But the key is that the parties must freely consent to mutually beneficial terms. But, bear in mind that this is just a basic outline of the contracting process. Laws vary from state to state, and contracts for the sale of goods (between merchants) are usually governed by the Uniform Commercial Code (UCC). It is highly advisable to consult a trusted attorney before entering into a contract, or as soon as a dispute arises.
*This article does not provide legal advice. Employers are advised to retain counsel from a trusted attorney with experience in employment law.
