Understanding Contracts

Understanding Contracts

Contracts are a part of everyday life, even if you don't run a business. Most people sign contracts to buy houses, lease apartments, set up cell-phone serviceā€¦ even join a gym. If you do run a business, the contracts you sign may make the difference between maintaining profitability and going out of business.

Let's start with the basics. A "contract" is any agreement where there is:

  • A mutual agreement
  • An exchange of valuable consideration (typically money)

Sound simple? It is. Contracts can be verbal or written, but as you can guess, written contracts are much easier to enforce. Consideration is simply something of value: for example, say you agree to sign a contract for cell-phone service. The consideration you receive is the cell service; the consideration you provide is the payment amount. Both sides receive something of value, so the contract is considered to be valid.

What makes up an effective contract? A basic contract should include:

  • Date of the agreement
  • Names of all parties
  • Clear description of the responsibilities and obligations of both parties
  • Terms of payment (or exchange of items of value)
  • Provisions for terminating or renewing the agreement reached
  • Signatures of all parties

Keep in mind a contract does not have to be called a "contract" to be legally binding. An agreement can create a contract; so can a memorandum of understanding. If terms are reached and consideration exchanged, a contract has been established.

What could cause a contract to be invalid? In order to be valid, three other conditions must be met: Competence, consent, and legality.

Competence refers to all parties having the legal ability to make a contract. Generally speaking, being over eighteen years old and having a sound mind qualifies as competence. Minors who enter into a contract can usually void that contract, but they may be required to pay for the value of the items consumed. (And they must return any existing consideration, of course.)

Consent refers to the fact all parties must agree to the terms of the contract. Consent does not require that all parties understand or even know what the contract says. (If you sign an agreement without reading it, you have consented to its terms.)

Legality requires a contract to involve a legal activity. A contract based on an illegal activity is not valid; for example, you cannot enforce an IOU provided as "payment" for illegal activities.

Now let's look at the basic types of contracts:

  • Express Contracts: Legal documents that formally describe all terms and conditions of the agreement. A rental car agreement is an express contract, since all terms are in writing.
  • Implied Contracts: Do not have clearly defined terms and conditions, and in some cases are not in writing. Implied contracts occur when, for example, you call a plumber to fix a sink. Even though you did not sign a formal agreement, the understanding is you will pay for services rendered. (If you wish to avoid entering into implied contracts, get estimates and agreements in writing ahead of time.)
  • Oral Contracts: Verbal agreements or "handshake deals" are a form of contract but are difficult to enforce since no documentation exists (unless witnesses were present). Oral agreements are common between small businesses, but rely on the good will and reliability of all parties. And as you can guess, oral contracts leave tremendous room for differences in interpretation and disputes to occur.
  • Written Contracts: Less formal than express contracts, written contracts are the most common form of contract. Written contracts spell out the basics of the agreement in significantly less detail than express contracts. Any written document, no matter how basic, can constitute a contract as long as both parties have signed and consideration has been exchanged.

But there are other types of contracts you may wish to use, especially where your employees are concerned:

  • Employment agreements. Employment agreements are made between employees and employers, specifying wages, benefits, vacation, the term of employment, etc. Employment contracts have become less and less common as more employers use "at-will" employment. "At-will" employment is when the employer and employee agree that employment can be terminated for any reason at any time (within legal guidelines, of course). Employment contracts exist outside at-will employment and more formally obligates both parties to meet specific conditions.
  • Sub-contractor agreements. A sub-contractor is a person hired to perform specific functions for a specific period of time. (A sub-contractor is not an employee.) A solid sub-contractor agreement specifies the terms of the arrangement as well as the responsibilities of all parties.
  • Non-Disclosure agreements (NDA). NDAs prohibit employees from sharing company-specific information with competitors or outside parties, even after they have left the company. Even when an NDA is not entered into, company policies regarding sharing proprietary material can spell out the agreement.

What is the bottom line on contracts? Read everything you sign, make sure you understand all the terms and conditions, and seek legal advice if you are unsure. You should especially consider seeking legal advice when you prepare agreements and contracts you will use; a lawyer can help ensure the documents you use protect your interests.


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