Overview of Contract Principles

08/03/2021

You’ve almost landed your first major customer/supplier after a long road of struggles. It’s been tough, maybe the toughest thing you’ve done. Most don’t understand the level of commitment necessary and the true extent of your sacrifice. But wait, you are staring down a 32 page agreement with pen in hand. Half the language makes no sense and the other half doesn’t sound nice. Your smaller customers/suppliers haven’t demanded a contract. This contract seems like a hurdle, a task, a chore, something in your way that is stopping you from closing the deal. But it’s not.

Contracts enhance business. At least they should. And you must learn to utilize them as such.

Hopefully your first brush with contracts comes long before your first major business interaction. Otherwise that interaction will be painful, and at least a few of your non-contract deals will cause a headache or two (and may endanger your entire future business). The importance of contracts really can’t be overstated.

As discussed in this chapter, a contract can be simple and easy to understand. You simply need to ensure that you have the proper elements. Contracts establish the rules of the relationship between the parties. In fact, you can view contracts as establishing the law as it pertains to the parties and their defined relationship. As such, contracts are more than a formality. Contracts are necessary, guiding, and protecting tools. Contracts enhance business.

What is a contract?
A contract is a legally enforceable promise. The law provides a remedy if a party breaks their contractual promise, otherwise known as a breach of contract. Without a contract, you are stuck with a promise, and if that promise is broken, you are left to your devices to make yourself whole. Unless you have some unsavory friends or a vigilante streak, you’re left with pestering, moaning, and whining as your remedial tools. And the other side knows it, which is why a contract in effect provides much more than a remedy at law.

The fundamental legal requirements to have a contract are that there is an offer, an acceptance, and consideration. Each of these will be discussed in greater detail later in this chapter. Only some contracts are required to be in writing, which means that a “hand shake” deal may actually be an enforceable contract. Despite this legal reality, common sense dictates having a written contract to avoid unnecessary dispute and costly litigation on whether an oral contract exists and exactly what the oral contract consists of. The prototypical contract is written and consists of recitals (background information), covenants (promises), representations and warranties (disclosures and more promises), and a signature page (acceptance).

What does a contract do (for me)?

Contracts provide an incentive structure. Because there is an underlying enforceable remedy, a contract greatly increases the likelihood that each party will satisfy their obligations. Although 99% of contracts aren’t litigated or enforced by a court, contracts provide enormous value by simply providing potential legal recourse. You may enjoy this advantage or be influenced yourself by the threat of litigation.

Additionally, a contract is effectively private law among, and established by, the parties. It provides the rules and regulations for private interaction similar to how the Utah Code establishes social rules and regulations. But a contract can be tailored and crafted to a very unique relationship or specific circumstances. A well drafted contract speaks to the parties and its reference provides valuable and current instruction. A contract can guide and answer future questions. Contracts solve problems or establish a mechanism by which problems can be solved.

Contracts can even avoid potential future conflicts.

To illustrate, consider the following example. Two equal business partners have established a successful restaurant chain. After 5 years of grueling but harmonious work including perfecting recipes, leasing prime real estate, and training employees and managers, the business partners have established 3 very successful restaurants. Now, one business partner wants to sit back and enjoy the fairly substantial passive income. The other partner wants to use business profits to move the business forward by franchising. After extensive and often boisterous debate, the partners still can’t resolve their fundamentally different goals. Tempers flare and the partnership is crumbling, endangering the business. Without a contract, the partners have no rules to help guide and resolve this conflict. It is like trying to play a game with a friend in which you not only need to play the game (with high stakes), but must first establish the rules! Establishing the rules is so exhausting that actually playing the game may never happen.

Likewise, the business partners, while heated and biased by their respective and adverse goals, without a contract, are forced to try and establish a framework and rules to resolve the dispute. But this is no game: the business and the partners’ substantial financial interests are at stake. The conflict may be more than the business can handle. But if the partners had set forth a partnership agreement that established rules on how to resolve partnership disputes, the partners could engage all their efforts on solving the problem. Without a contract, a partnership agreement in this case, to guide and establish a mechanism to resolve this partnership dispute, a possible result is dissolution of the partnership and liquidation of the business—both partners lose and the business is destroyed.

Further, and perhaps more profound, a well drafted contract can avoid conflict altogether by anticipating disputes. The partners in the above example could have established by contract that one of the partners has control or trumps the other if there is a difference on a major business decision. There would have been no resources or energy wasted on a conflict in that situation (of course the trumping partner will “win,” but, more importantly, the business wins).

Contracts protect you if things go wrong. But contracts can be much more than that. You can use contracts as a powerful business tool in ways that not only protect your business but also enhances or expands it. Contracts may set out responsibilities or important incentive milestones for employees and officers. Contracts can ensure that a new partner understands her role and duties, while also protecting the business and your interests should that partner fail. Simply, contracts can act to supplement your business plan. They have the power, however, to detract from your business goals as well. To ensure the success of your business, you must become comfortable with contracts. Not only are they an invaluable business tool, but you will often run into customers, suppliers, or circumstances that simply require entering a contract.

In short, your contracts have the ability to enhance your business.

What impact does a “bad” contract have?
The power of a contract goes both ways—a proverbial double edged sword. On the flip-side of enhancing your business, a contract can also severely debilitate you and your business. You may enter into a “bad” contract. The results can be catastrophic. What is a “bad” contract? Here is a quick list.

An unedited borrowed contract – remember, contracts are private law. They are malleable, flexible, and often highly tailored. Thus, it is an extremely bad idea to “borrow” a contract without extensively reviewing and editing it. If you get an employee contract from your friend’s uncle who is a successful business man, it may be catastrophic to use that agreement with your employees (and it may not be). Understand that when you borrow a contract, you are playing with fire. It is most often exhilarating to “resolve” a business problem by using a contract that you spent little time and money crafting, but the fallout could burn your entire business down or the consequences may be totally benign.
An unfair contract – Contracts are part of business. A contract can set out bad business deals. This isn’t so much a legal warning. Be sure you understand the business behind the contract, so you can assess if it is a “bad” contract. Of course, leverage is crucial in determining if a contract is unfair. Unfortunately, if you have no leverage, you may have to either enter a “bad” contract or walk away.

An unenforceable contract – Contracts have legal requirements, which will be discussed in detail later. If you have an unenforceable contract you are left unprotected and unawares. The repercussions are simply that you no longer have legal recourse. Again, depending on the circumstances, this could be a small problem or a business-debilitating dilemma.
An incomplete contract – Contracts are meant to govern a private relationship. If the contract fails to provide sufficient coverage, it may become the source of conflict instead of avoiding or solving conflict. There is no magic page number count, as circumstances dictate what is complete and what is not. An absent contract, in a situation where you need a contract, is also a “bad” contract and the most extreme type of incomplete contract.

Avoiding “bad” contracts is essential for your business’s survival. Professionals go a long way in pointing out bad contracts, or aspects of a contract that are bad. In many instances, professionals are necessary. Given the discussion above on how pivotal contracts are, every major business transaction should be accompanied by a contract duly reviewed and explained to you by an attorney.

In summary, contracts enhance business. Viewing contracts as a hurdle and then clearing that hurdle will protect your business legally. But adopting this minimalist perspective under-utilizes a powerful business tool that could otherwise enhance and expand your business. Successful entrepreneurs learn this lesson quickly and implement contracts gladly and often.

The remainder of this chapter will cover in more detail fundamental contract law, with an eye toward providing you with tools to identify and assess issues and risks related to contracts.

Forming a Contract
Defenses to formation
Special types of contracts for entrepreneurs

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