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Small Business Ownership: How and When to Write Formal Contracts

Business contracts outline important agreements you (or your business) enter into with others. If you own a small business, you should familiarize yourself with writing a good agreement, or contract. Sure, small business owners often operate on informal understandings that don't document or even completely verbalize to the other party. But if the agreement is important, it's worthwhile for you to take the time to draw up a formal contract.

So what constitutes a "important" agreement? Any agreement on which you are relying and that can affect the future of your business.

Contracts allow the parties the opportunity to

  • Clearly define their obligations to and expectations of each other
  • Limit their liability
  • Lay out payment terms
  • Divide up business risks
  • Make sure each side understands its responsibilities

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Here's a quick rule: If you've spent more than five minutes worrying about whether you need a contract, guess what? You probably do.

So, what makes a contract a contract? A valid contract typically requires the following four elements:

  • A meeting of the minds between the parties demonstrating they both understand and agree to the essentials of the deal
  • Consideration (something of value exchanged by each of the parties, such as cash, goods, or a promise to do something)
  • An agreement to enter into the contract (typically evidenced by both parties signing a written contract, although oral contracts can be valid, too, in some situations)
  • The legal competence of each party, meaning the parties are not minors and are of sound mind

Meeting of the minds

The first step in creating a contract is making sure that both parties are talking about the same deal, so that when they subsequently agree to enter into the contract they are both agreeing to the same thing. Seems obvious, right? Until you realize that the "vintage red car" you planned on buying from your brother-in-law isn't the Ferrari, it's his Pinto. Take the time to communicate your understanding of the deal to the other party, and listen carefully when he or she talks back.

Consideration

After the parties reach a meeting of the minds regarding the deal, they must both exchange something of value in order to create a contract. Often, one party provides its goods or services in exchange for the cash of the other party. But consideration can take many other forms, as long as each party is giving up something of value to it to convince the other party to enter into the contract.

You can read law treatises defining consideration until the cows come home, but in the real world your biggest issues related to consideration are how much and when.

If cash is exchanging hands in your contract, think through any assumptions you are making about the way payment will be made.

  • If you expect to be paid at the time the contract is signed, say so.
  • If one of the parties will be paying after the contract is signed, say whether the payment will be in cash, by check, by cashier's check, or by wire transfer. Be explicit about the way the money will change hands. For example, you likely want a cashier's check if you're turning over title to a car or other significant assets.
  • If payments will be made over time or based on external factors, such as the amount of business done, you may need to define the payment schedule by using a formula. Keep the formula simple and feel free to put examples of how the formula works right in the body of the contract.
  • If you have to use a complex royalty or other payment formula, test the formula with the other side to be sure you both understand it.

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Be wary of gift contracts, where someone gets something for nothing. If the value one party is receiving is truly free, so that only the other side is giving up something of value, then the parties probably haven't formed a contract. You usually can't make someone give you a true gift, no matter how many times the giver promised to do so.

Agreement to enter into the contract

After both parties understand the deal and understand what type of consideration will be exchanged by each party, they are ready to form an agreement. Usually, the parties demonstrate that negotiations have ended and an agreement has been reached when the parties sign the contract, unless it is an oral agreement.

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In business as in opera, it's not over until the fat lady sings — er, signs. It's fine, within reason, to negotiate changes in a written contract up until the moment you sign it.

Legal competence

Be sure that the party you're working with is legally competent to enter into a contract. Otherwise, your signed contract may be void and unenforceable (as in worth zippo). Even if the other guy wears a lampshade on his head, he may be legally competent. But watch out for the following situations:

  • Minors cannot enter into contracts without the additional signature of their parents or guardians. In most states, a minor is a person under the age of 18.
  • Persons lacking sound mind usually cannot enter into contracts because, the reasoning goes, they lack the ability to understand what they are doing and to create a "meeting of the minds." Persons lacking sound mind generally are those who are mentally handicapped or impaired by the use of drugs or alcohol to such an extent that they cannot understand the significance of their acts. So try not to do deals at your local watering hole late into Saint Patrick's Day.
  • Persons who lack authority to act on behalf of someone else may not be able to legally bind that other person or company. So make sure that the person signing on behalf of a company or other person has the legal authority to do so.
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