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Lesson 2: Bad Contracts
Wow, you must have LOVED the Goodlawyer Guide for Lesson 1!
Regardless of why you ended up here, congrats on purposely or accidentally increasing your legal knowledge! Keep reading on.
Topic 1: Contracts, Generally
What is a contract? Other than what the video said about “those things you sign but never actually read”, contracts are essentially a legally enforceable promise. Contracts add certainty to your business relationships, and they also determine the ebbs, flows, and behaviour of our business world. Before we get into how you can become a contracts pro, we need to look at the five essential elements of a valid contract. That means all five elements must be in place in order to make the contract legally enforceable.
Intention to Create Legal Relations
An agreement entered into by two parties is only enforceable so long as the parties that entered into that agreement had the intention to create legal (i.e., enforceable and binding) relations.
The first element of a contract is to make sure that unsuspecting individuals don’t accidentally stumble into a legally binding situation they didn’t sign up for. This may sound a little obvious, but relationships play an important contextual role. For example, the law presumes that there is no intention to create legal relationships between spouses, but that presumption can be rebutted if you get it in explicit writing (like a prenup). Likewise, when you’re engaging in talks and agreements between two business entities, the law presumes that you are doing so with the intent to create a legal relationship.
Best practices for this piece (and a theme that will be commonly repeated) is to make your intentions clear and unambiguous!
Offers are communications that come from one party to another indicating a willingness to enter into an agreement on certain terms. Offers will generally include terms like the subject item, prices, timelines, and more. But that doesn’t mean that any old offer is okay — there are certain requirements that an offer must meet in order to be legally valid.
At a high level, there are 2 kinds of “offers”: invitations to treat and true offers. An invitation to treat describes an indication of willingness to receive an offer; think of a yard sale without any prices on the items displayed. Obviously, the host of the yard sale is inviting visitors to strike a deal with them, aka inviting them to treat. Invitations to treat are harder to enforce legally because there might not be a clear offer on the table, even if a deal has been struck and agreed to by both parties.
True offers describe a situation where a business has actually made an offer with specified terms, like in an advertisement. If your business sells products by advertising them online, you have to be careful of using certain language that could otherwise create a valid, binding contract if someone takes you up on that offer. Obviously, that may be the entire point of the advertisement, but changing circumstances for your business may change the terms you want to offer your goods for. If you have an old, outdated offer online somewhere, you might have to live up to that offer whether you like it or not.
The same best practice applies here. Communicate your intentions clearly, whether they are merely invitations to treat, or if they are formal offers that you want the other to act upon.
On the other side of the Offer coin is Acceptance. In the legal world, this is called the “meeting of the minds” (lawyers am I right?). Basically it states that both parties of the contract know and agree to the deal they are entering into. It sounds obvious but this aspect of contract law is designed to keep people from getting tricked into legally valid deals that they didn’t know they were agreeing to.
When you’re accepting an offer, it is important to accept it on whatever terms were communicated in the original offer. Accepting the terms on the contract in the way it was set out is part of the validity of the contract. Contracts are all about predictability, certainty, and stability, so starting things off on the right note can help set a precedent for your new business relationship. Best practices for acceptance is to follow what is set out in the offer! If there is nothing set out, be reasonable in your judgement and think about what the best commercial practice would be.
Offers need acceptance. Got it. But in the real world (and in most business deals), it is unlikely that both parties will immediately come to an agreement based on a single offer and a single indication of acceptance. In response to a valid offer, a party can counter-offer and try to change the terms in the original offer. Many contracts exchange hands and undergo revisions as both parties try to reach an acceptable solution.
Consideration is some profit, interest, right, benefit, or any kind of value that is going to one side of the contract. It could also be a detriment, loss, responsibility given, or forbearance undertaken by the other. In plain english, that means there has to be a deal made for something. You can’t have a contract without some exchange of value.
Valid consideration doesn’t always have to be cash, it can be just about anything. While you need consideration by law, it doesn’t have to be adequate (equal). It does however have to be sufficient (enough), and all that really means is that it has to have some value. Again, an exchange of value must exist for a contract to be legally binding. Here’s an example that’s commonly known as the Peppercorn Theory: a peppercorn as consideration is definitely not adequate value in exchange for a car, but it is sufficient in the eyes of the law because it still has value, no matter how little the perceived value may be. If both parties understand and agree to that awful deal, then it stands.
Businesses should be wary about consideration when entering into contracts. If a party promises and promises, without any form of consideration for those promises, then those promises are not a valid or enforceable contract. If the consideration is flowing solely from one party to the other, there’s no legally valid contract there either. Again, there has to be an exchange of value.
There’s one more important circumstance when it comes to consideration. Let’s say that our friends at Ice Cream Co lease their ice cream churns from a supplier. The supplier decides that he will let them use the equipment free of charge moving forward because he loves their product so much and they’ve always paid their lease on time in the past. Well, there’s no longer a legally valid contract there because it’s using past consideration (previous lease payments) in place of present consideration. In simple terms, you can’t use a previous exchange of value in a new contract. There has to be a new exchange of value.
Certainty of Terms
In your contract, if you have an important term that is vague or so imprecise that neither party or the court system can give understandable meaning to the term, the contract will fail. I bet you can already guess what the best practices are to ensure that your contract has Certain Terms... Be clear, communicate often, and be as precise as possible when laying out the consideration of the deal.
Topic 2: Things to Keep in Mind
You may be realizing that there’s a lot more to contracts than just simple one-to-one transactions and good ol’ fashioned handshakes. While some are easy, many transactions can be multi-party, multi-termed, over indefinite periods of time, with responsibilities and reciprocations that can change throughout the duration of the contract. We’re not suggesting you become an expert in all the nuances of contract law, but becoming a “pro” in contracts starts with a key idea that you can start incorporating right away.
Recognize You Don’t Know What You Don’t Know
Sometimes, you just have to admit when you’re out of your league! Whatever you want to call it, acknowledging when you’re at the extent of your legal knowledge is the best way to approach a complicated legal situation. Even if you think that you fully understand every aspect of the contract you are entering, sometimes it’s worth an expert opinion (especially if it’s a BIG deal).
We mentioned the use of contract templates you can find online, and honestly, we get the appeal. Why would you pay for legal services when there’s an official looking document you can download free of charge? You may read over the free template contract and think to yourself, “All of this makes perfect sense and it applies to my situation. Woohoo!” and for simple, standard-form agreements between two parties, a template contract could indeed be an effective solution.
BUT, when you’re dealing with crucial aspects of your business like licensing agreements for intellectual property or supply agreements that span over multiple years, there’s going to be a lot of terms that you’ll want to include to protect you and your business. You might understand all of the terms in a sample licensing agreement, but you will most likely lack the expertise to recognize what’s missing, and what is missing from significant contracts is often just as important (if not more) than what’s included!
Representations, Warranties, and Conditions
Representations are a pre-contractual turn of phrase that can impact the legal outcomes of your contract depending on what you said during negotiations. On its own, a representation is what you are saying about what is going to be in the contract. The issue arises when the representation turns into a misrepresentation. While not all misrepresentations (innocent mistakes) are punishable, any purposeful or malicious acts to induce a party into entering a contract can result in failure of that contract. This is where warranties come in. Essentially, they state that your representations are true, and provide indemnity (an exit) for the other party if the representations are false.
Having the wits to acknowledge what you don’t know has to come into play before the physical contracts are signed. When you’re negotiating with other parties, you should try to keep in mind the legal repercussions of representations and warranties. As a general rule of thumb, the distinguishing factor between the two can be boiled down to the idea of reliance: did someone rely on what I said when they entered into the contract, or was it just a nice after-thought?
The most important part of a contract, and the one that needs to be most carefully considered are conditions. Conditions are the actual terms of the contract, and are where the exchange of value is clearly laid out and both parties of the contract know exactly what they have to do. Failure to perform on the conditions you are bound to entitles the other party to terminate the contract and potentially even sue for damages.
Topic 3: Why an Expert is Important
Knowing what you don’t know is a natural segue into the third topic we want to talk about (again) — get a lawyer! This isn’t a sales pitch. Although it’s up to you to decide, we truly believe that for the major contracts your business enters into, you should have a trusted and competent legal professional in your corner making sure your business is protected. The benefits of having a good lawyer on your team are too many to list, but we wanted to highlight three common situations where their perspectives can help you (maybe even save you).
Which Contract Reigns Supreme?
Remember when we mentioned that a lot of real-world transactions end up going back and forth on negotiations, particularly on major contractual issues? With the idea of representations and warranties in mind, it can be difficult to keep track of what’s actually going to end up in the final contract. This is especially true when you’re nearing the end of your contractual negotiations and you accept the majority of the terms set out, but still want to amend a couple things. Does that mean you’ve accepted the contract?
The situation described is often called the Battle of the Forms, and usually it is the last contract exchanged that dictates the transaction. However, it’s not black and white so at a certain point, it may be helpful to have someone who knows the ins and outs of contract law and contract formation to be your guiding light when you’re negotiating. At the end of the day, you’ll know what is going to be important for your business, and making sure those contracts specifically set out what you’re looking for is key to your success.
Enforceability of Contracts
Much of the disputes resulting from contract law is determining whether a contract that two parties signed is actually enforceable or not. We’ve seen a couple examples of uncertain terms, or ambiguous phrasing that would make it impossible to determine what a party meant, resulting in an unenforceable contract. That’s a perfect reason to sit down with a lawyer and see if they think your contract would hold up or not.
The other main area in which you may not have a legally valid contract, and therefore have major implications to your business, is when a contract is unconscionable. Unconscionability can take form in a couple of ways, but generally it means it's blatantly unfair to one party. The assumption is that two parties will enter into a contract on their own terms, so you may think it’s weird that any kind of negotiations would be unfair. While that’s frequently the case, for a small business or start-up negotiating with massive corporate entities there will be a large power imbalance to contend with. Getting hamstrung into signing a contract is often an underhanded business play that hurts many smaller companies, and if it extends into the threshold of unconscionability, there may be recourse for the affected party.
That being said, the idea goes the other way, too. If your business is entering into unfair contracts, or taking advantage of individuals with limited capacity (i.e., their mental cognition may not be sound), courts may find that those contracts are void. Businesses also need to be particularly wary about exclusion clauses that absolve the business of any liability in the event their product or service injures a consumer. Think about how many times you’ve skipped over the terms of service for apps you download or accounts you sign up for! There are strategies that a lawyer can present you with to make sure that your exclusion clauses hold up, even if the customer didn’t see them.
Disputes and Damages
The last topic is pretty much a given, and it’s what a lot of people imagine their only interactions with contract lawyers would boil down to. If your business ever ends up in a contractual dispute, it could have serious ramifications on your business... and you don’t need a lawyer to tell you that. Whatever the penalties or awards to the other party are, they have the potential to make a huge dent in your bank account.
Astute readers of these guides will know that Goodlawyer is a strong proponent of starting early, planning ahead, and addressing legal problems when they arise. The best practices to mitigate the risk of contractual disputes, and to lessen any kind of damage that would come up follows those very principles. Having a lawyer on your side early, before there is even any dispute to begin with, can go a long way into the future success of your business.
Topic 4: Common Contracts to Look out For
There are hundreds of different types of contracts out there, maybe even thousands. You probably won’t come across all of them in your entrepreneurial journey, but there are a few that will almost undoubtedly cross your path and be critical for your business.
1. Service Contracts / Sale Agreements
These are the most likely avenues that a start-up or small business will use to secure its revenue stream. These contracts generally lay out the details and terms that you wish to conduct your business under and are a good way to outline the specific scope of what you’re willing to perform or sell in exchange for enumerated consideration (money).
There are a lot of ways to customize these contracts to suit your business needs. Payment can be lump-sums or periodic installments, payment can be delayed or asked for upfront, liability can be split different ways, shipping costs can be assigned to one party, and the list goes on. We’ve said it before and we’ll say it again: for important contracts like these, you should talk to a lawyer who understands your business.
2. Confidentiality / Non-Disclosure Agreements
Many entrepreneurs are sitting on a great idea they believe could change the world. The practical reality of the situation is that you need help to properly develop your idea, commercialize it, and distribute your idea to users. As it’s nearly impossible to do all of that on your own, relationships have to be formed with partners along the way.
There will be many instances where you (the business owner) will have to divulge the inner workings of your idea to a potential partner. In those instances, you want to make sure that legally, the party you are talking to doesn’t rip your idea off or tell someone else about it. This is where NDAs and Confidentiality Agreements come in. These contracts outline the terms and obligations of both parties regarding the treatment and divulging of confidential information, and the consequences for breaching the agreement by spilling the beans.
We can’t emphasize these agreements enough — if your company has important secrets that are key to its business, you need to make sure your partners and anyone who knows them are keeping their lips locked tight.
3. Shareholders’ Agreements
These documents are really important for the internal governance of your corporation. As we’ve mentioned in Lesson 1, having a strong foundation to build your corporate structure on is instrumental to long-term success. Without agreements like this, shareholders can do anything they want with their valuable shares in your corporation. These contracts install a sense of certainty and security in managing your relationships with shareholders, and if constructed correctly, can provide the business owner(s) with a lot of control into how they want to see their operation run.
As you expand your business, these documents become even more important as various parties start entering your company in the form of outside investors and directors. Having strong corporate governance will allow you, the founder, to focus on what you do best without having to expend a lot of time and energy diving into the weeds of corporate law.
Contracts are extremely important and pervasive in our everyday life. Much of modern day commerce is built on the back of contracts law, where you can do business with someone from the other side of the country, knowing full well that what they signed up for is a legally enforceable promise. It adds certainty, stability, and clarity to your relationships with actors both internal and external to your business.
Want to keep learning about this topic before moving on to the next lesson? Here are some more great resources!
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