What Is a Contract?

Contracts are legally binding agreements, and they pervade almost every aspect of our personal and business lives. If you own or manage a business, you've likely created or been handed agreements at least a handful of times. For instance, you likely have or have had contracts with employees, contractors, vendors, commercial landlords, banks, utilities, insurance companies, and, of course, customers and clients.

What makes a contract special—and essential for business dealings—is that it's binding on the parties. If one party doesn't hold up its end of the bargain, the other party has legal remedies for any resulting damages. It's important to understand the basics of creating, interpreting, and negotiating a contract.

Contract Requirements

A "contract" is an agreement between two (or sometimes more) parties where each side exchanges something of value. Contracts can be written or verbal—although, some contracts must be in writing.

In general, every contract must meet a set of requirements to be valid and enforceable. Be aware that in addition to these general rules, federal and state laws might impose more requirements on particular types of contracts.

Contracts Start With an Offer

Every contract starts with an offer. It can be written or oral. To be enforceable, an offer must be:

• clear and definite, and
• made with the intention to create a binding contract if accepted.

For example, suppose you plan to open a laundromat business. You need to purchase machinery for your business so you meet with a local dealer to browse their inventory. While looking at their stock, the dealer says: "I might be able to cut you a discount and offer you a dryer for $5,000 or $5,500." In this case, the offer likely wouldn't be enforceable. The offer wasn't clear and definite—it didn't include a fixed price or refer to a specific dryer. The dealer probably didn't mean to create a binding contract because they used the language "might."

Now suppose the dealer says that they can sell you a specific model of commercial dryer for $5,000 if you purchase it today. This offer likely would be enforceable because the dealer referenced a specific dryer and offered it a specified price. Also, the dealer appeared to intend to create a binding contract by providing the specific details and timing of the offer.

Acceptance of an Offer to Contract

Once you have an offer, you need an acceptance of the offer to create an enforceable contract. As with an offer, an acceptance can be communicated in various ways. For example, you can:

• accept an offer in writing
• verbally accept an offer, or
• accept an offer through action or performance.

Keep in mind that the offer might include specific requirements for how you can accept the offer. For example, suppose an offer says that you must accept the offer in writing by sending an email to a specified address. If you walk into the store and simply tell the manager that you accept the offer, that doesn't count. You must follow the conditions of the offer and send the acceptance via email.

Consideration in a Contract

In a contract, both sides agree to give up something of value to gain something else of value. This value is referred to in contract law as "consideration." Consideration can be a promise to:

• do something (such as sell goods, provide services, or make a payment), or
• not do something (like not contract with another business or file a lawsuit).

For more guidance and details, see our article about contract consideration.

Contracts Must Have a Legal Purpose

The purpose of the agreement must not violate the law. In other words, you can't agree or have someone else agree to do something illegal. You'll need to consider all laws that might apply to the contract and parties, including local, state, and federal laws.

Here are some examples of unenforceable contracts that lack a legal purpose:

• a loan agreement that charges interest in excess of what is allowed by state usury laws
• a service agreement to hire someone to destroy a competitor's inventory, and
• an agreement to transport federally illegal drugs across state lines.

This element of a contract is typically easy to satisfy and fairly straightforward.

Contracts Must Be Between Capable Parties

The parties to a contract must have the capacity to make the contract. In general, you won't be considered to have the capacity to enter a contract if you:

• are a minor (under the age of 18)
• lack the mental capacity, or
• are seriously intoxicated or under the influence and the other side knows this.

States vary in their laws about who has the capacity to contract and how or whether they recognize the above instances. For example, states differ in their definitions and standards for what it means to be "mentally incapacitated." Many states say that a person must be able to understand the nature of the contract and its consequences to be capable of entering the contract.

Read our article on who lacks the capacity to contract for more information about this contractual element.

Mutual Assent of the Parties

Mutual assent is sometimes referred to as a "meeting of the minds." The contracting parties must intend to be bound by their agreement and must agree on the essential terms. If the parties differ on nonessential terms—for example, the offer says "pale blue" but the acceptance says "light blue"—then the contract will usually still be enforceable.

The Contract as a Document

Every contract is different. Some contracts are a single page while others can be close to 50 pages or more. A contract will typically reference the parties involved in the contract, lay out the terms and obligations of the parties under the contract, and provide specific protections for both sides.

While you'll see variations, many written contracts include some or all of the following elements:

• Introductory material (sometimes known as "recitals" or "whereas provisions"). This section introduces the parties and the contract itself. It typically covers the party names and addresses, the purpose of the agreement, and any relevant background information.
• A statement of the purpose or purposes of the agreement. If not included in your introductory paragraph, you should include a statement about the purpose of the agreement. For instance, if the contract is an amendment to an existing agreement, your contract should say that it's meant to serve as an amendment to a specific agreement.
• Definitions of key terms and conditions. Usually, agreements that are longer or use important terminology include a section for definitions. For example, if you have a master service agreement for software services, you might want to define terms like "Company Data," "Software," "System," and "Updates."
• The obligations of each party (and conditions that may trigger obligations). Under a contract, both sides will have obligations. The purpose of the contract will largely determine those obligations. For example, with a confidentiality agreement (also called an "NDA"), one side (or sometimes both sides) has the obligation of keeping the other side's confidential information private. Or, suppose, you have a sales agent agreement. Under that agreement, the sales agent might have obligations like reaching particular sales numbers and keeping an updated customer database.
• Assurances as to various aspects of agreement (sometimes phrased as warranties, representations, or covenants). Your contract might contain general and specific assurances about your ability to fulfill your obligations under the contract. For example, you might include a general warranty that says that your business is in good standing and licensed to perform the services outlined in the agreement.
• Boilerplate provisions. Rounding out a contract is a set of standard contract clauses called "boilerplate provisions." You can typically find these same clauses across different kinds of agreements. These provisions cover assignments, arbitration, amendments and modifications, notices, choice of law, force majeure, relationships, attorneys' fees, and more. (Find more in-depth information about these specific clauses in our standard contract provisions section.)
• A signature block. At the end of the agreement, you'll see room for the parties' signatures by the party names. Each party should sign and date. If a party is a business, also include the authorized signor's name and position in the company below the business's name.
• Exhibits or attachments. Some contracts include exhibits and attachments. While these come after the signatures, they're just as part of the contract as any other section. Exhibits and attachments can be documents that go into further detail about the work being done under the agreement, such as fees, delivery schedules, and service level standards. Exhibits and attachments can also cover additional terms and conditions such as behavioral standards, screenings, and escrow agreements.

Contracts can be short and sweet or long, detailed documents. In either case, make sure you know what each part of the contract says and what each party expects from the other.

For more on the drafting process, see our tips to making a solid business agreement.

Different Types of Contracts

Your business will likely use and come across many kinds of contracts. Some of the more common business contracts include:

• employment contracts
• NDAs
• service agreements
• master service agreements
• business loan agreements
• commercial leases
• equipment leases
• sales contracts
• licensing agreements
• bills of sale
• purchase and sale contracts
• severance agreements
• contractor agreements, and
• consulting agreements.

There are hundreds of business contracts. Some contracts might be more prevalent in your industry. It's important to have a good understanding of what a basic contract contains and how to interpret contracts generally.

The Contract as a Process

"Contract" is a noun, but it can be used as a verb too. When you contract with somebody, you participate in a process that typically involves three phases.

• Phase 1: Contemplating the deal. The parties each assess the prospective arrangement and its risks ("Can I trust her?") and attempt to predict the future ("Will I regret paying this price for the computer next month? Will it be outdated?").
• Phase 2: Reaching an agreement. During this phase, the parties negotiate and agree on the terms, usually formalized in a written contract or some other documented evidence of the arrangement (such as a receipt or purchase order, for example).
• Phase 3: Performance and enforcement. Once the contract is in place, the parties are legally required to perform their mutual obligations. If one party fails to perform, the other can sue to enforce the deal.

For strategies and tips on this process, check out our article on how to negotiate a business contract.

Contract Remedies, Damages, and Defenses

As mentioned earlier, if one party doesn't perform their obligations, the other side can sue. When a party fails to perform or another part of the contract's terms has been broken, the contract has been breached. Depending on the severity of the breach, the nonbreaching party might have certain remedies available.

Specifically, if one side materially breaches the contract (defeats the purpose of making the contract in the first place), the nonbreaching side can typically:

• end the contract
• sue for money damages, or
• ask a court to force the other side to perform their obligations (called "specific performance").

However, sometimes the breaching party has a legal excuse or defense for not fulfilling their side of the agreement. These defenses can include mistake, misunderstanding, misinterpretation, duress, and incapacity, among other defenses.

See our section on contract disputes for more on contract breaches and defenses.

Additional Information About Contracts

For more basic tips on contracts, read our article on making a legally valid contract. You can also review our section on contract terminology to learn more about contract terms.

Contracts can quickly become complex and disputed. If you need help drafting, negotiating, or enforcing a contract, you should speak with a contracts or business attorney. If you've breached a contract, talk to an attorney about your options and what you can do to limit the damages.

If you're looking for an A to Z guide on everything you need to know about contracts, you can read our book Contracts: The Essential Business Desk Reference, by Richard Stim (Nolo).