Everything You Need To Know About Formal Contracts
As your company grows, the more legal agreements and formal contracts you’ll have to make to secure your partnerships. These can be in the form of purchasing goods and services, haggling for lower prices, entering a new job, etc. As such, you must understand the aspects of formal contracts to protect your business and ensure professionalism while mitigating legal risks.
We’ll be sharing what constitutes a formal contract, the different types, when to use them and some important points to include in your formal contracts. Additionally, we will be introducing how you can efficiently keep your contracts organized with Contract Hound! Now let’s dive right in!
What Are Formal Contracts?
Formal contracts require the existence of a written and signed legal document, in addition to the verbal consent of parties involved. When these conditions are fulfilled, it is legally binding, and the obligations of parties are enforceable by law.
This list is not exhaustive, but some examples of formal contracts include:
- Business partnership agreements
- Financing/Borrowing agreements
- Land/Property Lease agreements
- Joint ventures
- Merger and acquisitions
- Employment contracts
If you need a primer on the differences between contracts and agreements, read our blog post on the topic.
What Constitutes A Formal Contract?
Formal contracts are made up of multiple elements: Offer, Acceptance, Consideration, Intention, Legality, Capacity to contract, etc. Without any of these elements, contracts drafted will not be legally binding. Of course, contract elements are not limited to just these few, but these are the main elements each business should take note of.
Offer – Performing a Promise
The first element necessary to form a formal contract is the offer. An offer is an expression made by one party (“offeror”) to another party (“offeree”), communicating the offeror’s willingness to perform a promise. The intention is that if the offer is accepted by the offeree, there will be a binding agreement between both parties.
However, not all offers result in acceptances. An offer can expire, or an acceptance can be withdrawn such that no contract results. These are 5 ways in which an offer can terminate:
- Lapse of time
- Failure of condition
- Death of offeror/offeree
Acceptance – Must Be Unconditional
If an offer exists, the next question is whether there is acceptance. An acceptance must be final, unconditional, and communicated to the offeror. If the offeree states that they accept the offer subject to a change in one of the offer terms, then there is no acceptance. In other words, conditional acceptance is treated as no acceptance.
In some cases, offerees may state that they accept the offeror’s offer, “subject to a written contract to be drafted by …” This means that the offeror agrees to the conditions stated in the offer but wishes to have the benefit of further advice or written documentation from their lawyers.
Consideration – Defining the Compensation
Consideration is essential for all contracts, except those which are under seal. In simpler terms, consideration can be viewed as the price or compensation for the promise given by one party to the other.
A simple illustration is as follows: Tom agrees to sell Jerry his book for $50. The consideration for selling the book is thus $50.
In short, consideration is rooted in the concept of reciprocity or bargain. It is something which is given in exchange for another thing. If only one side offers something, then it is not considered a contract but rather as a gift.
Intention – Creating Legal Relations
The fourth element in the formation of a formal contract is the intention to create legal relations. If this intention is absent, then the promise may not create any binding obligation at all.
Here’s a simple example: A photographer with a legally-binding wedding contract must take photos of the weddings they’re assigned to. They can only reject legally-binding work under exceptional circumstances stipulated in the contract.
In general, social and domestic agreements are viewed with the presumption of no intention. On the other hand, commercial agreements usually require the intention to create legal relations. In this case, the photographer and the wedding organizers are in a commercial relationship, hence the need for a formal contract.
Legality Of The Contract
For any contract arrangements to be legally valid, it needs to be created for a legal purpose and adhere to all applicable laws and regulations. In other words, if your terms are illegal, the contracts can’t be enforced.
Common examples of invalid contracts include:
- Gaming and wagering contracts
- Contracts contrary to public policy
- Contracts contrary to statutes
- Contracts in restraint of trades
Capacity Of Parties To Contract
Incapacity refers to the lack of capacity, which may characterize a contracting party. As a general rule, to form a valid contract, the parties must have the ability to do so. Certain groups of people, however, are viewed as not having the capacity to enter into contracts.
These people include:
- Mentally unsound or intoxicated persons
- People who are bankrupt
The rationale behind the concept of incapacity is rooted in public policy. For example, a young child is generally considered as lacking the capacity to contract due to their lack of sufficient understanding or experience to make binding agreements, similarly for mentally unsound or intoxicated persons.
What Is The Importance Of Formal Contracts In Business?
Proof Of Details & Agreed Terms And Conditions
This is the fundamental reason for drafting formal contracts. They are a form of legal proof of details on what the parties have mutually agreed upon. A contract will also explicitly state the obligations of all parties to the contract, such as services rendered by third parties, payment obligations, and so on.
Prevention Of Misunderstandings
The purpose of a formal written contract is to give each concerned party the chance to read and obtain a clearer understanding of the terms, conditions and personal expectations of each party. It also allows parties to revisit the finalized terms after a thorough discussion.
Security And Peace Of Mind
With reference to employment contracts, the duties, responsibilities, payment and overall relationship of employers and employees are written clearly. This gives both parties ample protection when some of them do not follow or breach any of the agreed terms or conditions previously stated in the contract.
Official Record Of The Business Agreement
Written contracts make it easy to establish what the parties involved have agreed on. This could include the management style after a merger or acquisition, payment of work completed, or terms and conditions in which a party can take advantage of to terminate a contract early.
Avoid Expensive Litigation Proceedings When Shading Happens
Written contracts come in handy and serve as great precautions when a party to the contract breaches any terms or warranties. Written contracts serve as a general reference on what the parties have agreed to determine who is at fault. Thus, a well-prepared written contract reduces the need for litigation proceedings which are costly and time-consuming.
When Should Formal Contracts Be Used?
- Situations involve the need to outline specific obligations and rights for a project.
- When there are many essential terms to adhere to, such as completion or payment dates.
- When you want to keep a degree of confidentiality between you and the other party.
- When large sums of money are involved.
- For employee agreements, etc.
Formal contracts require terms and conditions to be written clearly and without ambiguity. Each formal contract will not be the same, but here are some important points you might need to include:
- Profit-sharing arrangements
- Management structure
- Provisions for sharing losses
- How to resolve disputes between partners
- Skills & resources to be shared among the partnership
Formal contracts are flexible and can be tailored to the needs of your specific business, relationship, industry, etc., depending on what you have agreed upon with the other party. It is a best practice to have your business attorney or a legal representative review the contract and ensure that it is legally valid before signing.
Why You Should Use A Contract Management Platform To Manage Your Formal Contracts
Now that you know what a contract entails, it is time to organize all your contracts. As your organization grows, the more your formal contacts will increase in scope (i.e. the number of contracts you process increases) and depth (i.e. your contracts become more complex).
You’ll need a handy solution to automate and standardize your contract management process. Here are reasons why you should invest in one:
- A centralized platform to save all your contracts. A management platform can act as an intranet for all your employees relating to company contracts and other relevant documents. As everyone is on the same online platform and accessing the same formal contracts, this prevents miscommunications regarding browsing an outdated or wrong version of company contracts.
- Know who has access to your contracts. Employees can find out who has access to each document, and managers can speed up approval processes by approving contracts and chatting with employees within the platform.
- Notifications and reminders on key dates. These can help remind employees of critical milestones such as renewal and payment dates. They also eliminate the time-consuming process of following up!
- Integration with other tools vital in the contract management process. For instance, Contract Hound is integrated with DocuSign, meaning managers and relevant personnel can approve and sign contracts on-the-go at any time. This is especially beneficial in situations where time is of the essence, where you don’t have to mail the contract copy, print it out and get them signed.
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