Why do we have Contracts?
Contracts are essential to any business, regardless of size, industry or jurisdiction. They capture the basis of legal agreement between the parties, and they outline the terms and expectations of a business relationship. Whether you’re hiring a new employee, purchasing goods from a supplier, signing a deal with a client or engaging a contractor to build a large factory, having a well-written contract is crucial.
What are contracts in the business context?
In the business context, contracts are legally binding written agreements between two or more parties that outline the terms of their business relationship. While oral contracts are possible in business, I strongly recommend that written agreements are used.
Check out my post here for more information about contracts and what they are.
What is the purpose of a contract?
The purpose of a contract is to create a legally binding agreement between the parties to a transaction. Contracts establish mutual understanding on the terms of the “deal” and ensure that everyone involved knows (and agrees) what is required of them.
Written contracts outline the terms and expectations of the business relationship and record the rights, responsibilities and obligations of each party. In doing so, they provide a clear and enforceable framework for the transaction and enable a comprehensive audit trail to be kept where required by the parties.
Business contracts serve as a risk mitigation tool and a way for business deals or projects to be carried out under an agreed set of “rules”.
They also protect the interests of both parties, increase the chances of a successful outcome from the transaction, and make it easier for the parties to resolve any disputes that may arise.
Why are contracts important in business?
There are many reasons why contracts are important in business transactions:
1. Allowing the parties to agree necessary details and expectations
Contracts serve as a tool to gain written agreement between the parties to the necessary details and expectations of the “deal”.
A contract will specify payment terms, delivery dates, and other crucial details, ensuring that the parties are on the same page before the contract is signed.
In my Consultancy Services business, for example, I sign a contract with my clients when I provide my services to help them fix their Contracting Strategy. This contract outlines the scope of my consulting services (so that my client understands the work I will be doing for them and what deliverables I will be providing, eg revising their contracts, giving a Report with recommended improvements, and so). The contract also contains other details to ensure that the high standard of performance of my services is clear, and that the timing and conditions on my client paying me are agreed.
2. Providing protection for both parties
Contracts provide legal protection for all parties involved in a business transaction. A written contract outlines the obligations of both parties and sets out in detail any consequences of failure to perform those obligations.
If one party fails to comply with their contractual obligations, the other party can take legal action to enforce the contract (or will have various other possible remedies).
For example, a Construction Contract protects both the Contractor and the Principal, by making the scope of the works clear, requiring that the Contractor is paid for the construction works it performs, allowing for variations, latent condition and extension of time claims, and providing mechanisms to govern disputes and termination of the Construction Contract. It also contains contract processes and provisions barring claims when certain preconditions have not been met, which gives both parties certainty, protects the other party, and reduces the amount of claims that have no merit given the terms of the written agreement. Construction Contracts are a clear example of the importance of contracts in governing the transaction.
3. Serving as a record of rights, responsibilities, and obligations
Contracts serve as a record of the rights, responsibilities, and obligations of each party. This can help prevent misunderstandings and disputes later on in time, as it ensures that both parties have a clear understanding of what is expected of them.
For example, if your marketing agency agrees to provide a social media campaign for a client, your contract would outline the specifics of the campaign, including the target audience, the platforms to be used, and the timeline. It would also specify the number of outreaches your agency would do, how many posts you would upload on behalf of your client, how long you would provide the services for (eg 6 months from the Commencement Date), and so on.
4. Formalising a relationship between the parties and establishing trust
Contracts formalise the relationship between parties who want to enter into a business deal, making it clear that there is a binding agreement in place. This can help establish trust between the parties and provide a foundation for future business relationships.
If one party knows that the other party considers themselves bound by the terms of the contract, the first party is also likely to consider themselves bound. Both parties may therefore have a stronger trust in each other, which in turn will make the contract more likely to be successful.
Having a signed contract in place helps ensure that future business relationships are built on a foundation of trust and mutual understanding.
5. Ensuring confidentiality
Contracts can include clauses that help to protect sensitive information from being shared with third parties. These confidentiality clauses can be particularly important in industries where keeping your business information secret is critical to success.
For example, if your manufacturing and supply business works with a client in the healthcare industry, you may need to sign a contract that includes confidentiality clauses to protect patient information.
6. Providing an opportunity to increase revenue
Contracts can provide opportunities to increase your own revenue by including clauses that allow for your business to provide additional services in return for extra fees being paid.
For example, if your marketing agency agrees to provide a social media campaign for a law firm client, you could include a clause that allows for additional fees if the client wants to expand the campaign to include other platforms.
In turn, your contract may also include key performance indicators (KPIs) which encourage your company to help build up your client’s marketshare, thus increasing revenue for your client. Different payment mechanisms in contracts can incentivise your staff to work harder on behalf of their client for better reward.
Contracts with a Gainshare payment mechanism, for example, allow the parties to share in any revenue achieved above a stated benchmark. They significantly increase the investment that the parties on both sides feel in the performance of a contract.
7. Ensuring you get paid
Contracts provide a clear framework for payment, ensuring that the contractor or consultant gets paid for their services. This can be particularly important for small businesses, who may not have the resources to write off or chase down unpaid invoices.
For example, under a Lease Agreement between a mid-sized business and your company as Landlord, the Tenant will agree to pay the Landlord rent as consideration for possession and use of the premises. If the Tenant doesn’t pay, your company will have remedies under the Lease, and may ultimately be able to evict the Tenant.
8. Making private promises legally enforceable
By putting private promises in writing and under signature, they are more likely to be legally enforceable. While verbal or part-written and part-verbal contracts are legally enforceable, the problem lies in proving what exactly were the terms of the contract. By having the terms and conditions of a contract clearly written down, you remove the need to go to court to argue over the exact contractual terms. And you are able to work right from the start in building the relationship of trust that helps both parties get the most out of their contracts.
For example, if you agree to work with a client on a handshake agreement, there’s no immediate ability to force the client to pay you the money you believe you are owed.
You would first have to go to court to argue whether there was a contract and, if so, what are its terms. However, if you have a written contract in place, you have a legally binding document that can be used to resolve any disputes, reducing the chances you will need to go to court.
9. Locking in financial agreements
Contracts can also be used to lock in financial agreements, ensuring that both parties are protected from unexpected changes in the market.
For example, if you agree to provide a service for a fixed price, your contract can include clauses that protect you from unexpected costs or price fluctuations that could impact your profitability. Alternative, you could enter into a separate hedging contract to give your business this protection.
10. Negotiating contract terms to increase value
Contracts can be used to negotiate terms that increase the value of the agreement for both parties.
For example, if a client asks your business to provide perishable food goods to the client for a year, you could negotiate a discount for the client (and perhaps the free use of your own refrigerated truck, except for the cost of fuel) in exchange for a longer-term commitment of two years. Negotiations along these lines are a way that competing companies are able to contract successfully to their mutual benefit.
11. Preventing disputes between parties
By outlining the terms and expectations of the business relationship, and their legal obligations, contracts help prevent disputes between parties.
For example, a latent conditions clause in a contract may narrowly define “latent conditions”, limiting the amount of claims that can be made by the Contractor. If the Contractor considers that the claim does not fall within the definition, they are less likely to put in a claim than if the clause is confusing about whether or not certain latent conditions can be claimed.
In the event that a dispute does arise, the contract provides a framework for resolving the issue, potentially avoiding costly and time-consuming dispute resolution mechanisms and court itself.
12. Making the contract process more efficient
By having a their own template contracts in place, businesses can make the contract process more efficient. Using templates which contain the pre-approved risk allocations and the type of contractual agreement that the business will accept can save time and resources, allowing for more focus to be placed on other aspects of the business rather than negotiating and revising contract documents.
For example, your Local Council has a standard Minor Works Contract that it uses with all its contractors, which saves time and ensures consistency in how your business provides its services and prices in risk.
Conclusion
Contracts are essential to all businesses, whether small, medium or large. They provide a clear framework for the business relationship, outlining the terms and expectations of the business agreements.
By implementing contracts effectively, businesses can save time and resources, increase revenue, and avoid disputes with their counterparties.
So if you’re running a business, make sure you’re using contracts to protect yourself and your interests.
FAQ
Q: What is a contract?
A: A contract is an agreement between two or more parties that outlines the terms and expectations of a business relationship.
Q: What are the benefits of a contract?
A: There are several benefits of a contract, including:
Relationship building: A well-drafted contract can help build trust and strengthen the relationship between the parties by establishing clear expectations and obligations.
Legal protection: A contract provides legal protection to its parties by outlining the terms and conditions of the agreement between them. This helps prevent disputes and misunderstandings.
Clarity: A contract clearly defines the rights and obligations of the parties, making it easier to understand what is expected of them.
Accountability: A contract holds its parties accountable for their obligations and responsibilities. If a party does not fulfill its obligations, they can be held liable for any damages or losses suffered by the other party.
Risk management: A contract can help manage the risk associated with a business transaction, including by outlining the responsibilities and liabilities of each party and deciding in advance how particular events will be handled (should they occur).
Enforceability: A contract is legally enforceable, which means that if one party breaches the contract, the other party can take legal action to enforce the contract and recover any damages.
Q: Why are contracts important in business?
A: Contracts are important in business because they provide a clear framework for the business relationship, protect the interests of both parties, help to minimise risk, ensure the parties can comply with legal requirements, and prevent disputes, among other things. The importance of contracts cannot be overstated, and having a solid Contracting Strategy can lead to more revenue and more deals for a business, whether a service provider or any other business.
Q: What are the benefits of using contracts in business?
A: The benefits of using contracts in business include:
Ensuring that all parties understand the terms of the agreement (ie the terms of a contract – the agreed terms – are clear)
Protecting from risk and therefore minimising costs
Reducing the risk of disputes and lawsuits
Protecting the rights and interests of all parties involved
Providing a framework for the transaction.
