Small Business Legal Issues: Contracts

Overview

Whether business owners know it or not, the day-to-day conduct of every business is governed by dozens of contracts. Some are written, others oral; some are complex, others not. Nonetheless, contracts — promises given in exchange for other promises, to act in a certain way, or to pay money — order the day-to-day world of business, and life.

This article will briefly discuss how a contract can be formed. Then, we will explore two questions that all business owners will confront: How should I approach the contracts I receive? What type of contracts should I have in place to protect my business?

This discussion will provide you general information about contracts and contract law, but should not be considered as legal advice or opinion. While this module provides information generally applicable to most types of businesses, it is best to consult your professional advisors — accountants, insurance professionals and attorney — for advice specific to your own situation.

Outline:

  1. What Makes a Contract?
  2. What's the Deal?
  3. Reading a Contract
  4. Common Business Contracts
  5. Confidentiality
  6. Purchase and Sale of Goods
  7. Financial Contracts
  8. Joint Ventures
  9. Legal Compliance Warranties
  10. Contracts Inside Your Own Organization
  11. Business Structure
  12. Employment and Independent Contractor Agreements
  13. Buyout Agreements
  14. Intellectual Property Protection
  15. Resources

I. What Makes a Contract?

A contract doesn't have to be written in hard-to-understand words, in fine print, or on special paper to be legally binding. In fact, it doesn't have to be printed at all. An oral contract is just as enforceable as a written one.

Instead, a contract is simply a series of mutual promises. The promise may be clearly stated — I will pay you ten dollars if you shovel my sidewalk. A promise can also be implied — a doctor who treats an accident victim under emergency conditions can reasonably expect to be paid for his services.

Generally, contracts require an "offer," a promise by one person in exchange for the promise of another, and an acceptance, the other person's agreement to the proposed deal. Sometimes, these terms can be implied by actions alone, without a formal "offer and acceptance." In some cases, a validly formed contract will not be enforced — one party may be a minor, or mentally incapable of acting. In other cases, it may be uncertain if any contract exists at all. Each such case must be evaluated by an attorney on an individual basis.

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II. What's the Deal?

Despite these generalities, in business it is usually quite clear when a contract exists or has been proposed. When you receive a preprinted form with terms and a place to sign, you obviously have a contract in front of you.

But what are you to do? Can the contract be negotiated to improve the terms, or must you sign it because it is preprinted? If someone, in good faith, begins performing the contract before it has been signed, when does it become too late to back out?

In theory, every contract can be negotiated. In practice, unfortunately, many businesses offer standard terms to avoid the costs of negotiating each contract, or changing procedures for thousands of deals. On the other hand, depending upon how much a business wants a particular deal, often the preprinted form serves only as the start of extended discussions.

In addition, whether a written contract exists or not, many basic commercial terms are provided by general business laws enacted in every state, the "Uniform Commercial Code" (commonly called the UCC). By covering everything from offer and acceptance to warranties and damages, the UCC transforms the simple handshake into an elaborate system of rules. Technically, the UCC applies only to the sale of goods; for other contracts, hundreds of years of case law in this country and Britain provides much guidance, as do more generally applicable statutes in some states.

Although every case will be decided on its own facts, in disputed cases courts apply these rules to determine, with reasonable comfort, the terms that the parties intended, and whether they had agreed to be bound by them. Courts also pay attention to what a reasonable person might have believed — for example, even if I did not agree to the terms, anyone could easily believe that I had from my actions.

Courts answer these questions not only from oral or written statements, but also from the prior course of conduct between the parties, and industry custom. What does the parties' correspondence say? Did both begin performance as if they assumed that a contract existed?

To avoid surprises, particularly when larger sums are involved, it is often helpful to be quite clear in any written document to say whether a contract is intended. Sometimes a "non-binding letter of intent" establishes general terms while negotiations continue. In other cases, documents are clearly stamped as "draft" — and neither party takes any irrevocable action — until a contract is signed. How a court would apply the rules of contract depends on the facts of each case, so you should consult your advisors before you or the other side takes any expensive or irreversible steps.

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III. Reading a Contract

Let's suppose you have received a draft contract for a prospective deal. How should you read it? What should you look for, and what should you leave for your lawyer?

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IV. Common Business Contracts

We've just talked about how to read contracts, generally. Let's now be specific about common contracts most small businesses will see, beginning with those you get from outside your own organization.

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V. Confidentiality

Before starting any major deal or negotiation or discussing any information about a start-up venture, be sure you have a nondisclosure agreement in place if you will reveal any crucial information (client contacts or purchasing plans, manufacturing tricks, key foreign suppliers, etc.). Don't let a competitor use an acquisition negotiation as a pretext to learn your trade secrets — a common practice. If possible, don't ever reveal key technology, or disclose only a version unusable to a potential thief.

Read the nondisclosure form carefully, as well. Many "standard" forms include only a promise not to disclose. They lack  the "irrevocable harm" language courts insist upon to step in with an injunction to stop any wrongdoing.

Often, the most important part of a confidentiality agreement is the definition of what is confidential. Must something be labeled "secret" to be confidential, or is anything obtained during performance of the contract or negotiations potentially confidential? Obviously, your preference will depend upon whether you receive or disclose information.

Similarly, the agreement should define what is never confidential: public information, information you already know, and information you get independently. Don't agree not to use unrestricted knowledge! Most importantly, the agreement should also specify who must prove each of these exceptions. Often it is impossible to prove who knew what and when, and then the so-called "burden of proof" becomes the deciding factor.

Finally, remember that when a prospective employee or business partner refuses to sign even a simple confidentiality agreement, it should raise a red flag about their true intentions.

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VI. Purchase and Sale of Goods

In order for a contract for the purchase and sale of goods to be valid, it must clearly state a price and a quantity. Although courts can sometimes imply these terms by reference to other factors — a recognized price index, past buying patterns, agreements to purchase all of a firm's output or to sell all of a firm's requirements — ambiguity can be fatal. If the goods must meet specified quality or delivery requirements, the contract should also specify those terms with enough detail to let both sides know what is expected. For example, a contract for "polo shirts" is no help if you can only use blue ones, but received red. As discussed earlier, anything that you feel is important to the contract should be in writing rather than assumed.

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VII. Financial Contracts

Although you may have less opportunity to negotiate contracts with lenders or investors, these arrangements are contracts as well. Whether called a "note," "debenture," or "bond," in the case of debt, or "subscription agreement" or a "stock purchase agreement" for equity, do you understand all of the terms, and not just the payments?

For example, what rights do you have to delay or stop any sale of the collateral you provide — can the lender get it before default? Do you or anyone else (besides the business itself) have personal liability (commonly called a "guarantee," if the lender must first try to collect from the business, and collateral, or a "surety," if it can collect first from you)?

Although lenders often begin with very strong forms, most will make reasonable changes upon request, or tailor the forms to fit the facts — particularly in today's competitive lending environment. For example, you may have to list exceptions to many "standard" warranties about a business in a rider, so that you will not be in default as soon as the agreement is signed. Lenders will also usually allow written notice and a reasonable (but brief) time to fix an alleged default, to avoid incurring fees and costs of calling the loan prematurely.

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VIII. Joint Ventures

Typically, this term refers to a "one-time" isolated project by two firms, through any one of several formal entities. (See "Determining Your Company's Legal Structure" for details.) The joint venture agreement should specify what each party will provide (funds, physical facilities, personnel time, technology rights), what each person will do to further the venture, how costs and profits will be allocated, when the venture will end, and who will own any products or intellectual property resulting from the venture.

More importantly, both parties should have a clear understanding of the venture's goals. Mistaken assumptions about the other person's true intentions can waste time and effort, at best, and threaten relationships with valued business partners or clients, at worst, if the venture partner does not have the same long-term commitments to them that your business does.

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IX. Legal Compliance Warranties

Many large firms now routinely require vendors and suppliers to certify compliance with regulatory laws, both by themselves and their suppliers. "Hot" issues include child labor, worker safety and hours of work, discrimination, and environmental and occupational health, particularly abroad where our alphabet soup of regulatory agencies does not exist. Since the law in these areas can be quite complex — and vary greatly if foreign suppliers are used — pre-printed forms of this type must be reviewed carefully to insure that you understand your commitments and exposure. Can you safely warrant that all of your own operations meet all of OSHA, EPA, and labor standards, much less the operations of your suppliers and subcontractors?

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X. Contracts Inside Your Own Organization

Just as your business needs contracts to protect you against outsiders, it also must protect relationships within the firm, with employees and among investors.

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XI. Business Structure

Although few realize it, the documents that establish your business (see "Determining Your Company's Legal Structure") are themselves contracts among the organizers of a business. Articles of organization, by-laws, partnership agreements, operating agreements of limited liability companies — all are contracts setting the terms of the investment, and dividing profits, losses and responsibilities.

As a result, if you feel important provisions of your deal with your business partners are not in the forms you receive, you should discuss this with your professional advisors. Although generally used forms incorporate common start-up concerns, negotiated arrangements may include terms neither you nor your partners realized should have been highlighted to the person preparing the forms. In particular, while junior personnel (both attorneys and paralegals) can generally draft basic organizational documents far more cheaply than senior advisors, they may not have the breadth of training or experience to recognize when the forms require adaptation or may simply be inadequate.

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XII. Employment and Independent Contractor Agreements

These agreements specify the duties, rights and compensation of your personnel. Employees, who work exclusively for your business, will typically have oral, "at will" contracts terminable at any time. While adequate in most cases, employees with special skills or more complex financial rewards often get letter agreements or formal contracts specifying duties, regular and incentive compensation, and benefits and conditions for termination. Consider whether to specify the limits of each employee's authority to bind the business, special rights to knowledge or inventions the employee creates, and non-competition/confidentiality protection (discussed below).

Independent contractors (who generally receive a Form 1099 at the end of the year, rather than a W-2) are free to provide services to many businesses, so care must be taken to define the precise services and time commitment that will be provided. An independent contractor with permanent, full time duties for your firm could be challenged, which would cost your firm back payroll taxes and penalties. The IRS has attacked independent contractors vigorously in the last few years, particularly in high tech industries. Instead, independent contractors must agree to be responsible for their own payroll taxes and withholding, although if the IRS challenges the relationship, ultimately it will look at whether the individual was free to and actually did perform services for other clients.

Businesses often forget, in both employment and independent contractor arrangements, to specify ownership of any inventions or other intellectual property developed by the individual in the course of employment. If you intend that the business will own all rights to work product, that must clearly be stated; if you say nothing, independent contractors will own rights to work they create, and could resell it to your competitors.

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XIII. Buyout Agreements

Whatever your form of business organization, you should consider a "buyout agreement." This will help you avoid an unwanted and often disruptive change in ownership. Such crises can occur both when one partner decides to sell to resolve disputes or to satisfy financial needs, or involuntarily is forced to sell in a divorce or creditor claim. A buyout agreement also provides liquidity — a guaranteed buyer — for otherwise unmarketable non-controlling interests in a firm, which can be helpful to an estate after an owner's death or disability. Often called "shareholders' agreements" or "buy-sell agreements," these documents give the business and its owners a first right to buy back shares or partnership interest before a third party can acquire it.

Other common provisions include mandatory special tax elections, detailed provisions about who will manage the business, and how the interests in the company will be valued in a buyout. S corporations and profitable partnerships and LLCs, in particular, must require cash distributions each quarter to allow investors to pay estimated and final tax payments on business earnings, which are taxed to them personally in proportion to ownership. Courts will rarely order such distributions if not agreed by the business owners, and the absence of such protection creates an unneeded opportunity to coerce investors confronted with tax bills without the cash to pay them.

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XIV. Intellectual Property Protection

If you don't want your employees to compete against you after they leave your business — whether in a particular territory or product line, by taking customers, or hiring away employees — you must require a strong non-competition agreement when the employee is first hired. Although the particular restrictions courts will uphold vary greatly from state to state, without an agreement no state will allow you to block a former employee from using against you the contacts and knowledge you gave him.

Even if you are unwilling or, as a competitive matter, cannot require employees to agree not to compete against you, no employee or contractor should reasonably be concerned about agreeing not to use your confidential information. Although not every piece of information is confidential, having a written agreement will make it much easier to get a court order blocking a former employee from using key information for the benefit of a future employer.

Of course, you must always treat such key information as confidential, on a daily basis, by labeling it as "secret," and making it available only to select employees under controlled conditions. Courts will be unlikely to protect information available to anyone on a bulletin board or the Internet, or discussed in elevators and other public places.

Finally, as discussed above, your employment and independent contract relationships should specify ownership of work product. If your employees or independent contractors create patentable ideas or products, they should also agree to assist you in the application process, for no additional pay, even if that assistance is required after they have left your firm. Although your personnel or counsel may prepare the papers, you may need the inventor's signature during the process.

The bottom line? Proper protection is essential for every small business owner. Remember to consult an attorney before entering into any formal contracts or agreements.

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XV. Resources

Fred Steingold, "The Legal Guide for Starting and Running a Small Business" (Nolo Press, 1997)  

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