Table of Contents
What are Contract Elements?
Contract elements are the foundational components required for an agreement to be legally enforceable, which include offer, acceptance, consideration, intention to create legal relations, legal capacity, mutual assent, legality, and certainty. Each plays a role in ensuring a contract is fair, clear, and adheres to legal standards.
Every binding agreement has these components. Without them, it cannot be considered a valid contract.
That’s exactly what makes each element so crucial — they establish the legal framework that makes an agreement enforceable in court. They safeguard each party’s rights and obligations under the law. And they prevent potential disputes and uncertainties in business transactions.
- Elements of a contract
Importance of Understanding Contract Elements
Understanding the elements of an enforceable contract is a critical first step to being able to create and manage agreements, business deals, employment terms, and customer relationships across your entire organization.
Knowing the essential elements of a contract helps you identify and mitigate legal contact risk. Teamwide understanding ensures contracts protect the company’s interests (and those of its employees).
Today’s companies spend an average of $3.1 million on legal disputes, litigation, and compliance issues — a 29% increase from just one year prior. Although contract elements themselves can’t ensure full compliance, they do lend structure and transparency to agreements, making it easier for legal teams to identify an organization’s potential problems.
Clear contracts with well-defined terms and conditions provide a roadmap for the execution of business operations. This solidifies expectations, defines roles and responsibilities, and keeps all parties aligned on deliverables and timelines. By extension, it reduces misunderstandings and conflicts.
Contracts underpin strategic business relationships with suppliers, customers, and partners. A thorough understanding of contract elements makes it easier to draft, redline, approve, and eventually execute business deals in a way that’s mutually beneficial.
Properly constructed contracts protect a company’s financial interests by clearly outlining the terms of payment, delivery, and penalties for non-compliance (e.g., delinquent payments). A contract can guarantee compensation for the goods, services, and intellectual property they exchange as part of their contractual obligations.
Protection for All Parties
Verifying everyone involved is (a) on board with the agreement, (b) legally capable of executing it, and (c) fully aware of its contents is the key to long-term customer satisfaction, profitable partner relationships, and an overall professional reputation. It also makes new business development easier, since others know their interests are protected.
6 Essential Elements of a Valid Contract
1. Offer and Acceptance
An offer is an expression of willingness to enter into a contract on certain terms. One party requires a good or service and has the resources to pay for it. The other party has that good or service and will exchange the value they deliver for payment.
Acceptance is the unequivocal expression of agreement to the offer. The offeree normally accepts the offeror’s proposal by signing a legal document, but other forms of formal acceptance include an upfront percentage payment, performance of the requested action, or, in the case of some long-term business relationships, even silence or inaction.
Let’s say a software vendor offers a subscription to a new customer at $100,000 per year. At the point where they either signed a contract or made an advance payment, it becomes a binding contract.
2. Intention to Create Legal Relations
Intention to create legal relations is the contract element that…well…indicates the contracting parties’ discretion to enter into a binding legal contract.
But why would anyone sign an agreement that’s not intended to be enforced?
The answer is: there are plenty of reasons.
- Social or domestic agreements
- Letters of intent or memorandums of understanding
- To set a positive tone for a negotiation or collaboration
- Cultural or organizational norms
- To influence certain behaviors or outcomes
- For PR or marketing purposes
If you and/or the other party do want legal protection, this is the place to explicitly say so. Otherwise, you could end up in a position where you’re out of luck if someone walks away from the agreement without delivering on their promises.
Take the classic 1989 case, Kleinwort Benson v. Malaysia Mining Corp., as an example. The plaintiffs (a bank) lent money to a defendant’s subsidiary with a letter of comfort stating the defendant’s policy. When the subsidiary went into liquidation, the plaintiffs sought payment. The court ruled that the letter of comfort carried only moral responsibility, not legal relations.
Consideration is what each party gives and receives in exchange for the other party’s promise. Each contracting party must “pay” something (whether it’s money, tangible goods or services) to receive the benefits they’re entitled to under the contract. In other words, it’s what one party gives the other in exchange for their offer.
There are a two main types of consideration: executed and executory consideration.
- Executory consideration is the case when the promised action or service is yet to be performed. It’s a promise to do something in the future — for instance, an agreement to deliver goods at a future date in exchange for payment upon delivery.
- Executed consideration occurs when the promised action or service has already been completed. Had that payment been made before the item were delivered, it would also have been considered executed.
Contractual consideration must have some value, even if minimal. And it isn’t necessarily monetary; it can also be a promise to perform a particular action, refrain from doing something, or exchange services or goods.
4. Capacity of the Parties
Legal capacity ensures that all parties entering the contract are mentally competent and understand what they’re agreeing to. A non-competent person could be a minor, someone who is intoxicated, mentally ill, or otherwise mentally incapacitated.
As far as minors are concerned, contract laws vary from state to state. While it’s possible for those under the age of 18 to enter binding contracts with court approval or a state’s statute permitting it, the likelihood of a judge enforcing one is slim, even in the few circumstances where it’s allowed.
For a child to void a binding contract, they must still be under 18 when they do so. Minors also cannot void banking agreements or contracts for “necessaries” — goods and services required for their health and safety, like food and lodging.
5. Legality of Purpose
In contract law, the concept of legal purpose stipulates the contract’s object or reason must be lawful. There also has to be a legal reason for the parties to do whatever it is they’ve agreed to. If the agreement…
- is for an illicit purpose
- voilates laws or regulations
- goes against public policy
- is executed under misleading circumstances
6. Certainty and Possibility of Performance
Both parties need to clearly indicate they understand the contract terms and be reasonably certain about their obligations under it. Courts will void contracts that are too vague or ambiguous.
In cases where one party is unable to fulfill their duties due to circumstances outside their control, such as an act of God, impossibility of performance may be a valid defense for breaching the contract.
One example of this is the recent COVID-19 pandemic, which has caused many businesses to close and cancel contracts due to government-imposed restriction and safety concerns. In these cases, the parties might to invoke a force majure clause to excuse performance under the contract.
Additional Contract Elements
Express and Implied Terms
In a contract, express terms are the specific statements or provisions that have been explicitly agreed upon by both parties.
An example of an express term could be:
- A statement that outlines the payment terms or the delivery date for goods
- Specific clauses detailing what will happen if one party fails to comply with the contract terms
Implied terms refer to the unstated but legally binding obligations a court would assume to be part of a contract. They are not explicitly stated, but still have the same legal weight as express terms.
The usual reason for excluding implied terms is that they’re “too obvious” (for example, everyone knows not to steal from their employer or business partner).
Where you might run into legal grey area is when a court determines an implied term should have been included in the contract. That’s why, unless it’s very obvious (like the abovementioned examples), it’s best to outline all promises and expectations in writing.
Conditions and Warranties
Most agreements will have some conditions attached to them. A condition of a contract is a major term that must be fulfilled in order for the agreement to be valid. It could also refer to an uncertain event in the future, which could derail or change the outcome of the contract altogether.
If you’re selling marketing services, a contract condition could be your client’s payment being received on time each month, or their ability to share all the relevant data (logins, passwords, marketing analytics) you need to do your job correctly.
If there’s a contract breach, the condition protects the non-breaching party from having to fulfill their obligations. The breaching party is liable for any damages caused by the breach.
If the unwritten expectation when purchasing your product is that it will last for a long time or perform a certain way out-of-the-box, you’ll probably offer a warranty. This is common in B2B manufacturing.
A warranty is a written promise by the seller to repair or replace defective products within a specific period after they have been sold. The extent of the implied (by law) and express warranties will vary depending on your state, country, product type, and market you operate in.
Discharge of Contract
You might include a contract element specifically for what happens if the agreement becomes impossible to fulfill due to an unforseeable event (force majeure). Performance may become impossible (or impracticable) after a contract has been formed for several reasons:
- Destruction of the subject matter
- Death or incapacity of a party
- Frustration of purpose (if the goal or intended performance is no longer relevant)
- A major disaster or accident
- A declaration of war or changes in government regulations
- Explosions, strikes, boycotts, or labor disputes
For example, if you’re contracted to perform at a music festival that gets cancelled due to extreme weather conditions, your client won’t be able to hold you accountable for not being able to fulfill your obligations.
In any case where the performance becomes impossible due to an event outside either party’s control (and often against bot parties’ wishes), the contract will be terminated according to this section. This discharge of contract releases both parties from any remaining obligations under it.
Real-Life Contract Examples
Three real-life examples of business contracts that illustrate the diversity and complexity of agreements in the business world include supply agreements, employment contracts, and B2B sales contracts.
- Supplier contracts include provisions for pricing, quality standards, delivery schedules, and dispute resolution mechanisms to address any potential issues that could disrupt the supply chain.
- Employment contracts cover job descriptions, compensation details, the duration of employment, and clauses related to non-compete, confidentiality, and termination. Usually, they’re for highly compensated employees and 1099 contractors.
- B2B sales contracts handle warranties, payment terms, and project/product/service delivery details like levels of service, customizations, ongoing support, and maintenance.
High-Profile Contract Disputes
JPMorgan Chase Bank vs. Tesla
In 2021, JPMorgan Chase sued Tesla for $162.2 million over warrants Tesla sold to JPMorgan in 2014. The disagreement escalated after Elon Musk’s tweet in 2018 about considering taking Tesla private, which JPMorgan interpreted as an event that allowed them to adjust the strike price of the warrants.
Tesla countersued JPMorgan, accusing the bank of acting in bad faith and seeking an unwarranted windfall, while JPMorgan insisted it was merely a straightforward contract case.
The judge indicated the need for more evidence, including expert testimony, to determine if JPMorgan acted in good faith when it re-priced warrants after Musk’s tweet.
Gilead Sciences vs. US Government
Gilead Sciences filed a lawsuit against the US government alleging the Centers for Disease Control and Prevention (CDC) violated four Material Transfer Agreements (MTAs) and a Clinical Trial Agreement (CTA).
According to Gilead, the CDC was supposed to notify Gilead of any discoveries, innovations, or ideas resulting from the research using antiretroviral agents provided by Gilead, and was prohibited from seeking patents related to inventions developed from the drugs.
Caradigm vs. PruittHealth
In a significant SaaS contract dispute, a jury in the Northern District of Georgia awarded over $11 million to a software vendor, Caradigm, against PruittHealth, Inc., a health provider. The dispute arose when Pruitt attempted to terminate its 5-year subscription to Caradigm’s cloud-based service early due to dissatisfaction with the platform’s performance.
The court found that the contract did not allow Pruitt to terminate without identifying a material breach by Caradigm and following a cure process, leading to a substantial award for breach of contract, interest, and attorney fees.
Lessons Learned from Court Decisions
The bottom line is that contracts are vital for businesses, so it’s worth investing time and resources to get them right.
Some lessons we can learn from these high-profile contract disputes:
- Ensure clarity in contract terms to prevent ambiguity and disputes.
- Create a contingency plan to cover all possible situations.
- Automate contract compliance and regularly audit your major contracts to ensure you aren’t breaching any part of the deal.
- Formalize agreements in writing to ensure enforceability.
- Pay attention to your public actions outside of the contract and how they might influence the agreement.
- Keep money aside for legal costs and losses (40% of companies under $100 million and almost all companies over $1 billion spend $50,000+ and $200,000+ per litigation incident, respectively).
How Contract Management Software Helps
Contract management software — also referred to as contract lifecycle management (CLM) software — is cloud-based software that helps companies manage the entire contracting process, from creation and negotiation to execution and renewal.
- CLM simplifies contract creation. Contract AI, plus templates for different types of legal documents and a drag-and-drop editor, make it easy for your deal desk to generate, customize, approve, and execute contracts.
- E-signature speeds up execution. Up to 80% of agreements using e-signature software are signed in less than a day.
- Centralized storage and collaboration solve most contracting problems. With your contract repository as a single source of truth, you’ll reduce version control issues, automate approvals, and streamline negotiations.
- Permissions-based access secures all your sensitive documents. As an admin, you control your team members’ ability to access certain contracts. They’ll only be able to pull up the deals that directly concern them, which solves plenty of privacy concerns.
- Reporting and analytics provide actionable insights. Track everything from compliance to customer behavior on a single dashboard to uncover trends, patterns, and risks.
- Integrations streamline your whole contracting workflow. For example, integrating with CPQ (configure, price, quote) automatically turns sales proposals into first-draft contracts.
Importance of Professional Legal Advice in Contract Preparation
Even if you had all they knowledge required to navigate the legal landscape of contract law, you wouldn’t have the time. There are just too many (confusing) legal considerations when drafting a contract.
Engaging an experienced attorney in the drafting stage not only gives you peace of mind but also makes it easier to address the risks, complex terms, and loopholes that could send you to a courtroom.
Hiring a lawyer for review and advice on your important contracts will ultimately save you days worth of time, 6 figures (at least), and tons of job-related stress down the road. They can also offer valuable negotiation strategies to help you get the best deal possible.
People Also Ask
What are the two main types of contracts?
We can group contracts into two broad categories: fixed-price and cost-reimbursement contracts. Fixed-price contracts have a predetermined, definite price that’s not subject to change. In cost-reimbursement contracts, the contractor incurs costs, and the buyer reimburses those expenses (sometimes, plus a fee).
How is a contract enforced?
Assuming they’re legally binding, the potential for court enforcement is the primary distinction between contracts and other forms of agreements. When a party fails to perform its obligations under a contract, the non-breaching party can take them to court and sue for damages.
Why is consideration an essential element of contract formation?
Consideration is the value each party gives up in exchange for the other’s promise. It proves both parties intended to enter the agreement and signifies their mutual assent. This helps prevent fraudulent or coerced agreements and ensures fairness and equity in contractual relationships.