A contract is a legally binding agreement between two parties (people, companies, or both) in which something of value is exchanged. One party promises to do something in return for a something else. Since a contract is legally binding, if one party does not do what was agreed upon, the other party can sue them in court to either enforce the contract or receive compensation. Contracts are involved in personal and business dealings, so it is important that you understand the rules governing them.

What Makes A Contract Binding?

Not every agreement is a binding contract, but every contract has a few required elements.

Requirement 1: Consideration

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If you have ever seen a news article about a CEO who has a $1 salary, it is because of Consideration. He or she would not have an employment contract if the company did not have to give up something!
Consideration is the reason you are entering into a contract.  Both parties have something required of them, something they would not normally be doing except as part of the agreement. For example, Joe agrees to paint Tom’s house, and Tom agrees to pay for the service when the painting is finished. If one party agrees to do something but there is nothing required in return, this is considered a gift and not a contract.

Requirement 2: Offer and Acceptance

An offer refers to a promise one party makes in exchange for something in return by the other party.  It’s an invitation to enter into a contract based on specific terms.  An offer can be made orally or in writing.  It can be a short statement or long and detailed.  It’s important that your offer is reasonable and is clearly communicated, otherwise the party receiving the offer may not believe you are serious. 

For example, if Alice owns 10 shares of Google GOOG stock and offers to sell some of her shares to Bob, that it not a valid offer.  The offer was not clearly defined.  It would need to include how many shares Alice is offering to sell, at what price, and when Bob would receive them. 

An acceptance is when the party receiving the offer agrees to the terms being proposed.  The acceptance must be relayed in the manner that the offer specified. For example, if you received an email offer from Repair Guys to fix your car’s radiator for $550 and the offer stipulated that you must accept the offer in writing, then you would need to reply to the email showing your acceptance.  If you receive an offer and do not like the terms, you can reject the offer or you can start a new offer.  For example, if your email reply to Repair Guys stated that you would like the radiator repair to be done for $500, you are creating a new offer to which Repair Guys can accept or reject.

Requirement 3: Intent

Both parties need to actually intend to make a legally-binding contract. This might seem obvious, but this is the key difference between an informal agreement and a binding contract. For example, you might have an agreement where you mow your neighbor’s lawn for $10 a week. There’s a clear offer and clear acceptance.  But if you failed to mow the lawn one week, would your neighbor sue you? Probably not. What you created is an informal agreement, not a contract.

However, if you agreed to paint your neighbor’s house exterior for $800 by next Friday, and the neighbor has given you $200 up front to purchase paint, both parties clearly intended for a legal contract to be made. 

Requirement 4: Legal Capacity

Legal capacity means that both parties have authority under law to make a contract in the first place. In most cases, if any of the following situations apply, the party might be considered to not have legal capacity and a binding contract could not be created: 

  • Anyone under the age of 18
  • Someone who went bankrupt in the last 5 years buying something worth more than $6,000 (without telling the other party about the bankruptcy)
  • Anyone with a significant mental disability

There are exceptions to these guidelines.  For example, someone under the age of 18 can still enter a binding contract for a necessity, such as food or shelter. 

Requirement 5: No Forced Agreement

All contracts must be created through the free will of both parties.  You cannot force someone to enter into a legally-binding contract. 

Requirement 6: No Illegal Actions Required

If a contract is developed and the five previous requirements are included, your contract might still not be valid because it is asking a party to do something illegal. For example, you can’t have a legally-binding contract to sell illegal drugs.

Does A Contract Need to Be in Writing?

It depends! As long as a contract has all of the required elements, it is considered legal.  However, verbal contracts are tricky.  Unless you have witnesses to the oral contract, it is difficult to prove the contract contains all of the necessary parts.  By law, some contracts do need to be in writing, such as real estate sales.

If you want to make sure you have a legal contract, you should always get it in writing. More importantly, you should always read the full contract before signing!

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