What Is Required to Form a Binding Contract?

Most business owners are savvy enough to know that a contract is an enforceable agreement between two or more people or entities. However, you may or may not realize the fundamental elements of a valid contract. Understanding the basic components of a legally valid contract can be very helpful in conducting daily business activities so you don’t inadvertently make a legally binding agreement without knowing you are doing just that. There are four essential elements: capacity of the parties, mutual assent, consideration, and legality.

Capacity of the Parties

A core element of an enforceable contract is that the parties have legal capacity. This means that the parties must be capable of fully understanding what they are doing, as well as the consequences of their actions. For example, those who are under age 18 or in a coma would lack the capacity to enter into a contract. Sometimes, however, it is not so clear. An older person suffering from intermittent dementia, which comes and goes, would have capacity to contract during periods in which her mind was sound. Contracts will not be enforced against parties who were not able to understand what they were doing.

Ensure that you are only entering into agreements with those who have capacity and are not under the influence of drugs or alcohol at the time they entered into the agreement.

Mutual Assent

The next element of a legally binding promise is mutual assent. In law school, this is often called the “meeting of the minds.” Mutual assent means that the parties to the contract meant to enter into a binding contract on certain terms. This is usually proven by showing that an offer was made and that it was accepted.

A highly formalized example of mutual assent is the process of buying a house. The would-be buyer makes an offer to buy a specific house for a specific price. The offer is drawn up with all of the terms that the buyer wants and is sent to the seller. The seller is usually given a limited amount of time to accept the buyer’s offer. The seller may also reject the buyer’s offer and propose a counteroffer, with new terms, usually a higher price. The buyer is then free to accept or reject, or she may make a counteroffer herself. The process continues until it either falls apart or until the two reach mutually agreeable terms. Once those terms are found, there is mutual assent.

Mutual assent does not have to be evidenced in writing (unless for the purchase and sale of real estate), but can happen by email or even verbally.

Consideration

A contract is not valid and enforceable unless it is supported by consideration. In the home-buying example above, the buyer is promising to give money for the house, and the seller is promising to give the house to the buyer after payment is made. However, consideration is not always this straightforward. The idea is that both parties to the contract have to give up or receive something of value. A promise to do something, and even a promise not to do something a person has a legal right to do, may also serve as consideration.

In the case of a personal services contract in which you are delivering services, you are giving up your time as consideration to enter into the agreement whereas the other party is giving you a commitment to pay for your time.

Legality

The last element of a binding contract is that it must have a legal purpose. Judges will not enforce illegal contracts. It is easy to understand that a contract to kill a person would not be enforceable. However, as with many legal concepts, it is not always that simple. For instance, a contract to enforce a gambling debt might be legal in some states but not in others, depending on state law.

A Special Requirement: A Writing

Some contracts carry one additional element: They must be in writing. This requirement is known as the Statute of Frauds. The types of contracts that must be in writing are generally set forth in state law. The most significant type of contract to which this applies is contracts regarding land, such as agreements to buy land.

Business owners use contracts all the time, such as when renting space, hiring employees, and buying supplies. It’s very likely that you are operating with some undocumented agreements that are leaving you and your business at risk. If that’s the case, call today and make an appointment for a LIFT Foundation Audit where we can identify any of the holes in your legal, insurance, financial and tax foundation and work with you to fill those holes so your business can grow with minimum risk.