Basics of Contract Formation

Welcome back to Small Business Contracting Basics. Today we will discuss the very basics of contract formation law in California. Specifically, what does it take to form a legally binding contract? In very short a legally binding bilateral contract consists of three parts, the offer, acceptance of the offer, and consideration. In order to better business owners it is very important that business owners know when a contract is formed. This issue, like all issues of this series, is not meant to take the place of having a professionally drafted and customized legal contract constructed for your business and does not constitute in depth legal advice. Make sure that even after you have a better understanding of contract formation that you exercise restraint in the use of said knowledge. Nothing tends to put off clients like someone who attempts to “put one over” on a potential client.

Terminology

Before we get into brass tacks, as they say, we need to take an important step in preparation of any contract discussion. That is, we need to define our terminology. Never forget that if you can’t even agree with the other party on what words mean it is a fairly bad sign. In my experience it is almost always better to take the time to lay out a basic understanding of the what you mean when you refer to a “widget” (even if widget is a fairly common technical term) to eliminate the potential for disagreement. So getting down to it, it is generally understood that the following terms have the following meaning when it comes to talking about a contract in a legal sense and therefore I may end up using the following terms in this article. Offeror: is a person or legal entity that makes an offer. Offeree: is a person or legal entity that an offer is made to. Promisor: is a person or entity that makes a promise. Promisee: is the person or entity to which a promise is made. Bilateral contract: is a contract where parties exchange mutual promises Unilateral contract: is a contract (not as commonly seen) is a contract created by an offer than can only be accepted by performance

Offer

An offer is created when the Offeror communicates that he/she is willing to presently enter into a contract with the Offeree, that the communication describes specifically what the contract is, and that the Offeree could reasonably have concluded that a contract on those terms would be created by acceptance. To make this less clear but establish the basis of the California law on the subject, California has adopted the definition contained in Restatement Second of Contracts, section 24: “An offer is the manifestation of willingness to enter into a bargain, so made as to justify another person in understanding that his assent to that bargain is invited and will conclude it.” There tend to be more complexities in dealing with offers but they are not generally as common when dealing with business contracts in the modern world. If any of my readers are interested I will be able to address some of the more interesting and esoteric examples in future articles but this should serve as a good baseline for moving forward.

Acceptance

Acceptance is when the Offeree agrees unequivocally to be bound by the terms contained in the offer and communicates the acceptance to the Offeror. Likewise, California has adopted the a more complex definition contained in Civil Code Section 1585 “An acceptance must be absolute and unqualified, or must include in itself an acceptance of that character which the proposer can separate from the rest, and which will conclude the person accepting. A qualified acceptance is a new proposal.” Notice the wording in the very last sentence of the code section above? That is an important concept for business owners to understand when discussing contracts. If the Offeror states that “the price of the widgets is $2,500 with payment up front” and the Offeree then responds that “I accept, if I can pay half up front and half on delivery” there has been no acceptance. This tends to be a point where some individuals get confused especially when dealing with verbal contracts (to be discussed later) often because the words “I accept” are contained in the sentence. However, remember that acceptance must be unconditional and the statement contains that inconvenient “if” that destroys acceptance. The example exchange above is really a “counter offer” where the Offeree has rejected the initial offer and has proposed a new agreement. This is one of the reasons that it is so important to have clarity when dealing with contracts, if this is left unaddressed both sides could have very different ideas regarding what they have agreed or not agreed to do. Again there are so many bits of minutia that could be addressed in this section but for brevity’s sake I will say that we can address those in the future and leave this as a simple and very basic definition of acceptance.

Consideration

Consideration is, in its most basic sense, the benefit that is conferred on the Offeror and Offeree as the end goal of the contract. More specifically California Civil Code Section 1605 defines consideration as “Any benefit conferred, or agreed to be conferred, upon the promisor, by any other person, to which the promisor is not lawfully entitled, or any prejudice suffered, or agreed to be suffered, by such person, other than such as he is at the time of consent lawfully bound to suffer, as an inducement to the promisor, is a good consideration for a promise.” If that did not give you the clearest ideas of what specifically constitutes consideration don’t worry, consideration is defined in an incredibly broad sense and just about anything that you can think of can be consideration. An illustrative mental exercise to use when wrapping your head around consideration is to think of what normal people (I’m told) consider a “gift.” Now when you agree to give someone a gift you are, at least on the surface, giving someone something without receiving anything in return. Now an agreement to give a gift is the classic example of an agreement without mutual consideration. Don’t overthink it though and try to worm consideration in there through mental gymnastics a traditional gift does not contain mutual consideration needed for a contract. Generally speaking consideration need not be equivalent to be valid and courts are not typically willing to weigh the relative value of consideration so long as there is some consideration attached to the contract. However, in some instances the court will determine that a contract is “unconscionable” as the result of consideration being so grossly out of proportion as to make it unfair to the party seeking to escape the contract. Don’t worry too much about unconscionable contracts at the moment as I will cover that in more detail in future sections. Consideration must be legal. So no consideration can exist when the exchange of sex, murder, illegal goods, or slavery is used in place of more wholesome consideration like money, goods, or services. This means even if you were contemplating making a contract that used the above unwholesome kind of exchange (free advice, don’t) it would fail in court as lacking in consideration. As a further general note is that written contracts create a very slight presumption that a contract has mutual consideration. Additionally, the burden of showing there is no mutual consideration rests on the party that is seeking to avoid having an agreement considered a legally binding contract. This means, in case you were wondering, if you want to claim that there is no mutual consideration, you will need to bring proof sufficient to show the court you are correct.

Concluding Remarks

Now that we have addressed (in the most basic way possible) the parts required for a contract to be legally recognized as a contract we will be able to move on into more interesting topics dealing with contracts and some of the pitfalls that are associated with small business contracting. Keep an eye out for the upcoming sections on “Capacity to Contract” and “Common Contract Clauses.”

The above is not personalized legal advice and no attorney client relationship is created therefrom.