How to Protect Your Business With Contracts

You spend so much time building your business — be sure to adequately protect it. Learn about the types of contracts and how they can help you keep your company sailing smoothly, even through those inevitable rough spots.

OVERVIEW

Every business needs to protect itself from misunderstandings and miscommunications with partners or employees. The best way to achieve this is to create a contract between the parties. Contracts protect everyone involved by spelling out what is expected from each participant. There are several basic contracts that business owners should consider when setting up their business. This bit of prep work makes for smoother relationships. More importantly, ignoring or putting off these agreements will lead to problems that can't be reconciled easily or cheaply after the fact.

In this Quick-Read you will find:

• * The definition and makeup of a contract.
• * The different types of contracts.
• * The most important contracts to consider in a new business.

SOLUTION

A contract is any agreement between two or more people that includes an offer by one party that is accepted by the other(s) in exchange for some type of recompense (either money, goods or services). Most contracts will spell out the specific terms according to which the parties agree to perform their respective parts of the agreement. Likewise, the contract should detail the circumstances under which it cannot be enforced (illegal purposes, trickery, incompetence, etc.). Draw up contracts with the help of your attorney (for more information on finding a business attorney, see "Choosing the Right Lawyer for your Business").

There are four basic categories of contracts:

1. Express contracts are legal documents that lay out every detail and usually are in writing.

    

2. Implied Contracts usually do not have clearly defined components and in many cases are not written. These include such agreements as when you ask your supplier to come fix your copier: It is implied that you will pay when the work is finished, even though you've expressed nothing in writing to that effect.

    

3. Oral Contracts or handshake deals are verbal agreements and are difficult to support in court because there is no evidence of their existence unless witnesses heard the exchange. These agreements often exist for small business people who work with regular suppliers on an ongoing basis.

    

4. Written Contracts can be less formal than express contracts. As such, they are the most common and should be used for any business deal, since contracts are enforceable only if they can be proven. They also guarantee that all sides understand the expectations and terms of the agreement. Almost any written statements can be accepted as a contract if they include the client's signature, even a faxed version. By law, written contracts are also required when the terms can't be performed within one year or for goods costing more than $500.

The contract should be written in simple language and include the date, identities of the parties, a description of the goods or services to be exchanged, any other considerations and the parties' signatures. "Other considerations" may include specific details such as pertinent pricing arrangements or payment schedules.

Business owners should be prepared to deal with the following specific contracts:

• Employment contract: This spells out the conditions under which an employee is working, such as salary, vacation time, benefits, expense reimbursement, etc. Because American business strongly advocates "at-will" employment, this contract is seldom used, especially by entrepreneurial businesses where conditions can change quickly. "At-will" employment occurs when an employee and owner agree that either can terminate the employment at any time if done for cause (that is, within federal requirements for nondiscriminatory actions) and within a certain time period (such as with two weeks' notice). In most cases, a company has an employee manual that covers hiring conditions and benefits, but this does not constitute a formal contract signed by the employee.
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• Subcontractor agreement: A subcontractor is an individual or business that is hired to perform a specific job or duty for a specified period of time. They work for the company but are not considered employees. This frees the owner from a variety of financial obligations, but the Internal Revenue Service lists many requirements a subcontractor must meet to avoid being considered an employee. It is imperative a company be aware of these restrictions, or the subcontractor will be considered an employee, with the ensuing tax responsibilities for the company.
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• A related type of contract is a retainer. In this contract, the company agrees to supply the subcontractor with a certain amount of business in a specific time period or to pay the subcontractor a fee in exchange for being available if needed during a specified time. This is done when the exact work or amount is unknown, and ensures that the worker will be available for the assignment if/when it arises.

• Confidentiality agreement with a noncompete clause: This contract is fairly typical with entrepreneurs to ensure trade secrets on which the company is based are not taken to a competitor. The confidentiality element prohibits an employee from taking company-specific material (client lists, special manufacturing processes, intellectual property, software codes, etc.) to another company when he or she leaves. These contracts can be difficult to enforce, unless the material has a distinctive "fingerprint" that could not be developed without the stolen material. Company policy on copying material, removing documents and sharing of product information should be clearly stated in the agreement.
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• A noncompete clause prevents an employee from soliciting the clients of the business for a specified time, in the event they leave the employ of the business. This particularly applies to key client-contact personnel who may be critical to keeping major accounts satisfied. A noncompete clause cannot prevent employees from joining a competitor, but it can prevent them from having contact with existing clients during the prescribed period.

• Buy-sell agreement: Whether started by a sole owner or partners, every business should include in its incorporation a buy-sell agreement that outlines how ownership of the company's stock shares will be transferred. This protects the current partners, existing shareholders and their heirs. It should explain what happens if a shareholder wishes to sell, to whom the shareholder may sell, how long the shares may be offered for sale and what the conditions are for a "call" option (in which a partner may force another to sell shares) or a "put" option (in which a shareholder may force the others to buy shares).

  This becomes an issue especially when one partner dies, transferring the stock to a spouse, children or other heir. The surviving partner may not want these people involved in the company and may wish to compel them to sell the stock. Conversely, they may not want to be involved in ownership, but want instead to compel the other partner to buy them out. All conditions, prices and other details should be spelled out.

  Note that to achieve this, the company must have a valuation performed to ensure a proper price is levied on the stock shares. As indicated in the Quick-Read Solution "How to Value Your Company," the valuation can be based on one of the following:

  • - The initial contribution or purchase price of the stock.
  • - A formula price set down in the contract (such as 1.5 times current sales).
  • - An independent valuator's assessment. (This valuation is most accurate, but it must be updated each year to ensure it stays current with the company's true value.)

REAL-LIFE EXAMPLE

An office supply company had been growing rapidly for five years, thanks in large measure to its top salesperson, who worked closely with more than half of the company's biggest accounts. She realized her importance to the company and asked the owner to give her an equity position, but she was refused. She resigned and started her own business, calling all of her former clients to announce the business and ask for their orders. Four major clients shifted their business to her firm within two weeks. Because she had not signed a noncompete agreement with her original employer, she was free to solicit and accept this business immediately after starting her own business. Having a confidentiality agreement with a noncompete clause in place would have protected the office supply company from this situation.

DO IT

1. Consider which contracts are important to your business and to ensuring employees understand their responsibilities.

    

2. Create or update your employee manual to ensure it covers all benefits, duties, responsibilities and other elements that would be in an employee contract if you used one.

    

3. Create a buy-sell agreement that provides a process that ensures ownership of the company remains where you want it in the event of a possible change in the circumstances of the existing owners.

    

4. Value your company to ensure stock is evaluated appropriately when shares must change hands. Update this value each year as part of your yearly preparatory work.

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RESOURCES

Books

Law for Business, 8th edition, by A. James Barnes, Terry Morehead Dworkin and Eric L. Richards (McGraw-Hill / Irwin, 2002).

Purchasing Manager's Desk Book of Purchasing Law, 3rd edition, by Donald B. King and James J. Ritterskamp, Jr. (Prentice Hall, 1998).

Internet Sites

Uniform Commercial Code Locator

AllBusiness. See the "Agreements and Forms" section.

Article Contributors

Writer: Craig A. Shutt

[Craig Shutt interviewed Lisa J. Miller, CPA, of Colle & McVoy Inc. in Minneapolis, Minn., for this Quick-Read solution. Lynn Phillips, president of Page By Page in Newark, Del., supplied additional material.]

This Quick-Read Solution was originally published in 2000.