Every business carries out transactions that are formalized via contracts, from hiring employees and scheduling contractors to forming partnerships and seeking financial backing.
But is it always necessary to formalize things with a written agreement — and why do we actually need contracts?
In this article, we look at the purpose of these agreements and explore why contracts are important for establishing business relationships and protecting both parties’ interests.
What is a contract?
A contract is a legal agreement that sets out the terms of a transaction, deal, or exchange between two or more parties (these may be individuals or companies).
You might sign a contract to buy real estate, accept a job, or enter a business partnership. A sales agreement also counts as a contract.
Contracts outline the rights and responsibilities of each party, as well as the costs, benefits, and details of how the contract may be terminated.
They’re basically a promise that you’re going to take a certain action, such as completing work by a stated date or paying the other party for services rendered.
Both written and verbal contracts may be legally binding, but it’s best to use a written document for business agreements.
For a contract to be binding, it’s essential that both parties understand the entirety of the agreement and the obligations it sets out.
They must also show a clear intention to accept its terms.
This may be demonstrated by a signature, which is often an essential part of what makes a contract valid.
If you’ve never drawn up a contract before, you might be unsure of what to include.
Luckily, PandaDoc has a full library of contract templates that you can use for various situations to ensure you don’t leave anything out.
The purpose of a contract
So then, what’s the purpose of a contract?
In simple terms, the purpose of a contract is to establish and formalize a relationship by clearly defining terms and obligations.
This ensures all parties understand what they’re agreeing to and that there’s no room for misinterpretation.
Signing a contract demonstrates your commitment to the agreement and shows you’re trustworthy, which helps with building stronger relationships.
After all, as set out by the Harvard Business Review, trust is the basis for almost everything we do.
The document can also be used as a reference point if either party wants to check the terms.
Additionally, contracts offer legal protection in the event of a dispute and can be used in a court of law if necessary.
That said a clearly written agreement can actually help you avoid drawn-out arbitration or even going to court at all, saving your business time and money.
To be enforceable, contracts must contain these seven elements:
- Identification. A definition of the parties the contract applies to.
- An offer. The promise that one or both parties will (or will not, in the case of non-disclosure agreements) perform a specific action.
- Consideration. Something of value is promised in exchange for the actions.
- Acceptance. An expression that both parties agree to the terms.
- Awareness. Proof (such as signatures) demonstrating that both parties clearly understand and agree to the contract.
- Capacity i.e. each signatory has demonstrated the “legal capacity” to understand what they’re signing.
- Legality. All contracts are subject to the laws of the jurisdiction under which they operate.
Why are contracts important in business?
The importance of contracts and contract management in business cannot be overstated.
Whether you’re a startup or a multinational enterprise, robust contracts contribute to the smooth running of your company.
Here are 10 reasons why agreement is important in business.
1. They act as a representation of your obligations in writing
Business contracts create a reliable written record of the obligations involved in the transaction, whether it’s carrying out a project, meeting a deadline, or paying a specific sum of money on a certain date.
By putting this into writing, you’re formalizing these arrangements and showing you take them seriously.
Each party demonstrates with their signature that they intend to honor the agreement, and both sides can then be held accountable for the terms of the contract.
A written record also means the contract can be referred back to at any time.
2. They highlight the necessary details and expectations of the agreement
Why else are contracts important in business?
In part, because they set out how you’ll maintain the working relationship and how long it’s expected to last.
They highlight the duties of each party, how they should be performed, and how they will be tracked and measured.
As well as stating how the arrangement should work, the contract outlines what happens if things don’t go to plan.
For example, what if your roofing contractor can’t meet the deadline for completing the work because of poor weather?
What fees or penalties would be incurred for late payment of rent on a property?
Although you don’t want the contract to be too unwieldy, it’s good to cover all bases.
This saves you from having to re-draft the contract or create an addendum if something crops up that’s not covered.
3. They can help generate more revenue
Another reason why contracts are important is because they can help your business increase its revenue.
For one thing, a robust contract guarantees you’ll receive payment on a specific date, so your cash flow will be predictable and you can make business decisions accordingly.
With careful negotiation, you’ll be able to set terms that are beneficial to you too, such as agreeing a higher fee for the services you offer.
You can also grow your business through improved vendor relationships.
Plus, if you use document workflow software like PandaDoc, you’ll be able to speed up the contract process.
Getting contracts finalized quickly means you can sign more deals and bring in increased revenue, as well as reduce missed opportunities and time-consuming admin.
4. They ensure confidentiality
When it comes to what to include in a contract, businesses need to consider confidentiality as well.
It’s common in business transactions to add a confidentiality clause or non-disclosure agreement (NDA).
In fact, a study published by the Harvard Business Review in 2018 revealed that over one-third of the US workforce was bound by an NDA.
Times may have changed a little since then, but the exact number is still going to be significant.
You might include an NDA because you don’t want certain details to be made public, such as your financial status or the secret recipe for your restaurant’s house special.
Some businesses ask the other party to sign an exclusive contract, which means they can’t enter into relationships with other providers or competing companies.
A contract that includes confidentiality clauses should state what happens if someone is in breach of contract and the legal enforceability of the agreement.
5. They alleviate risks and avert disputes
Written contracts are also the best way to protect your business against risks, such as loss of money or legal disputes.
Because the details have been negotiated between the parties, with opportunities to raise any concerns, the signed contract should prove that both sides are happy with the agreement.
Of course, this doesn’t stop unscrupulous people from ignoring or breaking the terms of a contract, such as a builder disappearing with your deposit or tenants refusing to pay for damage to your rental property.
However, it ensures you have recourse if the worst happens, including legal action.
Essentially, a clear agreement will show who’s in the right.
6. They boost the effectiveness of operations
Contracts improve efficiency, too, because they clearly define what both parties are supposed to be doing and when.
If you hire a freelancer to create a video for your website by a specific deadline, you shouldn’t need to waste time chasing them up.
Or, if you’re expecting a payment, you can go ahead and order more stock as you can be confident the money will arrive.
Efficiency also gets a boost when you manage contracts online. Instead of sending emails back and forth, you can edit and sign documents in a few clicks.
And, with cloud storage, your contracts are easy to locate for future reference.
7. They aid overall compliance and adherence to legislation
As well as being a legal document itself, a contract can help you maintain compliance with relevant laws and regulations.
For example, you might need to consult industry-specific or state-specific legislation on things like the use of personal data.
The process of creating a contract focuses your attention on such matters, and the document can become a useful reference point if you want to check compliance policies in the future.
If you’re unsure, it’s a good idea to take legal advice on the compliance elements of a contract.
8. They maintain strong cooperation and interaction
The collaborative nature of the contract process has benefits for internal and external relationships.
During the creation stage, teams and departments in your business can share input, and there must also be close negotiations between the parties entering the agreement.
Contract management software enables collaboration on a contract without having to email multiple versions, which minimizes delays and helps prevent errors and disputes.
By starting your working relationship on the right foot, you can maintain more effective cooperation.
9. They give assurance and satisfaction to all parties
In addition, contracts help ensure security and peace of mind on both sides and build an atmosphere of mutual trust.
Once a contract is signed, this legally binding agreement gives everyone confidence that its terms will be adhered to — and that they’ll be protected if things go wrong.
As we mentioned, any issues should be ironed out at the negotiation stage, so both parties are satisfied with the arrangement.
It’s a good idea to invest in, special software for contract management and tracking, as this can provide a comprehensive audit trail of every edit or comment made and lends transparency to the process.
10. They solidify your organization’s image and philosophies
Finally, contracts (particularly if you use them frequently) can be seen as an extension of your brand.
We’re not just talking about putting your logo on the front cover a high-quality contract presents you as a professional and trustworthy business that’s willing to commit to agreed terms.
It also proves that you care about keeping a record of your relationships and are willing to stake your reputation on their successful outcome.
People who do business with you can thus expect the same level of care during the contract lifecycle.
The 4 different types of contracts
Now you understand why contracts are important, it’s time to learn about four different kinds of agreements that you might run into.
Verbal
A verbal contract is one that’s spoken, either in person or over the phone.
It’s legally binding as long as it meets certain criteria.
Both parties must intend it to be a contract and be capable of entering into one.
Verbal contracts will not suffice for some types of transactions, such as real estate sales.
However, a verbal, or oral, contract can be difficult to make stick as they rely on the memories of those that enter into them.
They’re easier to enforce if there are witnesses. That said, enforceability still relies upon their recollections and good character.
Written
Written contracts are documents that detail the obligations of both parties.
Each party must sign to make them legally binding.
Like a verbal contract, both parties must be capable of entering into a written contract — ie: they can have no mental impediment preventing them from understanding its terms and obligations.
Written contracts are sometimes notarized to bolster their enforceability, but this isn’t standard practice with most business agreements.
A notary will check if a contract meets the legal requirements and that both parties understand its implications and will also act as a witness to its signing.
Bilateral
A bilateral contract is an agreement between two parties.
This is the standard for business contracts and requires that both parties complete certain pre-agreed actions.
For example, party A promises to pay party B $500 to paint a room. In this example, a verbal contract is sufficient.
More complex business arrangements would likely need a written agreement to be legally binding and enforceable.
Unilateral
Unilateral contracts involve a single party making a promise, and these are often open offers to a group or community.
No other party is obliged to perform any action, but if they do, the party that made the offer must fulfill their promise.
One such example would be an offer of a reward.
Say someone lost their cat and put up a poster offering $200 for its return.
An individual finds the animal or supplies information leading to its recovery.
In this instance, the pet owner would be obliged to pay up.
Leverage PandaDoc and reap the benefits of accurate contract management
By now, you should be aware of why contracts are important for small businesses and large companies alike.
By clearly defining rights and obligations, they protect you against future disputes, demonstrate your professionalism, and help you generate extra revenue.
If you use software like PandaDoc, you can improve your efficiency by reducing the amount of time contracts take to create and sign.
This means you can easily draw up legally binding contracts from templates containing all the essential elements and get them signed electronically.
Disclaimer
PandaDoc is not a law firm, or a substitute for an attorney or law firm. This page is not intended to and does not provide legal advice. Should you have legal questions on the validity of e-signatures or digital signatures and the enforceability thereof, please consult with an attorney or law firm. Use of PandaDocs services are governed by our Terms of Use and Privacy Policy.
Originally published December 6, 2022, updated December 4, 2023
