How to Read a Basic Contract
Reviewed by Carina Jenkins, J.D.
If you’re entering into a legal arrangement or business deal with an individual or a company, it will probably involve a contract. Before you sign your name on the dotted line, you should know what terms you’re agreeing to.
While navigating legal jargon can be tricky, reading a contract doesn’t have to be intimidating. You just need to understand what elements these documents should contain and what red flags you should be watching for.
A contract is a legally binding agreement between two or more consenting parties, which defines mutual obligations and rights. These documents are typically required when one party makes an offer, and the other party accepts. They're designed to minimize misunderstandings and can reduce the likelihood of harm befalling any of the parties involved. Although a contract may be either verbal or written, written contracts typically carry more weight in court and are easier to enforce. Some kinds of contracts are required by law to be in writing.
There are various reasons why you may enter into a contract with another party. Homeowners may enter into contracts with service professionals who are executing repairs or renovations, while small businesses may enter into contracts with the vendors who supply the goods they need. Ultimately, however, most parties enter into a contract to clearly define the terms of an exchange and to protect the rights of the parties involved in the agreement.
You may also want to enter into a contract to:
- Define a business or employment relationship
- Set payment and/or service terms
- Clarify or reinforce existing agreements
- Shield yourself or your business from liability
- Prevent an employee from working for a competitor
- Buy or sell goods
When you sign a contract, you’re signifying that you’ve read the document, willingly agree to its terms and conditions and have the legal authority and mental competence to enter into a legally binding agreement. By signing a contract, you essentially agree to hold up your end of the bargain, as specified in the document.
A good contract can mean different things to different people, and these legal documents may vary considerably depending on the industry and specific agreement. However, to be legally enforceable, most good contracts contain similar sections:
- Title: A contract’s title should clearly and concisely reflect the document’s purpose. For example, a contract governing the terms of a supplier arrangement may be titled: “Supply Agreement.” To further define the purpose, some contracts may also include a subtitle.
- Preamble: This introductory paragraph should identify the parties bound by the agreement, the date of the agreement and any relevant locations.
- Background: This section covers each party’s reasons for entering into the contract and what the contract is meant to accomplish. It’s often distinguished by its use of “whereas” clauses.
- Consideration: Contracts typically involve multiple parties exchanging items or services of value. This acts as a binding promise and may involve some form of payment, monetary or otherwise. For example, Party A agrees to pay Party B $20,000 for the transfer of Property X.
- Terms: Contract terms detail what products or services are expected from the company supplying them, including the cost and other payment details. It also covers each party’s responsibilities, including the details of execution and a relevant timeframe.
- Signatures: Signatures of all participants are needed to finalize the agreement. These signatures indicate that all parties agree to the contract’s terms.
These items must be accurate and should clearly and completely define the agreement between parties using plain language. Essentially, a basic contract should be understandable and unambiguous, even for someone without a legal background.
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While it’s important to take the time to read a contract section by section, unfortunately, that isn’t always possible. If you have limited time in which to examine this important legal document, you may want to pay special attention to these three crucial clauses:
The ‘Dispute Resolution’ Clause
A contract’s dispute resolution clause provides steps to follow if disagreements arise between the parties. The dispute resolution clause may include remedies, such as mediation, arbitration or third-party input. It may also name outside agencies who are authorized to handle formal dispute proceedings, if required, and the relevant legal jurisdiction if the dispute escalates to the courts.
The ‘Force Majeure’ Clause
A force majeure clause lets all parties know how to proceed if a breach of contract occurs due to circumstances beyond anyone’s control. This may include natural disasters, labor strikes, fires and the passage of new laws that affect the contract’s terms. Because the force majeure clause may exempt the defaulting party from its contractual obligation, it should be worded clearly and carefully, and it should detail any circumstances under which a party no longer has to fulfill the agreement as contracted, including a complete cancellation or reduced performance requirements.
The ‘Confidentiality’ Clause
Depending on the nature of the contract, it may include a confidentiality clause. This clause dictates how sensitive information must be handled, potentially preventing parties from misusing trade secrets and other proprietary information. It may include information, such as financial data, intellectual property, personal or medical records and software code, as well as exceptions, such as legally required disclosures and cases involving expressed consent.
Signing a flawed contract can expose you or your company to unwanted liability. If you’re reading a contract without the help of a lawyer, it’s important to watch for common red flags:
- Calls for one or more parties to execute an illegal or impossible act
- Inclusion of a party who’s a minor or otherwise unable to participate legally in the contract
- Incorrect information, including the names of participating parties, negotiated terms and any applicable dates
- Lack of penalties for a party that commits a breach of contract
- Unreasonable non-competition agreements
- Unclear or unreasonable expectations concerning ownership of work
- Liability or indemnity clauses that unfairly favor a larger company
- Out-of-state legal venues for dispute resolution
- Automatic renewal clauses
- Unclear or unreasonable termination clauses
- Missing information or unfilled blanks for dates, prices or items
Legally, you don’t need a lawyer to write a contract. In fact, the internet has made it easier for an individual or a small business to draft a contract without a lawyer, and online DIY legal services offer templates for different types of contracts. However, to make sure your contract is legally binding, it should be vetted by a knowledgeable contract lawyer.
Hiring a lawyer to read over a major contract before you sign it may be well worth the cost. A knowledgeable contract lawyer can quickly spot red flags that could be easily overlooked by someone unfamiliar with contract laws. You may also want to call a lawyer for help if your contract contains unfamiliar or unclear language, or if you notice obvious red flags in the document.
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