An Introduction To The 5 Elements of a Contract


Contracts are intimidating. A lawyer will tell you that you shouldn’t write your own contracts, but the only other options is to shell out thousands of dollars in lawyer fees. When you’re a start up entrepreneur that’s bootstrapping every dime you put into your company, it’s best to find contracts related to what you’re doing, model those, and then later get them double checked by a lawyer who will “fill in the gaps”.

The reality behind a contract is that it’s just an agreement. It doesn’t have to take a certain form. It doesn’t have to have a certain header. It doesn’t even have to be written down in order to be legally binding. Contracts could be verbal, they could be written down on a napkin, and they could be just a sentence or two long.

The only five things that you need to make a contract legally binding are these five elements:

  • Offer

  • Acceptance

  • Consideration

  • Legal Capacity

  • Legal Subject Matter / Not Violating Public Policy

Offer

An offer is self explanatory and there’s not much to it. There are only a few things you have to consider to know whether an offer is legitimate or not:

  • Does is pass the reasonable person test? Would a reasonable person actually believe your offer. In the 1999 case Leonard vs. PepsiCo, (aka. the Pepsi Poitns Case), Pepsi was getting sued for a commercial they ran that created an “offer” for a Harrier Jet in exchange for 7 million Pepsi Points. Pepsi ended up winning the case because the ad that showed the Harrier Jet offer didn’t pass the reasonable person test.

  • Is the offer definite and certain? Did you actually come to an agreement on what the offer would entail? In the 2005 Outdoor Environments Inc vs Maro case, an employee was offered “a share of the profits” by the business owner. Because the offer was so vague, the employee got stiffed the profits because there was not definition of how big the share was.

(Note: There are a different set of laws for contracts relating to the sale of goods. These laws are governed by the Uniform Commercial Code (UCC) and are designed to keep the wheels of commerce moving. The UCC states that if it looks like you meant to have an offer, then you have an offer, even if you leave out certain terms like price, place of delivery, etc.)


Acceptance

This should also be self explanatory, but something to note is that you don’t need a signature to accept an offer. Offers can be accepted verbally, in written communication, or even through actions. The problem with verbal contracts is that there is no record to uphold it in the court, so it’s hard to prove that you had a contract. Action could also be acceptance. If you get an order, that says “Send me 300 t-shirts for $10 each” and you ship the t-shirts, that’s your acceptance. 

Something you should note, though, is the Mirror Image Rule. The Mirror Image Rule stats that if you try to change the offer in any way (say you cross something out on the contract then sign it) you are nullifying the previous offer. This means that you’re not actually accepting the offer but rather creating a counter offer. If you create a counter offer and it gets declined, then you lost your counter offer and you can’t go back and accept the previous offer unless agreed upon by the offeror.

The only exception to the Mirror Image Rule is when you’re selling goods. Then UCC (which governs all contracts related to the sale of goods) throws out the Mirror Image Rule in order to keep the wheels of commerce moving.

Consideration:

The third and perhaps most easily overlooked element of a contract is consideration. Consideration means that in order for you to have a contract, both parties must either do something or refrain from doing something. What this means is that a promise from somebody that they will do something IS NOT a contract. You must also do something in return to legally uphold their promise.

Imagine this scenario: You hire an employee, but you forget to use the module from Passio on how to properly hire employees. You later realize that you should have had your employee sign a non-disclosure agreement. You present to you employee the non-disclosure and say, if you want to keep working here, you must sign this non-disclosure. The employee signs it and you think you’re all covered…. but are you? NO! Your employee promised not to disclose important information, but what was your consideration?

Now say you did do that Passio Module on hiring employees, and you told them they needed to sign the non-disclosure in order to work for you, you would consideration. Your consideration would have been giving them a job. If you don’t do this before they start working and you fail to provide consideration, then your employee can now tell the world about the secrets of your business. How to you avoid this? You have to offer them something, a raise, a dollar, literally anything… as long as it was bargained for.

The second thing you need to know about consideration is that it must be bargained for. Consideration isn’t bargained for if the deal is made under any of these four conditions:

  • Duress - When the other party has no choice but to agree to the contract. (ex. You put a gun to their head.)

  • Undo Influence - A party you trust advises you to sign a contract that isn’t actually in your best interest.

  • Fraud - If there is any deception made in the agreement.

  • Mutual mistake - When both parties agree to something that they didn’t actually want.

As long as your consideration is bargained for, it doesn’t matter if you’re making a fair trade, the trade is legal and will hold up in the court of law.

Legal Capacity

The fourth element is legal capacity. This applies to contracts entered into by minors and people under the influence of alcohol or drugs. Let’s break each one down separately:

Minors

Yes, minors can enter contracts BUT there are some conditions. If a minor agrees to a contract with an adult (18+), then the adult is obliged to fulfill the agreement no matter what, but the minor can exit the contract if they become somehow disadvantaged. Additionally, if you’re a minor that’s entered into a contract that you want to exit, you better do it within a reasonable amount of time of turning 18 or else you will “ratify” the contract meaning that it will hold up as if you signed the contract as an 18 year old.

For example look at the case of Kobe Bryant. He signed into a contract as a minor to sign a certain amount of autographs a day. Later, after he turned 18, he got more famous and realized that he could be making bigger money by doing other things, but since he continued to sign autographs in accordance with this contract after his 18th birthday, he ratified the contract as an 18 year old.

If you are a business owner and you need to do business with a minor for some reason, you can still hold the minor accountable as long as the contract is “necessary”. The contract will still be voidable at the discretion of the minor, but the minor will owe you for the fair value of what they received.

People Under the Influence

Does this mean that every time you’ve had a few drinks you can go signing contracts willy-nilly and not pay repercussions? No. You’ve gotta be really drunk. Like black out, "I had no clue what was going on" drunk. The law uses the phrase incapacitated to the point that “you didn’t understand the consequences of your actions” and, even if you were black out, you’ve still got a pretty low chance of upholding your case in court. As you can imagine, judges don’t like drunks signing into agreements that they don’t plan to uphold, so you won’t get much pity in a court case.

Legal Subject Matter and Upholding to Public Policy

This fifth element is there for obvious reasons. All contracts to commit crimes are void. You shouldn’t be in the business of selling anything illegal, but if you are, just know that your contracts don’t have any legal power. Some examples of contracts that could be considered violating law or public policy would be contracts that take away certain rights and ones that charge too much interest. Interest rates are governed by Usury Laws and it prevents bankers from taking advantage of the general population.

As of right now, California is the only state that doesn’t allow non-compete agreements and in many states (especially democratic ones) they’re nearly worthless. Arbitration and Exculpatory Clauses (which give up your right to sue) could also violate public policy depending on which state you live in.

That's it!

When it comes to contracts. They aren’t as scary as they sound. This lesson was intended to help you realize how the law follows common sense. The only thing in here that isn’t common sense is consideration. Offer and acceptance are no-brainers, so just make sure that both parties have skin in the game. Don't sell an illegal product and do business with sober people and you're likely to have a binding contract.


There will be a point when you should actually have a lawyer look over stuff for you. One of those times is when you write your operating agreement. That could literally make or break your business, so use our operating agreement builder if you haven't yet.


If you’re still lost, browse the internet for examples of contracts that you can download and model your agreements after. Just be careful not to copy them word for word or else you might be infringing on a copyright.

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