Simple and Enforceable Contracts
For most contracts, legalese is not essential nor helpful; contractual agreements are best
expressed in simple, everyday English. Although lots of contracts are filled with mindbending legal gibberish, there’s no reason why this has to be true. For most contracts,
legalese is not essential or even helpful. On the contrary, the agreements you’ll want to put
into a written contract are best expressed in simple, everyday English.
All that is necessary for most contracts to be legally valid are the following two elements:
all parties are in agreement (after an offer has been made by one party and accepted
by the other)
something of value has been exchanged, such as cash, services or goods (or a promise
to exchange such an item) for something else of value.
In a few situations, a contract must be in writing to be valid. State laws often require written
contracts for certain transactions such as real estate sales or contracts that will last more than
one year. You’ll need to check your state’s laws to figure out which contracts must legally be
in writing. Of course, because oral contracts can be difficult or impossible to prove, it is wise
to write out most agreements, even if not legally required.
Let’s look a bit more closely at the two elements — agreement between the parties and
exchange of things of value — necessary for a valid contract.
1. Agreement between parties, a.k.a. offer and acceptance
Although it may seem like stating the obvious, an essential element of a valid contract is that
all parties really do agree on all major issues. In real life there are plenty of situations that
blur the line between a full agreement and a preliminary discussion about the possibility of
making an agreement. To help clarify these borderline cases, the law has developed some
rules defining when an agreement legally exists.
The most basic rule of contract law is that a legal contract exists when one party makes an
offer and the other party accepts it. For most types of contracts, this can be done either orally
or in writing. Let’s say, for instance, you’re shopping around for a print shop to produce
brochures for your business. One printer says (or faxes) that he’ll print 5,000 two-color flyers
for $200. This constitutes his offer. If you tell him to go ahead with the job, you’ve accepted
his offer. In the eyes of the law, when you tell the printer to go ahead, you create a contract,
which means you’re liable for your side of the bargain (in this case, payment of $200). But if
you tell the printer you’re not sure and want to continue shopping around (or don’t even
respond, for that matter), you clearly haven’t accepted his offer and no agreement has been
reached. Or if you say his offer sounds great, except that you want the printer to use three
colors instead of two, no contract has been made, since you have not accepted all of the
important terms of the offer — you’ve changed one term of the offer. (Depending on your
wording, you may have made a counteroffer, which is discussed below.)
Sure enough, in real, day-to-day business the seemingly simple steps of offer and acceptance
can become quite convoluted. For instance, sometimes when you make an offer it isn’t
quickly and unequivocally accepted; the other party may want to think about it for a while or
try to get a better deal for himself. And before he accepts your offer, you might change your
mind and want to withdraw or amend your offer. Delaying acceptance of an offer and
revoking an offer, as well as making a counteroffer, are common situations in business
transactions that often lead to confusion and conflict. To minimize the potential for a dispute,
here are some general rules you should understand and follow.
How long an offer stays open. Unless an offer includes a stated expiration date, it
remains open for a “reasonable” time. What’s reasonable, of course, is open to
interpretation and will vary depending on the type of business and the particular fact
situation. To leave no room for doubt as to when the other party must make a
decision, the best way to make an offer is to include an expiration date. And if you
want to accept someone else’s offer, the best approach is to do it as soon as possible,
while there’s no doubt that the offer is still open. Keep in mind that until you accept,
the person or company who made the offer — called the offeror — may revoke it.
Revocation is discussed below.
Counter offers. Often when an offer is made, the response will not be to accept the
terms of the offer right off, but to start bargaining. Of course, haggling over price is
the most common type of negotiating that occurs in business situations. When one
party responds to an offer by proposing something different, this proposal is called a
“counteroffer.” When a counteroffer is made, the legal responsibility to accept,
decline or make another counteroffer shifts to the original offeror.For instance, if your
printer (here, the original offeror) offers to print 5,000 brochures for $300 and you
respond by saying you’ll pay $250 for the job, you have not accepted his offer (no
contract has been formed), but instead have made a counteroffer. If your printer then
agrees to do the job exactly as you have specified for $250, he’s accepted your
counteroffer and a legal agreement has been reached. While it is true that a contract is
only formed if the accepting party agrees to all substantial terms of an offer, this
doesn’t mean you can rely on inconsequential differences to void a contract later. For
example, if you offer to buy 100 chicken sandwiches on one-inch-thick sourdough
bread, there is no contract if the other party replies he will provide 100 emu fillets on
rye bread. But if he agrees to provide the chicken sandwiches on one-inch-thick
sourdough bread, a valid contract exists, and you can’t later refuse to pay if the bread
turns out to be a hair thicker or thinner than one inch.
Revoking an offer. Whoever makes an offer can revoke it as long as it hasn’t yet
been accepted. This means if you make an offer and the other party says she needs
some time to think it through or makes a counteroffer with changed terms, you can
revoke your original offer. Once she accepts, however, you’ll have a binding
agreement. Revocation must happen before acceptance.An exception to this rule
occurs if the parties agree that the offer will remain open for a stated period of time.
This type of agreement is called an option, and it usually doesn’t come for free. Say
someone offers to sell you a forklift for $10,000, and you want to think the offer over
free of the worry that the seller will withdraw the offer or sell to someone else. You
and the seller could agree that the offer will stay open for a certain period of time, say
thirty days. Often, however, the offeror will ask you to pay for this 30-day option —
which is understandable, since during the 30-day option period he can’t sell to anyone
else. Payment or no payment, when an option agreement exists, the offeror cannot
revoke the offer until the time period ends.
Failure to plan and lack of funding are both leading contributors to small business failure in
the U.S. If you are planning to go into business with a partner, then it is critical that you set
up a partnership agreement. This is easy to do, but often overlooked during the business
planning process. Without an agreed-upon strategy on how you will handle certain
unforeseen events, how will you know how your partners will react? If you have a
disagreement, will they be willing to exit the business and sell you their shares? These are
important questions to address in the early stages of planning your business. It is easiest to
come to a consensus when all the partners have the same interest in mind—building a
Once the business begins to operate, the partners’ personal interests may vary considerably,
so it is vital to negotiate all of the terms while you all have similar objectives. This could
prevent major issues from arising further down the road, and it allows everyone to clearly
understand and sign off on the “rules” moving forward. This important step is not only for
start-ups. If you have an existing business that is a partnership without a partnership
agreement, you need to get one in place as soon as you are done reading this!
Let’s say you own a small company with one partner and you are both employees with equal
ownership of the company. For argument’s sake, let’s say you have been operating without a
formal partnership agreement for a year and a half and the money is really starting to roll in.
Suddenly, without prior notice, your partner has a life-changing event. This might include
personal bankruptcy, divorce, or even worse, a sudden death. Do you know what effect this
will have on your business? Who will own your partner’s shares? Do you have the right to
buy those shares in any of these cases?
Without an agreement up front, these questions cannot be answered easily and you run the
risk of having some unanticipated new partners. Imagine your partner getting a divorce and
now having to deal with the ex-spouse as an equal partner. Think of a partnership agreement
as a “prenuptial” agreement between you and your business partners. You don’t expect to
have the partnership break up, but you just never know what could happen down the road.
So what does a partnership agreement look like? It can be as simple as stating the terms in
which one partner would buy out the other, sometimes referred as a “Buy-Sell” agreement. It
should clearly state what occurs in the event that one partner needs to exit the business for
any number of reasons. The best way to generate a partnership agreement between you and
your partners is to consult an attorney and have the agreement created with your specific
requirements. If you would prefer to save a little money, there are other options available,
from legal business software to standard legal forms available from your stationery store.
Whichever method you choose, just make sure you have one in place. You can always go
back and revise it, but without one, you might be working those 80-hour work weeks for
An important component of the partnership (or buy-sell agreement) is the valuation portion of
the contract. If you need to execute the agreement, how are the shares going to be valued?
This can quickly turn a simple agreement into a very complex document, and is something
that needs to be considered carefully in the early stages. Not only does this need to be
established during the early planning stages, but it should also be reviewed on an annual
basis. The simplest form of valuation to use is a multiple of total revenue. For many small
businesses, this is the best option to use when setting up your initial agreement. Not only is it
easier to agree upon a fair calculation, but there is less room for subjective or questionable
amounts to be produced.
For example; if at the end of the first year your business had gross sales of $500,000 and you
agreed that you would use a multiple of two for valuation purposes, then the company has a
stated value of $1 million. This may not have anything to do with the true market value of the
business, but it should, as closely as possible, match your best estimate of the market value
for your business. As the company grows and additional shareholders become involved, you
may want to consider a different approach to the valuation within your agreement. As long as
all partners agree, this can be changed at any time. If fundamental changes occur in your
business, you can always update this valuation to reflect the current situation. This is
especially important when experiencing fast growth or bringing on additional partners.
As your business becomes more complex, so may your valuation terms. You may prefer to
create a formula that uses a multiple of earnings to value the business. The stock market is a
prime example of this type of valuation, also referred to as “market value.” You will often see
a reference to the PE (Price to Earnings) ratio when looking at the price for publicly-traded
stocks. This is no different from creating your own PE ratio to value the business. You are
simply stating the exact formula to use, since an open market for your shares does not exist
within a privately-held company.
There is no right or wrong way to value the business in a partnership agreement. It just needs
to be clear so it cannot be questioned, should you need to use it in the future. Ideally, it
should include an easy-to-understand formula or calculation on which all the partners agree.
As mentioned above, this can be as simple as a multiple of revenues, multiple of earnings,
multiple of actual book value or net worth, or anything else that can have a value associated
Many partnership agreements include a clause stating that when they need to value the shares
of the business, a CPA will be retained to place a real market value on the business. Although
this will most likely result in a true market value for the business at that point in time (since it
considers market competition, minority shareholder discounts, and many other market
factors), it is still subject to challenge. Depending upon the nature of the situation for
enacting the agreement, this could also create an increase in professional fees paid out,
particularly if one partner does not agree with the calculated valuation. Although this is a
widely accepted way to value the business in a partnership agreement, it is not always the
best option, particularly for smaller partnerships and businesses.
Determining the valuation for the business within a partnership agreement is meant to protect
the business from an unexpected change in ownership. Since this is an internal document, it
does not have any impact on the valuation of the business outside of the partnership, should
you and your partners want to sell the business to a third party. The true value of any business
is simply the amount someone is willing to pay for it.
Financing While Maintaining Equity
When starting a new business you may need start-up funds but lack the money to invest
yourself. What are your options, can it be done without losing equity in the company?
Start off by thinking about it from the other side. If you had $500,000, what would make you
want to give it to you and your business? You don’t want to give equity but you want
somebody to take a huge risk for your business. Are you ready to pay extremely high interest
rates, and offer a big equity kicker too? How are you going to convince somebody to take that
kind of risk without an upside?
That’s why start-up investment usually involves equity. Why else does somebody risk that
kind of money?
In your case, the signed contracts may be a bit of an advantage. Are they “bankable”
(meaning that the documentation is strong enough that you might be able to borrow off the
value of the contracts)? If so, that would be very unusual, but that would also be your easiest
route for financing—using the contracts as collateral.
However, bankable contracts are extremely rare. Banks need to have real collateral. The law
Start-up entrepreneurs and small business owners are too quick to criticize banks for failing
to finance new businesses. Banks are not supposed to invest in businesses, and are strictly
limited in this respect by federal banking laws. The government prevents banks from
investment in businesses because society, in general, doesn’t want banks taking savings from
depositors and investing in risky business ventures; obviously, when (and if) those business
ventures fail, bank depositors’ money is at risk. Would you want your bank to invest in new
businesses (other than your own, of course)?
Furthermore, banks should not be loaning money to start-up companies either, for many of
the same reasons. Federal regulators want banks to keep money safe, in very conservative
loans, backed by solid collateral. Start-up businesses are not safe enough for bank regulators,
and they don’t have enough collateral.
Why then do we say that banks are the most likely source of small business financing?
Because small business owners borrow from banks. A business that has been around for a
few years generates enough stability and assets to serve as collateral. Banks commonly make
loans to small businesses backed by the business’ inventory or accounts receivable. Normally
there are formulas that determine how much can be loaned, depending on how much is in
inventory and in accounts receivable.
A great deal of small business financing is accomplished through bank loans based on the
business owner’s personal collateral, such as home ownership. Some would say that home
equity is the greatest source of small business financing. This is a hard route to go, but still
quite common. I have personally taken out a second mortgage more than once, in keeping my
own business afloat, and I know how scary that is because I speak from experience. Still, I
did it, the business survived the hard times, and later I paid the second mortgage off and took
the lien off my house. The trouble is that if I didn’t come through, we would have lost that
Some companies are financed by smaller investors in what is called “private placement.” For
example, in some areas there are groups of potential investors who meet occasionally to hear
proposals. There are also wealthy individuals who occasionally invest in new companies. In
the lore of business start-ups, groups of investors are often referred to as “doctors and
dentists,” and individual investors are often called “angels.”
Sometimes you can get a private investor to give you money as a loan, but if so, you better be
ready for a very high interest rate and a huge equity kicker if you default. That is a lot of risk
they’re taking, and they want to get a lot of money back, or they simply take their money
Some investors are a good source of capital, and some aren’t. These less established sources
of investment may be necessary, but they should be handled with extreme caution.
Your next question of course is how to find the “doctors, dentists, and angels” who might
want to invest in your business. Look for lists, government agencies, business development
centers, business incubators, and similar organizations that will be tied into the investment
communities in your area. Turn first to the local Small Business Development Center
(SBDC), which is most likely associated with your local junior college, or the Small Business
Administration (SBA) offices in your area.
Aside from standard bank loans, an established small business can also turn to accounts
receivable specialists to borrow against its accounts receivables. The most common accounts
receivable financing is used to support cash flow when working capital is hung up in
accounts receivable. For example, if your business sells to distributors that take 60 days to
pay, and the outstanding invoices waiting for payment (but not late) come to $100,000, your
company can probably borrow more than $50,000. Interest rates and fees may be relatively
high, but this is still often a good source of small business financing. In most cases, the lender
doesn’t take the risk of payment—if your customer doesn’t pay you, you have to pay the
money back anyhow. These lenders will often review your debtors, and choose to finance
some or all of the invoices outstanding.
Some additional warning:
Be very careful in dealing with anybody who offers to help you find financing as a service for
money. These are shark-infested waters. We are aware of some legitimate providers of
business plan consulting, small business finance consulting, and related assistance, but the
legitimate providers are harder to find than the sharks.
In general, you should never pay money in advance for investment-finding services, and a
request for money in advance should be a warning signal. There are more fakes and frauds in
the business of finding investment than there are legitimate finders. Be careful!
Many entrepreneurs turn to friends and family for investment. I recommend against it,
frankly. Avoid turning to friends and family for investment. The worst possible time to not
have the support of friends and family is when your business is in trouble. When the business
is financed by friends and family, you risk losing friends, family, and your business at the
same time. I know an entrepreneur who stuck with a losing business for six years longer than
he should have because he started it with money from friends and family.
Never, NEVER spend somebody else’s money without first doing the legal work properly.
Have the papers done by professionals, and make sure they’re signed.
Never, NEVER spend money that has been promised but not delivered. It is amazing how
often companies get investment commitments and contract for expenses, and then the
investment falls through.
How to Form a Limited Liability Company
By now, you’re probably familiar with the advantages of running your business as an LLC:
limited liability protection and a simpler method of paying taxes than that imposed on
corporations. (To learn more about these benefits, read LLC Basics.) This article focuses on
the steps you will take to make your LLC a legal reality. Essentially, you must:
1. Choose an available business name that complies with your state’s LLC rules.
2. File formal paperwork, usually called articles of organization, and pay the filing fee
(ranging from $40 to $900, depending on the state).
3. Create an LLC operating agreement, which sets out the rights and responsibilities of
the LLC members.
4. Publish a notice of your intent to form an LLC (required in only a few states).
5. Obtain licenses and permits that may be required for your business.
Choosing a name for your LLC
The name of your LLC must comply with the rules of your state’s LLC division. (Typically,
this office is combined with the corporations division, and is part of the Department or
Secretary of State’s office.) While requirements differ from state to state, generally:
the name cannot be the same as the name of another LLC on file with the LLC office
the name must end with an LLC designator, such as “Limited Liability Company” or
“Limited Company,” or an abbreviation of one of these phrases (“LLC,” “L.L.C.” or
“Ltd. Liability Co.”), and
the name cannot include certain words prohibited by the state, such as Bank,
Insurance, Corporation or City (states differ widely on prohibited terms).
Your state’s LLC office can tell you how to check if your proposed name is available for
your use. Often, for a small fee, you can reserve your LLC name for a short period of time
until you file your articles of organization.
Besides following your state’s LLC naming rules, you must make sure your name won’t
violate another company’s trademark. Once you’ve found a legal and available name, you
don’t usually need to register it with your state; when you file your articles of organization
your business name will be automatically registered.
Filing articles of organization
After settling on a name, you must prepare and file “articles of organization” with your
state’s LLC filing office. While most states use the term “articles of organization” to refer to
the basic document creating an LLC, some states (including Delaware, Mississippi, New
Hampshire, New Jersey and Washington) use the term “certificate of formation.” Two other
states (Massachusetts and Pennsylvania) call the document a “certificate of organization.”
One disadvantage of forming an LLC instead of a partnership or a sole proprietorship is that
you’ll have to pay a filing fee when you submit your articles of organization. In most states,
the fees are modest — typically around $100. In a few others, they take a bigger bite:
consider California ($70, plus an $800 annual tax), Illinois ($400) and Massachusetts ($500).
Articles of organization are short, simple documents. In fact, you can usually prepare your
own in just a few minutes by filling in the blanks and checking the boxes on a form provided
by your state’s filing office. Typically, you must provide only your LLC’s name, its address
and sometimes the names of all of the owners — called members. You will probably also be
required to list the name and address of a person — usually one of the LLC members — who
will act as your LLC’s “registered agent,” or “agent for service of process.” Your agent is the
person who will receive legal papers in any future lawsuit involving your LLC. Generally, all
of the LLC owners may prepare and sign the articles, or they can appoint just one person to
Creating an LLC operating agreement
Even though operating agreements need not be filed with the LLC filing office and are rarely
required by state law, it is essential that you create one. In an LLC operating agreement, you
set out rules for the ownership and operation of the business (much like a partnership
agreement or corporate bylaws). A typical operating agreement includes:
the members’ percentage interests in the business
the members’ rights and responsibilities
the members’ voting power
how profits and losses will be allocated
how the LLC will be managed
rules for holding meetings and taking votes, and
“buy-sell” provisions, which establish rules for what happens if a member wants to
sell his interest, dies or becomes disabled.
For more on LLC operating agreements, read Creating an LLC Operating Agreement.
Arizona and New York: publication of notice
If you are forming an LLC in Arizona or New York, you must take an additional step to make
your company official: You must publish in a local newspaper a simple notice stating that
you intend to form an LLC. You are required to publish the notice several times over a period
of weeks and then submit an “affidavit of publication” to the LLC filing office. Your local
newspaper should be able to help you with this filing.
Licenses and permits
After you’ve completed the steps described above, your LLC is official. But before you open
your doors for business, you need to obtain the licenses and permits that all new businesses
require. These may include a business license (sometimes also referred to as your “tax
registration certificate”), a federal employer identification number, a sellers’ permit or a