Whether you’ve grown multiple businesses or are starting to build your first one, odds are your inbox has been flooded with a number of business contracts. Small business owners depend on these contracts for the success of their company. With that said, business contracts are legally binding and should be looked at with the utmost scrutiny.
However, too many small business owners briefly skim a contract and only sign on the yellow highlighted line. The smallest clause could be the untimely demise of your small business. Before you put pen to paper, learn how to spot these common contract red flags before it is too late or skip to our infographic below for a quick overview.
The Anatomy of a Business Contract
Before reading through a contract, it’s important to understand the various elements. To help small business owners identify red flags more clearly, we have outlined the main components of a business contract below.
The title, also called the agreement, should clearly describe and define what the contract is covering. For example, if you are hiring an independent contractor, your contract should be labeled something along the lines of “INDEPENDENT CONTRACTOR AGREEMENT.”
The preamble is the who, when, and where of a contract. It is an introductory paragraph that identifies the parties or entities subject to the agreement. The preamble should label the date of the agreement and where it took place. It’s important to make sure all the information in this section is correct before moving on.
The recitals (also known as the background) is the what and why of a contract. It covers the reason why each party is entering the agreement and what they hope to accomplish. This section is also referred to as the “whereas” clauses that foreshadow the main text.
According to the VLAA, “to be valid, a contract must be based on each party bargaining to give something of value (not necessarily money) to the other party.” In legal terminology, this bargain is called the “consideration” and is what distinguishes a contract from a gift. The consideration is usually some form of payment or money, however, it can also act as a binding promise of some sort. In a contract, one consideration is exchanged for another consideration. For example, company A will pay company B $5,000 for the completion of a project.
This is arguably the most important part of the contract because it lays out what products or services are expected from the company that was hired. It outlines the price and details of the payment (what amount is being paid and to who). It also explains what each party is going to do, how they will do it, and for how long.
This is what finalizes the agreement. Both parties must sign the contract and agree to its terms. For example, it signifies that the buyer agrees to the payment conditions and the seller accepts the specified work.
10 Contract Red Flags to Look Out For
Contracts are jam-packed full of legal jargon displayed in tiny print. As a result, many small business owners will gloss over a contract believing they understand, when in reality, they don’t. Take the time to understand a contract and learn how to spot the 10 red flags below.
1. Non-Competition Agreements
A non-compete clause is a legally binding agreement that serves to protect a business’s trade secrets and intellectual property. Individuals such as employees, business partners, or business clients may be asked to sign a non-competition agreement in order to prevent them from sharing a company’s confidential information.
The problem that many small businesses face is making sure their non-compete clause is enforceable. In order for a non-compete agreement to be valid, it must:
- be supported by consideration to protect the employer’s legitimate business interests or trade secrets,
be reasonable and realistic,
- include a time limit on the restriction, and
- have a reasonable geographic location covered by the agreement.
From the experts: “Non-compete clauses are common in contracts but the specific wording can differ, as well as the implications of the wording. Try to negotiate these clauses out of the contract as early as possible, or get their wording changed so that your future business with other similar companies is not put in jeopardy.” — Joe Bailey, Business Development Consultant at My Trading Skills.
2. Contracted Parties
This step may seem obvious, but you would be surprised at the problems this section has caused. Before signing a contract, double and triple-check that the correct parties, corporate entities, dates, and timeframes are listed. This is especially important for understanding where the money is coming from and who it is going to.
From the experts: “Another critical red flag is the inclusion of incorrect dates and timeframes. Time and time again we see contract dispute litigation that could be easily resolved had there been a careful review of deadline dates and timeframes. This error is typically clerical, but once the contract is signed, there can be significant consequences for parties. Dates should be cross-referenced with the final term sheet, confirmed with a calendar, and then verified with the other parties to the agreement before anyone signs the contract.” — Anthony M Kroese, Corporate Attorney at Goldberg Segalla.
3. Ownership of Work
The owner of the produced work should be clearly defined in a contract. As a business owner, you want to ensure you are not giving up a significant part of your business. For example, if you are hiring a software company to create a project management system for your business, it should be clear who owns the finished project and whether or not the hired software company has the right to sell the project management system to other businesses.
From the experts: “Contracts that require you to give up all rights to the work produced are bad for your business. Always look towards ensuring that your business retains the rights to the work produced, even if it is joint rights with the payor, or guaranteed continued access to the work done.” — Joe Bailey, Business Development Consultant at My Trading Skills.
If something goes wrong with the contract, who is responsible? What penalties will each party receive? Penalties are critical to define from the very beginning so there is less of a headache should something go wrong with the contract. It is also important to check if there is a “cure period” defined within the print, or the time one party has to fix any mistakes or discrepancies before penalties incur and legal gets involved.
From the experts: “Things can go wrong at any stage of an agreement, as many businesses are dependent on other factors in order for a contractual agreement to go through. Ensure that there is a ‘cooling-off’ period or a time to set things straight contractually agreed upon so that things don’t blow out of proportion before you can fix them. This can extend to issues arising outside of the pairing of you and the other contract party. Should you or the other get sued or have an issue, have it clear who is liable in such a situation. Finger-pointing is easy if it offers a chance of not having to pay substantial legal fees.” — Andrew Taylor, Director at Net Lawman.
5. Liability and Indemnity
Liability clauses establish how much a party will pay if something goes wrong with a contract. Indemnity clauses establish which party will be responsible for paying for any specific damages. For example, construction contracts include indemnity clauses as a way to protect the contractor from losses and lawsuits due to negligence.
Small businesses especially need to be wary of liability and indemnity clauses. Oftentimes larger companies will take advantage of their power and include favorable language in indemnity clauses.
From the experts: “A huge red flag especially when contracting to do work that may involve a third-party outside of the contract is an indemnity provision. If a contract is proposed to a client without an indemnity provision when it should be, it has me questioning who my client is working with.” — Eric J. Proos, Esq. is a small business owner himself and attorney.
6. Payment Terms
A trustworthy contract will provide clarity on payment terms. What amount is due by when and by which method of payment should be clear and understood by both parties. A solid contract will have an agreed upon price and schedule of payments. Make sure there is an initial down payment; if the project is drawn-out, request payments along the way.
From the experts: “The best solution is to make sure the payment obligation sets a specific time frame (e.g., 30-45 days of the date of the invoice), and remove any reference to conditions on payments. I also advise my clients to collect payment in advance if the other party will not agree to remove that clause.” — David K. George, Esq.
7. Venue Provision
If a lawsuit arises under a contract, the venue provision will determine the county and state where the lawsuit must be filed. The venue chosen will specify which jurisdiction’s laws apply. Business owners should be cautious signing an agreement where the choice of law is outside of the state they reside in. If possible, negotiate for a venue in your state or in an agreed upon neutral location.
From the experts: “Another red flag to be careful of is known as a venue provision. Despite the fact that your business is located in, for example, Florida, the other party might require in the contract that any lawsuit or arbitration matter is brought in another state. This is often done to discourage litigation and increase the cost for you, making it more likely that you would settle a legal case for less than its actual value.” — Stacey A. Giulianti, Esq., Chief Legal Officer at Florida Peninsula Insurance Company.
8. Automatic Renewal Clause
Automatic renewal clauses cover terms that automatically extend the contract beyond its original time frame. This language typically is placed deep inside the small print of B2B vendor contracts, making it difficult for business owners to identify right away. If the contract your signing is specific to a service being received or provided, there is no need for an automatic renewal clause to be in place.
From the experts: “I cannot count how many times clients were surprised by provisions that automatically renewed contracts for multiple years unless notice was given during a very specific time frame. This is quite routine in common business contracts for supplies (e.g. uniforms, linen supply services, first aid supplies, fire control supplies, and inspections, etc.). These automatic renewal clauses can cost a lot on a sale of the business if the buyer is unwilling to assume them.” — Guy Whitesman, a Florida Bar Board Certified Tax expert.
The Boilerplate of a contract refers to any miscellaneous provisions including jurisdiction, confidentiality, attorney fees, severability, and more. Many small business owners overlook this section of a contract because the clauses are often considered standard. However, which boilerplate provisions are included and how they are written can have a large impact on your liabilities and rights under the contract.
From the experts: “Each clause in the Boilerplate is meant to accomplish a goal for one party or the other. Whether it is controlling law, venue, assignability, merging all prior discussion into the current contract (e.g., superseding promises salesmen may have made in the negotiations) or other matters which create advantages or disadvantages to one of the parties.” — Guy Whitesman, a Florida Bar Board Certified Tax expert.
10. Termination Clauses
Termination clauses are a common problem in contracts. It is important that these clauses identify the exact reasons for which an agreement can be terminated. Whether it is you or the other party that wishes to terminate an agreement, make sure the reasons are clearly defined in the original contract. It’s also important to make sure your client can not terminate you for no reason without compensation for the work you completed.
From the experts: “The contract terms I am most concerned about are termination clauses. Many times those clauses come with a heavy price to pay if you terminate early. These types of clauses can be detrimental to new small business owners because the early years are the hardest.” — Shahara Write Menchan, Business Law Attorney, The Wright Firm, PLLC.
There is a reason why contracts are written in small print. Don’t make the mistake of glossing over an agreement the next time you have to sign. Every clause should be understood, discussed, and agreed upon.