What is a Contract? Definition, Importance, and Purpose
- Last Updated: Jan 06, 2025
- 15 min read
- Sirion
When you agreed to swap toys on the playground, you pinky swore. When you promised to return a friend’s favorite book in school, you shook on it. When you swore to love your partner forever, you exchanged rings.
Every agreement you make is sealed with something. In the business world, you use contracts. No matter the intention, contracts allow you and other parties to formally agree to specific terms and outline protections in unforeseen circumstances.
Keep reading to learn what a contract is, why you need one, and the essential elements you need to include to create the best agreements.
What is a Contract?
A contract is a legally enforceable document that creates mutual obligations between two or more parties.
Generally, you can enforce a contract using state or common law, commercial code, or industry/company-specific statutes.
What is the Difference Between a Contract and an Agreement?
The short answer? The level of formality and consideration.
Agreements
Agreements are promises between parties that are more informal (sometimes unwritten) and based on trust. This makes them unenforceable in court, so parties aren’t liable if they break the terms. Agreements also do not include “consideration,” an exchange of payment, goods, or services.
Contracts
Contracts are more formal, written pacts that are enforceable in court as long as they contain certain elements. Using specific terms, clauses, and language, contracts outline the obligations parties must fulfill in exchange for payment, goods, or services, i.e., the “consideration” aspect of the promise.
Why Do I Need a Contract?
Contracts are more than simple agreements. By formally laying out and agreeing to terms, contracts enable you to:
Establish a Record
Every contract contains important dates, terms, and performance metrics. Once you formally document those details, there’s no guesswork for that deal. You have a solid record that tells both parties exactly what is expected of them.
Ensure You Receive Payment
Your business can only thrive if parties pay you what they owe for your services. Every contract draft should include terms that outline the:
- Exact payment amount
- Payment schedule
- Method of payment
- Fees and other consequences for late payment
This way, there is no room for confusion, and you avoid value leakage and late or lost revenue.
Prevent Disputes
Disputes happen when there is too much room for interpretation around deals.
Contracts lay out explicit terms that all parties review and agree to. Because you and your counterparties will edit terms and account for challenges before you execute the contract, you significantly reduce, if not eliminate, the risk of contract disputes post-signature.
Keep Information Private
From financial data to intellectual property, you share a lot of sensitive information during your business dealings. You can use specific types of contracts, such as non-disclosure agreements, to make sure all that data is kept private between parties.
Increase Revenue
Besides including clauses that ensure timely payment, you can leverage your contracts to drive revenue in other ways.
Start by negotiating better contract terms that allow for more competitive pricing or create upsell opportunities for your enterprise. You can also improve your contract management processes to increase efficiency, free up your legal team’s time, and commit those efforts to more strategic tasks that boost company profits.
Now that you know some of the reasons you need to use contracts, let’s make sure you include all the right elements to make them legal.
What Elements Does a Contract Need to be Enforceable?
As we mentioned, contracts are only enforceable if they contain the correct elements. Those include:
- Offer — One party says they want to contract with the other.
- Acceptance — The party receiving the offer agrees to the contract’s terms.
- Awareness — Both parties confirm they are fully aware of the contract’s existence and terms and agree to fulfill the listed obligations.
- Consideration — Both parties exchange something of value, usually money, goods, or services, to ensure the contract holds equal weight for each side.
- Capacity — All parties need to meet the legal threshold to understand and agree to the contract’s terms and consequences.
- Legality — The contract’s terms cannot break the laws of the jurisdiction parties sign it in.
Once you have all the right elements, you can create the contract with the proper provisions.
What Should I Include in a Contract?
You should tailor your contracts to best meet your business goals and any important regulatory standards.
When drafting, remember to include contract clauses that relate to:
Termination
Every contract should include details on how a party can end the deal. Sometimes, you’ll put a time limit on the contract, for example, one year. In other cases, you may want to terminate the contracts due to a breach or mutual decision.
Dispute Resolution
While you can do your best to avoid contact disputes, it’s wise to proactively address how you’ll handle them. Including a dispute resolution clause that outlines how both parties will resolve conflicts ensures you get through contract issues as quickly and efficiently as possible.
Confidentiality
Don’t just agree to keep certain information private. Get it in writing. Confidentiality clauses are must-haves for your contracts so both parties know what data they need to keep between each other — and the consequences they’ll face for sharing it.
Indemnification
If a contracted deal goes south, you’ll want a way to protect yourself. Indemnification clauses define how Party A will compensate Party B if their actions cause Party B to experience a financial loss. Not only does this help remedy existing losses, but it also prevents future financial harm.
Amendment Provisions
Just because you sign a contract, it doesn’t mean one or both parties can’t make changes later down the line. You can add provisions that allow for future amendments — just be sure you understand how those amendments may change the contract as a whole.
What Contract Type Should I Use?
The type of contract you use will depend on the type of agreement you’re entering into—sales, employment, real estate, partnership, etc.
Some of the most common business contracts include:
- Unilateral Contracts — One party makes a promise, and the other accepts via certain actions.
- Bilateral Contracts — Both parties make promises and fulfill their respective contract obligations.
- Master Service Agreements — These contracts outline foundational terms for ongoing services between parties.
- Non-Disclosure Agreements — One or more parties must keep specific data confidential.
- Indemnity Contracts — One party compensates the other for a financial loss.
- Employee Agreements — These contracts outline a person’s terms of employment, such as compensation and responsibilities.
- Licensing Agreements — These contracts grant intellectual property rights to another party under specific conditions.
How Different Types of Contracts Relate to Each Other
Contracts are not static documents that exist within a vacuum. Contract A affects Contract B, which relates to Contract C. Together, they tell the non-linear, complex story of your business.
Consider the language used in sale contracts and licensing agreements. Both will include clauses relating to payment, intellectual property, and usage rights. They may also include similar templates. Their terms might even affect other teams, like Marketing or IT.
It all comes full circle. Contract to contract, you’ll find elements that overlap. That’s why it’s so important that you treat contracts as what they are—living, breathing documents that inform your enterprise.
You need to ensure the language across all your contracts is consistent and aligns with your company’s positioning. You need to deliver total clarity of terms and clauses. You need to track and analyze how contract relationships form and continue.
How do you do all that?
You invest in a technology-enabled contract repository that leverages contract data to help author new contracts and highlight inconsistencies.
Also Read: What is Contract Management?
AI CLM for Stronger Contract Lifecycle Management
If you’re going to use your contracts to improve business and improve risk management tactics, you need to know exactly what’s in them and where they are.
Using Sirion’s AI-native CLM platform, you can create, store, and manage your agreements to discover insights, manage risk, and automate busy work for a unified contracting experience.
With Sirion, you have every market-leading CLM feature you need in one place, built on AI.
See the Sirion difference for yourself.
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