What is a Contract? Definition, Importance, and Purpose

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.

Contracts are also often confused with other legal documents. Here’s how they differ.

Contracts vs Related Legal Documents

• Contract vs MOU (Memorandum of Understanding) – An MOU signals intent to collaborate, but unlike a contract, it isn’t legally binding.
• Contract vs SLA (Service-Level Agreement) – An SLA defines performance standards and metrics, often as part of a broader contract.
• Contract vs Purchase Order (PO) – A PO is an order to buy goods or services; a contract establishes the overall business relationship.

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.

But what if you rely only on informal agreements or verbal promises?

Risks of Not Using Contracts

Failing to formalize agreements leaves businesses exposed to:

• Unenforceability – Verbal promises often don’t hold up in court.
• Ambiguity & Disputes – Misunderstandings over terms, timelines, or payments.
• Revenue Leakage – Missed payments or underpayment without a written record.
• Compliance Failures – Risk of breaching laws, regulations, or industry standards.

Contracts don’t just enable business — they protect it.

To avoid these pitfalls, contracts must include certain legal elements that make them enforceable.

What Elements Does a Contract Need to be Enforceable?

As we mentioned, contracts are only enforceable if they contain the correct elements. Those include:

1. Offer — One party says they want to contract with the other.
2. Acceptance — The party receiving the offer agrees to the contract’s terms.
3. Awareness — Both parties confirm they are fully aware of the contract’s existence and terms and agree to fulfill the listed obligations.
4. Consideration — Both parties exchange something of value, usually money, goods, or services, to ensure the contract holds equal weight for each side.
5. Capacity — All parties need to meet the legal threshold to understand and agree to the contract’s terms and consequences.
6. 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.

Knowing the core elements is one thing, but what do they actually look like in practice? Let’s break down what truly constitutes a valid contract.

What Constitutes a Valid Contract?

A contract is only as strong as its foundation. For a contract to be valid, it must include:

• Mutual Consent – Both parties freely agree to the terms.
• Clear Consideration – Each side must exchange something of value, whether goods, services, or payment.
• Lawful Purpose – The subject matter cannot involve illegal activity.
• Competent Parties – Everyone signing must be of legal age and mental capacity.
• Definite Terms – The obligations, timelines, and deliverables must be precise and not left open-ended.

A valid contract is essentially a binding roadmap: clear in intent, equitable in value, and enforceable in law.

On the flip side, not every agreement that looks like a contract will hold up in court. Here are the situations where contracts may fail the enforceability test.

When Is a Contract Not Legally Enforceable?

Contracts that miss key requirements or violate basic principles risk being struck down in court. Common examples include:

• Lack of Consideration – If only one side benefits without giving value in return.
• Ambiguity – Vague, contradictory, or incomplete terms that create uncertainty.
• Duress or Misrepresentation – When one party is forced, misled, or not fully aware of what they are signing.
• Illegality – Agreements that involve unlawful activities or breach statutory rules.
• Incapacity – Contracts signed by minors or individuals not legally competent.

Simply put, an unenforceable contract looks like a deal on paper, but it won’t stand up in practice.

So how do you ensure your contracts stay valid, enforceable, and effective in practice? The answer lies in following a few proven best practices for drafting.

Best Practices for Drafting Contracts

• Use Plain, Clear Language – Avoid jargon that leaves room for misinterpretation.
• Define All Key Terms – Spell out responsibilities, timelines, and deliverables.
• Avoid Ambiguity – Replace vague terms like “reasonable” with measurable criteria.
• Plan for Change – Include amendment and renewal provisions upfront.
• Seek Legal Review – Ensure compliance with relevant laws before execution.

Even well-drafted contracts can face breaches when one party doesn’t uphold their end of the deal. Understanding what happens next helps you prepare for resolution and recovery.

What Happens When a Contract Is Breached?

When one party fails to fulfill their obligations, the contract is breached. The consequences vary based on the severity and terms of the agreement, but typically include:

• Damages – Monetary compensation to cover losses caused by the breach.
• Specific Performance – A court order requiring the breaching party to carry out their contractual duties.
• Termination – Ending the contract and relieving both parties from future obligations.
• Reputational and Relationship Costs – Beyond legal remedies, breaches can damage trust and long-term partnerships.

A breach doesn’t always mean business ends—it can also trigger renegotiations or corrective actions. But having clear dispute resolution clauses ensures the fallout is managed efficiently.

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 initiate the termination of contracts. 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.

Beyond these broad categories, contracts often differ depending on the specific business function they serve.

Types of Contracts by Use Case

While unilateral and bilateral contracts form the foundation, organizations rely on more specialized contracts for day-to-day operations:

• Sales Contracts – Define the exchange of goods or services between buyer and seller.
• Procurement Contracts – Govern supplier relationships, vendor deliverables, and pricing commitments.
• Employment Contracts – Establish terms of hiring, compensation, benefits, and termination conditions.
• Real Estate Contracts – Cover property sales, leases, and rental agreements.
• Partnership & Joint Venture Contracts – Define ownership, responsibilities, and profit-sharing between entities.
• Government & Regulatory Contracts – Ensure compliance with specific industry or jurisdictional requirements.

No contract exists in isolation. Often, different agreements overlap and influence one another.

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.

Understanding how contracts connect is one part of the picture. Equally important is recognizing the lifecycle every contract passes through.

The Contract Lifecycle Stages

Every contract is more than a signed document — it’s a living asset that goes through a series of stages from initiation to completion. Understanding and managing each stage is critical for minimizing risk, improving efficiency, and maximizing business value.

1. Creation & Authoring

This is the starting point where business needs are translated into contractual language.

• Teams typically rely on templates, clause libraries, and playbooks to accelerate drafting.
• Standardization here reduces errors, ensures regulatory compliance, and avoids reinventing the wheel with every contract.
• Example: A procurement team may pull a standard vendor template but tailor clauses around data security or delivery timelines.

2. Negotiation & Redlining

Once drafted, the contract enters back-and-forth discussions with counterparties.

• Redlining involves editing terms, striking clauses, and suggesting revisions until both sides agree.
• At this stage, legal teams focus on balancing risk while enabling business speed.
• AI-enabled CLM platforms can flag high-risk language, suggest alternative clauses, and track changes across multiple versions.
• Example: A supplier might push back on liability caps; negotiation ensures terms remain fair without stalling the deal.

3. Execution

Execution transforms the contract from a draft into a binding agreement.

• Traditionally, this required wet signatures and couriering documents, slowing down business.
• Today, digital and e-signature solutions allow contracts to be executed securely in minutes.
• Advanced systems also enforce compliance with internal approval workflows before execution.
• Example: Sales teams can close deals faster by sending a contract for e-signature immediately after negotiation concludes.

4. Post-Signature Management

The majority of a contract’s risk and value lies after the signature, during ongoing performance.

• This stage includes tracking obligations, monitoring compliance, and managing renewals.
• Without proper visibility, organizations risk value leakage from missed milestones, late payments, or unclaimed discounts.
• CLM platforms automate reminders, generate alerts for renewals, and provide dashboards to monitor performance in real time.
• Example: A service contract might include penalties for missed SLAs; automated tracking ensures both parties meet obligations.

Also Read: What is Contract Management?

As contracts grow in number and complexity, organizations are increasingly turning to digital tools and AI to manage them at scale.

The Role of Digital and AI in Contracting

Modern enterprises can’t afford to rely on manual processes. Digital contracting platforms offer:

• E-signatures for faster execution
• Centralized repositories for quick search and audit readiness
• AI-powered clause analysis for risk detection and negotiation insights
• Integrations with ERP and CRM systems to sync business data seamlessly

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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