In previous blog articles, we talked about Exceptions That Can Void A Contract and How to Get Out of a Contract. Both of these articles touch on a very important aspect of contract law that is often overlooked by small business owners: Consideration.
Consideration under contract law is defined as an exchange of value that is negotiated between parties. Without consideration, a contract cannot be enforced or is otherwise voidable (with only a very few exceptions). The exchange of value is interpreted broadly to not only include money, but property, a promise, doing something, or even not doing something. In broadest sense, if one agrees to do something he or she was not otherwise legally obligated to do, it may be said that he or she has given consideration. Conversely, agreeing to do something that is otherwise legally required, is not adequate consideration to a contract.
Consideration requires (i) a bargain regarding terms of an exchange, (ii) a mutual exchange between the parties (i.e. both parties must get something out of the contract), and (iii) the exchange must be something of value.
If one party was not in a position to properly bargain, either because of fraudulent information provided by the other party, duress (i.e. one party held a gun to the head of the other party), or other circumstance that made it impossible for a party to bargain, then there is no consideration.
Likewise, if one party receives no value whatsoever (i.e. one-sided consideration), this will not be sufficient (in most instances) to establish overall consideration to render the contract valid.
Finally, the value cannot be illusory — it must have actual value. For instance, agreeing to do something that is otherwise legally required, such an agreement is illusory and therefore will not be sufficient consideration to enforce a contract.
Applicability in Business
Usually, consideration is important because one business needs to unilaterally change the terms of a relationship with some other party, such as an employee, contractor or customer. For example, you may have determined it’s important that a particular employee (or contractor) agrees to not compete or solicit customers, years after that employee was hired. Or, you want to change pricing or services for customers. Or, you want to make sure you own the copyrights of the work produced by your contractor, after the project has already started (Read Don’t Get Screwed – Managing Website Vendors).
The fact-pattern is actually complex, and can spell long-term problems for businesses. It goes like this: Your company unilaterally makes a change, either in writing or in practice, and you continue “business as usual” with the other party. Over time, the other party fails to pay or there are some other problems in the relationship and you try to enforce — i.e. you try to get paid or you try to enforce whatever unilateral change you tried to put in place previously.
If you make a unilateral change to the relationship without proper consideration in place, your business may be unsuccessful in enforcing that change, costing your business significant expense, headache, loss of customers or worse.
It’s Critical to Add Consideration to Changes to Existing Relationships / Contracts
When you decide that your business needs to change something with an existing relationship, you owe it to the success of your business to think through the issues of consideration. If you’re not sure, I strongly encourage you to talk to a competent business attorney in your local jurisdiction.
Let’s discuss some examples.
Increasing Price for Services
Are you offering a service to your customers, and you want to increase the price for such services? Whether you can do this legally, and enforce the price increase, will depend on the nature of the pre-existing relationship (or contract) with your customers.
For example, do you have a 3-year contract with a customer and you want to change the pricing within the term of the existing contract? Unless you have language in your existing contract that permits you to increase the price, or there is some other pre-existing circumstance and clause you can rely on, your attempts to increase the price of your service will be invalid and cannot be enforced.
Contrast this to a month-to-month customer. With such a customer, you can increase the price with notice to the customer, under the theory that the consideration for an increase in price is the continued provision of service to the customer — and if the customer doesn’t want to pay the increase in price, he or she can terminate the relationship.
Many businesses would like to lock-in customers to long-term contracts. This consideration problem is one of the reasons you may want to be careful about long-term contracts — if you think there’s a chance you may want to increase pricing or change terms later.
Adding Terms to Employment Agreement
Did you hire one or more employees without an employment contract previously, or with a very simple contract, and now you want to add some additional terms to protect company customer lists, intellectual property, trade secrets or more?
Your ability to force existing employees to sign a new, more restrictive employment contract — without something more than merely the right to continued employment — will greatly depend on your state’s laws on this. In general, “at will” states are more forgiving than the rest, but there are a myriad of laws and exceptions for each state, so if you really want to force a new contract on existing employees, this is the one time you really should talk to a competent business or employment lawyer in your local jurisdiction to navigate the proper course.
Even if you pay your employees a bonus to sign a new employment contract, you need to give your employees the option to sign the contract and receive the bonus. Remember that consideration requires a bargain. If you force your employees to sign — even with a bonus — there is no bargain, given that employees who don’t sign would arguably lose their jobs. Therefore, the bonus could be viewed as inadequate to establish consideration, and therefore the new contract becomes unenforceable (although the employees would be able to keep their bonuses).
Therefore, your best bet is to (i) make signing the new employment contract optional, AND (ii) providing a cash bonus or pay raise (above-and-beyond what is standard) to sign the new employment contract. Otherwise, you risk the new contract being unenforceable. Again, consult with a competent business or employment lawyer in your local jurisdiction if you want to chart a different course.
Revising Terms with a Contractor
Unilateral changes to an existing contract between an employer and contractor could be unenforceable without proper consideration, and therefore (the lack of) consideration can help or hurt your business, depending on which side of the fence you sit for any particular issue.
If you want changes, the best bet is to seek mutual agreement with the contractor, but make sure consideration is adequate given the previous contract and the new agreement. Otherwise, you could end up paying money, releasing confidential information or not properly assigning intellectual property to your company’s detriment.
If the contractor is forcing changes on your business that you don’t agree to, the lack of consideration for the changes may provide salvation for your business — but be careful of “promissory estoppel” (i.e. a legal principle that a promise is enforceable by law, even if made without formal consideration, when a promisor has made a promise to a promisee who then relies on that promise to his subsequent detriment.). We told you this can be complicated.
Help With Contracts
Law 4 Small Business, P.C. (L4SB). A little law now can save a lot later. A Slingshot company.
Good and informative article!
Just wondering: if directors of a company give unsecured loan to their company from their own funds, and do not want to burden the company by charging interest on the loan, what ‘consideration’ can be mentioned in the loan contract to make the contract legal?
Hope you can enlighten on this aspect.
Thank you for your question.
First, the interest paid is not “consideration” such an agreement. Consideration is a “bargained for exchange of value,” and in this case, you’ve given them money in return for the promise to pay you back. That is the consideration.
Second, you should NOT be giving a loan with zero interest in this case. You could create inadvertent tax issues for yourself and/or the company. What you’re required to do, is charge at least the AFR, which stands for “applicable federal rate”. This is the minimum interest rate that the Internal Revenue Service (IRS) allows for private loans.