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This blog post is an overview of some common contract clauses that one should consider as part of any agreement between two small businesses. This information is only an overview. You should consult with an experienced attorney to assist you with your specific contract needs.

A basic agreement should contain the following elements at a minimum:

Identify the parties to the agreement
Detail the Goods/Service provided
Detail the compensation given for the Goods/Services and how it is to be paid
Dated signature from at least the party who is being presented with the agreement, preferably both parties though.

However, an effective agreement will require more things be considered and possibly addressed in an agreement. Here is a small list of some common clauses that may helpful in drafting an effective agreement. The text of each clause should be customized for your individual needs (There is no signal paragraph that works for all agreements).

INTEGRATION CLAUSE

An integration clause basically states that no matter what the two parties have discussed verbally or through other means prior to enacting this written agreement, the entirety of each party’s understanding of the agreement is within the agreement itself. By signing the agreement with such a clause, any prior considerations not mentioned in the agreement no longer exist: The document stands by itself as the whole agreement.

When contemplating whether to sign an agreement with such a clause, make sure that everything you are expecting to see in the agreement is there: an offline promise from the other party will not suffice. When drafting an agreement, this clause is helpful to make sure that the other party doesn’t try to hold you to something that you may have agreed to before the final agreement was reached. Promises are made in negotiations that may no longer be applicable when a final agreement is drafted. Also, it’s generally a good idea to state that the agreement may be amended if you are open to both parties agreeing to modification downstream. After the agreement is enacted, you are never obligated to accept suggested changes if you do not want them. However, you do have to the option to accept them if you’d like.

LIMITATIONS OF LIABILITY CLAUSE

A limitation of liability clause will do as the name suggests: it will limit your exposure to liability. When agreements cannot be met, at least one of the parties is harmed by it. How much harm they may endure is not always limited to what was discussed in the agreement. There are numerous types of damages that the harmed party may pursue (direct, indirect, consequential, special, etc.). Defining each type of damage is complex and outside the scope of this pamphlet, so let me give you a simple example:

Supplier is delayed in its delivery to Buyer of 1000 widgets at $5/widget for a total cost of $5000. These components are critical to the Buyer in building their device for another company that will bring the Buyer $100,000 in revenue. The Buyer’s agreement with that company includes having to deliver the completed devices by a certain date. When the Supplier cannot meet the delivery date, the Buyer looks for another vendor who can, but the Buyer can’t find replacement widgets in time. As a result, the Buyer cannot deliver the devices per the terms of their agreement with the company and the Buyer loses out on $100,000 of revenue. The $100,000 is an example of consequential damages. If the Supplier did not have a limitation of liability clause on their agreement with the Buyer that limits their exposure to consequential damages, the Supplier may end up paying far more in damages than they ever would have received on the original agreement.

When entering into an agreement, think about all of the possible ways that a breach of this agreement could harm you. These need to be considered in either drafting the agreement or agreeing whether to sign the other party’s agreement. Drawing the line on how to share that risk between each party is never an easy task. If you were in the position of the Supplier, you’d appreciate knowing what you’re getting into beforehand and not want to be responsible for anything other than the $5000 agreement you committed to. If you were in the position of the Buyer, you’d want assurances that the Supplier could deliver as promised, so as not to cost you $100,000.

NON-SOLICITATION VS. NON-COMPETITION VS. NON-DISCLOSURE CLAUSES

It is common for people to confuse these three clauses. However, each clause is very different from the others. Here’s a brief definition of each one:

Non-solicitation clause – restricts individuals and organizations from soliciting employees, customers, or business opportunities from another company or organization for a period of time. When sending your employees onsite to service another business, it’s probably best to have such a clause in place beforehand.

Non-competition clause – restricts individuals and organizations from providing services or engaging in businesses in certain markets and geographies for a period of time. The clause protects businesses from the potential that knowledge gained by an employee or business partner will be used in the future to compete against the business.

Non-disclosure clause – Commonly called a “confidentiality” clause, this clause acknowledges that the parties may have to share some information that may be confidential and restricts the other party in what they can do with that information. It may also address any damages associated with a breach of confidentiality. Imagine a disgruntled Coca Cola employee publicly disclosing the “secret formula.” The damages to the Coca Cola would be significant.

Sometimes, these clauses are added to an agreement as amendments after the agreement has been enacted, or they are enacted as separate agreements altogether. Since these clauses restrict the other party in some additional way, some form of compensation must be given in order to get the restricted party to accept these clauses when they were not part of the original agreement. If they are part of the original agreement, no additional compensation is necessary.

DISPUTE RESOLUTION CLAUSE

Litigation can be very expensive, and for many business-to-business agreements, the cost of litigation could be far more than the original agreement was worth. Providing for alternative dispute resolution (ADR) processes can be an affordable way to resolve any disputes. A dispute resolution clause often states that arbitration or mediation will be the avenue for resolving disputes.

Arbitration is similar to litigation in that the arbitration panel (often more than 1 person) will listen to both sides and make a ruling one way or the other. Mediation is generally conducted by a single mediator who does not judge the matter, but rather looks for ways at facilitating a compromised resolution to the situation. Sometimes, mediation is used first as a non-binding process, and if no resolution can be agreed upon through mediation, then arbitration is used as the binding process to resolve the dispute.

INTELLECTUAL PROPERTY CLAUSE

Often a business is sharing its intellectual property (copyrights, trademarks, trade secrets, or patents) with another company when there is a contractual agreement. How each party handles the other party’s intellectual property should be addressed in any agreement between them. A simple example may be hiring a web developer to create your website. You may provide them your trademarked logo and some copyrighted content, but you should make it clear that you own this material, not them (got that, Facebook). You may give them a license to use your material for the very specific purposes of the agreement, but nothing more. The web developer may have good reason to include your logo on their web page listing their past and current clients. This use of intellectual property should be negotiated up front and added to the agreement or as an addendum later, but the parameters of that use should be explicit.

FORCE MAJEURE CLAUSE

This clause allows a party to suspend or terminate the performance of its obligations when certain circumstances beyond their control arise, making performance inadvisable, commercially impracticable, illegal, or impossible. Typically, those circumstances are considered “acts of God,” but you may negotiate just about anything for an event triggering this clause (i.e., war, riots, strikes or lockouts, etc.). A force majeure clause should be explicit by defining the events, what happens when the event occurs, which party can suspend or terminate performance, and what happens if the even continues for a longer than anticipated time. For example, you may foresee a strike and suspend performance for 6 months until the strike has settled, but what if the strike lasts longer than 6 months?

SEVERABILITY CLAUSE

A severability clause ensures that if a court or arbitrator strikes down a statement or clause in the agreement, the remainder of the agreement is still enforceable.

GOVERNING LAW, JURISDICTION, OR VENUE CLAUSES

These are all very similar clauses. It basically states that the agreement will be construed under the laws of a certain state, jurisdiction, or venue (i.e., state is Minnesota, jurisdiction is federal court, and venue is Hennepin County). This clause often includes a statement that the prevailing party shall be awarded all reasonable attorney fees from the non-prevailing party. Although the likelihood of a court making such an award is low, you cannot get this award unless you have asked for it, so this text is often added when drafting an agreement.

There are many factors to consider when drafting or consenting to an agreement. It is important to consult with an experienced attorney to assist you before enacting any agreement.

When you are starting a business, one of the first things you need to determine is how to best structure your business by choosing the proper business entity (C-corp, S-corp, LLC, etc.). There are numerous options out there and each has its pros and cons. You, your attorney, and your accountant should discuss which business entity is best for you.

Here is a very brief overview of some common business entities and their characteristics:

UNINCORPORATED BUSINESS ENTITIES

General Partnership: Two or more people going into a for-profit business together will generally be considered a general partnership unless they specifically choose otherwise. General partnerships are not separate entities for tax or state legal purposes, so the income from the partnership “passes through” to the partners as personal income. The general partners are fully liable for the full amount of their partnership debts even when those debts exceed their investment in the partnership, exposing their personal property to cover business debts.

Sole Proprietor: When only one person starts a for-profit business, they will be considered a sole proprietor unless they specifically choose otherwise. Sole proprietorships are not separate entities for tax or state legal purposes, so the income from the business “passes through” to sole proprietor as personal income. Like a general partnership, a sole proprietor is fully liable for the full amount of their business debts even when those debts exceed their investment in the business, exposing their personal property to cover business debts.

INCORPORATED BUSINESS ENTITIES

C-corporation: In order to become a C-corp, you must file Articles of Incorporation with the state. Additional administrative work will be necessary to maintain a corporation. Namely, bylaws should be drafted, minutes of the board of directors and shareholders’ meetings should be kept, and a shareholder agreement is strongly recommended to define the relative rights and responsibilities of each shareholder class. A C-corp is treated as a separate entity for federal and state tax purposes, so the corporation is taxed on the corporate income and when dividends are paid out to the shareholders, this amount is taxed as personal income to the shareholders. The shareholders are only liable for the corporation’s debts to the extent of their investment in the corporation.

S-corporation: In order to become an S-corp, you must file Articles of Incorporation with the state. Additional administrative work will be necessary to maintain a corporation. Namely, bylaws should be drafted, minutes of the board of directors and shareholders’ meetings should be kept, and a shareholder agreement is strongly recommended to define the relative rights and responsibilities of each shareholder class. Unlike a C-corp, an S-corp is not treated as a separate entity for federal and state tax purposes, so the corporation is not taxed on the corporate income. The income of the S-corp is taxed as personal income to the shareholders. Although an S-corp generally does not pay any tax, it still must file an annual information tax return with the IRS and report each shareholder’s pro rata share of profits and losses on a Schedule K-1. The shareholders are only liable for the corporation’s debts to the extent of their investment in the corporation.

Limited Liability Corporation (LLC): In order to become an LLC, you must file Articles of Organization with the state. If there is more than one member of the LLC, it is strongly recommended that you have a membership and operating agreement in place to define the relative rights and responsibilities of each member. With an LLC you have the option to be treated as a separate entity for federal and state tax purposes or not. In MN, the default choice is to be treated as a corporation, in which case you will be taxed like a C-corp. However, in the Articles of Organization you can elect to be treated as a partnership with your income allocations defined in your membership and operating agreement. The shareholders are only liable for the LLC’s debts to the extent of their investment in the corporation.

Limited Partnership: An Limited Partnership (LP) is formed when the partnership files a Certificate of Limited Partnership with the state. An LP has both general partners and limited partners. The general partners have the authority to conduct the regular operations of the business. Limited partnerships are not separate entities for tax or state legal purposes, so the income from the partnership “passes through” to the partners as personal income per their allocable share of the business. The general partners are fully liable for the full amount of LP’s debts even when those debts exceed their investment in the partnership, exposing their personal property to cover business debts. The limited partners are only liable for the amount equal to their share of the investment into the LP, unless there is some other contractual obligation to take on more liability.

There are many more business entities that blend aspects from all the entities above. Determining which entity is right for you should be done with the help of an attorney and/or an accountant. Please contact me if you need help setting up your new business or would just like to talk through your options.

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Understanding Common Contract Clauses for Business