The Purpose of a Contract

by Kurt Schulzke on January 3, 2008

This afternoon, I taped a 90-minute “webinar” on the subject of Negotiation. One key to effective negotiation is gaining real commitment.  This is a skill or process that many new entrepreneurs only learn the hard way. A common scenario involves a couple of business partners who spend several weeks discussing, e-mailing and meeting to structure a deal or a venture. The discussion ends and they walk away, both sides thinking they have an understanding. Later — sometimes much later — they discover differences in their views about the terms of that understanding. One party thinks they’ve agreed to X while the other thinks it’s Y.

To avoid this problem it makes sense to put the agreement in writing, so lots of people do just that. They draft an “agreement” or a “contract,” sign it, and then each assumes that the contract benefits are locked in because they can go to court if the other side fails to deliver. Reality, however, is more complicated.

Depending on the subject matter of the agreement (a one-off sale or an iterative business relationship) and the importance of the ongoing relationship between the parties, the contract may mean nothing in practical legal terms. Example: If you really need that Chinese partner on your side to negotiate with the Chinese government or interface with Chinese suppliers or customers, it would be a big mistake to point to the contract and try to enforce its terms with implied or express threats of litigation. Even if such a strategy offered a high likelihood of “success” in court (and there’s truly no way to predict courtroom outcomes in advance of the jury’s verdict), heading for the courtroom or threatening to do would destroy a valuable strategic asset — the relationship with your business partner. This being the case, how should we view contracts?

I advise clients that contracts should be used to solidify the relationship by (a) creating a clear record of the nature of the mutual commitments and (b) building relationship infrastructure. By relationship “infrastructure” I mean process. A contract that memorializes a relationship expected to last for months or years should create a process for decision making and dispute resolution that is clear and satisfactory to all parties.

A one-off sale of land or raw materials isn’t such a big deal. A partnership, joint venture or long-term supply contract is. These kinds of relationships must be flexible to survive volatility in the relevant market. Such flexibility is the product of carefully-crafted relationship infrastructure. Building infrastructure is as much art as science. A knowledgeable attorney with robust business experience can add big value to the creative process. Time and money spent on this kind of advice on the front end of a deal is a much better investment than paying for a litigator on the back end.

In summary, contracts should not be viewed as weapons held in reserve to punish a wayward partner. Rather, they should be used primarily as tools for structuring relationships and memorializing or recording what the parties have agreed to do for and with each other. Additional pointers are provided in Contract Points to Ponder.