Contracts are the backbone of business. Contracts describe relationships. Contracts outline how you are to be paid and what you must do for that money. They also should talk about how long the relationship should last.
Contracts don’t last forever. At least they shouldn’t. Why is it then, that so many contracts leave out the length of time of a contract (this is called the “term”)? If they do include something about the term, the contract doesn’t include a way for the contract to renew or there is no way to stop (or “terminate”) the contract. All of these can lead to more problems than many other mistakes in contract drafting.
When it comes to the contract term, three things are often ignored: (1) Term; (2) Termination; (3) Renewal. These are important elements to any contract. Sometimes, you will not include the elements, but you need to consider the reasoning before ignoring the paragraphs altogether. If you are trying to do it yourself, you should really think about how these paragraphs fit your needs and how the proper use of them could prevent you from needing a lawyer to deal with your contract.
So, let’s talk about these ever-so-important contractual elements:
The term of a contract is the length of time the contract lasts. In many industries, there are standard terms. We are all familiar with them. How many times have you had to renew your cell phone contract for two years to get a discount on the newest phone on the market? Sometimes, the term is completely up to you (like for your own template contracts). The length of your contract term, however, is important.
The term of your contract determines the value of the contract.
You take the amount to be paid under the contract, the method of paying and you can calculate the value of your contract by the term. This is important in valuing your business. For instance, a lease agreement to pay $1,000 per month for five years is a $60,000 contract. It is important if you need to borrow money for your business. It is important so you can know which contracts are worth more to your business.
Of course, the contract is only worth that much if it doesn’t end before the term is up.
Termination is the way a contract can be ended before the term is up. Of course, a contract is terminated at the end of the term. When you are drafting a contract, you need to consider whether this is designed to be a contract for a set length of money that is simply spread out over the life of the contract (like the lease example above), or if it is a contract for a specified amount of money to be paid at specified intervals (like a month-to-month rental agreement). Termination is one of the terms that dictates the amount of money owed at the interval amounts of any given contract.
The right to terminate a contract at any time is what companies really mean when they say they have a service or product with “no contracts”. They really mean “no contract term” or, more specifically, “you can terminate your contract whenever you want to”. This is often called “termination for convenience”. That means you have a contract, but you can end it at any time you want (if you follow the contract term that outlines how you terminate the agreement). That, of course, does not play well in a 30 second commercial (or on a billboard).
Termination rights help you determine how much to charge.
This is a prime way you can value your business relationship. It helps determine your pricing structure. If you have twelve month agreements with no termination rights, you can value the agreement over the life of the contract. If, however, you have an agreement with a twelve month term, but a right to terminate at any time (say, with 15 days notice), your contract is only worth the value of the next month’s payment.
Termination rights are tricky. People want to know that they can get out of a contract if something comes up. People also want to lock in the best possible rate. That is why you pay more money if you have a right to get out of a contract. Sticking with the lease examples, a month-to-month lease is substantially more expensive than a 12 month lease, which is more expensive than a five year lease. The right to get out of a contract is one of the most valuable rights you can have. Therefore it will cost additional money.
For the contract drafting party, you also need to know if you can get out of a contract. You also need to determine if you must have a reason (called “termination for cause”) or if you can also simply terminate for convenience. Termination for cause is an often neglected part of the contract drafting process.
Contracts, at their most basic level, involve an exchange of some kind. Most often in small businesses, that is the exchange of services for money. If you are in the service business, and you have a twelve month contract, you are obligated to give twelve months of service in exchange for twelve months of money. The problem is, without any termination rights, you are obligated to give twelve months of service. Their failure to pay for the service is an issue separate from your failure to provide services. If they fail to pay and you fail to provide services, you both have breached your obligation under the contract.
It is always important to include, at a minimum, a right to cease services for failure to pay. But, do you want to consider a right to terminate the contract? Do you want to have a reinstatement fee for your contract? Are there certain rights you get to keep if the contract is terminated (e.g., Intellectual Property)? Would your right to terminate help you collect money you are owed? Of course, you may not want to terminate for failure to pay, but it is something to consider.
If the contract term determines the value of a contract, the renewal of the contract helps you determine the potential value of the contract. In Real Estate, the right to renew a contract is a precious one. If a tenant rents a space for five years, they want the right to continue in that space instead of having to move locations. That is why commercial leases often have the option to renew the contract. Do you have to renew? No, but you have the right. That means you can’t be kicked out of your building. It means the landlord cannot triple your rent if you choose to stay in the building. You have the right to renew under the terms of the contract (or whatever renewal rights are in the contract). That’s a valuable right. People are willing to pay for that right if you have something people want to keep.
Some contracts contain an automatic renewal, which means that the contract will renew if it is not terminated according to the contract (typically 90-120 days before the end of the term). This helps out the selling party. They have a client locked in to the contract if there is not an active termination on the part of the client.
Other contracts contain an option to renew. This is similar to the automatic renewal, but the option must be exercised to renew (typically 60-90 days before the end of the term). This helps out the purchasing party. They do not get stuck in a new term of a contract if they forget to terminate.
These options are important because it dictates what the contract looks like at when the term is over. If the contract has an automatic renewal, and the client neglects to terminate a contract, they’re stuck. On the other hand, if there is an option to renew, and there is no renewal, the contract is over and it becomes a month-to-month contract. Neglecting the end of the term of a contract may be dangerous depending on how your renewal rights work.
Contract Tip: Always calendar your renewal or option dates. You don’t want to miss them. Use a program that will remind you in time to take the action you need to take before it has passed.
As important as the terms of a contract are, one of the common issues that comes up in contract disputes is the issue of whether the contract is still in effect. Many times that comes down to the termination rights. If a contract has an automatic renewal and nothing was said, it clearly is still in effect, but what happens if the contract has an option to renew that was never exercised, but the parties continued as if the contract was still in effect? Typically the terms will be construed to be month-to-month, making it difficult to collect on a breach that extended for any amount of time because it would be considered that the contract was simply terminated and not that the other party defaulted and failed to pay. It is always important to consider which type of option makes sense for your contract. If you need a renewal at all. If there is no renewal, just make sure you intended to have only one term.
Just don’t forget about the term of your contract and how it is terminated or renewed. Whatever your choice, just make sure you have done your homework.