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Tom owns a small wood flooring business in an unincorporated town where people still sleep with their doors unlocked. Even though Tom has worked with every builder in the area and has watched his father, who started the business, conclude each deal with a handshake, he's always sure to get the terms of a new job in a contract. One thing that he didn't get in writing, however, was what would happen to the half of his business owned by his childhood friend, Bill, who recently passed away. Bill's family believes they now have rights to half of the business and would like to sell it to a new development company moving into town, while Tom had always wanted to keep his business small and personal. Now he risks losing half of what he's worked so hard to build.
You need to protect yourself. Small businesses should always have a contract in place to formalize their transactions. Putting the terms of an agreement in writing not only provides legal protection when disputes arise, often it also helps identify and solve any points of contention between the parties from the very start of the relationship.
For certain types of transactions, you must put things in writing if you want to collect money. Certain agreements cannot be enforced by a court of law unless the terms are in writing, such as:
• The sale of goods worth $500 or more
• Rental leases for time periods more than one year
• Real estate sales
• Contracts that require more than one year in which to complete performance.
The law may not mandate a signed agreement in other situations, but you would be foolish not to have one for certain types of transactions. The following are some transactions you should definitely get in writing.
Joint Agreements
Some things to get in writing are business operating agreements or co-owner agreements (called "partnership agreements" for partnerships, "operating agreements" for limited-liability companies and "shareholder agreements" for corporations). Key terms to include in these types of agreements are the initial capital contributions by each owner, how business profits will be divided if this allocation is other than along the lines of ownership interests, and what type of vote is needed for various company actions (for example, whether a simple majority will do or when a twothirds majority is necessary).
It is also wise to use buy-sell agreements among owners to spell out what happens when one owner leaves the company under specific circumstances, such as retirement, death or incapacity. Buy-sell agreements can be cross-purchase arrangements requiring remaining owners to buy out the interest of a departing owner, or redemption-type agreements where the business itself must acquire the departing owner's interest. Usually, these agreements are tied to valuation clauses to fix a monetary value for the departing owner's interest as well as a funding mechanism, such as the purchase of life insurance to pay for that interest.
Employment Agreements
When you hire someone, depending on the type of position, you may want to use a formal employment contract. This is common for executives and key managers, but may also be used for key salespeople and others with privileged information. Even though the contract may run for a fixed term (e.g., years), it is wise to have the company retain the right to fire the employee prior to the end of term for reasonable cause. All employees should be required to sign a confidentiality agreement that requires they refrain from disclosing business information, such as customer lists, price lists and other trade secrets. For valuable employees, you may want to use a noncompete agreement to prevent competition should the person leave. A non-compete agreement can be enforced if it is reasonable—one that runs for a modest time span of a year or two and is restricted to a limited geographic area.
Independent Contractor Agreements
If you outsource work to an independent contractor, use an agreement to spell out the terms of the arrangement. This is valuable from both a legal and tax perspective. Legally, the agreement states what the contractor must do to receive payment and your rights if the work is not satisfactory. Tax-wise, having an independent contractor agreement is helpful if the IRS claims the worker is really just an employee for whom employment taxes are owed. While worker classification is determined by the degree of control that can be exercised over a worker, having an independent contractor agreement at least lets the parties know that employment is not what constitutes the relationship.
Confidentiality Agreement with a Third Party
If you are planning to disclose any confidential or proprietary information in connection with a possible transaction, use a confidentiality agreement. As in the employment context, this will help to prevent disclosure of secrets.
Credit Applications
If you extend credit to customers, be sure to have them complete a written credit application. This allows you to check their credit history so you can make an informed decision about whether to extend credit and for how much money.
Promissory Notes
If you lend money to your business or if it lends money to you, an employee, another business or anyone else, have the borrower sign a note stating the terms of the loan—the principal amount borrowed, any collateral, interest rate and repayment terms and your recourse in case of default. Using a promissory note helps nail down debt treatment if there is a question about it. For example, say you lend your corporation money. Without a note, the IRS may say you made a contribution to the capital of your corporation rather than a loan. That would make repayments by the corporation to you taxable dividends rather than tax-free returns of your principal.
Think Like a Lawyer
Unlike large corporations that have inhouse legal counsel and outside attorneys on retainer, you may have to handle many of the contracts and agreements yourself. Here are some guidelines to help you:
Put all key terms in writing. For example, in defining financial terms, avoid using the phrase "negotiable." Instead, spell out a fixed amount or pre-determined formula. Be specific on time limits, such as when performance is required and when the agreement ends.
Think like a lawyer. Include legal terms that make the contract valid. For example, if you are contracting with a party from another state, specify which state's law will govern the contract in case of a dispute. Make sure the validity of the contract extends to your "successors and assigns." Include a severability clause, which provides that if one part of the contract is invalid, the other parts remain in effect.
Use preprinted forms and software. The Internet contains a wealth of standard agreements that you can modify and use for your situation. Some Web sites to investigate include: AllBusiness (www.allbusiness.com/forms/bs_forms_index.asp), FindLegalForms.com (www.findlegalforms.com), LegalForms.com (www.legalforms.com) and LegalZoom (www.legalzoom.com).
Consult a lawyer. Before you sign anything, have your contract reviewed by an attorney. The cost of this review should be modest (there should not be too many billable hours involved since you did the legwork). Whatever you have to pay is well worth it. You may have overlooked a key term or included something that could come back to haunt you, which could cost you more in the end than the upfront legal fees.
These days, the old-fashioned handshake rarely holds up in court, so documenting all major business transactions can save you time and money down the road. The more you properly document all your business relationships, the more likely you'll be able to protect your business.