Deals and agreements can take countless forms.
I’ll pay you ten dollars to mow my lawn. I’ll pay you $500,000 to build me a house.
The specific terms and conditions can take a contract in many different directions. However, when the final agreement is made official, the written or oral contract will fall into a specific category.
As you maneuver your contract management strategy for your business, picking out any types you might encounter is crucial to maximizing contract performance, preparedness, organization, and compliance.
But let’s begin with the basics.
What is a contract?
A contract is an agreement between entities that creates mutual obligations that are legally binding.
Elements of a contract
A contract serves two purposes: it clarifies the terms of an agreement, and it ensures that legal sanctions will be imposed in the event of non-compliance. A contract needs to possess the following elements to be legally binding:
- Capacity and competence (the ability to execute)
- Offer (terms and conditions)
- Legal intent
- Consideration (values exchanged)
- Mutual agreement
Without a formal contract comprising all its basic contract elements, it will be difficult (if not impossible) to demonstrate to the law that your agreement existed or your rights were breached.
As a result, signing a contract is critical. But, selecting the right type of contract is also an essential step in making things work. Therefore, let’s go over the most prevalent contract types in business.
Types of contracts
The type of contract being used in an agreement can refer to the document’s structure, details of compensation, requirements to be legally enforceable, or the associated risks. The contracts listed below are not all comparable to one another and can’t all be used interchangeably.
As promised, here is a complete list of every type of contract you could ever encounter.
Fixed-price contracts, also known as lump sum contracts, are used in situations where the payment doesn’t depend on the resources used or time expended. With fixed-price contracts, sellers will estimate the total allowable costs of labor and materials and perform the action specified by the contract regardless of the actual cost. Because of this, the fixed price presented in the contract usually includes some wiggle room in case unexpected costs occur.
The seller assumes a certain amount of risk using a fixed-price contract, so some will decide to present a range of prices instead of one dollar.
These types of contracts typically include benefits for early termination (meaning the duties were fulfilled) and penalties for missing deadlines. This common practice ensures that the agreement, performance of an action, or whatever the contract’s subject matter, is timely.
When entering a deal that uses a fixed-price contract, be prepared for the contract creation and approval process to take longer than usual. To ensure they account for all time and resources accurately, sellers will be extra careful in determining the price.
Fixed-price contracts are most commonly used for construction contracts. Contractors will decide to use a fixed-price contract because the simplicity can result in buyers paying a higher price upfront to avoid the hassle of tallying up the actual cost. However, that initial estimate can be hard to reach accurately.
A cost-reimbursement contract determines the final total cost when the project is completed or at another predetermined date within the contract’s time frame. Before the project is started, the contractor will create an estimated cost to give the buyer an idea of the budget. They will then provide payment for the incurred costs to the extent described in the contract.
Setting this expectation with cost-reimbursement contracts is to establish a ceiling price that the contractor shouldn’t exceed without the buyer’s approval. At the same time, if that ceiling is reached, the contractor can stop work.
Also used for construction projects, a cost-plus contract is a type of cost-reimbursement contract for situations where the buyer agrees to pay the actual cost of the entire project, including labor, materials, and any unexpected expenses.
The word “plus” refers to the fee that covers the contractor’s profits and overhead. In these agreements, the buyer agrees to pay that extra amount and expects the contractor to deliver on their promise.
There are four types of cost-plus contracts, and each one describes how the contractor is reimbursed to earn a profit:
- Cost-plus award fee contract: the contractor is awarded for exemplary performance
- Cost-plus fixed fee contract: the contractor is reimbursed with a predetermined amount
- Cost-plus incentive fee contract: the contractor is only given a reward if they exceed expectations
- Cost-plus percent-of-cost contract: the contractor’s reimbursement is a percentage of the actual total cost of the project
When using a cost-plus contract, the buyer can usually see the entire list of expenses to know what they’re paying for. They will also typically include a maximum price to know the most expensive-case scenario.
Contractors will use cost-plus contracts if the parties don’t have much wiggle room in the budget or if the entire project’s cost can’t be appropriately estimated beforehand. Some of these cost-plus contracts might limit the amount of reimbursement, so if the contractor makes an error or acts negligently, the buyer won’t have to pay for their mistakes.
Contractors will decide to use cost-plus contracts because they can make changes throughout the project, and the buyer gets the exact value they paid for. However, it can be frustrating to have the final price up in the air, and getting that number requires extensive attention to detail.
Time and materials contract
A time and materials contract is like a cost-plus contract, but a little more straightforward. In these deals, the buyer pays the contractor for the time spent to complete the project and the materials used in the process.
Time and materials contracts are also used in situations where it’s not possible to estimate the size of the project or if the requirements for completion are expected to change.
As a buyer, your money will be put toward the material costs and the rate you pay the workers for their time. At the start of the process, you will likely have to come to a mutual agreement on the price of materials, including a markup rate and hourly rates for labor.
Time and material contracts require logging everything happening on the work site, most notably the hours and materials used. Paying close attention to those details will help the contractor and buyer develop the most accurate estimate of the total cost.
Contractors will use time and materials contracts because it simplifies the negotiation process and it’s easy to adjust if the requirements of the project change. A downside is that tracking time and managing materials is tedious work.
Unit price contract
With a unit price contract, the total price is based on the individual units that comprise the entire project. When using this type of contract, the contractor will present the buyer with specific prices for each segment of the overall project, and then they will agree to pay them for the number of units needed to complete it.
The word “unit” in these contracts can refer to time, materials, or a combination of both. While the parties can estimate or make guesses, the actual number of units typically can’t be specified at the beginning of the project.
Say you are making a deal with someone to repave your driveway. It’s hard to tell exactly how much cement you’ll need, but the contractor says it costs $1,000 for each truckload of supplies and associated labor. So to redo your entire driveway, you must agree to pay $1,000 per unit. And if it took three units to complete the entire project, you would have to pay the contractor $3,000.
Unit price agreements make for easy-to-understand contracts, but on the side of the contractor, it can be easy for buyers to compare prices with their competitors and cause them to lose some business.
A bilateral contract is one in which both parties exchange promises to perform a particular action. The promise of one party acts as the consideration for the promise of the other and vice versa.
With bilateral contracts, both parties assume the role of obligor and obligee, meaning they have contractual duties to perform and expect something of value.
Bilateral contracts are most commonly used in sales deals, where one party promises to deliver a solution, and the other promises to pay for it. There is a reciprocal relationship here as the obligation to pay for a solution is correlated with the obligation to deliver the solution. If the buyer doesn’t pay or the seller doesn’t deliver, a breach of contract has occurred.
The key element of bilateral contracts is exchanging something of value for another item of value, known as consideration. If only one party offers something of value, this is a unilateral contract.
Unilateral contracts are agreements where a party promises to pay another after they have performed a specified act. These types of contracts are most often used when the offeror has an open request that someone can respond to, fulfill the act, and then receive the payment.
Unilateral contracts are legally binding, but legal issues usually don’t come up until the offeree claims they are eligible for money tied to specific actions they’ve performed and the offeror refuses to pay the offered amount. Courts will decide whether or not the contract was breached depending on how clear the contract terms were and if the offeree can prove they are eligible for payment based on the facts in the agreement.
Examples of situations where unilateral contracts are used include open requests where anyone can respond to a request, and in the case of insurance policies. In those contracts, the insurer promises to pay if something occurs that was included in the term of the contract. So essentially, the insurance company pays the client if they are covered for the situation they encountered.
An implied contract is an agreement based on the involved parties’ actions. Implied contracts are not written down and might not even be spoken. The agreement ensures the parties take the designated action to kickstart the contracts.
An example of an implied contract is a warranty on a product. Once you buy a product, a warranty goes into effect that it should work as expected and presented. This contract is implied because it went into effect when someone took a particular action (buying a product), which might not have been written down anywhere.
There are two different types of implied contracts:
- Implied-in-fact: contracts that create an obligation between two parties based on the situation’s circumstances.
- Implied-in-law: contracts where the law imposes a responsibility on someone to uphold their end of an agreement.
An express contract is a category of contracts entirely. In these types of agreements, the exchange of promises includes both parties agreeing to be bound by the terms of the contract orally, in writing, or a combination of both.
Express contracts are often known to be the opposite of an implied contract, which, as a refresher, starts an agreement based on the actions of the parties involved. With express contracts, all terms, conditions, and details of the agreement are expressed (get it?) by writing them down, saying them out loud, or both.
Comparing two types of contracts often means that the parties involved in the agreement can decide which one to use. This is not the case for express and implied contracts. The nature of the agreement determines that for you.
A simple contract is made orally or in writing that requires consideration to be valid. Again, consideration is the exchange of one thing for another and can be anything of value, including time, money, or an item.
Simple contracts are the opposite of contracts under seal, which do not require any consideration and have the seal of the signer included, meaning they have to be in writing. These contracts are officially executed once signed, sealed, and delivered.
While simple contracts require consideration, they don’t have to be express contracts to be legally binding. The agreement is a simple contract that can be implied as well.
An unconscionable contract refers to an agreement that is so obviously one-sided and unfair to one of the parties involved that it can’t be enforceable by law. The court will likely deem it void if a lawsuit regarding an unconscionable contract is filed. No damages are paid, but the parties are relieved of their contractual obligations.
There are a few things that make a contract unconscionable:
- Undue influence: when one party puts unreasonable pressure on another or to enter a contract, or when someone takes advantage of the other party to get them to enter a contract
- Duress: when one party threatens another to get them to enter a contract
- Unequal bargaining power: when one party has an unfair advantage over the other party, especially when one of the parties doesn’t fully understand the contract terms
- Unfair surprise: when the party who wrote the contract included an element within it that was not in the original agreement or expected by the other party
- Limiting warranty: when one party tries to limit their liability in the event of a breach of contract
If one or multiple events occur when making an agreement, the contract is null and void, and neither party is responsible for their end of the deal.
An adhesion contract, also known as a standard form contract, is sort of a “take it or leave it” situation. In these agreements, one party typically has more bargaining power than the other. When the offeror presents the contract, the offeree has little to no power to negotiate the terms and conditions included. This is contrasted with situations where the offeree can return a counteroffer to the original offeror in hopes of starting negotiations and reaching an agreement they both find suitable.
This lack of negotiation isn’t done with bad intentions. In the case of adhesion contracts, the offeror is typically someone who offers the same standard terms and conditions to all of their offerees. Every contract is identical.
For example, if you were buying insurance, the agent would draw up the contract as they do with every other client, and you would either accept or deny the terms. It’s not likely you’ll be able to negotiate a new contract that you prefer more.
Adhesion contracts must be presented as take it or leave it to be enforceable. Because if one party holds more bargaining power in any other situation, that could be seen as an unconscionable contract. It’s easy for that line to be blurred, causing adhesion contracts to be scrutinized often.
Aleatory contracts explain agreements where parties don’t have to perform their designated action until a triggering event occurs. Essentially, aleatory contracts state that if something happens, then action is taken.
Again, this type of contract is typically used in insurance policies. For example, your provider doesn’t have to pay you until something happens, like a fire that causes damage to your property.
The events that demand action described in an aleatory contract can’t be controlled by either party. Risk assessment is vital in creating aleatory contracts so both parties know the likelihood of that event occurring.
How to choose the right type of contract
Different types of contracts serve different purposes. You will need to take a call on what fits your purpose the most. Below are a few aspects you can consider before creating and signing a contract.
- Price and cost comparison. You must perform calculations to see how profitable the transaction would be. Will this contract type offer you the best pricing and payment options? Is there a better alternative that allows you to pay less while receiving more?
- Contractor analysis. Is the other party reliable? What is the likelihood that your project will be completed on time? Do they have the essential skills to carry out your request? Can you anticipate legal issues? Make sure that the contract you select protects your rights and is enforceable.
- Complexity of the requirements. Consider using many contract types if the conditions are incredibly complex with difficult-to-estimate consequences. This is typical of government and research initiatives.
- Uregency of the requirements. You may pick a riskier agreement immediately if you want anything from the other party. But, avoid entering into an unconscionable contract.
- Project time frame. You need to be aware of how long the whole thing will last. If the contract takes several years to complete, you must carefully assess the market and account for potentially substantial changes.
Be ready for anything
Your business might not encounter every one of those contract types, but it’s your responsibility to be prepared for any that might come your way. After reviewing all those examples, familiarize yourself with the contracts your business will likely encounter. An extra layer of preparedness never hurt.
Compliance can take many forms with all the different types of contracts. Look at these seven tips for contract compliance that will keep you in line no matter the circumstances.
This article was originally published in 2020. The content has been updated with new information.