Contracts 101: What is a Contract, and How Does It Operate?


Contracts. Chances are everyone has signed some type of contract, whether it was an employment contract, a purchase agreement to buy a house, or a contract to buy a vehicle. And if you haven’t actually signed a contract, then it’s highly likely that you’ve made an oral contract with another person. In fact, contracts between parties are an everyday occurrence, and they are more common than the average person realizes.

Here, we will examine the basics of contracts—what they are, how they are formed, how they operate, and the 3-step formula for creating a legally binding contract.

Next, let’s see how a contract is formed.

Back to Basics: Definition and Formation

Simply put, a contract is a promise or a set of promises between two different parties. When such promises exist, the law recognizes each party’s performance as a duty, and failure to carry out your promise can result in the other party taking legal action against you.

There are really only two types of contracts: express contracts and implied contracts. Express contracts are formed by actual words, either spoken orally or written down on a piece of paper. An example of this would be an employment contract. As an employee, you may be required to read through a company policy or handbook and sign a paper stating that you’ll agree to abide by and uphold the rules set forth in those memoranda. On the other hand, implied contracts are contracts that are formed by the conduct of the parties. For example, if Aaron tells Beth that he’ll mow her lawn if she cooks him dinner, and Beth then cooks him dinner, Beth has accepted Aaron’s offer by taking action through her cooking.

So what’s the basic formula for the formation of a contract? Well, to those in the legal world, the 3-step formula is:

(1) Offer + (2) Acceptance + (3) Consideration = Contract (K)

Huh, you ask? Basically, a contract, (the symbol for a contract being the letter K), is an offer by one party, acceptance of the offer by the other party, and consideration for the deal. Still clueless? Let’s break these concepts down one-by-one.

Next, we’ll explore the first step in creating a contract.

Step 1: The Offer

First, the offer. An offer is some type of promise or commitment to enter into a contract that is communicated to the person you want to contract with. When you make an offer to a person, the terms of the offer must be so certain and definite that it creates a sense of expectation in the other person that you are truly looking to enter into a binding agreement. If your offer is wishy-washy or vague, it will likely not be enough to create a binding contract, even if it is communicated to the other party. Let’s use a hypothetical to illustrate the difference between definite and indefinite terms.

Let’s picture Amy and Bob, two neighbors in a suburban area. Amy approaches Bob and says that she’ll paint Bob’s house on Saturday at 9:00 a.m. and have it finished by 5:00 p.m. that evening, IF he will pay her $500 on that same day. This is an example of a clear and definite offer. If Bob accepts Amy’s offer, and she performs as she promised to do, he’ll be legally obligated to pay her $500 on Saturday.

Now, let’s picture Amy and Bob, but this time let’s say that Amy agrees to paint Bob’s house soon at a price between $300 and $500. This is not a valid offer because it is too indefinite. Amy has not listed an exact price, nor has she established a clear date for the performance. This is merely the potential beginning of negotiations between Amy and Bob. Legally, this is referred to as “preliminary negotiations” as between Amy and Bob because no actual offer has been made.

Next, we’ll tackle the second step in creating a contract.

Step 2: Acceptance

The concept of acceptance does not apply unless two things have happened. First, someone must have made an offer to another person that was definite and certain. Second, the offer must have been made and communicated to the person who is meant to accept the offer. In other words, once the offer has been made to the appropriate party, the power of acceptance has been created in that person, and they now have the right and ability to accept the offer if they so choose.

In order to accept an offer that is made to you, you must accept all of the terms that were stated in that specific offer. If you only choose to accept some of the terms, and even go so far as to suggest the addition, subtraction, or alteration of other terms, then you have now made a counteroffer to the person who made the original offer. Confused? Let’s back up and use an example to flesh this out.

Adam offers Betsy $400 if she’ll paint his house. If Betsy agrees to paint Adam’s house for $400, or if she begins painting his house, then she has accepted the offer. However, if Adam makes that same offer to Betsy, and she says that she will paint his house for $500, then Betsy did not accept the offer. Instead, Betsy made a counteroffer, and Adam can either accept or reject this suggestion.

Another important aspect of acceptance is the idea that, like the offer, it must be communicated to the person who made the offer. Generally speaking, acceptance of an offer can be done through any "medium reasonable in the circumstances" (U.C.C. §2-206). However, there is one major exception to this principle: if the person making the offer states that the offer must be accepted in a certain manner (e.g. through a signed letter in the mail), then that is how one must accept that particular offer.

One of the most common methods of acceptance (aside from just telling the person making the offer that you accept) is acceptance by mail. When one accepts an offer by mailing a letter to the person who made the offer, acceptance of that offer is effective when the letter is sent, provided that it was properly stamped and sent to the correct address. This is legally known as the "Mailbox Rule."

Lastly, let’s discuss the third step in forming a contract.

Step 3: Consideration

Consideration basically means that the parties to the contract have each bargained for something that has legal value. In other words, the parties have obtained something that is either beneficial to their positions or detrimental to their positions.

Let’s use a hypothetical to demonstrate this concept:

Rick promises to pay Kristi $1,000.00 if she quits smoking. Here, there is a bargain because Kristi quits smoking as a result of Rick promising to pay her a sum of money. Additionally, there is legal value in the contract because both Rick and Kristi incur a detriment. Once Kristi quits smoking, Rick must pay her $1,000.00. In other words, he is required to give up money that belongs to him. With regard to Kristi, she is incurring a detriment because she is legally entitled to smoke (assuming she is over eighteen years of age). By giving up something that she is legally entitled to do, she is incurring a legal detriment. In conclusion, there is a valid oral contract between Rick and Kristi, with a valid offer, acceptance of that offer, and valuable consideration.

Finally, let’s wrap up what we’ve talked about with a few key points to remember.


In conclusion, the rules underlying the formation and operation of contracts is fairly straightforward, and having a clear understanding of those rules will help you to better understand the significance of the documents you are signing and the agreements you are making.

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