Consideration

What does Consideration mean?

Consideration in finance is the value that is exchanged in a transaction that can be in the form of goods, money, services, and other forms of value.

Consideration is a key element of a contract and is required to be present in a contract for it to be considered valid. 

When parties enter a contract, there is generally some exchange. This exchange is between two different parties, offering something of value to the other party.

It is a legal term in contract law used to represent a transaction between two parties, with each party giving up something of value. It is probably an essential element of a contract because it is often the part people forget about when entering it.

Usually, it’s an exchange of a good or service for money, but it doesn’t always have to be this way. 

A common method to see whether this specific exchange is present in a contract is through the benefit/detriment analysis. Each party should receive a benefit through the contact while also giving up something that causes somewhat of a detriment. 

Valid examples:

• Money
• Services
• Property
• Forbearance (Giving up something you have a legal right to do)

Non-valid examples:

• Gifts
• Love and affection
• Illusory promise
• Pre-existing obligations

According to contract law, a valid contract is an agreement between two competent parties based on the genuine consent of the parties. This agreement is supported by consideration and is made for a lawful objective. Some contracts must be written too.

If a contract offer is missing any of these parts, it will not be binding. 

In finance, contract law and the elements of a contract are important for mergers & acquisitions. 

Understanding Consideration

There are two types of contracts:

• A bilateral contract.
• A unilateral contract.

A bilateral contract is when two parties each promise to carry out an act of something in exchange for something else. It is the most common of the two. 

A unilateral contract is different from a bilateral contract in that it is one-sided. The performing party is free to decide whether or not to fulfill the requested service. On the other hand, the offering party is bound by law to compensate if the request is fulfilled.

So, the person offering the money (or whatever the reward is) has to pay regardless of who accepts the agreement as long as they complete the requirements.

On the other hand, the party that takes the action is not required or bound by law to enter into the contract.   

In the unilateral contract situation, two parties are still exchanging something of value. 

There is a consideration for both contracts:

• Unilateral Contract: The performance or service rendered and the promise of a reward.
• Bilateral Contract: The exchange between the two parties.

Valid vs. non-valid example

In financial transactions, consideration is referred to the price paid to acquire something. Below we discuss some valid and non-valid example of the consideration.

Valid Example

Imagine you and your brother are entering into a contract. Your brother is a nicotine addict, and you have been trying to get him to quit for years. 

Finally, one day he agreed on a deal. If you pay off his college debt, he will give up smoking. As odd as this may sound that one is giving up his right to a legal activity, it is entirely legal.

This is called forbearance and is considered to be valid in a contract. So if your brother breaks the contract and continues to smoke cigarettes, it would be considered a breach of contract. As a result, you could receive your money back or even compensation for damages. 

Non-Valid Example

Now for this example, imagine you are contracting with a neighbor. For some reason, you and your neighbor despise each other and never get along. 

Your neighbor has been vandalizing your yard for the last month or two. Instead of contacting the police, you go to your neighbor's house and make a deal.

You agree to do your neighbor's landscaping work for free if he stops vandalizing your yard. Now, this is not a valid contract.

Your neighbor not vandalizing your yard would be considered a moral obligation. That means if you don't follow through with this agreement, there is nothing he can do about it legally. 

Misconceptions Around Consideration

It is a confusing subject and is why many contracts end up voidable. However, conducting business in today's economy would be extremely hard without legally enforceable contracts. 

That's why It's important to have a firm grasp on the subject before entering into a contractual agreement, especially for business owners. 

Well-drafted contracts can make the situation less stressful and avoid fewer headaches in the future. You won't have to worry about the other party not fulfilling their obligations, as it is legally required that they do so. 

It's important to remember that in most cases, the court won't enforce its opinion about the contract being made. They will make sure that an exchange is present and lawful, but that's only in most cases. 

Sometimes, the exchange is so lopsided that the court may intervene and void the contract. In other cases, the exchange won't be considered valid because of other circumstances. 

To protect yourself in a contract, you must be aware of some of the most common misconceptions about consideration. A solid understanding can protect you and your business in the future.

These misconceptions are:

Fairness 

A court will usually not impose its opinions on whether the value of the goods or services is considered "fair." 

Only in extreme circumstances where it "shocks the conscience" of the court does the court impose its opinion and rule the contract not valid. Usually, there needs to be some exchange with things of value to be valid.

For example, imagine you have a contract with your friend where you agree to give one of your video game controllers to your friend in exchange for your friend's highly expensive baseball card collection. Regardless of how unfair this deal looks, if all the aspects of a valid contract are in place, this contract will be legally binding. 

It doesn't matter how unfair the contract may look to anyone if the two parties agree it's a deal they want to make. 

Even if there is a valid exchange, other aspects of the contract still need to be correct. Some people make a big mistake, for example, contracting with a minor. Most of the time, contracting with a minor can lead to a voidable contract.

This can hurt the party of age:

For example, an automobile dealership is contracting with a minor for a car. The minor drives off the lot with the car and comes back a week later. The car is totaled, and the minor demands his money back. Since the minor was one of the parties to the contract, the contract is now avoidable.

In some states, the minor may not be required to pay for the car's damage and may receive his or her money back.

Nominal Consideration

It refers to when one party is contracting with another party, and one party's goods or services don't have any value in relation to what the other party is offering. 

Since courts usually don't express opinions about fairness, it is generally accepted in a business setting, including an option contract or a compromise contract. 

This type of deal can be useful for people who want to hide details of the transaction from the public. 

An example would be one party exchanging $7,500 for another party's pen. Since both parties are offering something of value, even if the value of the pen isn't remotely close to the value of the money, it is enforceable.

If there was no pen in the agreement and the party promised to gift the other party $7,500, then that would not be considered a valid contract because there is no exchange between two parties with a gift. 

Pre-existing Legal Duty

Whatever is written in the contract (or said in a verbal contract) applies. For example, if one part raises the contract's price halfway through completion, a new contract would be required. 

Once a contract is entered into, each party has a legal duty to fulfill its obligation, so each party must act on what it agreed to do.

So, if one party already has a pre-existing duty to perform the action, it can't be considered. Instead, some new aspect needs to be introduced from the party with the pre-existing obligation. 

For example, imagine a business and contracts with Jerry for specific parts needed for operations. They have been in the contract for a while and still have a couple of years left. 

Due to inflation, the price of the materials has been rising, and the contract is no longer a good deal for Jerry. However, due to their good relationship with each other, Tom decides he will pay Jerry more for the materials to make him a happy business partner. 

So the two write a new contract and only change how much Tom will pay for the materials. Since Jerry already has a legal obligation to provide Tom with the materials at a price listed in the previous contract, the new contract is not valid. 

For the contract to be valid, both parties must devise a way to avoid having Tom's pre-existing duty as a clause. 

What If It Seems Disproportionate?

Courts usually don't offer an opinion on the fairness of an exchange. Therefore, the contract is usually fine as long as both parties offer a valid exchange of goods and services. 

The only time the courts intervene is when the situation "shocks the conscience" of the court.

This means that the value of the exchange is so lopsided that it is considered bad faith. In addition, the exchange is extremely disproportionate to the point where it indicates that one party acted unfairly or hid information that could be used to make the deal fairer. 

If a court rules this way, the contract will likely not be enforceable. 

This only happens in extreme circumstances. The court wants to avoid subjectivity in distributing justice. Most importantly, the court will not get involved and include their opinion about the deal's equity. After all, different people place different values on items.  

Do You Need To Include The Word "Consideration" In The Contract?

Generally, contracts include a statement at the beginning of the contract (a recital) stating that the contract is being entered into "for good and valuable consideration, the sufficiency of which is acknowledged" or something along those lines. 

Many writers mistakenly think this is all they need to do. In most states, this is not true. The statement doesn't satisfy anything and won't constitute a valid contract. Just by saying the contract includes consideration doesn't mean it is present in the contract. 

The consensus among legal scholars is that a contract generally doesn't need to include anything else besides a statement that "the parties agree." Of course, there are exceptions to this rule, such as in the case of unilateral contracts.

In these contracts, a recital (along the lines of what's discussed above) should be included because it's not self-evident that a bargained-for deal has occurred.

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