When entering into contracts—whether for a business transaction, an employment arrangement, or a settlement involving personal or professional disputes—it is important to anticipate what happens if one party breaches the agreement. One common tool used to address potential breaches is a liquidated damages provision that provides for a specific amount of damages or a formula to calculate damages. But not all liquidated damages clauses are enforced, depending on the circumstances. Courts enforce or strike down these provisions depending on how they are drafted and whether they reflect the real risks involved.

Here’s what every business owner, executive, and professional should know:

What Are Liquidated Damages?

Liquidated damages are a sum of money agreed upon by the parties to be considered damages in the event of a breach of the contract at the time the contract is signed. Theses liquidated damages are meant to compensate a party mostly when calculating actual damages later would be difficult or complicated. In short: they are a way to put a clear, enforceable dollar figure on a potential breach before it happens. The idea is to avoid messy disputes later by setting expectations upfront.

For example, a consulting firm and a consultant might agree that if the consultant solicits the firm’s clients after leaving the firm in breach of a non-solicitation agreement, then the consultant owes $50,000 in damages or a sum equal to two times net revenue from that client for the prior two years, or some other formula based on past data.

When Are Liquidated Damages Valid?

Courts will enforce a liquidated damages provision if:

The amount was a reasonable estimate of the probable loss at the time of contract signing
The actual loss would have been difficult to quantify precisely at that time
The amount is not grossly disproportionate to the anticipated harm

For instance, a non-solicitation agreement that anticipates lost profits from a former employee soliciting clients may be upheld if it reflects a realistic projection of what the employer could lose by that employee taking clients away.

Similarly, in contracts between sophisticated parties, such as stock-purchase agreements or business sales, courts are more likely to defer to a liquidated damages provision that was the product of arm’s-length negotiation with the advice of counsel.

When Are Liquidated Damages Invalid?

Courts will strike down a liquidated damages clause if:

The damages could have been readily calculated at the time of the contract
The fixed amount is grossly disproportionate to any probable or actual loss
The clause is in effect a penalty, intended more to punish the breaching party than to compensate the non-breaching party

For example, a city government contract that imposed a penalty of 125% of any shortfall in minority hiring goals would be found invalid because the city could not tie that amount to any measurable loss due to breach of contract. Rather, that sum is simply a punitive penalty. Arbitrary or punitive amounts—especially if they seem designed to compel performance through fear rather than compensate a loss—will not survive judicial scrutiny. They get struck down.

What Happens If Liquidated Damages Are Not Permitted?

When liquidated damages clauses are invalid, struck down, or found unenforceable by a court, then the parties have to revert to common damages analysis and calculations. Such analysis typically requires an assessment of what harm the non-breaching party actually suffered due to the breaching party’s actions. This is because the general purpose of breach of contract damages is to make the non-breaching party whole. In other words, one must consider what damages did the non-breaching party suffer due to the breach and how those damages can be proven.

When Are Liquidated Damages Permissible?

Liquidated damages are generally permissible in:

Business contracts (consulting agreements, stock purchase deals, joint ventures)
Employment agreements (particularly concerning non-compete and non-solicitation clauses)
Settlement agreements (although with important exceptions relating to employees)

Settlement agreements with employees have other laws and regulations that may apply. Liquidated damages tied to nondisclosure or non-disparagement clauses in settlements of employment discrimination or harassment claims, for example, are often prohibited by law in some states and under federal regulations by the National Labor Relations Board (“NLRB”). In New York, such clauses are not enforceable if they penalize a party for speaking out after settling discrimination or harassment claims and in certain circumstances, NLRB regulations prohibit negative comments about the work environment under the National Labor Relations Act.

Other Key Considerations

Per breach or per occurrence. Liquidated damages can be structured to apply separately to each breach if clearly stated in the contract. For example, $1,000 per day for a delay in performance.
Sophistication matters. Courts give more weight to liquidated damages clauses negotiated between sophisticated parties, especially when both sides had legal counsel.
Label does not matter. Calling a provision “liquidated damages” will not save it if it operates as a penalty. Stating that the damages provisions is acknowledged by all parties not to be punitive or a penalty similarly will not make an otherwise invalid liquidated damages clause valid. Courts look at substance over form.
Mitigation not required. If the clause is valid, the non-breaching party typically does not have to prove they tried to minimize their damages.

Why It Matters for Business and Professional Clients

For businesses, executives, and professionals involved in complex transactions or sensitive settlements, a well-drafted liquidated damages clause can provide predictability and protect against uncertainty. A poorly drafted or excessive clause can expose a party to unnecessary litigation—and sometimes wipe out the entire protection intended. Having knowledgeable counsel who understands how to structure enforceable liquidated damages provisions from the start can make all the difference and avoid headaches later on.

When it comes to litigating these clauses, we have been on both sides. We have had to enforce them for non-breaching parties; and we have had to articulate for the breaching party why the liquidated damages clause was actually an unenforceable penalty. We know the strategies on both sides and can assist you if you find yourself at odds over a liquidated damages provision.

We can help you in Albany, Buffalo, Rochester, New York City, and everywhere in between.

You may learn more about us and how we operate by visiting these pages: About Us and What Sets Us Apart.

To learn more about these topics, check out our Legalities & Realities® Podcast and other related blog posts:

The Glennon Guides: Am I Stuck In This Practice?: A Guide On Non-Compete Agreements For Doctors, Nurses, Dentists, And Other Health Care Providers

This blog post is for informational purposes only and does not constitute legal advice. For specific legal counsel, please contact our office directly.