What does liquidated damages refer to in a contract?

Liquidated damages refer to a predetermined amount set in a contract to be paid as compensation in the event of a breach. This amount is established at the time the contract is formed and is intended to provide certainty for both parties regarding the consequences of failing to meet their contractual obligations. The rationale behind liquidated damages is that it can be challenging to accurately assess actual damages resulting from a breach, so the parties agree upfront to a specific compensation that reflects a reasonable estimate of potential losses.

This concept helps prevent disputes over damages in the event of a breach, as it provides a clear expectation for both parties. Liquidated damages must be reasonable and not punitive; they should correspond to the estimated loss that a breach would likely cause. This makes it a practical tool for managing risk in contractual relationships.

In contrast, penalties for wrongful termination, conditions for contract renewal, and fees for contract modification do not align with the principles of liquidated damages, which specifically address compensation for breach rather than punitive measures or changes to the contract structure.