How to Structure an Early Termination Fee in a Contract

Jeff Storch | 04.11.25

When entering a contract with another party, you may wish to include a mechanism to ensure you receive appropriate compensation if the other party wants to terminate it early. It’s important to remember that although a contract may impose a fee for early termination, the fee should not be structured or referred to as a ​“penalty.” Contract law is designed to ensure each party gets the benefit of the agreement — whether measured by anticipated profit, value received, or another reasonable measure. A bald ​“penalty” generally is not enforceable. 

That is, if you set a monetary charge for early termination, the amount should not be punitive (a penalty) but instead compensate you for your lost reasonable expectations. Lost reasonable expectations might include things like lost profit, lost opportunity cost (for example, turning down a different contract to take this one), or costs incurred in the early termination (for example, switching employees to a new project before you planned).

If you cannot easily determine these costs, you could agree ahead of time to a ​“liquidated damages” payment. (Practically, paying ​“liquidated damages” versus a ​“penalty” might not sound like much of a difference, but the terminology matters under contract law.) This could be set using a percentage of the original contract or a per period fee. It should not be designed to be more than what you would have received (net profit) if the contract had continued to completion, as anything more than that could be interpreted as a penalty.

To start, you could determine your net profit over the life of the contract and divide that by the number of weeks in the profit. That gives you roughly what each week is worth — so for example, if the other party terminates 10 weeks early, the early termination fee could be up to 10 times one week’s profit.

But that is a very simplistic way of calculating. There may be immediate costs to you at the start of the contract that you want to recover and that are not even over time. And your actual transition costs to a new project might be different (for example, if the cost of materials or labor increases after the contract started). How closely you want to examine your costs and profits are up to you, but again you should be comfortable that any number or formula you choose is a reasonable forecast of damages and not a penalty.

Therefore, before including an early termination fee in your contracts, you should calculate what is reasonable and discuss it with your accountant and attorney.

• Contracts