Legal Considerations for the Creation of a Two-Person Entity

With thousands of corporate formations under our belt, one of the trickiest issues we see is the creation of two-person entities. Of course, this situation does not have to be tricky – it’s simply a matter of anticipating any potential issues from the start. If you’re considering creating a two-person entity or already have one and want to bolster protection for both partners, ensure the smooth functioning of the business today, and address potential future challenges, this article may be helpful. We’ll delve into the key legal considerations when forming a two-person entity and highlight how JonesSpross can assist throughout the process, from formation to exit strategy.

Covering The 4 Ds (death, disability, divorce (spouses), divorce (entity partners)

Planning for unforeseen events such as death, disability, or divorce is vital for the continuity of a two-person entity. A proactive plan should be established to safeguard both partners’ interests. In the event of a partner’s death, a buy-sell agreement can be implemented, ensuring the surviving partner can purchase the deceased partner’s interest. This agreement can outline the valuation method and funding mechanisms, such as life insurance or installment payments, to facilitate a smooth ownership transition.

Similarly, addressing disability provisions is crucial to ensure the business can continue if one partner becomes incapacitated. This may involve appointing a proxy to make decisions on behalf of the disabled partner or implementing a disability buyout plan that allows the other partner to purchase the disabled partner’s interest. Clearly defining the triggering events, valuation, and terms in the partnership agreement are essential to mitigate potential conflicts and disruptions.

When the owners of a two-person entity are married, and a divorce occurs, it is essential to address the potential implications for the business. No one wants to be partners with their partner’s ex-spouse. This situation must be handled by the divorcing spouse acquiring the interest or the other partner being able to acquire the interest from the ex-spouse.

More about the fourth "D"- Divorce between partners

Divorce can significantly impact the stability and continuity of the entity, making it crucial to have a plan in place. JonesSpross recommends the “nuclear option” or “push-pull” mechanism to address this concern.

Under this mechanism, one partner offers to buy the other partner’s interest or sell their interest at a predetermined price. The non-offering partner then has the choice to accept the offer and sell their interest at the specified price or buy the offering partner’s interest at the designated price. This mechanism ensures that a fair resolution is reached and the decision is final and binding, minimizing the potential for protracted legal battles or business disruptions.

Decision-making processes

Establishing a clear framework for decision-making is vital to avoid deadlock situations within a two-person entity. While minor decisions may be resolved through consensus or a simple voting process, meaningful choices can be more challenging. When a tie in voting occurs on non-critical matters, resorting to a method like a coin flip may be a practical solution to break the deadlock.

A more comprehensive approach is required for significant decisions, such as selling the company, raising substantial funds, or borrowing above a predetermined threshold. Each partner can appoint a trusted business advisor representing their interests. If selected advisors cannot reach an agreement, involving a neutral third advisor whose decision holds majority weight can help resolve the impasse. This approach ensures that important decisions are made with careful consideration and a balanced approach.

Below is a sample provision that could be used.

Notwithstanding anything to the contrary contained in this Agreement, in the event Principal #1 and Principal #2 are the sole owners and Principal #1 and Principal #2 cannot agree on a course of action that is to be determined by the Members, upon mutual agreement, Principal #1 and Principal #2 agree to flip a coin to decide how to proceed. In the event Principal #1 and Principal #2 do not mutually agree to flip a coin, Principal #1 shall choose one independent business person, and Principal #2 shall choose a second independent business person. The two business persons so chosen shall appoint a third person who shall cast the deciding vote on the issue giving rise to the deadlock.

Additional issues to proactively address

In addition to the considerations above, several other significant legal issues should be considered when creating a two-person entity. These include establishing roles and responsibilities for each partner, determining profit-sharing and compensation arrangements, defining ownership percentages, and outlining the process for admitting new partners or transferring ownership.

Identifying each partner’s roles and responsibilities can mitigate potential conflicts and misconceptions. Determining fair profit-sharing and compensation arrangements ensures transparency and equity in the partnership. Defining ownership percentages clarifies each partner’s stake in the business and their decision-making authority. Explaining the process for admitting new partners or transferring ownership provides a structured approach to handling changes.

JonesSpross Formation, Compliance, and Financing Services

JonesSpross specializes in providing comprehensive legal support for two-person entities of all sizes, from inception to exit strategy. With our expertise and experience, we can guide partners through establishing a solid legal framework, including addressing the 3 Ds, decision-making processes, divorce considerations, and other significant legal issues. By ensuring the partnership agreement and related documents are meticulously drafted, JonesSpross helps create a strong foundation for the two-person entity, enabling partners to focus on their business goals while minimizing legal risks. Whether it is navigating challenges or planning for the future, JonesSpross is a trusted partner for two-person entities, providing the necessary legal expertise every step of the way.

JonesSpross on two-person entities

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