Entity-Purchase Agreement

What Is an Entity-Purchase Agreement?

An entity-purchase agreement is a type of business succession plan used by companies with more than one owner. The plan usually involves the company taking out an insurance policy on each partner in an amount equal to the value of their stake. Should an owner die or become incapacitated, the sum collected from the insurance is then used to buy out their share of the business.

When the entity in question is a corporation, an entity-purchase agreement may be referred to as a stock redemption agreement, a corporate purchase agreement, or an entity redemption agreement. In the case of a partnership, the entity-purchase agreement might be called a partnership liquidation plan.

Understanding an Entity-Purchase Agreement

An entity-purchase agreement is one form of a buy and sell agreement: a legally binding contract commonly used by sole proprietorships, partnerships, and closed corporations that stipulates how a partner's share of a business may be reassigned if that partner dies or otherwise leaves the business.

In the case of an entity-purchase agreement, each owner must first consent to sell their interest in the business under a specified circumstance. If possible, insurance policies are then taken out on each of them, with the company acting as the beneficiary and paying all the premiums. Should one of the owners die, the company can file a claim and use the payout from this event to buy the deceased individual's share of the business from that person's estate.

Once the contract is signed, there's no getting out of it. An entity-purchase agreement legally obliges the company to buy the deceased person's share of the business from their heirs, as well as obligating the estate to sell it back to the company. That means it is not possible to keep the inherited interest or sell it to another party. The agreement also establishes the price to be paid either based on a fixed amount or a formula.

Important

In successful businesses, additional insurance would be purchased as the value of the company continued to increase.

Death isn’t the only event that can trigger a reassignment of ownership interest. Some entity-purchase agreements may specify other occurrences that qualify, including when an owner has a long-term disability, retires, gets divorced, goes bankrupt, is fired, loses their professional license, or is convicted of a crime. Not all of these scenarios are insurable, meaning that funding for a buyout will sometimes need to be secured in another way.

Entity-Purchase Agreement vs. Cross-Purchase Agreement

The other most common form of a buy and sell agreement is a cross-purchase agreement, though it is not like an entity-purchase agreement, where the business purchases one insurance policy for each owner. Under a cross-purchase agreement, each owner is required to purchase a policy on behalf of every other owner. 

Occasionally, partners might opt for a mix of the two, with some portions available for purchase by individual partners and the remainder bought by the company.

Benefits of an Entity-Purchase Agreement

The advantage of an entity-purchase agreement-based succession plan is that the owners know their respective stakes in the company will be paid out to their estates, and that the business will continue to be run by the other partners, ensuring a smooth transition.

Having this type of succession plan, which is paid for by the company, allows the owners to avoid any out-of-pocket expenses. It also limits the risk of a forced sale of assets and reassures owners that their families will be taken care of in the event of a death or any other unforeseen circumstance.