Glossary term
Entity-Purchase Agreement
An entity-purchase agreement is a buy-sell arrangement in which the business itself buys a departing owner’s interest.
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What Is an Entity-Purchase Agreement?
An entity-purchase agreement is a buy-sell arrangement in which the business itself buys a departing owner’s interest. It is also called a redemption agreement because the company redeems the ownership interest rather than having the remaining owners buy it directly.
The agreement is common in closely held corporations, partnerships, and LLCs that want a predictable ownership-transfer process after death, disability, retirement, termination, or another triggering event.
Key Takeaways
- An entity-purchase agreement has the company buy the departing owner’s interest.
- It differs from a cross-purchase agreement, where remaining owners buy directly.
- It can simplify funding because the business is the buyer.
- Tax basis, insurance ownership, creditor risk, and cash flow must be reviewed.
- The agreement should define triggers, valuation, payment terms, and funding.
How It Works
The owners and company agree in advance that the business will purchase an owner’s interest when a specified event occurs. The agreement sets the valuation method, timing, payment terms, and funding source. Funding may come from cash, installment notes, borrowing, insurance, or a combination.
For death-triggered agreements, the company may own life insurance on each owner and use the proceeds to buy the deceased owner’s interest from the estate. The remaining owners then indirectly own more of the company because the redeemed interest is retired or held by the entity according to the governing documents.
Entity Purchase Versus Cross Purchase
Feature | Entity purchase | Cross purchase |
|---|---|---|
Buyer | The business entity. | The remaining owners. |
Funding | Often centralized at the company. | Each owner may need funding. |
Administration | Can be simpler with many owners. | Can become complex with many owners. |
Tax basis | May differ from direct owner purchases. | Remaining owners may receive basis in purchased interests. |
Creditor exposure | Company-owned assets may face company creditor risk. | Owner-held assets may avoid entity creditor risk. |
Financial Consequences
Entity-purchase agreements can make succession more orderly. The company is the central buyer, so owners do not need separate purchase arrangements with every other owner. That can be attractive when there are several shareholders or when owners have unequal financial resources.
The tradeoffs are important. Company cash used for a buyout may reduce working capital. Insurance owned by the company may be exposed to business creditors. Tax treatment can differ from a cross-purchase agreement, especially for basis and entity classification.
What to Review
The agreement should be coordinated with the company’s operating agreement, shareholder agreement, loan covenants, insurance policies, estate plans, and tax planning. It should also include a valuation method that remains workable as the company grows or changes.
A stale valuation formula can become a major problem. Owners should revisit the agreement periodically rather than waiting until a death or dispute.
Estate and Family Liquidity
An entity-purchase agreement can be especially important when an owner’s family is not involved in the business. The agreement can give the estate a buyer for an illiquid ownership interest while letting the company continue under the remaining owners’ control.
The liquidity promise is only as strong as the funding plan. If the business lacks cash, insurance, or borrowing capacity, the estate may receive a note or delayed payments when it expected immediate liquidity.
Lender consent can also matter. A company buyout may violate loan covenants, reduce liquidity, or require approval before cash leaves the business. The buy-sell agreement should be coordinated with financing documents rather than reviewed in isolation.
Entity purchases can also shift ownership percentages automatically. Once the departing interest is redeemed, the remaining owners may own larger relative shares without writing personal checks, which can be useful but should be understood in advance.
The Bottom Line
An entity-purchase agreement lets the business buy a departing owner’s interest. It can simplify business succession, but funding, tax, creditor, valuation, and governance issues must be handled carefully.