Entity Purchase Agreement - All You Need to Know

Imagine growing a business on your own or with a team of co-owners only to lose ownership after a significant life-changing event happens to you or a co-owner.

But what if you could put a plan in place to ensure the business survives beyond your ownership, with little to no infiltration from an external buyer?

In today's guide, we explore how you can use an entity purchase agreement as a clear exit strategy to ensure your business continues beyond your ownership with minimal or no intake of new owners.

While entity purchase agreements can be easier than other types of buy-sell agreements, you would still need the help of qualified M&A experts to secure its success.

At Exitwise, we connect you with top industry-specific M&A experts such as advisors, investment bankers, tax accountants, wealth advisors, and attorneys.

These experts can help you streamline the entire M&A process and maximize the sale outcome. Reach out to us today to optimize the benefits of an entity purchase agreement.

What is an Entity Purchase Agreement?

An entity purchase agreement is a legally binding agreement entered by business co-owners outlining the terms and conditions for selling an owner's interest in the business to the business entity itself after a life-changing event occurs.

Technically, an entity purchase plan is a business succession plan or exit strategy that shows how ownership will be restructured after a co-owner leaves through death or other life events. 

It is one of the four major types of buy-sell agreements.

Here are some key attributes of an entity purchase agreement:

• The plan is used for succession in businesses with more than one owner. 

• When an owner dies or leaves the business after a life-changing event, the business buys back the departed owner's business interests.

• The plan can have different names depending on the type of business: 

  • If the business is a corporation, it can be called a stock redemption plan, corporate purchase agreement, or entity redemption agreement. 

  • In a partnership, the agreement can be called a partnership liquidation plan. 

How Does an Entity Purchase Agreement Work?

Let's see how an entity purchase plan works:

• The business itself acts as a buyer, acquiring the ownership interest of a departing owner. 

• The business funds an entity purchase agreement by taking out separate life insurance policies on each co-owner's life. 

• In doing so, the business acts as the policy applicant, owner, premium payer, and beneficiary. 

• When a co-owner dies, the business entity uses the death proceeds from the insurance to buy the co-owner’s interest in the business. 

• Essentially, the business entity buys the departed co-owner's interest in the business from the co-owner's heirs or estate, compensating them fairly as set out in the terms. 

Note: There can be other life-changing events apart from death, such as divorce, being convicted of a crime, leaving the business voluntarily, retirement, being fired, losing a professional license, or bankruptcy. 

Since it's not easy to insure in some situations, the business entity has to secure funding for the purchase through other means. 

Importance of Entity Purchase Agreements in Business Succession

As mentioned, an entity purchase agreement is a key business ownership succession tool. 

Here's why it's important:

• Preserves the Business/Ensures Continuity: The agreement can preserve or ensure the continuity of the business. Even if one co-owner departs, the agreement clearly outlines the next steps the business will take to ensure there aren’t any disruptions.

• Saves the Owners Money and Time: Since the business itself funds the purchase of the departing owner's stake in the business, the owners do not have to incur any out-of-pocket expenses. The plan also saves the owners time because there is a ready buyer. 

• Centralized Premium Payments: When the business takes out life insurance policies, it pays all the premiums. The centralized approach simplifies cash flow management because the premiums become a consistent and predictable business expense. Payment defaults are minimal, unlike when the co-owners have to pay the premiums themselves. 

• Reduces Conflict Among Owners: Disputes among the surviving co-owners are typically minimal because the business itself executes the plan. 

• Ownership Control: An entity purchase agreement helps owners control who can become shareholders or partners in the business. When you have more control over entry to ownership, you can avoid any other major disruptions to the business. 

Types of Buy-Sell Agreements

We’ve already mentioned that an entity purchase agreement is a type of buy-sell agreement, which explains why it's also called an entity purchase buy-sell agreement.

Let's check out the other major types of business buy-sell agreements:

1. Cross Purchase Agreement 

In a cross purchase agreement, each co-owner has to take out a life insurance policy on the life of every other owner. 

The plan here is more complicated than in an entity purchase agreement. 

We'll see more about cross purchase agreements in the upcoming comparison section. 

2. Unilateral or One-Way Agreement

If you are looking for a suitable buy-sell agreement for a small business, you can use a one-way agreement. 

One-way buy-sell planning is ideal for a sole business owner looking to sell their interest to someone with no ownership interest. Such a buyer could be a key employee, third party, or family member. 

You can also use the unilateral agreement if you are looking to sell your ownership interest to one or more co-owners who don't reciprocate your desire to sell their own interests. 

A one-way buy-sell agreement insurance system is similar to that of other types. The intended buyer buys a life insurance policy on the business owner's life. They then pay the premiums and are the beneficiary of the policy. 

3. Hybrid or Wait-and-See Agreement 

A hybrid or wait-and-see buy-sell plan combines the attributes of both entity-purchase buy-sell agreements and cross purchase agreements.

The idea is to provide flexibility on who purchases the departing co-owner's business interest. 

You can also use this option for situations where a combination of individually-owned and business-owned insurance policies makes sense. 

In the hybrid plan, the buyer of the departing co-owner's stake is not identified until a life-changing event occurs. The buyer could be the business entity itself, the other owners, or both. 

The amount of interest each purchaser will buy is also not disclosed until the event happens. 

Once the event occurs, the business has the first right of refusal to buy the business interests. 

If the business doesn't buy or fails to buy all the interests, the other owners have to buy them accordingly. 

The reverse also applies: if it makes more sense for the other owners to buy the interests and they don't buy or fail to buy them all, the business entity has to buy them accordingly. 

Entity Purchase vs. Cross Purchase Agreements

Let's now see how entity purchase and cross purchase agreements compare as the two most common types:

How to Structure an Entity Purchase Buy-Sell Agreement

When it comes to structure, the first thing you decide on is the type of buy-sell agreement to use. Structuring the specific type of agreement refers to adding and negotiating different components. 

Here are the components to include in an entity purchase buy-sell agreement:

• Triggering Events: Ensure the agreement highlights all the kinds of occurrences that can activate the buyout provision. These events can include death, retirement, loss of professional practicing license, and more. 

• Recent Business Valuation and Accepted Valuation Methods: Specify all the business valuation models you prefer to use in determining how much your entire business is worth. Specify the valuation methods for calculating how much each owner's interest is worth. You should also attach the most recent business valuation report, including the current worth of every owner's stake in the business. 

• Funding Sources or Mechanisms: Include details of how the buyout will be funded, such as using insurance policies taken out on the co-owners’ lives, cash reserves, etc. 

• Rights and Responsibilities: Include all the rights and responsibilities of each co-owner, heirs of the departing co-owner's estate, and the business entity. The entity, co-owners, and heirs in an entity purchase plan funded using a life insurance policy can never reverse or quit their obligation once signed. The heirs must sell the business interest, and the business entity must repurchase it from the heirs.

• Written and Signed Consents of Each Stakeholder: Ensure the agreement includes each co-owner's and other stakeholders' signed consents to show they clearly understand the agreement and their role. 

• Tax Implications Provision: Research and have each co-owner understand the tax implications of the sale or purchase of any co-owner's stake in the business. 

• Transaction Details: Decide on favorable transaction details, such as the purchase price for the owner's interest, buyout period, and payment terms. 

• Transfer Restrictions: Include restrictions that bar the transfer of ownership interest to a third party without the explicit permission of the remaining co-owners or the business entity. 

Buy-Sell Planning Best Practices for Businesses

Even as you have these components written down correctly, following best practices when making the agreement can help protect your interests further. 

Ensure you observe the following:

• Always review the agreement periodically to ensure it reflects your business's current situation or future plans.

• Always revisit your business's value to ensure the amount in the agreement reflects its current worth. 

• Decide a favorable buyout period, such as five or ten years, to make purchasing the co-owner's business interest easier.

• Always revisit the agreement together periodically to ensure all the co-owners understand the terms clearly. 

Most importantly, you'll want to work with M&A experts, such as wealth advisors, investment bankers, tax accountants, and M&A lawyers, to help you write and negotiate a favorable entity purchase agreement. 

For example, you can consult with legal and tax experts to ensure you comply with relevant laws and minimize tax implications. 

At Exitwise, we believe the best decision you can make when selling your business is to hire and work with industry-specific M&A experts. 

Our entire company and service is dedicated to helping you find, recruit, and work with M&A professionals to optimize your exit strategy. 

Chat with our team today to get started!

Frequently Asked Questions (FAQs)

Here are answers to common questions about entity purchase agreements and buy-sell planning:

How is Life Insurance Used in Buy-Sell Agreements?

How life insurance is used in a buy-sell agreement depends on the type of agreement. 

For example, in an entity purchase agreement, the business entity takes out life insurance policies on each co-owner. The entity then uses the death proceeds to buy back a departing co-owner's business interest. 

Why Choose an Entity Purchase Plan Over Other Options?

You can choose an entity purchase plan over buy-sell options for two key reasons:

• First, an entity purchase plan is easier to structure and administer because there is only one policy for each co-owner.

• Secondly, the premium payments are equalized and timely since the business entity pays them rather than individual co-owners. 

What Factors Determine the Success of Buy-Sell Planning?

The success of buy-sell plans depends on factors such as:

• Starting the plan as early as possible after you start the business

• Ensuring every co-owner and other stakeholders understand their roles, rights, and responsibilities

• Doubt-proof transfer restrictions

• Suitable funding options that match well with different trigger events

• Well-thought-out and inclusive trigger events

• Regularly updated business valuation

• Regularly updated agreement provisions

Again, working continuously with M&A experts throughout the agreement's life can boost its success tremendously. We can help you find and work with the best experts in your industry.

What Are Common Funding Mechanisms for Entity-Purchase Agreements?

Besides life insurance policies (which apply only upon the death of a co-owner), you can use other funding options for different trigger events in an entity purchase plan. Try options such as:

• Cash reserves 

• Selling some business assets

• External financing/borrowing/loans

• Installment payments/installment note

• Sinking fund (made by setting aside some of the business’s profits)

Conclusion

Creating a healthy entity purchase agreement is paramount to ensuring your business continues and ownership is held more closely after a co-owner departs.

You'll want to make one to protect the business from infiltration by third parties who may not share your vision. However, it's challenging to create an effective agreement on your own. 

At Exitwise, we can help you find and work with industry-specific M&A experts, such as tax accountants and attorneys, to assist you with the agreement creation. The right M&A professionals can help you write and negotiate a favorable entity purchase agreement that duly safeguards the continuity of your business. 

Schedule a no-obligation chat with our team today to optimize your exit strategy.