A Brief Introduction About the Entity Purchase Agreement
An entity purchase agreement is usually a type of business succession plan utilized by companies that have more than one owner. The plan requires the company to issue an insurance policy on the lives of owners equivalent to each owner’s interest.
In the event of the death of any of the owners, the sum collected by the company from the insurance, which is equal towards the deceased owners’ stake, is utilized to pay the deceased’s estate for its share of the business.
Who Takes the Entity Purchase Agreement?
An entity purchase agreement is a lawfully binding agreement between co-owners of a business that governs the situation and states how business interests would be transferred, towards whom, and under what circumstances.
In an entity buy-sell agreement, the business entity agrees to buy a deceased owner’s interest, and the estate agrees to sell at an agreed-upon purchase price.
Purpose of the Entity Purchase Agreement
A buy-sell agreement states how business interests would be transferred. An entity purchase agreement is made so that the business agrees towards buying the interests of any owner when he or she dies, becomes disabled, or retires. These plans are often financed with life insurance and disability buyout insurance.
Contents of the Entity Purchase Agreement
An entity-purchase agreement consists of many legally binding clauses which include:
- Who could buy a departing partner’s or shareholder’s share of the business (this might contain parties outside the agreement or be limited to other partners/shareholders)
- The value of the business that would be purchase and the basis on which it would be valued including the value when one member withdraws
- For funding the business, the kind of obligations and coverages the business will take on itself such as LIC, disability buyout, or other forms of insurance, and how it will pay for those expenses.
- The means and the process by which the transfer of interest of one member shall be made to the business including when one member dies, withdraws, or becomes unable to continue the business. It should also mention how the business will assume the liabilities and other obligations of the transferred interest
- In case of inability or withdrawal of an owner, how the insurance paid on the owner by the business would be treated – whether the transfer would be done at the surrendered cash value, or an agreed rate, and what happens when the policy does not have a surrender case. The timeline for exercising this option must be mentioned as well
- If the owner recovers from his disability and decides to retain his ownership, he may do so by reimbursing the value paid to him. The timeline for doing so must be mentioned as well
- The events would trigger a buyout, (the most common events that trigger a buyout are: death, disability, retirement, or an owner leaving the firm) and;
- The price to be paid for a partner’s or shareholder’s interest in the partnership.
How to Draft the Entity Purchase Agreement
An entity-purchase agreement has two common forms of agreements:
The business owners ideally should visit an experienced attorney to discuss the agreement. Once the entity purchase format is decided upon, the attorney can draw up the agreement.
The agreement includes several important factors:
Buyout Events: Mention the triggering events like death or retirement, the bankruptcy of an owner that would potentially trigger a buyout. However, at times the disability or divorce of an owner is often. As, in the event of a divorce, the stock could potentially be passed in the hands of the ex-spouse, and not the stockholders.
Valuation: The agreement should meet a consensus on the value of the business, as this could prevent valuation disputes amidst a departing owner and the remaining owners. Valuation also enables anticipation of how much funding is required for a buyout. The valuation would require
- revaluating the business every year.
- A business appraiser to value the business. The appraiser develops a valuation based on factors, like annual earnings.
Funding: The company can create funds using a savings account or another alternate investment. The company can also borrow the money from a bank, but this could incur interest costs. The most common form of funding option for the company is to obtain life and disability buyout insurance on the owners.
Benefits & Drawbacks of the Entity Purchase Agreement
Benefits
- Forms a market and establishes a fair price for the business interest
- Furnishes the funds to make the purchase
- Avoids a forced sale of assets
- Could give liquidity to the estate of the deceased/retired business owner
- Makes a smooth transition for management and control of a business
- The deceased’s estate is guaranteed prompt and full payment
- The number of policies that is essential to initially be purchased is limited to one policy for each owner
- Because the business is paying the insurance premiums, there is a pro-rata share of the costs among the owners consistent with their share in the business without concern as to age, smoker status or health ratings
- Life insurance cash values are presented as an asset on the business balance sheet
Drawbacks
An important disadvantage of this agreement is that the remaining shareholders do not obtain the benefit of a “step-up” in cases when the corporation buys the deceased shareholder’s interest. The continuing shareholders keep their original basis in the corporation.
What Happens in Case of Violation?
The agreement can outlines the conduct standards expected of owners and dictate the terms of a forced sale by the detrimental owner. In cases of fraudulent business practices, assisting a competitor, or significantly violating the company’s deeply held values(1), calls for a penalty to be paid for the valuation of the ownership interest by the breaching owner.
An Entity-Purchase Agreement is often suggested by business-succession specialists as well as financial planners to make certain that the buy-sell arrangement is well-funded and guarantees money when the buy-sell event is triggered.