What it means
An entity-purchase agreement, often called a stock redemption agreement, is a contract signed by the company and all of its owners. It obliges the company to redeem (buy back) a departing owner's shares, and obliges that owner or their estate to sell them at a price the agreement already sets out.
Without such an agreement, the shares of a deceased owner can pass to a spouse or an adult child who has no interest in running the business. The surviving owners suddenly share control with someone they never chose, and the family is left holding an asset that is hard to value and harder to sell.
Funding is the part that makes the agreement work in real life. Most companies buy a life insurance policy on each owner, pay the premiums from company funds, and collect the proceeds when a policy pays out.
The cash therefore arrives at almost exactly the moment the obligation to pay it out arises. The main alternative is a cross-purchase agreement, in which each owner personally buys a policy on every other owner.
An entity purchase needs only one policy per owner, so a group of five owners needs five policies rather than the twenty a cross-purchase would require. That difference in administration is why larger ownership groups usually prefer the entity version.
The trade-off is mostly about tax and cost base. In a cross-purchase the surviving owners generally increase the tax cost of the shares they acquire, while in an entity purchase they usually do not, which can mean a larger tax bill if they sell the business later.
Valuation method matters just as much, and agreements that lock in a stale per-share figure tend to cause the very argument they were written to prevent.
In practice
Real-world examples.
Example
A two-partner architecture firm signs an entity-purchase agreement valuing the practice at $2,400,000, with each partner's half worth $1,200,000. When one partner dies unexpectedly, the firm redeems her shares for $1,200,000 using insurance proceeds. The surviving partner moves from 50% to 100% ownership without spending a dollar of his own money.
Example
A five-owner engineering consultancy compares structures and finds that a cross-purchase would need twenty separate life policies, one for each owner on each of the others. The entity-purchase route needs only five policies, all owned and paid for by the company. The finance director chooses the entity version purely to cut the administrative burden of tracking premiums and beneficiaries.
Example
A family bakery uses an entity-purchase agreement for a planned retirement rather than a death. The founder's 40% stake is valued at $1,200,000 and redeemed in five annual instalments of $240,000, funded from trading cash flow. The agreement includes a security clause so the founder can reclaim shares if an instalment is missed.
Formula
Calculation
Redemption price = agreed business value x departing owner's ownership percentage
Remaining owner's new percentage = old percentage / (1 - departing owner's percentage)
Harbour Freight Systems has three equal owners, each holding one third. The agreement values the business at six times EBITDA, and EBITDA for the valuation year is $1,500,000.
Agreed business value = 6 x $1,500,000 = $9,000,000
Redemption price for one third = $9,000,000 / 3 = $3,000,000
The company holds a $3,000,000 life policy on each owner. When one owner dies, the insurer pays $3,000,000 into the company and the company immediately pays $3,000,000 to the estate for the shares, so the company's cash position is unchanged and its value stays at $9,000,000.
Each surviving owner's new share = (1/3) / (1 - 1/3) = (1/3) / (2/3) = 50%
Value of each survivor's stake = 50% x $9,000,000 = $4,500,000, up from $3,000,000
Neither survivor paid anything personally, yet each is now worth $1,500,000 more on paper, because the company retired the third stake using insurance money it had been funding through premiums all along.Case study
Seen in the real world.
The following is an illustrative, entirely fictional scenario. Redwood Instrument Company was founded by four engineers who each took a 25% stake and agreed, over a long lunch, that "we will sort it out if anything happens". Nine years later the company was making $2,000,000 of EBITDA and one founder died in a cycling accident, leaving his shares to his brother, who had never worked in the business and wanted cash immediately.
The remaining three founders had no agreement, no valuation method and no insurance. The brother's lawyer argued the business was worth $16,000,000, the founders argued $9,000,000, and the disagreement ran for fourteen months while a major customer contract went unsigned because the ownership position was unclear.
After settling at $12,000,000 and funding a $3,000,000 buyout from a bank loan, the three survivors put an entity-purchase agreement in place. It set a valuation formula of six times trailing EBITDA, named a trigger list covering death, permanent disability, retirement after age sixty and voluntary exit, and was funded by company-owned life policies sized to the current formula value and reviewed every year.
Watch out
Common mistakes.
- Signing the agreement but never funding it, so the company has a binding obligation to pay millions with no source of cash when the trigger event arrives.
- Fixing a per-share value in the document and never updating it, which usually means the estate is either badly short-changed or the company is badly overcharged.
- Assuming an entity purchase and a cross-purchase are interchangeable, when they produce different cost bases for the surviving owners and different tax outcomes on a later sale.
Questions
People also ask.
Who actually owns the life insurance in an entity-purchase arrangement?
The company owns the policies, pays the premiums and is the named beneficiary, which is the key structural difference from a cross-purchase.
Does the company need spare cash to make this work?
Not if it is properly insured for death and disability triggers, though retirement and voluntary exit triggers usually need an instalment plan or a borrowing facility.
Can an agreement cover a divorce or a bankruptcy?
Yes, and well-drafted agreements normally include both, so shares cannot end up with a former spouse or a creditor of one owner.
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