What Is an Entity Agreement?

An entity agreement, also called a buy-sell agreement, is a binding contract between business owners that establishes the right to buy back a withdrawing owner's interest in the company. This is typically used with partnerships or limited liability companies (LLCs) where the ownership interest is closely held and never intended to be sold to outside parties. The entity agreement ensures that if a partner has to leave the company for any reason, his ownership interest is purchased by the remaining owners, instead of sold or transferred to a third party.

Ownership interests in partnerships and LLCs are not designed to be freely transferable to third parties. The law treats these types of business arrangements as personal contracts between the owners and adheres to the underlying tenet that one person cannot force another to enter into a contract. Comparatively, ownership of a corporation is designed to be freely transferable to third parties, so shares of stock are issued to owners that can be sold on an open market. When an owner needs to withdraw from a partnership or LLC for any reason, including disability or death, he cannot necessarily sell or transfer his interest in the company at his discretion.

The laws governing the formation of business partnerships and LLCs allow the owners to decide what will happen to an owner's interest if he needs to withdraw from the company. Owners can enter into an entity agreement that establishes the procedure for the remaining owners to buy back the withdrawing owner's interest. This agreement can be a separate document or can be part of the company's operating agreement that deals with owner relations beyond the matter of withdrawal.

Typically, an entity agreement sets the terms for the buy back. Most importantly, it should establish a way of valuing an owner's interest at the time of the sale to avoid valuation disputes. Closely held business interests are often hard to value without selling the business because of the lack of a third-party trading market, such as the stock markets that corporations use to determine the value of single shares of stock. Without a provision addressing how to arrive at the price the remaining owners will pay to buy the withdrawing owner out, the withdrawing owner can refuse to sell because of an insufficient offer.

Courts consider an entity agreement to be a binding contract. It is important to realize that the withdrawing member does not necessarily have to agree to the provisions of the buy-sell arrangement for it to be effective. Most jurisdictions require the owners to submit governing provisions to an ownership vote. If the majority of owners vote to implement an entity agreement that controls the way the company buys back ownership interests, it is binding on all of the owners.