Buybacks by public companies have historically made the news as a way of returning excess capital and cash to shareholders whilst boosting earnings per share – a measure often used as a trigger for executives’ bonus payments!
Whilst these are not often motivations for private companies, there are often good reasons to use a share buy-back:
In this article, we explore these reasons for share buybacks by private companies and how they work.
A share buyback involves a company purchasing its own shares from one or more of its shareholders, and, in most cases, leads to a reduction of the company’s share capital (as the bought-back shares are immediately cancelled) with a replacement non-distributable reserve being created. Whilst the concept of a company buying its own shares might seem strange, buybacks can be an extremely attractive option for both the buying company and the selling shareholder particularly where there is no ready market for the shares.
Whilst buy-backs can, in certain circumstances, be done without sufficient distributable reserves to cover the nominal value and the buy-back premium, we have assumed, for this article, that the company has sufficient distributable reserves to effect the buyback.
Typically, a share buyback will be implemented for one of the following reasons:
When a shareholder wishes (or is required) to sell their shares it is often advantageous for the shares to be bought back by the company, perhaps because the departing shareholder cannot find a willing buyer or because the existing shareholders do not want the shares to be more widely held or want to retain control of the company but cannot afford to buy the shares from the departing shareholder themselves.
The reasons why shareholders may look to sell their shares are hugely varied, from leaving a company’s employment to retirement, or simply seeking better or different investment opportunities.
The purchase price on a share buyback is generally divided into a capital element and a distribution element for tax purposes, but there are special regimes available whereby unquoted companies can, subject to the satisfaction of certain conditions, avoid the buyback being treated as a dividend. Tax advice should be sought on individual circumstances, but capital treatment may be available to:
One effect of a buyback is to increase the earnings per share and therefore improve the company’s price/earnings ratio, which is generally only important for listed companies.
A buyback will also increase a company’s gearing (i.e. their ratio of debt to equity). Whilst this may lead to higher costs for and reduced availability of borrowing options, maintaining leverage within certain parameters can be a requirement of financing agreements or company policy.
The general rule is that companies are permitted to buy back shares as long as:
Buybacks can be straightforward, where there are only a handful of shareholders, and the parties are keen to take a pragmatic approach. However, there is a prescribed legal methodology which must be followed to avoid the buyback being void. A buyback that is discovered to be void, say, five years later, is very difficult to repair as the company will have failed to buy back the relevant shares, which will still be owned by the selling shareholder. Further, that selling shareholder may have died or may be untraceable. This impacts not only on share ownership but also any distribution or other decisions made by shareholders during the intervening period.
The amount paid for the shares is usually a commercial decision between the company’s directors and the selling shareholder. Directors though, do need to be mindful of their statutory duties when negotiating the purchase price. In particular, their duty to act in a way which promotes the success of the company for the benefit of its shareholders as a whole.
The process for a buyback typically involves:
After the transaction has completed, the selling shareholder(s) will need to declare the transaction to HMRC in their next tax return and ensure that any tax arising is paid accordingly. The company’s accounts and records will need to be updated post buyback and a copy of the buyback agreement will need to be available for inspection by the shareholders for at least 10 years from the date of the buyback.
We cannot emphasise strongly enough the importance of getting the procedure for a buyback right. If a share buyback does not comply with the requirements of the Companies Act 2006, quite apart from the buyback itself being void, the officers of the company will be in breach of the Act, which is a criminal offence with potential penalties including a prison term of up to two years and/or an unlimited fine.
In the majority of cases, the company will purchase the shares using its existing distributable reserves and its own cash resources.
Another option is for the company to issue new shares specifically to finance the buyback.
It is also possible to buy back shares using capital (i.e. the company’s available cash or liquid assets) but the process is more complex (including additional requirements such as a prescribed solvency statement by the board and an auditor’s report) and therefore tends to involve more lengthy timescales and additional costs.
There are various circumstances in which a company cannot purchase its own shares using the buyback procedure.
The shares must be paid for in full in cash at the time they are transferred, which means that payment cannot be made in instalments or on a deferred basis. This means that a selling shareholder cannot simply lend the monies to a company to fund the purchase price for his or her shares. It also means that the company cannot pay for the shares using a non-cash asset. It is for these reasons generally accepted that the purchase price must in fact be transferred to the selling shareholder i.e. it cannot be a “paper only” exercise.
It is possible to establish a series of transactions, each independent of the others, whereby shares are gradually bought back from a shareholder. However, this is not usually recommended for either the company or the shareholder, as it gives no certainty and means that the exiting shareholder will continue to be involved with the company, despite having mapped out an exit path.
Another misconception is that where the company does not have sufficient available distributable profits or capital to fund the buyback, the company can simply borrow funds from a lender to pay for shares under a buyback. If shares are to be bought back using capital, there are additional requirements which must be satisfied to avoid the buyback being void and the officers committing a criminal offence.
Other than the form and timing of payment for the shares, two of the most common issues which arise on a share buyback are the terms and conditions that can be included in the buyback agreement and whether the selling shareholder can loan their share proceeds back to the company (which we have already covered in section 4 of this article).
The general principle is that the terms of the buyback are up for negotiation between the selling shareholder and the company, provided they do not breach the relevant sections of the Companies Act 2006.
A selling shareholder may wish to include a clause that entitles them to further payment if the company is sold in the near future. This is often known as an ‘anti-embarrassment’ clause. This is generally not possible under a buyback agreement as the shares must be paid for in full at the time of transfer.
For the reasons outlined above, buybacks are useful but very easy to get wrong. It can be difficult to work out whether or not a company is in a position to proceed with a buyback.
It is important to get expert legal, tax and accounting advice at the outset to ensure that you structure the buyback correctly and manage the expectations of all involved.
This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice. The information in this article will not be updated following publication.