Understanding the mechanisms behind share buybacks is crucial for entrepreneurs, startups, and small to medium-sized businesses. Share buybacks must strictly comply with the Companies Act 2006 and include some fairly detailed procedures that need to be followed.
In this guide, we’ll explore the intricacies of share buybacks and what they could mean for your business. For your information, we’ll be considering limited companies and not public companies. Public companies are subject to different share buyback rules.
What are share buybacks?
Share buybacks occur when a company purchases its own shares from its current shareholders and it is not purchasing redeemable shares. This process involves the company using its funds to buy back a predetermined number of shares, reducing the total number of shares available in the market.
A company can purchase its shares:
- Out of sufficient distributable profits (this needs to be verified by an accountant)
- Out of the proceeds of a fresh/new issue of shares
- Using cash
- Out of its capital
These types of share buybacks carried out by limited companies are called “off-market purchases”. Legal and accountancy advice should be sought to decide on the most suitable type of share buyback for your limited company.
Why do companies buy back shares?
There are several reasons which drive companies to engage in share buybacks.
The most common reason for limited companies is that share buybacks can be used as a tool to manage the company's capital structure. Companies can purchase the shares of a shareholder which may otherwise be difficult to sell. Also, by reducing the number of outstanding shares, a company can improve its earnings per share (EPS) and enhance shareholder value.
It can also be a strategic move to signal that the company believes its shares are undervalued. By repurchasing shares, the company demonstrates confidence in its financial health and future prospects, potentially boosting investor confidence or downplaying any company issues.
Share buybacks can be tax-efficient for companies, by returning cash to shareholders. Rather than paying a form of dividends, which may be subject to higher taxes, a company can repurchase its shares. This provides existing shareholders with a more tax-efficient return on investment.
Do I have to sell my shares in a buyback?
No, as an investor, you are not obligated to sell your shares during a buyback. Share buybacks are entirely voluntary for shareholders. If the company announces a share buyback, you have the choice to retain your shares.
What are the benefits of share buybacks?
The advantages of share buybacks include:
- Enhanced Earning Per Share (EPS)
- Increased shareholder value
- Efficient capital structure management
1. Enhanced Earnings Per Share (EPS)
One of the primary benefits of share buybacks is the potential improvement in earnings per share. With fewer shares outstanding, the company's earnings are distributed among a smaller number of shares, leading to a higher EPS.
2. Increased shareholder value
Share buybacks can result in an increase in shareholder value. When a company buys back its shares, it signals confidence in its future performance, potentially attracting more investors. This means the amount shareholders receive in the future increases.
3. Efficient capital structure management
Companies can use share buybacks to optimise their capital structure. By repurchasing shares, they can strike a balance between debt and equity, leading to a more efficient and sustainable financial structure..Share buybacks can be a really useful means for a limited company to help a shareholder exit the company without having to find a third party purchaser of the shares.
Are there downsides?
While share buybacks offer several advantages, there are also potential downsides to consider:
- Misallocation of resources
- Market timing risks
- Debt incurrence
- Complex legal process
1. Misallocation of resources
Companies might engage in share buybacks at the expense of other crucial investments. This could be things like research and development, or capital expenditures. This could lead to prioritising the wrong use of resources and hinder long-term growth.
2. Market timing risks
If a company repurchases its shares when they are overvalued, it may not provide the desired benefits. .
3. Debt incurrence
Some companies fund share buybacks by taking on debt. While this can be a good strategy, it also exposes the company to interest rate risks and increases its overall leverage.
4. Complex legal process
A share buyback can be complicated and a company will need to take legal and accountancy advice to ensure that the correct type of share buyback is used and all the procedures set out in the Companies Act 2006 are followed.
How does a company organise share buybacks?
In the UK, the process of organising share buybacks involves compliance with legal requirements. Companies must follow the laws and procedures outlined in the Companies Act 2006. This includes obtaining shareholder approval, ensuring that the company has sufficient distributable reserves (or other rules if using one of the other share buyback methods), and adhering to any restrictions on the timing and volume of buybacks.
A company intending to repurchase its shares must convene a general meeting or use the written resolution procedure and seek approval from shareholders through a special resolution. Once approved, the buyback must be completed within a specific timeframe and the company must make the necessary filings with the Companies House.
We recommend you always take legal and accounting advice before you undertakes a share buyback.
What does this mean for the remaining investors?
With fewer outstanding shares, the ownership share of the company for the remaining investors in the company becomes more significant. This can lead to an increase in the proportional ownership of earnings and assets for those who retain their shares. This can result in higher dividends and sale proceeds in the event of a sale of the company.
Additionally, if the company's share price increases following a buyback, the value of the remaining shares may also rise. However, it's essential for investors to consider the long-term implications of the buyback on the company's financial health and growth prospects.
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Share buybacks are a useful process to enable a limited company to return value to its shareholders. They're also a great tool to help manage the capital structure of the company and find a buyer for shares where there may not be a market otherwise.
Navigating the intricacies of share buybacks requires a clear understanding of the Companies Act 2006 and the financial position of the company. If you're considering carrying out a share buyback or you're seeking guidance on where to start, book a free 15 minute consultation with one of our expert lawyers or call us on 020 3808 8314.