Why would a company buy back its own stock?

There are various reasons for wishing to dispose of shares held in a private limited company. One method of disposing of shares occurs when the company itself offers to purchase the shares being offered for sale, effecting a buyback of those shares. In multiple-owner private companies, a share buyback is often driven by the exit of one of the shareholders.

So, is share buyback a good thing?

When considering whether a share buyback is the most appropriate route to dispose of a shareholder’s shares, there are several factors to consider.  It is critical that each step in the buyback process is carried out correctly to avoid any potential for the transaction being rendered void.  If that happens, it can mean that the shareholder whose shares were to be bought back still technically owns the relevant shares, even though they have been paid for them, and that can be difficult to fix.

Here are our top five tips for ensuring an effective share buyback:

1. Financing

Share buybacks can be financed in three possible ways:

From distributable profits – this is the most common source of funding for a share buyback. Rather than returning the profits as a dividend distribution to members, retained profits can be used to finance a buyback of shares in the company.

From capital – a reduction of capital can provide funds to allow shares to be bought back by the company.

From the proceeds of a fresh issue of shares – by issuing additional shares in the capital of the company, such monies can be used to finance the buyback of existing shares.

The appropriate funding method will very much depend on the company. However, financing from distributable profits is the most common method of financing.  It should be mentioned that there are also provisions under law for very small buybacks out of capital which use a simplified process.

2. Approval

The company will automatically be authorised by law to purchase its own shares unless there is an express prohibition in its articles. Assuming no such prohibition exists, the shareholders would then be required to approve the terms of the share buyback agreement between the company and the shareholder selling their shares. This approval takes the form of an ordinary resolution.

3. Price

The price must be paid in full in cash at the time of the purchase. It cannot be deferred or paid in instalments. If the company does not have sufficient funds to purchase all of the shares at once then the shares may be bought in tranches, with each tranche being paid for in full when the shares for that tranche are transferred to the company.

Share buyback accounting

Where the consideration for the buyback is being funded from distributable profits as well as another financing method (eg. a fresh issue of shares), it is essential that each share is financed entirely from one source of funds, rather than partly from profits and partly from a fresh issue of shares.

Stock repurchase tax treatment

While there is no legal requirement for the buyback price to be the market value of the shares, tax considerations may be relevant and advice should be sought on this.

4. Tranches

If a buyback is structured such that the return of shares is made in tranches, the payments for the buyback must be made conditional on the company possessing sufficient distributable profits to pay for each tranche as and when it falls due.

Given the uncertainty of anticipating future distributable reserves positions, there is always a risk when structuring a buyback in tranches over a substantial period of time that sufficient distributable profits will not be available. It is helpful for the buyback contract to account for the necessary actions to be taken in such situations.

5. Next Steps and stock buyback rules

Following the buyback, stamp duty must be paid on the purchased shares. Stamp duty is currently set at 0.5% of the purchase price where the price is more than £1,000.  A form SH03 should be submitted to HMRC for stamping along with the stamp duty amount. The stamped form must then be submitted to Companies House.

If the shares are being cancelled (as opposed to being put into treasury), then the company books should be updated immediately on return of the shares (and not on stamping of the form SH03).  Additionally, a form SH06 must be submitted to Companies House to update the register in respect of the share cancellation.

Finally, it is a requirement that the company keep a copy of the buyback contract at the company’s registered office for a period of ten years.

Once the statutory registers are updated, and the necessary submissions made to Companies House, the updated statement of capital will be available on the public record via the form SH06.  Any share certificates returned by the shareholder will be cancelled, and the buyback concluded.

The timing of approvals and execution of documents is well defined by the Companies Act and by ensuring the steps outlined above are followed, and the documentation is approved by the necessary parties, will result in an effective share buyback that benefits shareholders.