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What is a share buyback and why do companies undertake them?

Posted
August 27, 2024
Corporate and Commercial
Adith Zafar

A “share buyback” is where a company buys back it shares from its shareholders. A company may choose to undertake a share buyback for a several reasons, including to return surplus cash to its shareholders or to facilitate an exit route for shareholders seeking to leave the company. The shares will then either be cancelled or they may be held in treasury (if purchased with distributable reserves) by the company.

Companies must be mindful of the strict statutory procedure to be followed when effecting a share buyback. 

This guide is a useful reminder of some key considerations when carrying out a share buyback. It focuses, in particular, on share buybacks carried out by private limited companies.

Main reasons for undertaking a share buyback

Return surplus cash to shareholders – a company may have surplus cash as a result of outstanding profitability, the sale of a business, having cash in readiness for a potential acquisition or a planned expansion that has fallen through, and/or simply having cash that is not earmarked for a particular purpose and cannot be invested to produce a suitable return. A share buyback can return some, or all, of that cash to the shareholders, avoiding the inefficiency of holding excess cash in the company without any planned use.

Provide an exit route for shareholders – a company's articles may provide that, where a shareholder wishes to exit the company and the remaining shareholders do not wish to purchase the departing shareholder's shares, the company can repurchase the shares itself. This ensures that a third party does not acquire a stake in the company and the remaining shareholders do not have to pay any money directly to the departing shareholder.

Increase the company’s gearing ratio – a share buyback can be used to increase a company's gearing, that is, its ratio of debt to equity, as, following a share buyback, the amount of equity (depending on how it is calculated) may be reduced. This will therefore increase the company’s leverage, since buying back shares followed by cancelling them will reduce the amount of equity held in the company.

Types of share buyback

The statutory procedure to be followed depends on whether the proposed share buyback is a "market" purchase or an "off-market" purchase. A private limited company carrying out a share buyback will always make an off-market purchase. Market purchases involve shares listed on the open market and are therefore unlikely to be of relevance to private companies.

How share buybacks are funded 

A company can fund a share buyback in a number of ways.

Out of profits available for distribution (distributable reserves) – instead of distributing profits in the form of dividends, a company may use its accumulated profits to buy back shares. This is the most straightforward way to achieve a share buyback for a private limited company. The company must have sufficient distributable reserves to fund the share buyback. If the funds are not paid from distributable reserves liabilities can arise. 

Out of the proceeds of a fresh issue of new shares - a company may choose to issue new shares and use the subscription money to finance a buyback. The company must demonstrate that the purpose of the new share issue is solely to finance the share buyback. We therefore suggest that the buyback is made at the latest within a few months following the issue of the new shares

Using the capital of the company - a company can purchase its own shares out of capital (subject to any restriction or prohibition in its articles). As such a payment is potentially to the prejudice of the company's creditors and puts the company at greater risk of insolvency, this is the most complicated method of financing a buyback. A company opting for this financing method must therefore follow a prescribed procedure (which involves the directors making a statement specifying the amount of the permissible capital payment for the shares and confirming that the company can pay its debts, a report by the company's auditors, and publication of a notice in the Gazette). There is a de minimis exception available which permits the purchase of small amounts of shares out of capital without having to follow the aforementioned procedure. A company must have express authority in it articles to take advantage of the de minimis exception. 

Legal Framework and preliminary considerations

Part 18 of the Companies Act 2006 (CA 2006) must be complied with when carrying out a share buyback. If a share buyback is not carried out in compliance with these provisions, the transaction could be rendered void and a statutory offence will be committed by the company and every officer in default. Officers in default are liable to a prison term of up to 2 years, an unlimited fine, or both (s.658). In addition, the exiting shareholder(s) may still hold legal title to the shares, despite the company having paid the purchase price. 

Prior to the buyback, the company’s articles of association (and any applicable shareholders’ agreements) should be reviewed to consider whether the buyback is permitted. Specifically, it must be determined whether there are any prohibitions or restrictions in the articles on the purchase of the company's own shares (or any specific consent rights). This includes pre-emption provisions, which require the shares to be offered to the existing shareholders before being transferred to another party (in this case, the company). Any prohibitions or restrictions on transfer should be waived or amended prior to the buyback taking place.

Whether the company has more than one class of shares needs to be considered, specifically whether the share buyback will result in the variation of the rights attaching to those classes of shares (in which case class consent to vary will be required). 

The shares which are to be purchased must be fully paid (s.691(1)). Where the shares are only paid in part, the company should call up the balance or, alternatively, reduce the nominal value of each by the amount unpaid via a reduction of capital.

Buyback contract and approval of shareholder(s) 

To effect a share buyback, a company must enter into a contract with the shareholder(s) whose shares are to be purchased. This express agreement must be approved before the purchase. Ordinarily, it can be a simple agreement providing for the company to purchase the shares or it can be a contract under which the company may become entitled or obliged to purchase the shares in the future subject to certain conditions being adhered to.

The contract for an off-market share buyback must be approved by the shareholders either before the contract is entered into or the contract must state that no shares will be purchased until its terms have been approved by resolution of the shareholders. Unless the articles provide otherwise, the agreement can be approved by an ordinary resolution. The ordinary resolution can be proposed at a general meeting of the shareholders or by written resolution. Where the written resolution procedure is followed, a copy of the agreement must be circulated to each eligible member (and to the company’s auditor if it has one) either at the same time, or prior to, the written resolution. The shareholder(s) whose shares are being purchased will not be able to vote on the resolution.

As mentioned above, the shares which are to be purchased must be fully paid up and the shares generally must be paid for at the time of purchase (other than shares bought back for the purposes of, or pursuant to, an employee share scheme). This can present a challenge where a company would seek to stagger the payments (for example, to make the buyback more affordable). If the company does not have the funds to pay for all of the shares at once, it is possible for the shares to be purchased in tranches, with payment for each tranche made in full each time and the selling shareholder retaining some of their shares until the final tranche has completed. Although this might make the buyback more affordable for the company, it should be noted that the selling shareholder will retain the rights attaching to the shares they continue to hold (for example, voting rights or rights to dividends) until their shares are fully bought back. 

Post-buyback requirements

Stamp duty must be paid by the company at the rate of 0.5% of the purchase price on purchases over £1,000.

There are also a number of Companies House filings to be performed including:

  • Special resolutions: Any special resolutions passed in relation to the buyback (i.e. to approve the buyback agreement or adopt new articles) must be filed at Companies House within 15 days of being passed. Where the company has adopted new articles, a copy should be filed along with the special resolution.
  • Form SH03: The stamp duty payment to HMRC should be accompanied by a Form SH03 (a return of purchase of own shares). The Form SH03 should be filed at Companies House once HMRC confirm that the correct amount of stamp duty has been paid. It should be filed within 28 days of the shares being delivered to the company. 
  • Form SH06: Shares which have been bought back using distributable profits can either be cancelled or held in treasury. Where the shares are cancelled, a Form SH06 (notice of cancellation) must also be filed at Companies House within 28 days.

Lastly:

  • the company's register of members must be updated to reflect the buyback (along with the register of transfers and PSC register, if required); 
  • a copy of the buyback contract must be kept at the company's registered office for a period of 10 years following the buyback; 
  • share certificates relating to the shares bought back will need to be cancelled; and
  • the company must update its accounts to reflect the change to the company's issued share capital or any relevant reserves.

About 

Adith Zafar

Adith joined the Corporate Commercial department as a paralegal in March 2024. He brings with him experience in both corporate and employment matters having previously worked at regional and international firms based in the City.

In the corporate sphere, Adith has worked with a variety of clients ranging in size from start-ups to SMEs. His experience includes assisting companies with equity investment rounds, setting up EMI share option share schemes, facilitating share buy-backs, obtaining SEIS/EIS tax relief, as well as sales and acquisitions.

In the employment sphere, Adith has assisted both employers and employees. His experience includes drafting and negotiating settlement agreements, assisting with redundancy procedures, and assisting in the representation of clients in employment tribunal litigation. Notably, Adith has managed the volume employment tribunal litigation of the UK’s largest facilities management and professional services company. This involved Adith independently managing his own caseload of tribunal cases.

Adith holds a LLB Law degree and is currently working towards completion of the Solicitors Qualifying Examinations (SQE) in order for him to qualify as a solicitor.

Outside of work, Adith can either be found at the Emirates Stadium supporting his beloved Arsenal FC or spending time with his family.

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