Share Buybacks: part 1 – Potential advantages and legal requirements

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Share buybacks, historically a feature of American business finance, have become increasingly popular in the UK since their introduction in 1981 – to the point where they now seem to be a permanent feature of our corporate landscape. Big names like Diageo, Ryanair, and Lloyds have all put share buyback schemes into motion within the last year. However, share buybacks are not just the domain of big, publicly-traded companies – they can offer significant opportunities to smaller businesses, too. That said, there can be inherent drawbacks. An element of risk is involved and there are legal requirements to be met, which means that offering such a scheme should not be undertaken without seeking independent legal advice first.

Put simply, share buyback occurs when a company (either public or private, limited or unlimited) buys back a portion of its own shares from shareholders. Here, I’ll examine the potential advantages of share buybacks, before moving on to consider the procedure and financing issues in part two.

Advantages for PLCs

Share buybacks can provide six distinct potential benefits for a company by:

  1. Returning surplus funds to the shareholders

If your company has accumulated cash reserves that are surplus to its operating costs, or other expenses, then a share buyback can return some, or all, of that cash to the shareholders, avoiding the inefficiency of holding extra cash in the company itself.

For example, if your company built up a cash reserve with the intention to buy another company but then the sale fell through, a share buyback could be used to distribute that cash amongst the shareholders. Alternately, if your company has been incredibly profitable, then a share buyback could distribute that extra profit as an alternative to, or perhaps alongside, a traditional dividend.

  1. Increasing the earnings per share (EPS) for shareholders that remain following the buyback

If a company buys back some of its shares, the bought shares are effectively redeemed by the company, reducing the total amount of shares issued by the number that were bought. This reduction in shares outstanding increases the EPS which, in turn, increases the price/earnings ratio of the company and the price of the remaining shares.

For example, if your company issues 100 ordinary shares at a price of £1 each and makes £100,000 of net profit in the year that can be attributed to the holders of those shares, then your initial EPS is £1000 per share and your price earnings ratio is 1:1000. In the following year, if your company buys back ten of those shares and still makes £100,000 of net profit, then your EPS will increase to £1111 per share and your price earnings ratio to 1:1111.

Obviously, your company would have to fund the buyback somehow but, by buying back the shares at the right price and with specialist advice, the resulting increase in value of the remaining shares can outstrip the interest that would have been generated on the buyback funds if they had just remained unutilised in the company’s bank account.

  1. Increasing the net assets per share for shareholders that remain following the buyback

In a similar vein , a carefully considered buyback can increase the net assets attributable to each share by decreasing the volume of shares available, increasing the net assets per share and potentially leading to an increase of share price.

  1. Enhancing the liquidity of the shares by creating a market

Although potentially more relevant for a publicly traded company, share buybacks can increase demand for shares of your company. This could be advantageous if you are searching for a private buyer for a proportion of your company’s shares.

In this scenario, you would be demonstrating to potential private buyers that a market for your shares exists and, moreover, make an existing market between buyers more competitive if you were to price your buyback effectively.

  1. Providing an avenue to increase the company’s gearing

A share buyback can reduce the amount of equity in your company, thereby increasing your company’s ratio of debt to equity and its gearing.

If your gearing ratio is lower than the average in your industry and you are worried that this makes you less attractive to investors who might be concerned that your company is not taking advantage of its available leverage to provide greater returns, then a share buyback can provide a means by which to increase gearing without taking out further loans.

  1. Providing an avenue for a shareholder to exit the company entirely

The most common use for a share buyback is for a shareholder to exit the company entirely. In a situation where none of the other shareholders wish to, or are able to, take on the leaver’s shares, your company can instead offer to buy them back.

Buying back shares in this situation can provide a tax-efficient method for extracting a shareholder if, for example, they are retiring. They also represent a possible avenue for extracting some value from the company through a partial buyback of a shareholder’s position, as might be necessary, for example, following an award made to the spouse of a shareholder after matrimonial finances have been settled as part of a divorce.