Why would a company buy back shares?

A share buyback is a simple enough concept to understand, even if the actual procedure can cause the most diligent individuals to come unstuck. It involves a company buying back its own shares from shareholders at an agreed price (typically, market value). The company must ensure that a buyback satisfies certain criteria or it will be unlawful and declared void.

Recently, the Government started a review into how companies use share buybacks amidst concerns that they are being used to inflate executive pay.

An invalid share buyback is the stuff of nightmares for corporate lawyers and companies alike, which begs the question: why carry one out in the first place?

Why would a company look to buy back its shares?

To return distributable profits

Companies can return distributable profits to shareholders in several ways, with dividend payments being the most common method. A buyback involves a company repurchasing its shares at market value and then returning the cash to the shareholders. By reducing the number of shares on the market, the company also reduces the number of shareholders to which it may have to pay dividends in the future. This reduces the burden on the company’s capital going forward.

Share buybacks are a popular way for a company to return value to investors. On the back of a successful year, Diageo Plc recently announced plans to buy back an extra £660m of shares this year. Whitbread plc also started buying back around £500m worth of shares following its sale of Costa Coffee to Coca-Cola.

To give shareholders an exit route

A buyback can be used to facilitate the exit of a shareholder. This is particularly useful for a small company, where share ownership is shared between a handful of investors and they wish to maintain the existing equity-split. By buying back the exiting member’s shares, the existing membership and voting arrangements within the company remain largely the same, without members having to use their own funds to buy the shares from the exiting shareholder.

To increase share value

For a traded company, if all other factors remain constant, a buyback of shares can help to increase the value of shares due to its impact on the ratio used to evaluate share performance.

By reducing the number of shares in issue, the profit attached to each share will go up, increasing earnings per share (EPS). Main Market and AIM traded companies are reminded by the Investment Association’s share capital management guidelines that they should only undertake a buyback if it would increase EPS. A statement to this effect is usually included in the buyback resolution.

It is the use of share buybacks that led to the Government’s review referred to above. As EPS is often used to measure a company’s performance, it can be linked to an executive’s remuneration package. So buying back shares to increase EPS can increase an executive’s pay. But there may also be perfectly genuine reasons for a company wanting to increase EPS.

To facilitate employee share schemes

Employee share schemes are a popular way of incentivising staff but problems can occur when employees leave but they still hold shares in the business which would be better used to incentivise other continuing employees. To help overcome this, some of the strict requirements for a buyback are relaxed in the case of a buyback made for the purposes of an employee share scheme.