There are many reasons why a shareholder may choose, or be required, to sell their shares in a company prior to an exit by all shareholders. In an owner managed business, it could be because they have ceased to be involved in its day-to-day operations (perhaps triggering leaver provisions in the company’s articles) or it might be a practical solution for resolving a dispute between shareholders.
To facilitate the sale of shares in these circumstances, a buyback of shares by the company can be a very helpful tool.
Advantages for carrying out a buyback
A key advantage of a share buyback (as opposed to a sale to the continuing shareholders) is that it avoids the need for the continuing shareholders to personally fund the acquisition from their income. It can also simplify otherwise complex and lengthy pre-emption processes and negotiations.
A buyback of shares will also maintain the existing ownership balance by evenly distributing the resulting concentration of shares amongst the continuing shareholders. This is because, shares bought back by a company are usually cancelled, meaning that each continuing shareholders’ percentage of the total share capital rises by a pro rata amount.
There is a risk that the selling shareholder will be charged income tax in respect of the gain on their shares but, if the shareholder meets certain conditions, it could come within the capital gains tax regime. If so, Business Asset Disposal Relief may also be available. To ensure that the conditions are met, it’s usually recommended that advance clearance is sought from HMRC.
Financing a buyback of shares
To protect creditors, a company may only acquire shares out of its distributable reserves. These are its ”accumulated, realised profits (so far as not previously used by distribution or capitalisation) less its accumulated, realised losses (so far as not previously written off in a reduction or reorganisation of capital)”.
As such, by purchasing the shares, the reserves available for distribution to the shareholders will be reduced.
In addition to having distributable reserves, the company will also need to have sufficient cash to fund the purchase (it being possible to have one without the other). Whilst borrowing funds for the purposes of financing a buyback will not improve the company’s distributable reserves, it may be a solution to provide the necessary liquidity to make the payment to the exiting shareholder.
There are other ways in which the company may finance a buy-back, but these are technical in nature and will involve additional steps. For instance, it is possible for shares to be purchased out of capital, but this will require the directors to make a statement of solvency making them personally liable if the company is unable to pay its debts.
There are a number of steps and formalities. These include:
- checking that a buyback of shares is not prohibited by the company’s articles of association (and amending the articles if necessary);
- ensuring that there are no pre-emption rights on a sale of the shares that need to be disapplied or complied with;
- obtaining shareholder approval from the continuing shareholders;
- ascertaining and justifying the availability of distributable reserves;
- preparing an off-market buy back agreement between the company and the exiting shareholder;
- making filings at Companies House (including a form SH03 for the buyback and a form SH06 for cancellation of the shares); and
- paying stamp duty on the SH03 and registering the transfer in the company’s registers.
If a buyback process is being considered it is important to remember that the process is governed by the Companies Act 2006 and must be carried out strictly in accordance with the legislation. Many buybacks performed by companies without professional advice result in a flawed process. Non-compliance is a statutory offence committed by the company and every officer in default (who is liable to a prison term of up to 2 years, an unlimited fine, or both).
The timing and formalities of the relevant steps are therefore important and there are pitfalls for the uninitiated. For example, it is not lawful for the company to pay for the shares using deferred payments and all of the consideration payable by the company on a buyback of shares must be paid on completion. If the company is unable to fund the buyback in one go, we do provide some solutions for how the company buyback can be structured in order to deal with this.
Non-compliance can also cause issues on due diligence when the company is sold. It goes without saying that it can be extremely problematic to find out that a non-compliant (void) buyback means that there is a risk that a former shareholder still holds shares. Buyers are unlikely to want to take this risk and will require the situation to be resolved or they will insist on indemnities from the remaining shareholders should an issue materialise. We have the expertise to help companies deal with these issues, but it is, of course, preferable to get the buyback process right in the first place.