Buy-back of shares is a method of financial engineering. It can be described as a procedure which enables a company to go back to the holders of its shares and offer to purchase the shares held by them.
Buy-back helps a company by giving a better use for its funds than reinvesting these funds in the same business at below average rates or going in for unnecessary diversification or buying growth through costly acquisitions.
When a company has substantial cash resources, it may like to buy its own shares from the market particularly when the prevailing rate of its shares in the market is much lower than the book value or what the company perceives to be its true value.
This mode of purchase is also called ‘Shares Repurchase’. A company can utilize its reserves to buy-back equity shares for the purpose of extinguishing these or treasure operations. The former option results in reduction of the paid up capital, and consequently higher earnings and book value per share. Naturally, the market price of equity goes up.
The reduction in share capital strengthens the promoter’s control and enhances the equity value for shareholders. In the latter option, companies buy their shares from open market and keep these as ‘treasury stock’.
This enables the promoters to strengthen their control over the shares bought back, without any investment of their own. In case of treasure operations, there is a diversion of company’s funds to buy shares and reduction in the value of equity for the shareholders.
The main aim of shares repurchase might be reduce the number of shares in circulation in order to improve the share price, or simply to return to the shareholders resources no longer needed by the company.
The shares repurchase may be by way of purchase from the open market or by general tender offer to all shareholders made by the company to repurchase a fixed amount of its securities at pre-stated price.
Reasons for Buy-Back:
There are reasons why a company would opt for buy-back:
- To improve shareholder value, since buy-back provides a means for utilizing the companies surplus funds which have unattractive alternative investment options, and since a reduction in the capital base arising from buy-back would generally results in higher earnings per share (EPS).
- It is used as a defense mechanism, in an environment where the threat of corporate takeovers has become real. Buy-back provides a safeguard against hostile take-over by increasing promoter’s holdings.
- It would enable corporate to shrink their equity base thereby injecting much needed flexibility.
- It improves the intrinsic value of the shares by virtue of the reduced level of floating stock.
- It would enable corporate to make use of the buy-back shares for subsequent use in the process of mergers and acquisitions without enlarging their capital base.
- Buy-back of shares is used as a method of financial engineering.
- It is used for signaling the effects of buy-back on the share price.
Financing Aspects of Buy-Back:
Finance is the nerve centre for the business activities and success is more depending on the better and efficient management of funds and finance. In order to buy-back of shares and securities in large numbers, the company needs huge amounts of capital and funds which may be mobilized through one or more of the sources viz.
- Internal sources
- Sufficient cash position
- Selling of temporary investment with the least possible loss
- Raising of working capital needs
- Raising cash by issuing fixed deposits
- Raising by issue of debentures and loan bonds
- Cash credit from commercial banks
- Overdraft from commercial banks etc.
Benefits of Buy Back:
The benefits derived from share repurchase program are as follows:
- Firms whose profitability was below their industry average enjoy greater share price growth after shares are repurchased than firms whose profitability was above their industry average.
- Firms whose sales growth was below their industry average enjoy greater share price growth after shares are repurchased than firms whose sales growth was above their industry average.
- Profitable and growth firms that repurchase shares provide a clear indication to the investors about the strengths of the company.
- Repurchasing firms with debt ratios below but sales growth rates above their industry average experience substantially higher share price growth after repurchasing than firms with debt ratios above but sales growth below their industry average.
- Repurchasing firms with profitability and debt ratios below their industry average demonstrate higher share price growth after repurchasing than firms with profitability and debt ratios above their industry average.
Drawbacks of Buy Back:
- This could enable unscrupulous promoters to use company’s money to raise their personal stakes.
- It opens up possibilities for share price manipulation.
- It could divert away the company’s funds from productive investments.
Legal Provision as to Buy-Back:
Buy-back enables the company to go back to its shareholders and offers to purchase from them the share they held. With the introduction of sections 77A, 77A A and 77B in the Companies Act, 1956 through the Companies (Amendment) Act, 1999, now the companies allowed buy-back shares.
They buy-back of shares are also subject to the SEBI (Buy-back of Securities) Regulations, 1998. The said legal provisions are summarized as follows:
- The Sources of funds for buy-back of shares or other specified securities of a company are:
(a) Free reserves or
(b) Securities premium account or
(c) The proceeds of issue of any shares or other specified securities.
- No buy-back should be made out of the proceeds of an earlier issue of same kind of shares or same kind of other specified securities.
- Explanation to section 372A of the Act provides that ‘reserves’ as per the last audited Balance sheet of the company are to be taken as free reserves. The amounts credited after the close of financial year to free reserves and the securities premium account should not be utilized for buy-back.
- The company may buy-back its own shares or other specified securities in any of the following manner:
(1) From the existing security holders on a proportionate basis, or
(2) From the open market, or
(3) From odd lots, or
(4) By purchasing the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity.
- A company may buy-back its shares or other specified securities to the extend 10% of its total paid-up equity capital and free reserves by passing only a Board resolution.
- If buy-back is beyond 10%, it must be approved by shareholders resolution. In any case, buy-back of equity shares by a company cannot exceed 25% of its total paid-up equity capital in that financial year.
- Where the companies buy-back its own shares, it shall extinguish and physically destroy the securities so bought back within seven days of the last date of completion of buy-back.
- A company can issue bonus shares at any time after the buy-back of shares. Regulation 19(l)(a) of the SEBI (Buy-back of Securities) Regulations, 1998, a company shall not issue any specified securities including by way of bonus till the date of closure of the offers for buy-back made under the regulations.
- Section 77(8) prohibits further issue of shares (including allotment of further shares) under clause (a) of sub-section (1) of section 81 for a period of six months except by way of bonus shares.
- A company can buy-back its shares every year but subject to the satisfaction of other conditions such as debt-equity ratio, limits of buy-back stipulated in section 77A etc. Promoters can participate under tender offer or buy-back through book building subject to full disclosures being made in the letter of offer.
- A company cannot buy-back equity shares from the promoter or person in control of the company if the buy-back is through stock exchange.
- Passing of resolution by a company does not create any obligation on the company to buy-back its securities. Buy-back becomes irrevocable only when the letter of offer is filed with the appropriate authority or public announcement of the offer to buy-back is made.
- The company should pay the consideration only by way of cash/ cheque /bank draft.
- The cost of buy-back of securities should be taken as an expense and charged to the Profit and Loss Account.
- Listed companies are required to intimate the stoke exchange of general meeting and resolution passed thereof.
- The buy-back shares of a private limited company are subject to the compliance of Private Limited Company (Buy-back of Securities) Rules, 1999.
A listed company is required to open an escrow account which is to be used as a security for the purpose of making payment in respect of buy-back of shares. The company should deposit in an escrow account opened with a scheduled commercial bank on or before the opening of the offer for buy-back of securities, such sum as specified below:
- Where the estimated consideration payable for buy-back does not exceed Rs. 100 cores, 25% of the consideration payable.
- In case the consideration payable for buy-back exceed Rs. 100 crores, 25% up to Rs. 100 crores and 10% of the balance.
- The companies are required to maintain a ‘Register of Securities Bought back’ which should contain the prescribed information. .
- The company is required to extinguish and physically destroy the security certificates bought back in the presence of the Registers or Merchant Banker or Statutory Auditor within seven days from the date of acceptance of securities. Mere stamping ‘cancelled is not sufficient.
- The securities offered for buy back, if already dematerialized, should be extinguished and destroyed in the manner specified under SEBI (Depositories and Participants) Regulations, 1996 and the bye-laws framed thereunder.
- Where a company purchases its own shares out of free reserves, then a sum equal to the nominal value of the shares so purchased shall be transferred to the ‘Capital Redemption Reserve’ and details of such transfer shall be disclosed in the Balance sheet.
- Disclosure are required to be made in Directors Report as to reasons for failure of buy- back, if shares are not bought back within 12 months from date of Board or Shareholders resolution.
- A company should not keep the offer for buy-back open for a period exceeding 30 days.