In this article, Asim Ansari, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses buyback of shares by companies

Introduction

Under Section 68 of the Companies Act, 2013, read with Section 77A of the Companies Act, 1956, signifies that any company limited by shares or company limited by guarantee having a share capital can buy its own securities, whether it is a public company, private company or an unlisted company.

The Companies (Amendment) Ordinance (October 31, 1998, and January 7, 1999) have allowed companies to buy back their own shares subject to regulation laid down by SEBI. The ordinance lay down the provisions concerning buyback of shares. Section 77A of companies act empowers a company to purchase its own share or other specified securities in certain cases.

What is buyback of shares?

The buyback of shares is also known as ‘share repurchase’. Buyback of equity shares is a capital restructuring process. It is a financial strategy that enables a company to buy back its equity share and securities from the shareholders. Buyback of shares is the method of cancellation of share capital. It leads to a reduction in the share capital of a company as opposed to the issue of shares which results in an increase in the share capital.

A share repurchase is a strategy by which a company buyback its own shares from the market, usually because management thinks the shares are undervalued, reducing the number of outstanding shares. The company buys shares directly from the market or from its shareholders at a fixed price. Buyback of shares is reverse of the issue of shares by a company where it offers to take back its shares owned by the investors at a specified price. This offer can be binding or optional to the investors.

In a no-growth situation, buy-back option is expected to help to correct the positively twisted equity share capital in the existing capital structure of a lowly leveraged company that earns stable returns.

Provisions of Buyback under Section 68

If the company makes any default in the process as provided under section 68 or in case any listed company of any regulation made by SEBI:-

1. Such company shall be punishable with fine not less than 1 lakh rupees but may exceed up to 3 lakhs
2. Every such officer who is involved in the process who is in default shall be punished for a period which may extend to 3 years or fined not less than 1 lakh rupees.

Objectives of Buyback of Shares

1. Unused cash: If the company has a huge cash reserve with not many future projects to invest in and if the company thinks the market price of its shares is undervalued, they can buy back shares as a reward for their shareholders.
2. Tax Gains: The companies prefer buyback to reward their investors instead of distributing cash dividends because dividends are taxed at higher rate than capital gains. At present, short-term capital gains are taxed at 10% and long-term capital gains are not taxed.
3. Market Perception: By buying shares back from the shareholders at a higher price than the prevailing market price indicates the company shares valuation should be higher.
4. Exit Option: If a company wants to exit the market from a particular country or want to close the companies it can offer to buy back its shares that are trading in the market.
5. Escape monitoring of accounts and legal controls: If a company wants to avoid the regulations of the market regulator by delisting. They avoid any public scrutiny of its books of accounts.

Methods of buyback

A company can buy back its own shares from:

• From the existing shareholders on a proportionate basis
• From the open market
• From old lots
• By purchasing securities issued to employees of the company pursuant to a scheme of stock option or sweat equity

Conditions for Buyback

1. It shall be authorized by the articles of the company.
2. The ratio of debts owed by the company after the buyback shall be more than twice the paid-up capital and its free reserves.
3. All the shares or specified securities for buy-back are fully paid.
4. A company cannot withdraw the offer of buyback once it is declared.
5. The company cannot use any money borrowed from financial institution or banks for buyback of shares.
6. The company shall not utilize any proceeds of an earlier issue of same kinds of shares and securities for the purpose of the buyback.

Why is Buyback of shares beneficial for the company?

There are several reasons which are as follows:

Fair Market Value

When repurchase of shares is announced, In exchange for giving up an ownership stake in the company and dividends to the shareholders, they are paid the fair market value of the stock at the time of buyback of shares. The process of share repurchases helps a business reduces its cost of capital, consolidate ownership, and benefit from temporary undervaluation of the stock. Repurchase of shares also helps to free up profits to pay executive bonuses and inflate important financial metrics.

No burden of paying dividends

The process of share repurchase can be interpreted as the company is doing well in the market and it no longer needs any equity funding. The company refunds shareholders’ investment because it thinks of reducing its average cost of capital, instead of carrying the burden of paying dividends and unneeded equity. When a company voluntarily returns its equity capital, it indicates that the company has no viable projects in which to invest.

Reissue at higher prices

The buyback of shares seems beneficial for the company’s goodwill in the market as they are capable enough to buy back its own stock. It is not always that repurchase signify the issuing company has run out of uses for equity funding. Sometimes if the company feels their stocks are undervalued, they buyback from the shareholders at the deflated prices and later when the market prices inflate, the company reissue the number of shares at high prices. This step helps the company in increasing total equity capital while keeping the number of shares outstanding stable.

Limited number of ownerships

Buyback benefits in sharing the ownership to a lesser number of people. The process is also used as means of consolidating ownership. Each number of share represents a small stake in the ownership, so if the number of shareholders will be less, the ownership control will be shared with a lesser number of people. The company wants its control in hands of its core leadership rather than much in hands of the shareholders.

In addition, the shareholder\’s dividends are paid from company’s net profit, so if there will be less number of shareholders, the pie will be divided into few pieces. Buyback enables businesses to increase the compensation of the executive by making the company look more profitable.

What does a Buyback signify about a given company’s Financial health?

The common interpretation of buyback of stock is that the issuing company is booming financially. Buybacks often mean giving back a portion of the company’s profit to the shareholders to reward them for their investment in terms of dividend payments without the unwanted bonus of immediate taxation. After utilizing the equity capital for growth, the business generates enough revenue to fund its own continued expansion and return capital to its investors.

The process of stock buyback doesn’t mean that company no longer requires capital funding but it founds the cheaper way to raise it. The Debt financing comes at a lower cost than equity because of the lower risk to lenders.

If a company’s stock is undervalued it can take advantage of stock valuation by using a Buy low and sell high strategy as buyback enables the business to repurchase shares at low prices and sell it again when the price goes high. It helps business to keep the total number of shares outstanding stable while increasing their total equity.

The buyback may indicate the issuing company has become the target of a hostile takeover because when one company takes over the other one, the target company on hand is used to pay off its liabilities.

The EPS (earning per ratio) is one the most common metric used to indicate effective management, so an instant knock to the EPS ratio by executing a buyback can mean that larger portion of the company’s profit goes in the pockets of its executives.

While a buyback in the above scenario may not be a negative or positive reflection of a company’s financial health, it is more concerned when assessing a potential investment.

Advantages of buyback of shares

1. It might increase confidence in the investor’s on the company’s board of directors as they know directors are ever willing to return surplus cash if it’s not able to earn above the company’s cost of capital.
2. Buyback helps a company to reduce its excessive share capital that is not required for the time being and helps the company to utilize its large sum of free reserves.
3. Buyback of shares can increase returns on equity. It has a greater effect when more undervalued shares are repurchased. This is the most profitable course of action for the company.
4. Companies may buy back its own shares as protection against unfriendly takeovers from others companies.
5. The buyback is considered as the quickest method for reduction of share capital. It involves lower cost transaction.
6. It acts as an excellent tool for financial re-engineering. In case of profit-making, the companies having high dividend payments, buy back can boost their bottom lines since dividends attract taxes.

Disadvantages of buyback of shares

1. The biggest disadvantage of the buyback is that cash which is being used by the company to repurchase securities can be used for another productive purpose like installing the new manufacturing unit, hiring new staff, increasing the market expenditure to boost sales which in return can result in an increase in the profits of the company. But if the company goes for buyback it overlooks all the profitable alternatives which can be used.
2. The next drawback of the buyback is that sometimes it may give a wrong signal to them about the company so as to increase the price of the stock so that promoters can sell their stocks. Hence innocent investors get trapped when the news of buyback comes into the market domain as the prices of the stock rise.
3. It creates a negative image in the market that company is no more profitable as the company uses its excess cash for buyback of stocks. It creates a negative image in the mind of long-term investors who are looking for capital appreciation due to growth I the company.

Conclusion

A share buyback is an effective way for management to boost up the company’s undervalued share price and reduce dilution. The process requires management to show confidence in their business operations. It is not necessary that every buyback automatically benefits shareholders. It is important being an investor one should gauge the purpose and the timing of a buyback and also have a look at the overall financial situation of the company. A shareholder must reconsider all his views before purchasing shares of the company which is involved in the process of a buyback.

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