What is the difference between capital reduction and share buy back?

What is the difference between capital reduction and share buy back?

Share buyback and capital reduction are options open to SMEs, but do you understand what they both are or why you might use them?

A company may want to undertake a reduction of share capital for various reasons, including to create distributable reserves to pay dividends to shareholders. Companies do share buybacks for various reasons, including facilitating the exit of any existing shareholder, company consolidation, equity value increase, and looking more financially attractive.

In this blog, we look at both options and where a business may consider using these options.

Is a share buyback the same as share capital reduction?

A share buyback is where a company buys back its own shares from a shareholder, either out of distributable profits or out of capital. For many SMEs the shares are cancelled which then raises the percentages held by the other existing shareholders.

A capital reduction is when a company reduces the amount of its share capital, by making payments to shareholders out of its capital or increasing distribution reserves. A capital reduction can also be done when shares are cancelled for zero consideration. Returning capital allows a company to reduce its share capital without the consent of all shareholders.

When would you use a share buyback or share capital reduction?

A private company may use a share buyback to buy back their own shares in order to return surplus cash to shareholders, or to provide an exit route for a retiring shareholder. Share buyback can also be used for company consolidation, equity value increase, and to look more financially attractive.

Capital reduction of share capital can be used for a number of reasons including increasing shareholder value and producing a more efficient capital structure. Reducing a company's share capital can create distributable reserves, to pay dividends in the future. Capital reduction will return surplus capital back to shareholders, when going through a de-merger, and reducing or eliminating paid-up or unpaid shares.

How does capital reduction work?

In line with the Companies Act 2006 and there are two ways it can be undertaken depending on the type of company:

• By special resolution with confirmation of the court – private limited companies can use this option. Public limited companies must use this option.
• By special resolution supported by a solvency statement of the directors – this option can only be used by private limited companies. However, there may be instances when a private limited company may opt to take the option above to obtain a court order (see below).

A confirmation of the court may be opted for in a private limited company when not all the directors are willing to sign the solvency statement or if they opt to be guided by the court where there are creditors who may oppose the capital reduction.

Both share capital reductions require a resolution and shareholder approval by at least 75% of the shareholders of the company.

What is the process for doing a capital reduction?

The process for undertaking a capital reduction is as follows:

• Passing of a special resolution.
• Issuing of a statement of solvency by the directors.
• A statement of capital, showing the company’s share capital as reduced.
• A statement by the directors confirming the solvency statement wasn’t made more than 15 days before the date the special resolution was passed.
• The filing of form SH19(644) with Companies House.

What are the advantages of capital reduction?

The advantages of a capital reduction can be as follows:

• Simplify a company's capital structure, making it more efficient.
• Distribute dividends to shareholders, increasing their value.

Elimination or reduction of accumulated losses.

How does a share buyback work?

A company acquires shares via a share buyback by buying back shares out of distributable profits or out of capital.

Distributable profits are the company's profits that are available for distribution (for example as dividends). A company's capital will be maintained if a buyback using distributable profits/reserves is used.

A buyback contract needs to be in place before a purchase out of distributable profits. The contract will need to be approved by an ordinary resolution. This requires members holding at least 51% of the voting shares to approve the resolution.

Buying back shares out of capital is a much more complex process and therefore, many companies now opt to buy back shares using distributable reserves. To buy back shares out of capital, directors must issue a statement including the amount of capital to purchase shares. The contract needs to be approved by the company's shareholders and members holding 75% of voting shares and should be filed at Companies House within 15 days. Notice must also be served to creditors and the directors' statement and auditor’s report need to be available for inspection if required.

What are the advantages and disadvantages of share buybacks?

The advantages of share buybacks are:

• Tax efficient way of rewarding shareholders.
• A way of returning excess cash to shareholders.
• Can increase remaining shareholders ownership percentage.
• Can be used to facilitate a shareholders exit.

The disadvantages of a share buyback can be as follows:

• Cash could be put to better use for future investment such as R&D or acquisitions.
• Buy back could increase some shareholders ownership percentage more than you wish.
• Will likely need clearance from HMRC to agree tax implications in advance.

Conclusion

There may be a number of reasons why a share buyback or a capital reduction could be right for your company. It's important to understand the reasons for undertaking each of these two options and which one would be better suited to your needs.

A share buyback can have tax advantages for a shareholder who wants to reduce their shareholding or end their shareholding in a company. A company's decision on whether to undertake a reduction of share capital or a share buy-back is often driven by tax considerations. Generally, the buyback out of distributable profits is a much simpler and easier route than a buyback out of capital.

The tax consequences need to be carefully considered before using either route, contact us for help and advice.