Shareholders of companies usually look forward to a steady stream of ever-increasing dividends from the respective company, which is the sum of money that the company pays to its shareholders out of its profits.
Keeping that in mind, one of the key goals of these shareholding companies is to maximize shareholder wealth. However, these company executives also want to maintain a balance between keeping their shareholders satisfied and staying agile when and if the market goes into a recession.
One of the ways it strikes a balance between the two is through repurchasing their shares, a process more commonly known as buying back, or buybacks.
This is also a way for companies to return wealth to their shareholders and share it with their investors.
What Are Buybacks?
Simply put, buybacks are stock repurchases when a company buys back its own outstanding shares. This decreases the number of the company’s shares that are available on the market.
It is as if the company is investing in itself and is using its own cash reserves to buy its own shares. Because a company cannot really be its own shareholder, buying back allows it to absorb the value of its repurchased shares which reduces the number of shares accessible to the open market.
This results in fewer claims or shares attached to the earnings of the company. Consequently, the comparative ownership of the proportion of shares significantly increases for each investor.
Why Buybacks can be Good for Your Privately Held Company?
One commonly asked question about buybacks is whether they are good or bad for your company.
There are several reasons why companies resort to buybacks and there are quite a few benefits attached to buybacks. Particularly for privately held companies.
1. Improved Financial Ratios
One major benefit provided by buybacks is that it helps a company improve its financial ratios. These are defined as metrics upon which the market is usually heavily focused. Buybacks reduce the number of shares that are outstanding.
This happens because when a company repurchases its shares, it usually revokes them or holds them as treasury shares which simultaneously decreases the number of outstanding shares.
Buying back further helps reduce the cash numbers and assets on the balance sheet. This reduction in assets increases the Return on Assets (ROA), and also increases the Return on Equity (ROE) because of less outstanding equity.
2. Undervalued Share Price
A share repurchase often occurs when a company believes that its shares are undervalued. Undervaluation is believed to occur as a result of investors’ inability to look beyond a business’ short-term performance.
Instead of keeping cash surpluses in the bank, the management of the company decides to purchase its shares at what is apparently a ‘cheap’ price. This not just reduces the number of outstanding shares but buying millions of dollars of its own stocks reassures investors and encourages them to buy and purchase shares.
Doing this also restores the confidence of investors in the company’s business operations which is beneficial for the company in the long-run.
3. Reduced Dilution
Companies often tend to issue new shares through capital raisings, for instance, which results in the dilution of existing shareholders. Dilution basically refers to a reduction in the ownership percentage of shares of stock due to new equity shares being issued by the company. Dilution also deteriorates the financial appearance of the company.
So, by buying back their shares, companies can diminish the adverse effects of dilution. Reduced outstanding shares because of buybacks also help increase the ownership of the company’s management.
4. Capital Re-structuring
Debt is a cheaper way of financing business operations. It also provides a leverage in the capital structure that helps the shareholders with increased value of their stock. If and when the company is able to access the debt markets at advantageous costs, it may choose to replace some of its equity with debt.
Substituting debt for equity also helps the company reduce its Weighted Average Cost of Capital (WACC), or sometimes called the hurdle rate. A lower hurdle rate makes a number of projects economical which the company would have passed on earlier, thereby improving the margins and growth rate of the company.
How to Locate Shareholders Who May Want To Sell Their Shares?
Since the best time for a company to repurchase its shares is the time when the business is undervalued, that’s when it starts making offers and propositions to its shareholders and investors so that why would sell their shares.
Because undervaluation often occurs due to the inability of investors to see past a company’s short-term performance, companies begin to make optimistic promises and forecasts about its performance.
Also, during a recession, companies tend to favor buybacks over dividends as buybacks are more discretionary in nature and allows a lot more flexibility in its financial affairs.
How to Complete the Transactions to Buy Back Your Shares?
Normally, the process of buying back shares for private companies is carried out through tender offer.
What Is a Tender Offer?
A ‘tender offer’ is basically an offer or bid to purchase some or all of the shares of shareholders in a corporation. The offer is usually made at a premium to the market price.
In other words, this happens when investors propose to buy shares from every shareholder of a company at a particular price for a given period of time. The suggested price per share is typically higher than the company’s stock price which gives a huge incentive to shareholders to sell their shares.
What happens is that companies may present their shareholders with a tender offer to submit or put forward a portion of their shares or even all their shares in a given time frame. The offer specifies both the price range the company is agreeable to pay which is usually at a premium to market price, and the number of shares it wishes to repurchase.
When investors decide to go with the proposed offer, they also mention how many shares they want to tender as well as the price that they are prepared to accept. Once the company collects all the offers, it then assesses them and finds the ideal mix that allows it to buy the shares at the lowest price.
Keep in mind though that despite the many benefits, the buyback process can be turn out to be rather expensive. You would need to invest not only in offering a higher price for the shares, but also in a variety of fees such as attorney or lawyer costs. The process also usually requires time as banks need to verify the tendered shares as well as issue payments.
The Process of a Tender Offer
The process of buying back shares through a tender offer is as follows:
- First of all, your company needs to decide whether it’s able to run a tender offer. That means having the time and resources to do so. You will also need a 409A compliant valuation.
- Raise the funds necessary.
- Determine the terms of your tender offer.
- Prepare the necessary documents with a lawyer or an attorney.
- Present the offer and invite shareholders to participate, providing them with enough time to make a decision.
- Allocate a time frame during which the shareholders can sell their shares.
- Close the tender offer.
In a nutshell, buybacks can prove to be an efficient way for companies to reduce dilution and increase its undervalued share price. They also help companies display increased confidence in their operations to the market.
Michael Norton is a content creator and marketing strategist for Funds INC, a company that specializes in commercial finance.
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