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If your company is thinking about purchasing its own shares — also called a share buyback — you might wonder what effect share buybacks will have on your company’s accounts. By purchasing your company’s shares, you effectively lower its share capital’s value while reducing the value of its assets. This is because there is a connection between the number of shares a company has outstanding, the value of the company’s assets, and what lawyers call the doctrine of share capital maintenance.
This article will explain the effect of purchasing your company’s shares, such as on your company’s share capital, and provide a brief overview of some essential legal concepts.
Share Capital
A company’s share capital refers to the number of outstanding shares a company has issued to its shareholders and their value.
The value of your company’s share capital is equal to the net asset value (NAV) of your company adjusted for its profit and losses and other accounting treatments. NAV is calculated as the total value of all your company’s assets, less all outstanding liabilities. By accounting for any profits or losses incurred in the accounting period, you derive the value of your company’s share capital.
Importance of Share Capital
The law restricts your company’s ability to alter its share capital. For example, corporate law prevents you from paying shareholders cash that does not arise from your company’s profits. This is because the value of the share capital is the value of the assets your company’s creditors can claim against you should your company face financial difficulties.
Additionally, the law requires your company to file its financial accounts each year. The information you supply allows creditors to inspect your account and determine:
- the current value of your company’s share capital; and
- how much the value has changed from year to year.
In other words, by restricting the ability of your company to alter its share capital value, the law provides creditors with a degree of comfort that there is a reserve pool they can draw from if necessary.
The restrictions the law imposes on your company exist to preserve its share capital. This is called the doctrine of share capital maintenance.
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Effect of Share Purchases on Share Capital
The legal process a company must follow to purchase its own shares is an exception to the doctrine of share capital maintenance. This is because:
- Your company uses its own valuable assets (usually cash) to pay its shareholders in exchange for purchasing shares in itself.
- This results in the company having fewer outstanding shares and fewer assets.
The effect is that the value of the share capital is now less. From the perspective of your company’s creditors, the reserve pool they can draw on if your company cannot pay its debts is now smaller. This appears to contradict the doctrine of share capital maintenance.
Therefore, the law only allows your company to purchase its own shares under limited circumstances and through three routes, namely:
- its profits;
- cash raised from a recent share allotment; or
- using its own capital reserves in what is called the De Minimis procedure.
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Balance Sheets and the Effect of a Share Purchase
By law, all companies must submit a balance sheet to Companies House once a year. The balance sheet shows three essential values:
- your company’s assets, such as cash held and the value of land and equipment;
- any outstanding liabilities, such as any loans and unpaid invoices to your suppliers; and
- the shareholder’s funds, which is the value of all the shareholder’s investments in the company.
Notably, the company’s net assets are the difference between its assets and liabilities. The net asset value forms the top half of the balance sheet, and the value of the shareholder’s funds forms the bottom half. The name “balance sheet” comes from the fact that the top half equals the bottom half.
The balance sheet must provide enough information for the reader to work out the value of the company’s share capital. In most cases, this is the net asset value plus or minus the profit and loss account. However, certain other factors can influence the value of the share capital. These include:
- the share premium account, which is a separate account that reflects the difference between the value of any shares issued for more than their nominal amount; and
- the capital redemption reserve, which the law requires you to account for when you complete a share buyback.
An Example
Below is YouCo Ltd’s (a make-believe company) balance before and after it completes a share buyback of 100,000 x £1/share at a 20% premium or £1.20 per share/£120,000 in total. This was funded through its profits.
You will see that for the purposes of completeness, the balance sheet does not list the assets and liabilities individually. Instead, it just gives the net asset value of the company.
Also, assume that you issued a portion of the shares at a total premium value of £40,000, which is reflected in the share premium account.
Effects
YouCo has spent £120,000 of its surplus profits to purchase shares from specific shareholders. As it has spent some of its cash, the value of its assets has decreased. Likewise, there are now 100,000 fewer shares held by shareholders, so the equity share capital has been reduced by £100,000.
The company currently has 100,000 shares of a nominal value of £1,000 in total (or £1 each). Where a purchase is funded with profits — as most share purchases are — the law requires that a company credit its capital redemption account by the aggregate nominal value of shares purchased.
This account forms part of the company’s non-distributable reserves, which means the company cannot distribute the value in this account. This gives creditors similar protection as if this value was maintained in the company’s share capital. Ultimately, the company cannot distribute the value held in the account to its shareholders outside of two avenues.
By following a lawful share purchase, your company can use the capital redemption account to:
- cancel the shares and reduce the total equity capital of the company like a reduction in share capital; or
- issue existing shareholders with shares equal to the value of the reserve.
Key Takeaways
If your company purchases its own shares, its net value will go down the amount paid by the shares. This lowers the value of your company. Likewise, there are now fewer shares in existence, which lowers the value of the share capital. This goes against a general rule of company law, which is that a company cannot reduce the value of its share capital.
Therefore, the law requires your company to credit a new account called the capital redemption reserve account with the value of the nominal shares it purchased.
If you need help purchasing your company’s shares, our experienced commercial lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us at 0808 196 8584 or visit our membership page.
Frequently Asked Questions
The value of your company’s assets decreases by the purchase price of the shares. Likewise, the total value of your company’s share capital decreases by the total nominal value of its purchased shares.
What is the doctrine of maintenance of share capital?
The doctrine of maintenance of share capital restricts the ability of a shareholder to demand a return on the value of the money they transferred to the company in exchange for shares.
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