What Exactly Is Buy Back of Securities?

On the news of corporate actions like bonus, split, open-offers, mergers, acquisitions, dividends, rights, buy-backs etc., a stock suddenly takes off to a steep growth, providing enhanced returns to an investor in addition to the expected fundamental returns. Where, many would know that such actions jack up the stock prices, we have tried to introduce through this note a conceptual understanding of buyback of securities.

Buy back is a process, which enables a company to offer to purchase from its shareholders with the only objective or reducing share capital. The reasons of buy back can be (1) to improve shareholder value by increasing value per share (2) to protect it against possible hostile takeovers (3) to pay surplus cash not required by business and (4) to rationalize capital structure. These reasons are good for the shareholders. In order to compensate the existing shareholders for giving away their improved shareholder value and also for providing a shield from being taken over, a buy back offer by a company is generally made at a premium to the current market price.

Many times, there are rumors about news of such buy backs. Before, believing such rumors it is prudent to understand conditions under which a company can go for a buy back. The Companies Act 1956 has laid down certain principles for a company going for buyback.

1. For a buyback, the company can only use a fund amount up to 25% of its total paid up capital plus FREE reserves.

2. A company cannot buyback shares more than 25% of its TOTAL PAID UP EQUITY CAPITAL in a financial year.

3. Post buy buyback, the ratio of debt in the company cannot be more than two times the value of its total paid up capital and free reserves.

4. All the shares for which the company has proposed a buy back should be fully paid up and the company should not have defaulted in payment of interest, repayment of deposits, redemption of debentures or preference shares and timely payment of dividends

5. A company cannot buyback through any subsidiary company including its own subsidiary companies or through any investment company or group of investment companies.

News of buyback of any company not fulfilling any or all of the above conditions should therefore considered to be just a rumor.

On the pricing front, the minimum price of a buyback can be calculated as

The pricing, however, can change depending on the decision of the company on the number of shares to be bought back.

The company can buyback its shares from (a) existing shareholders (b) through the open market or (c) through reverse book building. In any case, a shareholder has to tender shares to the offer through the offer document and consideration is paid on a pro-rata in case of over tender.

As for the shareholders, if the buy back is through a tender within the existing shareholders, the offer would remain open for a period ranging between 15-30 days, within which, they can tender their shares, if they have received a letter of offer from the company. The shareholder shall receive the consideration in a maximum of 22 days after the closure of the offer.

For the purpose of taxation, the difference between the cost of acquisition and the value of consideration received by the shareholder shall be deemed to be the capital gains arising to such shareholder.