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How do share buybacks work?

An overview of the factors that a company needs to take into account when considering doing a share buy back

A share buyback (or a company purchase of its own shares) is when a company buys back shares from an existing shareholder.  Either they are bought back and immediately cancelled or can be bought and then become treasury shares.  Companies holding treasury shares must not exercise any rights (including any right to attend or vote at meetings or participate in any rights issue made to holders of the class of treasury shares) in respect of those shares.

A buyback can be made in four ways: (i) by using sufficient distributable profits, (ii) from the proceeds of a fresh issue of shares made for the purpose of financing the buyback, (iii) financed out of capital, or (iv) financed out of capital using the de minimis exception under section 692(1ZA) Companies Act 2006 (“CA 2006”).  It’s worth noting that a private limited company can only buy back shares that are fully paid.

There are a number of restrictions to the ability of a company to do a buyback, and a number of processes that a company must go through. 

The first important restriction is that buybacks must generally only be made from distributable profits (these are only created once a company’s accumulated, realised profits (so far as not previously used by distribution or capitalisation) exceed its accumulated, realised losses (so far as not previously written off in a reduction or reorganisation of capital)). This means that most early stage businesses will not be able to do this for some time. It is important to note that only shares bought back using distributable profits can be bought back into treasury.

The main exception to the above is for the buyback to be from capital pursuant to the de minimis exception under section 692(1ZA) CA 2006, but in this case it is very restricted in that the amount must be the lower of £15,000 and 5% of the aggregate nominal capital of the company at the beginning of the financial year in which the buyback takes place.  As most private limited companies have an aggregate nominal capital of only up to £100 or maybe £1,000, this severely restricts the amounts that can be paid pursuant to a buyback.  In effect, it means that buybacks out of capital will typically be only for nominal value or lower (provided that the above 5% rule is not breached).  An example of a case when this may be of use is for shares that are bought back at nominal value as part of a bad leaver clause. If a company intends to rely on section 692(1ZA) CA 2006, it must be expressly permitted to do so in its articles of association. Shares that are subject to a buyback using this method of financing cannot be bought back into treasury. 

The second restriction is that buybacks are treated by HMRC as a distribution, so will be subject to income tax rather than Capital Gains Tax (ie if they are EMI shares they will lose the CGT @ 10% specific benefit).  For unquoted trading companies, there is an  exception if the shares have been held for 5 years or more and the buyback is to benefit the company’s trade (for example where the shares are bought back from a dissenting shareholder).  In this case advance clearance from HMRC can and should be sought.

Like most changes in equity, it is important that a buyback is formally authorised, by passing both Board and Shareholder resolutions.  The Board resolution must also approve the nature of the buyback.  A selling shareholder will also need to enter into a buyback agreement with the company which will be approved in the Board and Shareholder resolutions. 

The company's articles and any other shareholder agreement should be checked to ensure that there are no pre-emption provisions or any similar restrictions on the transfer of shares, which may, for example, require shares to be offered to existing members before they can be transferred to any other party (including the company). Any such provisions or restrictions would need to be waived or amended before the company undertakes a buyback. To the extent that the company has a shareholders’ agreement, effecting a buyback may require investor consent.

 The company’s articles should be checked to ensure that they do not restrict or prohibit the company from purchasing its own shares. In some circumstances, such as a buyback of leaver shares, there may be a power of attorney that allows a director to sign the agreement rather than the selling shareholders.

It should be noted that a buyback of shares can affect S/EIS relief. Professional advice should be sought if you have or intend to have S/EIS investment and wish to do a share buyback.

Once the resolutions are passed, there are a number of steps to be undertaken:

1) Hold a board meeting approving (i) entry into the buyback agreement, (ii) the nature of the buyback and (iii) circulating a shareholders’ resolution.

2) Circulate and pass the shareholders’ resolution (the buyback agreement must be made available to all shareholders and can be appended to the shareholders’ resolution). The shareholder resolutions will be passed as ordinary resolutions except in the case of a buyback financed out of capital (excluding the de minimis exception) which must be passed as a special resolution and must approve the use of capital. It is important to note that the a shareholder who holds the shares that are being bought back cannot vote on the matter under the shareholders' resolution and will not be included in the pass rate.

3) The company and the selling shareholder are to enter into the buyback agreement.

4) Complete a form SH03 and, if the repurchased shares are being cancelled, a form SH06 and send to Companies House.  Any special resolution that has been passed in connection with the share buyback should also be filed at Companies House.

Before form SH03 is filed at Companies House, the company will need to pay stamp duty if the price of buyback is over £1,000. The stamp duty will be 0.5% of the price of the buyback. No stamp duty is payable if  less than £1,000 is paid for the bought back shares.  Payments for stamp duty should be made electronically. Once paid, an electronic version of Form SH03 should be sent to HMRC by email to stampdutymailbox@hmrc.gov.uk.

5) Update the share register accordingly and cancel the share certificates in respect of the shares bought back.