Share buyback in instalments
- John Deane
- Updated: Sun, 15th Jan 2017
Can a company pay for a share buyback in instalments, if it cannot afford to pay the share seller in one payment? Answer: Yes. A share buyback can be made in stages.
Structuring share buybacks in tranches
Share buybacks are fairly common. They are a good way to resolve shareholder disputes. However, disputes often arise when the company lacks cash. Then the company cannot afford to buyback the shares in one payment.
The share buyback must be made from distributable reserves. Distributable reserves are similar to working capital. Directors must be confident they have sufficient cash to pay creditors after using funds for the share buy back.
Directors of cash strapped companies feel more confident if they pay for the shares in instalments.
Structuring a share buy back in instalments
First, the directors agree the price for the shares bought back. The valuation is not always clear cut for private companies with no trade sale. Private company valuation is an art.
Second, the directors calculate a comfortable cash flow forecast. For example, the company buys back 1000 shares for £1m, as follows:
- Day 1: the company pays £400k and receives legal title to 400 shares,
- The beneficial title in and to all shares passes on the same date;
- Six months later: the company pays a further £300k and receives legal title to 300 shares;
- Twelve months later: the company pays the final £300k, and receives legal title to the final 300 shares.
Thus the company maintains adequate distributable reserves throughout the year.
Share buybacks: 5 hidden traps
The above structure is workable. However, care is required. The share buyback risks being void. Sellers face new tax risks. We commonly encounter five risks:
1. Share buyback: Part payment & share rights
The seller may remain entitled to certain rights attached to the “sale shares”, if we don’t amend the articles and/or shareholders’ agreement. The seller may even remain the legal owner of the tranche shares. Thus we often:
- Amend the rights attached to the “sale shares”;
- Vary the rights attached to the tranche shares, so
- There are no income, voting, or capital rights.
2. Unwittingly convert capital to income
If the seller hasn’t held the shares for over five years, when signing the buyback agreement, then HMRC taxes the instalments as dividend income. There is no avoiding this. HMRC taxes the consideration as a capital payment if the seller:
- Held the shares for five years.
- Is UK resident for tax purposes.
- Has “substantially reduced” their holding in the company.
- Following the sale, does not directly or indirectly hold more than a 30% interest in the company’s capital,
- Gains a 10% capital gains tax rate, if the seller meets the entrepreneurs relief conditions.
Assessing conditions 1, 2, and 4 is usually straightforward.
3. Has the company bought back sufficient shares on day 1?
When paying in instalments, ensure you meet condition 3. Otherwise, this causes problems.
A seller’s shareholding is “substantially reduced”, if, on day 2, the seller’s shareholding, expressed as a percentage, is less than 75% of the seller’s holding prior to day 1.
Suppose the seller holds 1000 shares. The company’s share capital is 5000 shares, all of the same class:
- Prior to day 1, the seller’s holding is 20%.
- On day 2, the seller’s holding must be less than 15% of the company’s share capital,
- Being 20% x 0.75.
- On day 1, the company buys back 400 of the seller’s shares.
- Assuming the sale shares are cancelled, the seller now owns 600/4600.
- On day 2, the seller’s holding will be 13.04%.
- The seller’s holding is “substantially reduced”, as it is below 15%.
Hence, the day 1 payment is usually the largest instalment.
4. Is entrepreneurs’ relief a certainty?
There are rumours that HMRC’s stance is changing. The change is:
- The seller must meet the criteria for entrepreneurs’ relief throughout the instalment payment period, i.e.
- Until legal title to all shares has transferred.
Thus, the seller must remain an employee or director during the tranche period. However, it is impractical for a seller to remain an employee, as a nominal salary will not be attractive to a seller.
It may be possible for the seller to remain a director, providing:
- The remaining shareholders retain control, and
- Can outvote the “seller director” at board level.
We amend the corporate documents. The rules are complex.
5. Share buyback: Misjudging the required cash flow
Does the company still have to pay if the company’s reserves are not as healthy as forecast? The company must have sufficient distributable reserves to pay each and every instalment.
From the company’s perspective giving the seller security is unattractive. What if the company doesn’t pay? Is the seller then a creditor with an undisputed debt? If so, perhaps the seller could serve a statutory demand and winding up petition.
Clearly the company should avoid this risk. Perhaps, the instalment payment could be a preference payment capable of being avoided by the liquidator.
We avoid problems by thinking through the possibility of delaying payments. Otherwise the company could face a breach of contract claim from the seller. We suggest negotiating flexible solutions, e.g. a clause that the share buy back due under instalments that the company is incapable of immediately funding “rolls over” to a future date.
We obtain HMRC clearance for the tax elements. However, HMRC does not confirm entrepreneurs’ relief, but we can confirm if it is available. In addition, you need to factor in time to obtain shareholder approval.
Share buyback in instalments: potential dangers
We often see oversights and errors. You can avoid many problems if both parties know the issues before commencing the deal.
John Deane is a partner in the commercial team. John acts for both shareholders, and companies.