A share repurchase is a method where a company buys back its shares from its existing shareholders. Companies repurchase their shares to control the number of outstanding shares and hence key financial performance metrics.
A company can use one of the top 4 methods of share repurchase arrangements discussed in detail below.
Share Repurchase Arrangement
A share repurchase or also known as a share buyback program is a transaction where a company repurchases its previously issued shares.
A share repurchase arrangement is a method to reduce the number of outstanding shares of a company. The transaction usually results in higher share prices for the remaining shares when executed properly.
Stock buyback programs are often executed with an aim to boost earnings per share (EPS). Unlike the common notion, companies use this method when they want to distribute surplus profits.
A company can use one of the various methods to buy back its shares from existing shareholders.
How Do Share Repurchase Arrangements Work?
When a company decides to repurchase its previously issued shares, it must consider the impacts of the strategy first. The foremost factor is the impact on EPS, ROA, and other financial metrics.
Repurchased shares are either canceled or treated as treasury stocks. A company cannot keep its own shares under ownership legally. Ultimately, repurchased shares become obsolete and the company has to issue new shares when required in the future.
A share buyback arrangement reduces the outstanding shares. It means it reduces the EPS and improves other financial performance metrics such as return on assets and return on equity.
With decreased outstanding shares, the dividend amount per share increases. However, shareholders would expect the same dividend payout ratio for the coming years as well.
It’s important to remember that a share repurchase program only improves the EPS of a company. It does not improve the overall profits or growth of a company instantly. Although the strategy can help a company improve its financials in the long run.
Since companies offer a premium to their existing shareholders, they spend huge money on these arrangements. Share repurchase arrangements can also have negative signaling effects on a company. For instance, it may send a signal to existing shareholders that the company does not have positive NPV projects to invest in.
Top 4 Methods of Share Repurchase Arrangements
There are various reasons to initiate a share repurchase program by a company. Therefore, the choice or the method a company chooses would also make a difference.
Let us discuss the top 4 types of share repurchase arrangements with their pros and cons.
1. Open Market Share Repurchase Arrangement
A company can decide to repurchase shares from the open market (stock exchanges) directly. A company’s brokers are assigned the task of buying back shares from the open market.
This method does not involve many legal obligations. However, the company must adhere to certain SEC regulations that apply to all types of share issuance and repurchase programs.
A company’s brokers plan and buy shares from the open market at market prices. Thus, the company does not need to set or predetermine a price for this program. However, a company can plan to execute the program at a suitable time.
Pros and Cons of Open Market Share Repurchase Arrangement
The open market share repurchase arrangement offers flexibility to the company. A company can start or cancel the program at any time. It does not involve complex legal procedures as well.
It is a cost-effective method for several reasons. A company does not need to offer a premium on existing share prices. Also, the company can save on the brokers’ fees partially as well.
A drawback of this method is that it requires a lengthy period to complete the targeted share repurchase. Company brokers may need to wait as retail investors may not hold a substantial number of shares or they may not willingly put them on sale.
Another limitation of this method is that the company cannot control the maximum cost of the strategy. As it takes longer, the share price may appreciate by the time the plan is executed.
In short, the open market approach is a simple, cost-effective, and flexible option for a company although it offers some limitations.
2. Fixed-Price Tender Offer
Companies can use the fixed-price tender offer to buy back shares as well. In this method, a company invites its existing shareholders to bid for the tender of selling their shares back to the company.
The company sets a fixed price that includes a premium above the current share price. The premium is usually added in percentage terms so that it adjusts with the changing share prices.
Interested shareholders then submit their bids for the number of shares they are willing to sell at the specified price. The company may allocate proportional capital to the bidders if it receives more bids than required.
Usually, large institutional investors participate in fixed-price tender offer programs. They can decide to retain the ownership stakes by keeping the shares and selling a fraction to the company to take immediate profits from the premium offered.
Pros and Cons of Fixed-Price Tender Share Repurchase Arrangement
The fixed-price tender arrangement can be completed quickly. A company can set a fixed price of the repurchase option and add a premium. Interested investors can submit their bids and the process can be completed quickly.
This method does not dilute the shareholding stakes of existing shareholders if the plan is canceled for any reason. Thus, institutional investors consider this method a safer option.
The drawback of this method is that large investors may not show interest in the offer. The company may need to extend the offer period or increase the premium. This way, the approach may prove costly as compared to other methods.
3. Dutch Auction Tender Offer
A Dutch auction tender offer is a method whereby shareholders bid to set a suitable price for the buyback arrangement.
The company sets a minimum bid price and invites all shareholders to bid for selling their shares to the company. Bidders set their prices and the number of shares they are willing to sell back.
The company then reviews the bids and sets a suitable price that covers the required number of shares. Usually, the price is the lowest bid that falls within the range of the tender price and that covers the required number of shares.
Pros and Cons of Fixed-Price Tender Share Repurchase Arrangement
This method follows the Dutch auction style. The company covers all bases of setting the right bid price and the required number of shares. All bidders receive the same share price even if they set a bid lower than others.
This method also allows the company to complete the transaction quickly. A company can use this method when it is unsure about the bid price. It means bidders can set their required premium on existing share prices themselves.
Although the company does not control the bidding process, it holds the right to cancel the auction at any time. If it does not receive favorable bids, it can move on to other options with a share repurchase arrangement.
A limitation of this approach is that large shareholders may set a selling price too high. Also, the company may not receive sufficient bids from institutional shareholders.
4. Direct Negotiation
As the name suggests, a company can directly negotiate with one or more shareholders to buy back its shares. Usually, a company would approach institutional investors to buy back the required number of shares.
The company can set a minimum offer price adding a premium to the market share price. Both parties then negotiate a suitable price that offers some benefits to both of them. This way, both parties can create a win-win situation with an agreed-upon share price.
It is a cost-effective method for the company. However, the negotiation process may take longer time than other options.
Pros and Cons of Fixed-Price Tender Share Repurchase Arrangement
A company private approach a large institutional investor using this method. It means the company does not need to disclose the plan until executed. It can have several positive signaling advantages for the company.
Another benefit is the price can be negotiated directly between two parties. It means both parties will undertake the option when beneficial.
It is a cost-effective approach as it eliminates any broker commissions and other legal costs associated with the process.
On the flip side, this approach can take a longer time to complete. Both sides would consider a different suitable price for the arrangement that may need time.
Also, a company may need to approach more shareholders as some of them may not be willing to sell shares straight away.
This method may also have negative signaling impacts when disclosed to the public. Common shareholders may perceive the move negatively. Hence, share prices may decline when the plan is acknowledged by the market.
