Passing the Torch: How to buy out an exiting Shareholder

When a shareholder decides to retire or move on, what is the most effective way to achieve a clean and commercially sensible exit?

Shareholder exits are usually achieved by the exiting shareholder:

1. selling their shares to one or more of the remaining shareholders; or
2. selling their shares back to the company. Alternatively,
3. the remaining shareholders may create a new company to acquire 100% of the shares in the existing company.

Each of the three options will be explored in greater detail below.

Share Purchase by Remaining Shareholders

One or more of the remaining shareholders can buy the departing shareholder’s shares. In this scenario, the remaining shareholders must use their personal funds to do so. The obvious barrier is the financial burden placed on those individuals, particularly where the exiting shareholder holds a substantial shareholding.

If the remaining shareholders want to use funds held in the company, they will usually need to extract those funds by way of dividend. This means they will pay income tax on the dividend and can only use the net amount received to fund the purchase. As a result, this route may be unattractive for the remaining shareholders.

Share Buybacks

A share buyback can provide a straightforward exit route, with the company buying back the departing shareholder’s shares and cancelling them. This can provide a clean break for all parties and results in a proportionate increase in the percentage shareholdings of the remaining shareholders.

For the exiting shareholder, a share buyback may be less attractive if the sale proceeds are taxed as income, which would usually be at a higher rate than capital gains tax. However, if the exiting shareholder has held their shares for more than five years and is making a genuine exit, it should be possible to apply to HMRC for clearance that the sale proceeds will be treated as capital.

The buyback route may be attractive for all parties if capital tax treatment is available. However, there is a statutory process that must be followed, and the consequences of getting it wrong can be severe, including the entire buyback being declared void. If the company is later sold, the buyer’s solicitors are likely to scrutinise any historic buyback of shares to ensure it was carried out effectively.

A limited company is only permitted to purchase its own shares in accordance with Part 18 of the Companies Act 2006 (CA 2006), which sets out the following requirements:

1. Shareholder approval is required;
2. Consideration for the share buyback must be paid in cash at the time of the purchase; and
3. The buyback must be financed out of distributable profits, the proceeds of a fresh issue of shares or, in the case of a private limited company only, out of capital.

A shortage of distributable reserves or available cash at completion may mean that a share buyback is not viable. So, what options are available if cash flow is tight or there are insufficient distributable profits?

Share Buybacks in Tranches

While deferred payments of the purchase price are prohibited, there is a partial workaround for this. A share buyback agreement can be structured as a series of separate buybacks completing on different dates, provided that each buyback is paid for at its respective completion.

The company must have sufficient distributable profits to pay for each tranche at the time of purchase. Entering into a buyback agreement structured in tranches therefore creates a risk that the company will not have sufficient distributable profits to fund the buyback on the relevant completion date.

The exiting shareholder also remains the legal owner of the unbought shares until each tranche completes, meaning they retain certain voting or dividend rights in the interim.

This may not be a particularly attractive option, as it does not provide a clean break immediately. It also may be harder to get approval for capital gains tax treatment where a buyback is being completed in tranches.

Using a New Holding Company

A new company (NewCo) can be set up by the remaining shareholders to acquire 100% of the existing company (Target). NewCo issues shares in itself to the remaining shareholders and pays cash to the exiting shareholder. This means the remaining shareholders exchange their shares in Target for shares in NewCo and roll over any capital gains tax into their shares in NewCo.

NewCo can fund the purchase of the exiting shareholder’s shares through borrowing from Target. It can also pay the consideration in instalments, funding any deferred consideration out of future profits or cash generated by Target. Any deferred consideration does not need to be conditional on the availability of distributable profits, which can provide greater certainty for the exiting shareholder.

Perhaps the most significant downside is stamp duty. This is calculated at 0.5% of the total value of Target rather than just the value of the exiting shareholder’s shares.

Final Comments

The right exit strategy will depend on the company’s circumstances, cash position and the objectives of everyone involved. A company with limited cash flow buying out a significant shareholder may need a very different approach from a business with healthy distributable profits buying out a smaller shareholder.

If you have any questions about buying out an exiting shareholder, please contact Hughes Paddison’s Corporate and Commercial Team at jdr@hughes-paddison.co.uk or on 01242 574 244.