This case study is based on the experience of a business owner who owned 70 percent of his business. The balance was owned by two individuals, one of whom owned 20 percent and was causing much difficulty. The controlling shareholder wished to reacquire the shares of the troublesome stockholder, whose interest was valued at $200,000. But after working through the numbers, the business owner decided that the cost to the company would be too great. He decided to simply live with the troublesome minority shareholder.
When a corporation buys common stock from its stockholders, the transaction is referred to as a “corporate stock redemption,” and the stock so acquired is called “treasury stock.” Corporate stock redemptions are considered by company owners principally for the following reasons:
- Peace: To silence a troublesome minority stockholder.
- Obligation: For example, one of your executives is leaving the company and he or she has the legal right to require the company to buy the stock he or she purchased previously under a stock option plan.
- Mandated Buyout: When a court of law orders the company to buy out a minority owner’s shares.
- Investment. Management might cause the company to buy the stock from willing sellers because they think it will provide a fair return on investment and raise the value of the shares that remain.
- Stay below the 500-shareholder threshold. Private firms that have 500 or more shareholders can be required to make public filings similar to public companies.
As principal owner of your business, you have to be concerned with any corporate stock redemption, for the following reasons:
- Many states restrict or prohibit the purchase of stock by the company from its stockholders, principally depending on the availability of cash and capital surplus within the company to effect the stock repurchase. Basically, you cannot “impair” the capital account and solvency of the business by repurchasing “equity” securities.
- Other stockholders may complain because of the effect on the corporation, particularly its balance sheet. The operating agreement of the company may also require that such a transaction be approved by some percentage of the shareholders.
- You may be accused of unfair dealing if you don’t offer all owners the right to sell their stock back to the company at the same time, price and terms.
- Your creditors may object since the stockholders’ equity account drops after a redemption. For this reason, most loan agreements prohibit or restrict a company’s repurchase of equity shares or interest.
- You may be sued by the selling stockholder if you know of certain facts that affect the value of the stock and these facts are unknown to the seller (material insider information) at the time of the stock repurchase.
Effect on the Company
Below is a description of the subject business owner’s analysis, with explanatory remarks. Note that this approach can be applied to companies with other forms of ownership, including S-corporations, partnerships and limited liability corporations (LLCs). Let’s start with the stockholders’ equity account, in which there are 100,000 shares of common stock outstanding.
Let’s also assume that total company debt is $1 million and that of the 100,000 shares outstanding, 20,000 shares are being acquired by the company (20 percent of the outstanding common stock). The agreed-on purchase price is $10 per share (two times the company’s $5 book value per share), which represents a $200,000 total purchase price. Based on these facts, here’s the result:
- Corporate cash declines by $200,000 (20,000 shares times $10).
- Stockholders’ equity decreases from $500,000 to $300,000 — a reduction of 40 percent.
- Leverage increases from 200 percent ($1 million total debt divided by $500,000 equity) to 333 percent ($1 million debt divided by $300,000 equity). This assumes that no additional capital was borrowed to finance the stock repurchase. If that were necessary, the debt-to-equity ratio would have risen even higher.
Effect on Remaining Owners
The remaining stockholders increase their ownership percentages. Since 20,000 shares are in treasury, a stockholder owning 10,000 of the remaining 80,000 shares will now own 12.5 percent of the corporation (10,000 shares divided by 80,000). Before the purchase, this stockholder owned 10 percent (10,000 shares divided by 100,000). The percentage ownership position of all stockholders will increase by 25 percent.
Book value per share declines from $5 to $3.75 — $300,000 pro forma (after repurchase) stockholders’ equity position divided by 80,000 shares. The pro forma decline in book value occurs because the buy-back price of $10 per share was double the previous book value per share of $5 ($500,000 stockholders’ equity divided by 100,000 shares). That’s why other minority stockholders may not be in favor of the transaction — unless they also are given the right to sell shares back to the company on the same terms.
Based on last year’s net income of $75,000, earnings per share would increase from $0.75 to $0.94 ($75,000 net income divided by 80,000 shares). But note that if debt is used to finance the stock purchase, pretax income (and net income) should be adjusted downward to reflect the resulting interest expense. Company cash is being used for nonproductive purposes. This may significantly impact the company’s future growth and its profitability and, as explained below, can negatively impact the company’s borrowing ability.
Finally, the tax basis of each share of stock owned by the remaining shareholders remains unchanged despite the fact that the value of each share has risen due to the lower number of shares outstanding. When the remaining shareholders sell their shares, as if the entire company were sold, the taxable gain will be greater than it would have been had the buyout of the 20 percent owner been effected by a direct purchase from the shareholders. Such a purchase would have required the shareholders to use personal funds to effect the purchase, but a step-up in the basis of the stock would have occurred and the tax owed in a subsequent sale would be less.
Effect on Company’s Value
Since $200,000 is purchasing 20 percent of this company, the value placed on the business is $1 million ($200,000 divided by .20). In terms of fundamental valuation methods, this $1 million value represents:
- A price-earnings multiple (P/E) of 13.3 times last year’s net income of $75,000.
- 2.0 times stockholders’ equity of $500,000 before the stock repurchase.
- 3.3 times stockholders’ equity of $300,000 after the stock repurchase.
This value analysis is presented to give you additional information to help you in deciding whether or not to effect the buyout. You also will have to determine the value of the company going forward. For example, if this company were projecting net income of $150,000 next year, the $1 million value would represent a P/E multiple of only 6.7. This alone could justify the stock repurchase, particularly if the company’s growth continues on course.
Access to Capital
The company redemption/purchase of common stock also has dramatic effects on the company’s creditors, who now have a lower stockholders’ equity account under their debt position, and a debt-to-equity ratio of 3.3 to 1 ($1 million debt divided by $300,000 stockholders’ equity). In addition, the company’s future borrowing capacity is substantially lower. Thus, if you are going to redeem any stock, be sure your overall cash position (today and projected) is more than adequate to finance growth and contractual debt repayments.
What If You, the Owner, Are the Seller?
If you are the owner and your common stock is being purchased by the company, read “Owner Stock Repurchase Tax Traps” on page 4. Proceeds of your sale could be taxed to you at ordinary income rates rather than capital gain rates unless you completely sever your relationship with the company. Also, for liability reasons, make sure that the:
- Stock redemption price is at fair market value as established by an independent appraiser.
- Shares are purchased by the company on an arm’s-length basis.
- Acquisition price and terms don’t discriminate against other stockholders.
- Tax impact of the sale/purchase on both you and the company has been reviewed by your accountant.
In any stock purchase by your company, get sound legal and tax advice before moving ahead. In addition, remember this important legal fact: You, as a director and officer of the company, have a fiduciary obligation to all of your minority stockholders, irrespective of the number of shares they own. So be very careful.
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2014.
This publication is intended to provide general information on the subject matters covered. It is sold and distributed with the understanding that neither the publisher nor any distributor or advertiser is engaged in providing legal, tax, insurance, investment or other professional advice. The advice of a qualified professional should be sought before any reader applies a concept presented herein to his or her particular situation or business.
D.L. Perkins, LLC is solely responsible for this content.