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Everything you need to know about share capital reduction.

By Joanne Hue, Last updated: 2023-01-09 (originally published on 2022-11-28)

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Share capital reduction, commonly referred to as share buybacks, is the process of reducing a company’s shareholder equity through the cancellation and repurchasing of shares. Equity held by shareholders refers to the sum that a company’s founders have contributed to the enterprise. This covers the funds they have directly invested as well as the total amount of profits the business has generated. This also accounts for reinvestments since the establishment of share capital

You may choose to reduce your share capital for various reasons. A corporation may reduce its capital as a result of a drop in operating profits. Revenue loss that cannot be compensated in predicted future profits could also result in a reduction.

 It could boost shareholder value and help create a more effective capital structure. A company’s share is proportionately reduced after a reduction. Share capital reduction does not affect the company’s market value. However, it leads to a decrease in the number of shares that are outstanding and tradable.

Objectives of Share Capital Reduction

 Steen Rosenfalk identifies the following objectives to share capital reduction :

Dividend payments: 

Most commonly dividend payment is the objective to share capital reduction. The erasure of collected losses through capital reduction allows the reserves you can distribute. Otherwise, the payment of dividends would be difficult. Accumulated losses can have a detrimental effect on a firm’s retained profit and loss reserves. As a company can only pay dividends out of profits reserved for the intent, it could hinder the payment of dividends to shareholders.

Demergers: 

The process of dividing a company’s operations into multiple companies is referred to as a “company split,” also known as a “capital reduction.” Deployment diagrams are frequently used in conjunction with divisions.

Returning surplus capital:

 If a company has capital that will no longer be needed shortly, it may decide to return it to its shareholders. This often happened when a large number of shares were issued to finance a deal that never took place. The obligation to pay unpaid share capital or to return paid-up share capital to shareholders can be met by the return of excess capital.

Distributing non-cash assets: 

Although it is uncommon, a business might employ a capital decrease to give its shareholders ownership of actual assets. The shares could be canceled or devalued in this situation. Shareholders receive distributions from their assets as payment in return. If the necessary steps are taken to protect creditors, the value of the distributed property may be greater than the amount by which the share capital is diminished.

Share redemption: 

Despite a company’s wish, it cannot redeem its shares without enough distributable reserves. According to UK company law, subject to certain limitations, shares may only be redeemed with the proceeds from the issuance of new shares or with the company’s distributable profits. In the event of a loss or if it does not have enough distributable reserves to redeem its shares and does not intend to issue new shares, a corporation may decide to lower its capital. After that, the shares are redeemed for cash equal to the proceeds of the redemption.

Structuring mergers and acquisitions as part of a scheme of arrangement: 

Often, capital reductions are used to structure mergers, acquisitions, and group reorganizations. The scheme of arrangement must be approved by the target company’s shareholders and the court to decapitalize it to zero. In this procedure, shares of the target company are revoked and then reissued to the company with the highest offer as payment on behalf of the target company’s owners. The target company’s share capital is diminished if the company’s shares are canceled and reissued. After the reserve established by the cancellation is activated, bidders receive fully paid shares.

Companies can do this to lower their issued share capital and increase shareholder value. A company’s share capital will decrease as it pays capital to shareholders. In other words, shareholders receive a refund of the value they paid, or would have paid, to the company to purchase their shares.

The Corporations Act of 200 recognizes equal and selective reduction. Equal reduction is only applicable for ordinary sales and the reduction is proportional to the amount of share the holder possesses. Selective reduction is the share capital reduction that is not done equally.

General Requirements for Share Capital Reduction

In the UK, The Companies Act of 2006 outlines the requirements that must be met for share capital reduction. However, some companies have to follow distinct regulations regarding capital reduction under The Companies Act of 1985.  Under section 641, Company Act 2006, a limited company is permitted to reduce its capital. However, such a company cannot reduce capital if the Article of incorporation restricts it. A limited liability company may, by special resolution and a statement of solvency, lower its share capital. Members may only employ this procedure if they still own irredeemable shares following the reduction.

Conclusion

A company is mostly free to lower its share capital in any way. In particular, the company has the right to cancel or reduce its obligation to reimburse partially paid-up shares, repay capital that has been paid up more than the company’s requirements, or pay up shares that are not represented by lost or accessible assets. By canceling the capital, you can accomplish this. Before deciding to reduce capital, a company’s directors should be aware of how crucial it is to make sure all standards are satisfied. Reducing share capital can be a complicated and time-consuming process. The danger of potential liability for directors is augmented by the wider implementation of solvency requirements.

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