Buyback of Shares – Is it purely a financial decision or it has governance implications?

Buyback of shares is often considered a financial decision for the company, but there is also a governance angle attached to it. A decision to buy back shares involves the use of the company’s surplus cash, and therefore the Board needs to consider whether it is the most appropriate use of capital at that point in time.

The buyback has implications, which may not be obvious. These include implications relating to cost of use of capital, credit rating of the company and financial ratios. While taking this decision, it must be ensured that buyback should be funded by excess free cash flow, and not through some temporary funds.

What are some of the things that the Board should consider before planning a buyback:

A Board should not treat a buyback as a routine corporate action, but as a capital allocation decision that must deliver better results than any alternate use of cash available at that time. The following questions should ideally be considered before considering a buyback.

1. Are the shares of the company undervalued?

   A number of managements, when they feel that their shares are undervalued, undertake a buyback to give the share price a boost, and to signal confidence to the market.

2. Why should buyback be preferred over payment of a special/ interim dividend?

   Buybacks are typically viewed as a one-off event, with no future commitment of recurrence. If a company chooses to pay special dividends, it could result in an expectation for future dividends too, which a company may like to avoid.

3. What are the alternate uses of the funds?

   Before returning cash to shareholders, a company should consider the opportunity cost of the funds, and some of the alternate uses, such as
   –  Reduction in debt and associated costs.
   –  Future plans of expansion.
   –  Upgradation required for existing plants/ offices.
   –  Investment in technology/ AI
   –  Future working capital requirements (though most companies would not use surplus cash for this)
   While deciding this, the company must also not lose sight of the possibility of any sudden need for capital due to changes in the geopolitical or macroeconomic environment.

4. Could the buyback influence management’s performance measures?

   A reduction in the number of shares outstanding will increase the earning per share (EPS), even when the company’s total earnings have not increased. The Board should therefore ensure that the improved EPS is not the primary reason for undertaking the buyback. This becomes more important when management compensation is linked to EPS. Also, this should not be used as a method to show better performance to the market. Buyback should also not be a way to neutralise any existing ESOP schemes.

5. Should Boards consider multiple buybacks?

   A single buyback may be part of a deliberate capital allocation decision. However, multiple buybacks may signal a lack of attractive growth opportunities for the company. This could adversely impact the reputation of the company.

6. Does the buyback benefit promoters disproportionately?

   The Board should consider whether the proposed buyback could materially affect the ownership or voting rights of promoters and the promoter group. If a promoter does not participate in the buyback, while other shareholders tender their shares, the promoter shareholding would increase in percent terms, thereby impacting the voting rights.

Conclusion:

While the management may propose buyback, the Board should ensure that it asks the right questions, and that this process does not lead to the display better performance, not backed by numbers. The opportunity cost of capital must be considered.

Prajesha Nair