Buyback Beware - How early stage companies can avoid the pitfalls of share buybacks

It's a tense moment in the Dragon's Den, as the entrepreneur shrewdly negotiates with the millionaire Dragon in front of her. The Dragon wants 5% more equity than the entrepreneur had hoped to part with, but the entrepreneur wants the investment just a little bit more. Taking a deep breath, she asks whether the Dragon would be willing to drop the level of investment by 5% if she meets her revenue targets after 12 months. Happily, the Dragon agrees and the room erupts in applause at the well-negotiated deal.

Somewhere, likely in a home office, the entrepreneur's lawyer grimaces. Or, very likely, the entrepreneur doesn't have a lawyer appointed yet at all.

Why the concern?

Giving back shares in a UK company is not so simple. In fact, it's downright complicated. And most entrepreneurs and early stage companies aren't aware of how complex this can be—and they usually only find this out a little too late. Read on to find out more about the likely traps and how to avoid them.

A summary of buyback requirements

Many are surprised to learn that there is no mechanism under UK company law that enables a shareholder to simply return their shares to the company. This can only be done via a repurchase (buyback) of shares strictly pursuant to Part 18 of the Companies Act 2006 which states, amongst other things:

• buybacks must not be expressly restricted or prohibited in the company's articles of association;
• if the buyback is conducted via an agreement with a shareholder, the buyback contract (or a summary of its terms) must be first approved by a resolution of the shareholders, and the contract or summary must be made available to shareholders for a certain period in advance; and
• buybacks may be paid for either from distributable reserves (requiring the company to not only be revenue-generating, but profit-generating) or out of capital (requiring the company to obtain shareholder approval, deliver a director's statement and audit report, and file a public notice in the Gazette).

Most early stage companies will not have distributable profits and, therefore, could only seek to finance a buyback out of capital. However, the requirements are onerous and costly, and in many cases would vastly outweigh the value of the shares being returned.

There is a de minimis exception for buybacks out of capital provided that this is expressly contained in its articles of association. Under this exception, a company can conduct buybacks in a single financial year for up to an aggregate consideration of the lower of (i) £15,000 and (ii) 5% of the paid-up nominal value of the company's share capital at the beginning of the relevant financial year. The company needs to have the express authority to conduct the buyback and obtain shareholder approval, but it does not need to provide a director's statement or audit report. However, in reality this de minimis exception (if available) will often be insufficient repurchase the relevant shares.

Any shares repurchased out of capital must be cancelled and may not be held in treasury.

Trapped in the dragon's den

Whilst the buyback requirements may sound straightforward on an initial read, in practice many companies often find themselves unprepared when they are faced with the need to conduct a share buyback, and usually quite quickly.

The most common pitfalls that early stage companies face when seeking to conduct a share buyback are:

• needing to amend their articles to remove any express restriction or prohibition to conduct the buyback or to add an express authorisation for a de minimis buyback, in either case which requires a special majority of 75% of shareholders to approve the amendment—passing shareholder resolutions may require significant coordination to ensure the requisite level of approvals can be obtained within the necessary timeframe;
• having had a shareholder already purport to return their shares for value, without having complied with the Companies Act requirements—under law, this repurchase cannot be considered to have taken place and, therefore, the returned shares become "phantom shares", the returning shareholder a "phantom shareholder" and the company's cap table left in disarray. Further the company's directors may be criminally liable for a failure to comply with Part 18 of the Companies Act;
• valuing their shares at a level meaning the buyback cannot fall within the de minimis exception and thus can only conduct the buyback using distributable profits (which they are unlikely to have as an early stage company) or out of capital which (as described above) is more complicated;
• having agreed a buyback verbally or in a contract without obtaining shareholders' prior approval—firstly, the agreement must be documented either in a purchase contract or as a summary of terms to be made available to shareholders in order to approve the terms, and secondly any written buyback agreement must either be approved in advance or be conditional upon receipt of shareholder approval (and there is no certainty that a sufficient number of shareholders to reach the requisite approval will give their consent); and
• trying to avoid the Part 18 requirements buy repurchasing the shares for nil value—this is considered a gift under English law and would need to be completed in accordance with relevant legal requirements for gifts. Further, this could have adverse tax consequences for the company and the other shareholders.

Avoiding the dragon

So what can an early stage company do to avoid these pitfalls? Here are a few initial tips:

• check your articles from the outset to ensure they do not contain any restrictions or prohibitions on buybacks and that they include the express authority to conduct a de minimis buyback out of capital, and make necessary amendments to provide you with flexibility in the future—if you do this early enough, the founder(s) may have the ability to carry the amendment vote on their own, making the process much more simple;
• if you want to have a share claw back mechanism for employees or shareholders, ensure you discuss this with your lawyers so that it is documented properly and can be implemented legally -at a minimum such provisions should be expressed as conditional upon shareholder approval or, if possible, you should seek to obtain shareholder approval in advance;
• if the de minimis exception does not apply, you could consider a reduction of capital to create the necessary distributable reserves in the Company so that you are able to do a buyback out of distributable reserves (and not out of capital, which is more complex);
• consider agreeing the price to be paid for the reduction in equity from the outset, subject always to any necessary legal or constitutional requirements in the initial subscription / investment documentation—in this way, you remove a commercial risk of an argument with the investor around the value of the shares to be bought back and this helps to further simplify the process;
• consider finding a different buyer, such as the founder(s) or other shareholders, to purchase the shares (thereby bypassing the buyback mechanics required under the Companies Act). In this scenario, the articles may include a pre-emption process on transfer of shares (so the company may need to ensure the shares are first offered to other shareholders, pro rata to their holding, before completing the transfer), and stamp duty may be payable by the purchaser; and
• never repurchase shares without ensuring you can do so in compliance with Part 18 of the Companies Act - consulting with a lawyer before taking any action is strongly advised to avoid getting trapped in a pitfall and suffering the unfortunate consequences.

In the end, when it comes to changes to its share capital, it is critical that an early stage company gets it right every time as once a person is a shareholder, it can be difficult to remove them. Shares are usually the currency in which the company trades as it launches its new business and seeks to raise the capital to fuel its growth. So, any errors or issues can have a serious adverse effect on the company's ability to execute on its growth plans.

If you have any further questions about conducting a share buyback, Ashurst's High Growth & VC team can help! Contact one of our lead Partners below.