We’ve all heard of companies selling their shares in the stock market. That’s how the conventional flow works, doesn’t it? The money flows from us, the investors, to the companies. Equity share assets are provided in return. That flows from the company to the investors.
Companies buying back their shares is completely the opposite. There are two main reasons why any company would do that.
- To provide an exit to the shareholders
- To consolidate their own stake
Share buybacks provide returns to shareholders.
When you invest in a company, you almost always do it with the intention of making capital gains. But this does not always happen. Even if you have chosen a good company with solid financials, it does not always translate to an increase in the share value.
If you’ve invested in a company like this with a long-term horizon, and the share price is not growing, you can get frustrated. How long will you keep your capital locked in an investment that is not performing?
In situations like these, companies offer share buybacks to compensate their investors. They want to assure the shareholders that they have potential and they are worth staying invested in. It is a chance to offer some value and instil some faith in the investors.
Sometimes, the buybacks are also used to provide strategic boosts to the share price.
The secondary equity market works on the principle of demand and supply. The number of shares in circulation is fixed — whether the share price rises or falls depends on the interaction of demand and supply. If the demand is higher, the share price rises and if the supply is higher, the share price falls.
If the share price is in a downtrend, a share buyback policy can sometimes work as a backstop and change the price trend. By buying back some of the outstanding shares, there is an artificial boost in the market demand which can push the share price higher.
Another situation where companies buy back shares is to offer exits to their employees. These are called ESOP buybacks.
Buybacks help companies to consolidate their holdings.
Companies that are listed on the stock exchanges are generally quite large in size. They have lakhs and lakhs of shares in circulation in the market.
Often it so happens that during the steep climb to success, companies have to raise multiple rounds of funding and they dilute their own ownership stake. For instance, when you’re starting off on your entrepreneurial journey, you will probably have about 50-100% of the ownership, depending upon the number of partners.
By the time you’re ready to go for an IPO, however, your shareholding can come down to as low as 10%! Take the example of Zomato, for instance. As per the latest reports, founder Deepinder Goyal only has about a 4.69% stake in the company.
Companies dilute their stake when they need money. But when they have surplus money, sometimes firms will roll out share buyback policies to increase their own ownership stake.
