What it means
A company's issued share capital is the money its shareholders have committed and cannot, in principle, get back except by selling their shares to someone else or on a winding up after creditors have been paid. That permanence is what makes creditors willing to lend: the capital is a buffer that absorbs losses before the creditors do.
Allowing a company to hand capital back to shareholders at will would undermine the buffer, so the law permits it only under conditions. Two forms are common.
Redeemable shares are issued on terms that they will or may be redeemed: a fixed date, a date range, or at the company's or the holder's option, at a price set by the terms. Preference shares are frequently redeemable, giving investors a fixed dividend for a period and their money back at the end, much like a bond but ranking as equity.
Share buybacks are the repurchase of ordinary shares that were not issued as redeemable, either from all shareholders proportionately or from particular holders, typically to return surplus cash, to support the share price, to buy out a departing shareholder or to change the capital structure. The funding rules are the heart of the topic.
In the United Kingdom and many jurisdictions modelled on it, shares may be redeemed or bought back out of distributable profits, out of the proceeds of a fresh issue of shares made for the purpose, or (for private companies, under stricter procedures) out of capital. Where distributable profits are used, the company must transfer to a capital redemption reserve an amount equal to the nominal value of the shares redeemed, so that the total of share capital plus this reserve is unchanged; the reserve can be used only to pay up bonus shares.
Where a fresh issue funds the redemption, the new capital replaces the old and no reserve is needed. Any premium paid on redemption above nominal value must generally come from distributable profits (or, within limits, from share premium if the shares were issued at a premium).
In the United States, redemptions and repurchases are governed by state law tests of solvency and surplus rather than by a reserve mechanism, with the same underlying purpose. The accounting reflects the legal route.
Redemption out of profits: debit share capital (nominal), debit retained earnings (premium), credit cash; then debit retained earnings, credit capital redemption reserve (nominal). Redemption from a fresh issue: the new shares are recorded as usual and the redeemed shares removed.
Shares bought back may be cancelled or, where the law allows, held in treasury for reissue. Redemption has consequences beyond the entries.
Returning cash reduces assets and equity, raises gearing, and, by reducing the share count, raises earnings per share if the cash was earning less than the company's return on equity. Redeeming preference shares removes a fixed dividend obligation.
Buying out a shareholder changes control. Tax treatment for the shareholder (capital versus income) depends on the jurisdiction and the structure, and often drives the choice between a buyback and a dividend.
In practice
Real-world examples.
Example
A company buys back 5% of its ordinary shares for $20 million from surplus cash, cancels them, and transfers $500,000 (their nominal value) to capital redemption reserve.
Example
A private company redeems the preference shares held by a retiring founder over three years from profits, under a redemption schedule in the articles.
Example
A bank calls its perpetual preference shares at the first call date because a cheaper form of regulatory capital has become available.
Think of it
“Capital redemption is buying back shares or paying off preferred stock-returning capital to owners.
Formula
Calculation
Capital Redemption Reserve transfer = Nominal value of shares redeemed minus Proceeds of any fresh issue made for the purpose
Premium on redemption = Redemption price minus Nominal value (charged to distributable profits, or to share premium within legal limits)
Worked example. A company has the following equity: ordinary share capital 1,000,000 shares of $1 = $1,000,000; 6% redeemable preference shares 400,000 of $1, issued at par, redeemable at $1.10 = $400,000; share premium $200,000; retained earnings $950,000. Total equity $2,550,000. Cash is $1,200,000.
The preference shares fall due for redemption at $1.10, a total of $440,000. The company decides to fund $150,000 of the redemption by a fresh issue of 100,000 ordinary shares at $1.50 (nominal $100,000, premium $50,000) and the rest from distributable profits.
Entries:
- Fresh issue: debit cash $150,000; credit share capital $100,000; credit share premium $50,000
- Redemption: debit preference share capital $400,000; debit retained earnings $40,000 (premium on redemption, as the shares were issued at par); credit cash $440,000
- Capital redemption reserve: nominal value redeemed $400,000 minus fresh issue proceeds $150,000 = $250,000; debit retained earnings $250,000; credit capital redemption reserve $250,000
Equity after: ordinary share capital $1,100,000; share premium $250,000; capital redemption reserve $250,000; retained earnings $950,000 minus $40,000 minus $250,000 = $660,000. Total $2,260,000, which equals $2,550,000 plus $150,000 raised minus $440,000 paid. Cash falls to $910,000.
Creditor protection check: before, share capital plus non-distributable reserves = $1,000,000 + $400,000 + $200,000 = $1,600,000. After: $1,100,000 + $250,000 + $250,000 = $1,600,000. The permanent capital base is preserved; distributable reserves have fallen by $290,000, the amount of capital returned to shareholders that was not replaced by new capital ($440,000 minus $150,000).
Effect: the company no longer pays $24,000 a year of preference dividends; ordinary shares in issue have risen by 10%, so the saving must exceed the return the new shareholders expect on $150,000 for the exercise to help ordinary earnings per share.Case study
Seen in the real world.
A family engineering company had issued $2,000,000 of redeemable preference shares to an investor ten years earlier, carrying an 8% dividend and redeemable at par at the company's option after seven years. The dividend cost $160,000 a year and the company now had $3,000,000 of cash and bank facilities at 5%. The finance director proposed redemption.
The company had $2,600,000 of distributable profits, so the redemption could be funded from profits with a $2,000,000 transfer to capital redemption reserve, leaving $600,000 distributable. The board hesitated: the transfer would restrict future dividends to the family. The finance director explained that the restriction was legal form, not economic substance: the company would still have the same assets, would save $160,000 a year, and could rebuild distributable reserves from the higher retained profit within four years.
She also checked the articles, which required three months' notice, and the investor's terms, which imposed no premium. The redemption proceeded.
Return on ordinary equity rose from 11% to 13%, the family's dividends were maintained from current profits, and the investor, who had received 8% for ten years and par back, had no complaint. The note to the accounts explained the capital redemption reserve, and the auditors confirmed the solvency and reserves tests had been met and minuted.
Watch out
Common mistakes.
- Redeeming or buying back shares without confirming the legal funding route and the availability of distributable profits, which can make the transaction void and the directors liable.
- Forgetting the capital redemption reserve transfer, which understates non-distributable reserves and can lead to an unlawful dividend later.
- Treating the capital redemption reserve as an economic cost. It is a reclassification within equity that restricts distributions; it does not reduce the company's assets.
Questions
People also ask.
What is the difference between redemption and a buyback?
Redemption applies to shares issued as redeemable, on their terms. A buyback is the repurchase of shares not issued as redeemable, requiring shareholder approval and, for listed companies, market rules. The funding rules are similar.
Can the capital redemption reserve be used for anything?
Typically only to pay up bonus shares. It is otherwise treated like share capital.
Why would a company issue redeemable shares at all?
To raise capital that ranks as equity (helping gearing) but that can be returned when no longer needed, or to give an investor a defined exit.
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