There are several reasons why a company may choose to repurchase some or all of the outstanding shares of its stock. This move, called a stock buyback, can serve as a way to consolidate ownership, reward shareholders for their investments, boost important performance metrics or even to increase executive compensation.
Executing a stock buyback can also be a strategic maneuver used to fend off hostile takeovers. In fact, this strategy was once so popular that many companies, to prevent investor panic, would specifically state that newly announced buybacks were not a result of a takeover attempt.
A takeover occurs when one company, called the bidder, seeks to acquire another company, called the target, by purchasing enough shares of stock to have a majority stake in the company. Since each share of stock represents a portion of company ownership, owning more than half of the outstanding shares essentially means the bidder owns the target company. If the target company does not want to be acquired, the takeover is considered hostile.
One way that target companies attempt to fend off hostile takeovers is to make the business less valuable to a potential bidder. When a company acquires another, any assets of the target company are used to pay off its debts after the acquisition. By using any cash on hand to repurchase stock, the target company effectively reduces its asset total. This means a bidder would need to use other assets to meet the target's financial obligations.
For example, assume company ABC's balance sheet shows assets totaling $1 million, of which $500,000 is cash. Further assume that the company has debts totaling $400,000. If company XYZ acquires ABC in its current state, the $500,00 in cash can be used to pay off this debt in its entirety, leaving $100,000 that can be used for other purposes. For XYZ, this means that the potential liabilities associated with acquiring ABC are limited since it has more assets than debts.
However, if ABC uses that cash to repurchase shares of stock, then that $500,000 is returned to shareholders and is no longer part of the asset total. If XYZ acquires ABC under these conditions, it must either use its own assets or liquidate some of ABC's remaining assets to pay off its debts. Clearly, ABC is a much less desirable target in this scenario.
Stock buybacks also limit the ability of the bidding company to purchase the necessary number of shares by decreasing share availability and increasing the price per share. Those shareholders that decline a repurchase offer are likely those who have a considerable stake in the company and do not want to give it up. If a buyback eliminates all other shares but those owned by this type of highly invested shareholder, then the bidding company has a much more difficult time acquiring the requisite 50% since the remaining shareholders are unlikely to sell.
Lastly, reducing the number of shares outstanding forces the bidding company to make a formal announcement about its takeover bid sooner. The Securities and Exchange Commission, or SEC, requires businesses to announce publicly when they have acquired more than 5% of another company's stock. A stock buyback, therefore, ensures that a target company receives early warning of a potential takeover threat by lowering the 5% threshold.