Capital Reduction: Definition, How It Works, and Example

What Is Capital Reduction?

Capital reduction is the process of decreasing a company's shareholder equity through share cancellations and share repurchases, also known as share buybacks. The reduction of capital is done by companies for numerous reasons, including increasing shareholder value and producing a more efficient capital structure.

Key Takeaways

  • A capital reduction is the decrease of a company's shareholder equity.
  • Capital reductions are generally done through share cancellations, paid-back capital, or share repurchases (buybacks).
  • Companies do capital reductions for a variety of reasons, such as for increasing shareholder value or producing a more efficient capital structure.
  • Capital reductions must be performed according to the law and a company must undergo a series of steps to correctly do a capital reduction.

Understanding Capital Reduction

A capital reduction is when a company reduces the amount of its share capital, which can be done by making payments to shareholders out of its capital equal to the amount of money paid by a shareholder to acquire the company's shares or by a share buyback. A capital reduction can also be done when shares are cancelled for zero consideration.

Returning back capital allows a company to reduce its share capital without the consent of each individual shareholder. A share buyback reduces a company's share capital by purchasing back shares from shareholders; however, unlike returning capital, a buyback requires the shareholders that have been offered buybacks to determine whether they want to sell back their shares or not.

To reduce share capital, a company must comply with regulations and obtain approval before proceeding with the process. The law will vary in each country.

A company is required to reduce its share capital using a set of specific steps. First, a notice must be sent out to creditors of the resolution of the capital reduction. Second, the company has to then submit an application for entry of the reduction of share capital within a certain period after publication of the initial notice. Share capital reduction is then expected to be paid to shareholders a few months after the entry of reduction in the commercial register.

Reasons for Capital Reduction

Capital reductions are done for a variety of reasons. These include creating distributable reserves, so as to pay dividends in the future, returning surplus capital back to shareholders, when going through a de-merger, simplifying the capital structure to be more efficient, and reducing or eliminating paid-up or unpaid shares.

The act of capital reduction may also be enacted in response to a decline in a company's operating profits or a revenue loss that cannot be recovered from a company's expected future earnings.

Example of Capital Reduction

Company ABC has 1,250,000 shares outstanding and the share price is $25, which results in a market capitalization of $31.25 million for Company ABC. Company ABC announces a share buyback and buys back 500,000 of its shares. These shares no longer trade publicly and reduce the number of shares outstanding the company has. Company ABC now has (1,250,000 - 500,000) = 750,000 shares outstanding.

With 750,000 shares outstanding at a share price of $25, the company has a market capitalization of $18.75 million. The buyback program resulted in a decrease of the company's market capitalization by $12.5 million.

Why Would a Company Do a Capital Reduction?

A company would perform a capital reduction for a variety of reasons, such as creating reserves to pay a dividend, reducing or eliminating accumulated reserve losses to make future distributions, giving back surplus capital to shareholders, making the capital structure more efficient, and reducing or eliminating unpaid shares.

How Do You Do a Capital Reduction?

There are a few ways to do a capital reduction. One way is by making payments to shareholders out of the company's capital for a value equal to what a shareholder paid in acquiring the company's shares. Another way is through a share buyback.

Is Capital Reduction a Good Thing?

A capital reduction can be a good thing. It can be used to simplify a company's capital structure, making it more efficient. It can also be used to distribute dividends to shareholders, increasing their value. It also allows for the elimination or reduction of accumulated losses.

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