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The basics of shares

What’s the difference between authorised and issued shares? What about share buy-backs and treasury shares?

Let’s start right at the beginning. When a company is formed (whether private or listed) the founders decide on an initial number of shares and these are the authorised shares, in other words those that have been authorised by the owners.

However, the owners may elect not to issue all the authorised shares, keeping some in reserve for later use. So let’s take as an example a new company that starts life with 100 authorised shares but only issues 60 of them. These 60 shares are the ones that are tradable on the exchange and will be used to determine the market cap of the business (market cap is number of issued shares times share price, representing the total value of the company).

The remaining 40 shares can only be used (issued) with shareholder approval and could be used to raise cash (this is when shares are sold into the market and the company receives the money, such as via a rights issue). Alternatively, they could be used (again only with shareholder approval) in lieu of money when buying assets or paying off debts or even paying director bonuses. 

For example, the company wants to buy out a competitor and instead of using cash it uses 10 of the un-issued shares. It means the people who sold their company now own 10 of the now 70 issued shares, or 14.3% of the company. In one sense using shares to do deals means you get the assets for free, but the concern here is that you are essentially giving away a part of the company. 

However, if you pay cash for the competitor you just bought it through a one-off payment whereas the shares are an everlasting payment and have a permanent claim on future profits alongside existing shareholders. 

Typically, what happens is that at the annual general meeting (AGM) the directors will request that the shareholders give them the authority to use a specific amount of the un-issued shares for transactions. This means that they will be allowed to use the shares and don’t have to get shareholder approval every time they want to transact. Authority is generally given for a limited number of shares so that directors can do medium-size deals but would require additional approval for larger deals.

Then we have share buy-backs. A board of directors can decide to buy back the company shares. They would once again need shareholder approval and if this is granted, they would buy back the shares in the open market. These purchased shares become treasury shares until such time as they are “destroyed”, effectively meaning they no longer exist. 

Here the aim is to increase the value of the remaining shares in the market. Going back to our example of the above company that now has 70 issued shares and let’s say they’re trading at R100 each. That would give the company a value (market cap) of R7 000. If the company now buys back 20 shares, there would be 50 issued shares left and – assuming all else is equal – the company is still worth R7 000 but each share would have a value of R140 as there are 20 fewer shares with rights to the company’s value of R7 000.

Of course it doesn’t always work as smoothly as that and the company has spent money to buy back the shares, meaning it has less cash and as such the value of the company would have decreased, but longer term it can add value to the remaining shares.

As a rule I prefer debt to using shares for acquisitions and I am not a fan of share buy-backs as often they happen at high prices when directors have no other ideas of how to grow the company.

This article originally appeared in the 18 August edition of finweek. Buy and download the magazine here.

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