Redeemable shares explained: what they are, why companies use them, how redemption works

Redeemable shares are shares that the company can buy back from its investors at some point in the future, on terms that are fixed when the shares are created. They sit somewhere between equity and debt, which is exactly why companies use them. Here is what they are, why they are used and how the redemption actually works.

What are redeemable shares?

In short, redeemable shares are shares that the company that issued them can buy back from its investors. Depending on how they are structured, the investor can also decide to request that the company buys the shares back. So they are redeemable either at the command of the company, or at the request of the investor, or both.

That flexibility is the whole point, but it also means the terms need to be nailed down from the start. An investor is buying a promise about the future as much as a share, and that promise has to be written down.

Redemption terms: who, what price and when

There are three main factors to consider when thinking about redeemable shares:

• Who can make the decision. Who has the right to request or require that the shares are redeemed: the company, the investor, or either of them?
• What price is paid. What does the company pay the investor when it buys the shares back?
• What the terms are. When, and in what circumstances, can the relevant party enforce the redemption right?

These three points are the terms attached to the redemption rights, and I come back to each of them below.

Redeemable shares and the articles of association

My pro tip is to always document the different classes of shares the company has, including the redeemable shares, in the company's articles of association. You also want to make sure the articles allow the company to buy back its own shares. If the articles do not allow that, the company cannot issue or create redeemable shares in the first place.

So before you offer redeemable shares to anyone, check the articles. If they are silent or restrictive, they need amending first. In my experience this is the step that gets missed most often, usually because the company is still on the standard model articles it adopted on incorporation and nobody has looked at them since.

Why are redeemable shares used?

The main advantage is flexibility, for both the company and the investor:

• Flexibility for both sides. The company and the investor each get a clear route in and a clear route out.
• Raising capital without giving up control. The company can raise equity capital without permanently giving up control, because typically redeemable shares, or redeemable preference shares, do not carry voting rights.
• A guaranteed exit for investors. Investors get an exit strategy with clear terms, despite investing in shares rather than lending money.

Redeemable preference shares vs debt

Redeemable shares work a lot like debt. The company has to repay the money by buying back the shares at some point in the future, just as it would repay a loan. Instead of paying interest, the company pays dividends, and typically those dividends are paid at a fixed rate, just like interest on a loan.

That comparison leads to my second pro tip, aimed at companies. Consider using redeemable shares, typically structured as redeemable preference shares, when you want to raise capital but:

• you do not want any charges registered against the company, or
• you are not able to have additional charges on your Companies House profile, perhaps because you already have charges there, and
• you want more flexibility when taking on capital investment.

A lender would usually want security. An investor in redeemable preference shares is taking shares, not a charge, so the company's Companies House profile stays clean. From the investor's side, they still get a fixed return and a defined point at which their money comes back, which is what they would have wanted from a loan anyway.

How are redeemable shares redeemed?

The first step is that the company has to decide the terms on which it will offer the redeemable shares to its investors. Investors can then decide whether to invest on those terms or not. It is up to the company, its directors and its shareholders to decide what terms and conditions attach to the shares, although in practice the company often arrives at those terms through negotiation with the investors.

Company decisions needed to redeem shares

The decisions come back to the three factors above.

• Who can trigger the buyback. For example, the company might decide that whenever it is ready, it can tell the investor it is taking the shares back and returning their money.
• What price is paid. There are three broad options. It could be the nominal value of the shares, as shown at Companies House. It could be the market value, which goes up and down depending on when the redemption happens and how the company is doing. Or it could be a predetermined purchase price that the company is bound to honour.
• How a predetermined price is set. If you go with a fixed price, it could be the same price the investor paid, so you are returning their investment exactly plus the dividends they received along the way. Or it could be a multiple of their investment. For example, you could say there will be no dividends, but the company will return 1.5 times the amount invested within, say, two years.

Redemption as a share buyback (Companies Act 2006)

Something very important to keep in mind: when redeemable shares are redeemed by the company, this is treated as a share buyback. Share buybacks under the Companies Act 2006 are very strictly regulated. A very specific process has to be followed, and the money used to fund the buyback is closely scrutinised, because different rules apply depending on what kind of money is being used.

This is where a lot of companies trip up. They agree the commercial terms with the investor and then discover, when the time comes to redeem, that the funding route they planned on is not available or needs a more involved process than they expected.

How to fund a share redemption

There are typically three main ways to fund a share buyback:

• Out of profits. If the company has distributable profits, instead of paying them out as dividends it can use that money to buy back the shares from its investors.
• Out of a fresh issue of shares. The company issues new shares to, for example, different investors, and uses the money coming in from those new investors to pay the previous investors and buy back their shares.
• Out of capital. The company uses share capital it already has. This is the most complex and difficult option, because there are strict rules protecting the company's ability to pay its liabilities and its creditors. If you reduce the company's share capital, you are effectively reducing the assets available to pay creditors if the company were liquidated. So this option is typically a last resort.

If you are planning to use redeemable shares, it is worth thinking about which of these three routes you expect to use at the point of redemption, not just at the point of issue. A redemption date that falls in a year when the company has no distributable profits, and no new investors lined up, leaves only the capital route, and that is the one you want to avoid.

Next steps

If you are considering raising money through redeemable preference shares, start with the articles of association: check that they allow buybacks and that the new class of shares will be properly documented. Then settle the three terms, who can redeem, at what price and when, before approaching investors, and speak to a corporate solicitor about the buyback process and how the redemption will be funded. If you are weighing up preference shares against ordinary shares more generally, see ordinary shares vs preference shares.