Pop quiz #1: when a business redeems a shareholder’s interest, should the redemption price be calculated before or after the effect of the redemption?
Answer: before, because:
- The fact that the company is the buyer should have no bearing on the price.
- Stated another way, the price should be the same as if a third party bought the shares, which would have no effect on the company.
- Theoretically, the investment decision (to purchase shares) and the financing decision (how to pay for them) should be separately evaluated.
(I am keeping it simple here, assuming that the redemption is at pro rata share of equity value, ignoring issues related to change of control, premiums and discounts.)
When companies redeem shares, however, the remaining shareholders need assurances that the price is affordable. In addition, lenders need assurances that debt service will not be jeopardized (and may have restrictive covenants that need to be addressed.)
Pop quiz #2: how do you analyze affordability?
Answer: the good old justification of purchase test. Start with the pre-redemption financial forecast of cash flow to equity used to value the shares. Modify it to include the redemption cash outflows (down payment, term money, covenants not to compete, consulting fees, etc.) as well as other applicable changes (such as savings on redeemed shareholder compensation and replacement compensation). See what the resulting equity cash flows are. If they are still positive, then the redemption is affordable, but check to see what kind of safety margin there is (what if sales drop 10%?). Also see what cash flow to invested capital (which is available for debt service) is, on the same basis.