Redemption Conniption

Alpha Company’s shareholders have a problem.  One is retiring and needs to be bought out.  The shareholders have agreed that Alpha will buy the shares (for cash). They also agree on the value of the stock before the buyout. Everything is cool, except for one thing.  The remaining shareholders think the buyout price should be reduced by the cost of the buyout, and the retiring shareholder believes that it should not. 

Who is right, why, and how would you explain your position to the shareholders? 

I think – in fact, I know – that the retiring shareholder (the seller) is right!  The confusion arises because Alpha Company is buying the shares.  If one or more of the other shareholders (or anybody else, for that matter) were PERSONALLY buying them, there would be no effect on Alpha Company (except for a change of share ownership). This is because no COMPANY dollars would be involved in the buyout.  Its financial position would be unaffected.  THAT is the proper way to think about the buyout.

The fact that Alpha is buying the shares certainly reduces the value of the remaining equity (debit equity, credit cash), but the remaining shareholders will each have larger ownership interests after the buyout.  These effects offset each other. The buyout price is not so high that it will change the Company’s business or financial risks and returns. (The agreed pre-buyout price was approximately $100,000, the Company had cash of $600,000 of which at least $200,000 was unequivocally in excess of its needs, it had no debt, and so forth.)

If the buyout price were to be reduced to reflect the Company’s purchase of the shares, then the selling shareholder would be paying for part of his own redemption, which is not correct or fair.