This article explains the fundamentals of treasury stock; why and how it happens, and how it is reported on the balance sheet. In addition the fundamentals can affect ownership in a small business and a section calculating a buy back’s effect is illustrated.
As an owner of small business treasury stock fundamentals are an essential piece of knowledge that if not used properly or misunderstood can greatly affect your ability to direct the company’s future.
Treasury Stock – A Buy Back of Existing Shares
Sometimes, during its growth cycle a company comes to a crossroads of sorts and must decide on expanding operations significantly or waiting some years before expanding. In some cases the company has essentially achieved its goal and further growth or divestment will have no direct benefit to owners. One of the key signs is an accumulation of cash, significant debt reduction and high earnings per share.
Options with excess cash include issuing dividends, expanding operations or buying back ownership from existing investors. The third option is referred to as Treasury Stock.
The actual process involves several steps.
Step 1 – The board of directors issues a corporate resolution to buy back stock for a certain set value.
Step 2 – The offer is tendered to existing shareholders and those shareholders interested respond with an affirmation or acceptance.
Step 3 – Shares are bought back by exchanging cash for stock.
Step 4 – The shares are held in the treasury for future use.
Treasury Stock Reporting Format
Treasury stock is reported in the equity section of the balance sheet. It is placed in the stock section under all issued forms of common stock (classes of stock). The account balance is traditionally debit based and therefore has parenthesis around the value as illustrated below:
Balance Sheet (Limited Presentation)
December 31, 2015
Common Stock Par Value $1.00 $100,000
100,000 Shares Issued and Outstanding
Capital Paid in Excess 392,500
Sub-Total Common Stock $492,500
Offer Tendered 12/01/2013 7,500 Shares (78,000)
Offer Tendered 12/01/2015 10,000 Shares (108,000)
Sub-Total Treasury Stock (186,000)
Lifetime Earnings as of 12/31/2014 708,291
Current Earnings – 2015 117,342
Sub-Total Retained Earnings 825,633
Total Equity $760,533
Naturally this is an expanded presentation format. In a condensed version it would look like this:
Balance Sheet (Limited Presentation)
December 31, 2015
Common Stock $492,500
Treasury Stock (186,000)
Retained Earnings 825,633
Total Equity $760,533
Often treasury stock is carried on the books indefinitely. Publicly traded companies may but rarely reissue purchased shares. Most often they simply issue a new class of stock.
In small business there are several technical issues where treasury stock can be beneficial or detrimental depending on how well thought out the plan is.
Treasury Stock in Small Business
There are many different reasons to utilize treasury stock in small business. As the business grows owners issue more common shares to fund the growth. The shares are issued to extended family, friends and colleagues increasing the overall number of unique shareholders. When this happens the company is commonly referred to as ‘Closely Held’. Invariably disputes over management style or even how the wealth is distributed creates discourse within the group and treasury stock is a method to provide an ‘Out’ for a discontented investor. Other reasons include:
* Better alignment of total outstanding shares to corporate structure and wealth
* Consolidation of ownership
* Opportunity for existing owners to exit by creating a demand for shares
* A part of a large plan to sell the company or transfer ownership to employees
The key to treasury stock is that the buyer of stock is the company itself and it is a tool to consolidate ownership. To illustrate this business concept I’ll use an example of how ownership is realigned using treasury stock as the tool.
Suppose a closely held business has seven different investors, five of them are family members and two are discontented investors. The two discontented investors want out and no particular family member has the financial wherewithal to purchase the shares.
However the company has the cash resources and working capital to buy the discontented owners at a reasonable price. The board authorizes a treasury stock offer. The following is the before and after ownership schedule:
Investor Shares % of Ownership Shares % of Ownership
Family ‘A’ 2,000 26.667% 2,000 30.769%
Family ‘B’ 1,500 20.000% 1,500 23.076%
Family ‘C’ 1,000 13.333% 1,000 15.384%
Family ‘D’ 1,000 13.333% 1,000 15.384%
Family ‘E’ 1,000 13.333% 1,000 15.384%
Discontented ‘F’ 500 6.667% -0- -0-
Discontented ‘G’ 500 6.667% -0- -0-
7,500 100.000% 6,500 99.997%
Notice the reallocation of ownership benefits the investors with stronger ownership positions prior to the buy back. Before the treasury stock purchase, family member ‘A’ required at least two other shareholders to agree with him in order to control the company. After the treasury stock purchase ‘A’ only needs ‘B’ to fully control the company.
The treasury stock purchase benefits ‘A’ and ‘B’ to the detriment of family members ‘C’, ‘D’ and ‘E’. Even after the treasury stock purchase, ‘C’, ‘D’ and ‘E’ still lack the ability to control the company even if they vote as a block. The still need either ‘A’ or ‘B’ to affect change.
How is this possible? It all depends on the shareholder agreement.
The underlying arrangement between owner’s in a small business, especially a closely held company, is a shareholder’s agreement. All parties owning a position in a small business sign a document defining how the relationship works between each other. This subject is a in-depth subject and very detailed. This article limits the issue to the fundamentals of treasury stock.
The shareholder agreement often has a clause or article explaining the process of authorizing a treasury stock offer. Most agreements mandate a super majority of ownership to authorize a buy back (often not less than 60% but can be as high as 80% of outstanding shares). In addition, the clause may dictate restrictions as identified here:
A) Limit the amount borrowed from third parties to fund the treasury stock purchase.
B) Set minimum standards for funding of purchase such as the quick ratio or cash ratio.
C) Identifies the formula to set share price or a not to exceed a set level of book value, such as ‘Not to exceed 140% of book value per share’.
D) Sets the time frame and open acceptance period for the treasury stock buy back.
This clause is the shareholder agreement is essential to understand for any shareholder’s rights and options related to a treasury stock buy back. Understand the wording well to protect your investment.
Summary – Treasury Stock
Treasury stock is a tool used to consolidate the pool of investors or number of shares outstanding. In small business it is used to buy out disgruntled investors or address the concerns of some investors. The shareholder agreement typically has a clause in it outlining the terms, conditions and procedures that must be followed for a treasury stock offer. The information is reported on the balance sheet in the equity section. In small business, it is essential for any investor to understand treasury stock fundamentals. ACT ON KNOWLEDGE.
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