Implementing a Buyback Program? Mind the details

Originally published on CFO.com.

Amid roaring stock markets, fueled by expectations for lower interest rates and perceptions of a more business-friendly regulatory regime, a new record likely was hit in 2024 for announced share buyback programs. More than a trillion dollars in repurchase plans were announced through October.

We are seeing more companies consider launching first-time share repurchase programs as their performance improves. At the same time, we’re seeing companies with active programs and weaker fundamentals struggling with how to execute them in the still-challenging macro environment.

All of this is even more relevant in a stock market environment where pressure is rising on high-flying companies to justify rich valuations and on companies that haven’t participated in the run-up to support theirs.

That makes now a good time to dive deeper into why management teams and boards considering repurchase programs must plan thoughtfully and take a long view of the implications.

To repurchase or not to repurchase

Both management and the board should start with two simple questions: “Why?” and “Why now?”

There are typically two motivations for buying back stock: playing offense and playing defense. Offensive programs focus on returning excess cash to investors or more tactical purposes, like addressing short-term valuation disconnects or managing share dilution related to equity compensation. Defensive programs employ buybacks to support an underperforming stock and/or discourage potential activism.

In either case, management teams are often mistaken if they think they can mask underlying fundamental challenges with a timely buyback.

Successful offensive programs begin with clarity on how a new plan fits into the company’s capital allocation framework. Ideally, that framework will have been articulated publicly well in advance of the repurchase announcement.

For companies with attractive organic growth opportunities, the highest among the three priorities should be investing in the business. The second is usually balancing the capital structure, including maintaining the optimal mix of debt, equity and cash to fund the business and pursue strategic goals, including M&A. The third is typically deploying excess cash, which leads to a conversation around repurchases or dividends, including special dividends.

Many smaller companies prefer repurchase programs to dividends for their greater flexibility in execution and to avoid the perception that they have entered a period of slower growth (dividends are also taxable, though that’s a lesser concern).

That said, some companies have employed special dividends effectively to return excess capital to shareholders sporadically while maintaining operational flexibility.

Of course, there is another option, which is to do nothing and stockpile cash on the balance sheet. However, that decision creates several points of risk: (1) potential earnings-multiple declines as investors discount interest income; (2) fear that the building cash signals business deterioration or plans for a disruptive acquisition; and (3) the heightened potential for shareholder activism.

The point is that investors want to see excess cash put to best use. So, when evaluating a share repurchase program, think through the short- and longer-term signals you’re sending to investors.

Execution can be revealing

Once a program is in place, the focus turns to how to execute it.

Many companies implementing first-time buyback programs say they will execute repurchases “opportunistically.” This approach gives companies the flexibility to buy outside of investors’ direct line of sight on a schedule that suits them.

With that flexibility, however, comes higher investor expectations. Investors study buying patterns for insights into how management thinks about valuation and future business performance.

First, many investors expect management to behave like stock pickers — buying low and selling high — and should be better at timing repurchases given their information advantage.

This perception becomes problematic in hindsight when companies buy at prices that seem attractive initially, only to face subsequent share price declines. As prices continue to fall, the cycle often repeats as companies buy more shares to sustain investor optimism that recovery lies ahead.

The truth is, though, many companies can’t effectively predict share prices better than skilled investors, and may even suffer from over-optimism regarding their business plans.

Second, if the company’s buying patterns are inconsistent or intermittent, investors may infer that the purchase window might be closed for a strategic reason, such as a pending acquisition or major announcement. Worse, the company’s fundamentals are weakening and there’s concern about future liquidity needs.

Finally, there is the inevitable question of what happens when the authorization is exhausted. As companies approach that point, investors can adopt an attitude of, “What have you done for me lately?” This can create awkward moments if there is doubt among management and the board on what to do next.

Tactical programs enable companies to better evade some, but not all investor scrutiny. These programs can consist of a simple strategy, such as returning a stated percentage of free cash flow every year. This approach is by definition a long-term commitment and a signal that the company is highly cash generative relative to its reinvestment needs.

Another targeted tactical approach is a program tied to offsetting share dilution, but “buyer” beware: investors tend to see this use case as a clunky acknowledgment of the cash cost of stock compensation and a tool for managing earnings.

Importantly, neither of these options will impress investors if the program is executed at high prices or the company foregoes high-return organic growth opportunities.

Investors will apply a similar lens for defensive share repurchase programs. While such programs might be an unavoidable desperation tactic, they can be counter-productive if investors judge that the program protected the company from aggressors at the expense of precluding clear value-creation alternatives.

Minding the details

So, with an understanding of the powerful lens investors apply to buyback activity, how should management teams and boards be thinking about designing, communicating and executing their plans?

Provide a clear framework. Clearly articulate capital allocation priorities before announcing an initial share repurchase program, ideally at an event like an investor/analyst day. This is particularly critical for companies with large bases of desirable growth-oriented investors who are betting on the company’s effective long-term use of capital.

Explain the rationale. Communicate with confidence why the repurchase plan is in shareholders’ best interest. Whether the company is playing offense or defense, buybacks are ultimately about capital allocation, and if investors don’t believe the company is optimizing for value creation, the stock will have bigger problems.

Plan strategically. Plan with the capitalization table in mind. Companies with large legacy holders such as VCs, private equity or a founder’s trust should think ahead to the potential liquidity needs of those investors. A buyback program can be part of a strategy to resolve the overhang efficiently, but the structure must allow for that purpose.

Consider stock liquidity. If you’re a smaller market-cap company, think carefully through longer-term share liquidity implications. It’s important to balance the potential net reduction in share count over time with maintaining enough liquidity to remain investable by the types of funds you want in your stock.

Think long-term. Be ready to discuss what comes next. Buybacks in the normal course (e.g., not tactical or defensive) are usually expected to become a fixture, not a one-and-done. Plan early on whether soon-to-expire or completed authorizations will be renewed or not. Investors will sniff out uncertainty pretty quickly.

Expect the unexpected. Many companies with active repurchase programs run into unplanned opportunities — perhaps a large, attractive acquisition, or an organic investment requiring a big step-up in capital expenditures — that could necessitate a suspension of the buyback. These companies will need to be ready to make the case for why the new investment is a better use of capital.

All in, repurchasing stock usually should be viewed as a long-term commitment by management and the board as part of the company’s capital allocation framework.

Like any capital allocation decision, buyback programs should be planned rigorously, benchmarked against alternative uses of capital, and designed with a strong understanding of the implications for investors. After all, it’s ultimately their money you’re spending.