What Is a Reverse Stock Split? Everything You Need to Know

Table of Contents:

1. Reverse stock split meaning
2. How does a reverse stock split work?
3. Reasons companies reverse split stock
4. Benefits of reverse stock splits
5. Risks of reverse stock splits
6. FAQs about reverse splits
7. The bottom line

Publicly traded companies may execute any number of corporate actions that affect shareholders. One of these actions is called a reverse stock split, which consolidates existing shares of its stock into fewer shares at a higher cost. This means a company takes the total outstanding shares in the market and divides them by numbers such as 2, 5, 7, 10, etc.

Key Takeaways:

• A reverse stock split consolidates stockholders existing shares of a company into fewer shares without changing the value of their stock.
• Companies may implement a reverse stock split to prevent being delisted from the stock exchange.
• A reverse stock split can increase shares of common stock prices by decreasing the outstanding shares of stock.
• Since a reverse stock split raises stock prices, it can gain the attention of big institutional investors.
• A reverse stock split can carry a negative connotation with stock traders and institutional investors.

Reverse stock split meaning

Reverse stock splits occur when the board of directors of a company chooses to reduce the number of outstanding share counts and consolidates them into fewer shares with a higher share price. Since the new share price is raised substantially, the companys total market value remains the same, as does the value of your investment.

How does a reverse stock split work?

When a companys board of directors decides to implement a reverse stock split, it cancels its current outstanding stock and administers new shares that equal the proportionate value of shares owned before the split.

Unlike other corporate actions, stock splits arent governed by the U.S. Securities and Exchange Commission (SEC). Instead, they would be approved by either the shareholders or board of directors, depending on whats outlined in the companys bylaws and the states corporate laws.

Once a public company notifies its shareholders of the split, all existing shares are switched to fractional shares. Suppose an investor doesnt already own shares divisible by the reverse split proportion. In that case, they will have fractional shares unless the company decides to pay them cash for their fractions.

The steps leading to a reverse stock split might include:

• The company evaluates its situation, and management proposes a reverse stock split to the board of directors.
• The board of directors will vote on it and approve it, which may be subject to the approval of a vote by the shareholders.
• The company announces the split, the details of the split ratios, and the effective date of the split.
• On the effective split date, the company cancels current shares and administers new shares to existing shareholders in direct proportion to their shares before the split.

Reverse stock split example

Although there isnt a set formula for deciding the ratio of a reverse stock split, some of the most common splits are 1:2 (1 for 2), 1:10, 1:50, and 1:100, which are chosen depending on the companys goal for how much they want to trade at on the stock exchange.

An example is XYZ company deciding to do a reverse stock split of 1:10 (1 in 10). In this situation, the shareholders would receive 1 share for every 10 shares they previously owned. If a shareholder owns 1,000 shares of stock, they would own 100 shares after the reverse stock split was completed.

As mentioned, when implementing a reverse stock split, the companys value doesnt change. Therefore, even though outstanding shares will be less, the price increase of those shares is equally proportioned to the value before the split.

The same holds true for the investor. For example, suppose an investor owns 1,000 shares worth $1, and there is a 1 in 10 reverse stock split. In that case, the investors stock is reduced to 100 shares, but they would now be worth $10, giving them a total value of $1,000, which was the value before the split.

Reasons companies reverse split stock

When a company decides to implement a reverse stock split, it reduces the number of outstanding shares in the market. There are a few reasons a company might want to do this, including to:

Boost a companys share price

Investors want to invest in companies they can believe in and that they feel will be successful. When a companys stock drops to single digits, it can shake confidence in investors and can be viewed as a penny stock, which carries a negative stigma. Conversely, when they implement a reverse stock split, it raises stock prices and boosts the companys overall public image.

Boost the companys share price and reduce the risk of being delisted

One of the advantages for a company to be listed on the stock exchange is that they have an opportunity to attract equity investors, but if their stock price drops below $1, the stock risks being delisted from the stock exchange due to minimum price requirements. However, when a company implements a reverse stock split, it can boost its share price to avoid delisting.

Gain attention from analysts and investors

High-priced stocks are perceived as an indicator that a company has more value, which draws the attention of market analysts. When analysts provide favorable feedback about a company, it works as a great marketing tool that attracts the attention of big investorssomething that doesnt happen when stock prices are too low. Many companies will do a reverse stock split to increase stock prices to get attention.

Benefits of reverse stock splits

When a company decides on a reverse stock split, it considers both advantages and disadvantages of how the split can affect the company. Advantages include:

• Preventing removal from the exchange – to dive deeper into how a company can benefit from a reverse stock split, we need to understand that when stock prices drop too low, a company can become vulnerable to significant pressure.
• The New York Stock Exchange (NYSE) and Nasdaq have minimum listing requirements that must be met. If a stock remains too low over a period of time, it will be delisted, which, in turn, can affect that company negatively across the board and jeopardize the business.
• Satisfy jurisdictional regulators – meeting regulations can depend on the number of shareholders, so by reducing the number of shares of stock, the company can lower the number of shareholders to meet regulation laws.
• Spinoff pricing – when a company decides to create a new company, it can sell more shares of the existing business and introduce the new company. It makes the existing company the parent company and does a reverse split to attract investors.

Risks of reverse stock splits

When a company implements a reverse stock split, investors generally see it as a sign that the company is in trouble. This is because the reverse stock split sometimes indicates that the stock has dropped to the point where its in danger of being delisted and can be viewed as a last-ditch effort to survive.

The negative connotations attached to this type of move can lead investors to believe that company management is hiding company problems and inflating prices without any promise of improving their situation. It can be a red flag for investors and deter them from taking a chance.

FAQs about reverse splits

Q: Are reverse stock splits positive or negative for a company?

A: Although they wouldnt generally be considered positive or negative, reverse stock splits can indicate to investors that a company is in trouble. When a company turns to a reverse stock split, it indicates a sharp drop in its stock price and worry of being delisted from the stock exchange. It sometimes comes with a negative connotation and can hurt a companys overall reputation.

Q: Is a reverse stock split beneficial for shareholders?

A: Companies often turn to a reverse stock split when the business is having difficulties, but if a company utilizes it in conjunction with improved operations and business practices that can be positive for growth for the company, shareholders can enjoy the benefits of that reorganization and increased profits.

Q: Can shareholders lose money in a reverse stock split?

A: Many shareholders choose to cash out when a reverse stock split occurs due to the uncertainty that comes with the changes and fluctuations, but for those who keep their shares, theres a chance the company wont rebound, and they can lose money.

Q: Does a reverse stock split mean shareholders make money?

A: Since the value of your shares doesnt change with a reverse stock split, shareholders dont profit from the stock split alone. However, if the company changes its business operations and increases its value, stock prices can continue to rise.

The bottom line

When a company implements a reverse stock split, the action reduces the number of outstanding shares and increases share prices in proportion to the old price. Although a shareholder holds a smaller number of shares, the value remains the same as the old amount.

While raising prices can help to reignite a companys image, reverse stock splits sometimes are a sign that a company is in trouble and holds a negative connotation with investors.

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