Let’s review how a reverse stock split works, why companies may use them, and what investors should know about them.
Definition and Example of a Reverse Stock Split
Reverse stock splits are when companies consolidate shares, typically to increase the share price. Each share is converted into a fractional share, and the share price is increased by the amount of the reverse split. For example, say a stock was priced at $1 per share and an investor owned 500 shares. After a 1:10 (one for 10) reverse split, the stock would trade for $10 per share, and the same investor would own 50 shares. Companies often reverse split their shares to either increase trading volume by attracting more investors with a higher share price, or to stay listed on a stock exchange by remaining in compliance with the exchange’s share price standards. Exchanges such as the New York Stock Exchange (NYSE) and Nasdaq have listing requirements that include share price and volume staying above certain levels. A recent example is the 1:8 reverse split that General Electric (GE) underwent in 2021. Shareholders approved the reverse split in May to align GE’s share price and numbers of shares outstanding with similarly sized competitors after the company divested several subsidiaries. Prior to the reverse split, which took place on August 2, 2021, the stock traded in the low teens. On the day of the split, it traded for around $104 per share. Over the next six months, it traded as low as $92 per share. This illustrates a risk investors face with reverse stock splits, which is that they can lose money as a result of the fluctuations in prices after the split. Reverse stock splits typically are announced several weeks to months in advance.
How Does a Reverse Stock Split Work?
Reverse stock splits are not governed by the U.S. Securities and Exchange Commission (SEC) like other corporate actions. Generally, the split must be approved by either the board of directors or shareholders, depending on the company’s bylaws and state corporate law. On the day of the split, every existing share is converted into a fractional share. When General Electric did its reverse split, each share became one-eighth of a share. In other words, investors received one share for every eight shares they owned. However, the total value of their investment remained the same. Investors who don’t own a number of shares that are divisible by the reverse split ratio will either have fractional shares as a result, or the company will pay the investor cash for those fractions. The exception to fractional shares is when a company does a reverse split as a mechanism for going private. Businesses can deregister from the SEC if they have fewer than 300 shareholders, and one way to get below that number is with a reverse split that eliminates most marginal holders. For example, if most shareholders of a stock own fewer than 1,000 shares, the company can do a 1:1,000 reverse split and squeeze out the investors who own fewer shares by paying them for their holdings. Those shareholders would either have to accept that price or buy more shares to total 1,000. If the company sets a price for small shareholders that is above the current market price (to incentivize investors to sell their stock), there may be an arbitrage opportunity. Using the example above, investors could buy 999 shares at the current market price and make a profit when squeezed out by the reverse split.
Reverse Stock Split vs. Stock Split
A stock split is the opposite of a reverse stock split. In this case, a company that has a high share price increases the number of shares outstanding to reduce the price of the stock. This is often done to keep the stock price affordable for individual investors. A recent example is Intuitive (ISRG), which had a 3:1 split on Oct. 5, 2021. In this case, investors received three shares for every one share they held.
What It Means for Individual Investors
Reverse stock splits often occur because a company wants to raise its stock price. Companies with stocks that are priced too low can be excluded from exchanges such as the NYSE or the Nasdaq. Investors’ holdings are not directly affected by a reverse stock split, but resulting fluctuations in the share price that could follow may cause investors to lose money. Investors should research their investment choices, including a company’s motivation behind a reverse stock split.
title: “What Is A Reverse Stock Split " ShowToc: true date: “2022-12-17” author: “Jeremy Short”
If a company’s share price has fallen steeply, it may fail to meet a minimum stock price, which is one of several criteria required for being listed on a major exchange such as the New York Stock Exchange (NYSE). In order to avoid the embarrassment and practical disadvantages of being delisted from an exchange, the board of directors of a corporation may declare a reverse stock split to increase the quoted market value of its shares.
How Does a Reverse Stock Split Work?
Many companies list their common and preferred stock on one of the major stock exchanges, such as the NYSE or Nasdaq. Doing so gives greater liquidity to shareholders. To be listed on such an exchange, the corporation must meet several criteria, including a minimum number of round lot holders (shareholders owning more than 100 shares), an absolute number of shareholders, a specific net income threshold, a total number of public shares outstanding, and a minimum stock price. These requirements are designed to ensure that the common stocks classified as exchange-traded securities are only made up of reputable, respected, financially-viable enterprises. In times of market or economic turmoil, including during a major recession, individual businesses or even entire sectors may suffer a catastrophic decline in the per-share stock price. If the market price falls far enough, the company risks being delisted from the exchange, which is a severe hardship for existing stockholders. For example, companies that trade on the NYSE risk being delisted if their per-share price drops below $1 for 30 days in a row. To illustrate the concept, assume you own 1,000 shares of Bubble Gum Industries, Inc., each trading at $15 per share. The business hits an unprecedented rough patch, losing key customers. It suffers a labor dispute with workers and experiences an increase in raw commodity costs, eroding profits. The result is a dramatic decline in the stock price, falling all the way down to 80 cents per share. Long-term, you believe the business will still be fine, but short-term prospects don’t look good. Management knows it has to do something to avoid delisting, so it asks the board of directors to declare a 10-for-1 reverse stock split. The board agrees and the total number of shares outstanding is reduced by 90%. You wake up one day, log into your brokerage account and now see that instead of owning 1,000 shares at 80 cents each, you own 100 shares at $8 each. Economically, you are in the exact same position as you were prior to the reverse stock split: you still own $800 worth of company stock. But the company has now bought itself time to improve its business before getting booted from the exchange.
