What Is a Reverse Stock Split?
A reverse stock split is a corporate action taken by a company to reduce the number of outstanding shares while concurrently increasing their value. This tool is most often used by companies with declining stock prices, enabling them to regain their stature on the public market. The most common reverse stock split ratio is 1-for-2, meaning that shareholders receive one-half share for every one share they own. For example, if a company has 100 shares worth $50 each, a 1-for-2 split would result in 50 shares worth $100 each.
Reverse Stock Splits: Overview
A reverse stock split involves a company consolidating its existing shares, typically by a predetermined ratio. This is done to reduce the number of outstanding shares while at the same time increasing each remaining share’s value. The result is that the company’s total market capitalization (value) remains the same. In some cases, a reverse split can have a positive effect on a company’s share price. However, it also carries the risk of further signaling to the market that the company may be financially troubled and thus have a long-term negative reaction.
Why Do Companies Do a Reverse Stock Split?
There are several reasons why companies choose to do a reverse split, ranging from the strategic to the practical. Generally speaking, companies choose to do a reverse stock split with the goal of improving the company’s perception on the market. By reducing the overall number of outstanding shares, a company can boost the value of their remaining shares and attract new investors.
Additionally, some companies are subject to delisting from certain stock exchanges if their stock price falls below a certain level for a certain period of time. A reverse split can dramatically improve the value of the company’s stock and thereby prevent delisting from one of the exchanges. This can give the company better liquidity through increased trading and more bargaining power when negotiating with vendors and lenders.
Advantages of a Reverse Stock Split
The main advantages of a reverse stock split are improved liquidity, reduced float, and increased share prices.
• Improved Liquidity: By reducing the number of shares outstanding, there are fewer shares to trade, which can make the trading process smoother and more efficient.
• Reduced Float: Similarly, a lower float (or the number of outstanding shares) makes it easier for buyers to purchase large blocks of the company’s stock. This can be beneficial to companies which are subject to takeover, as larger buyers will find it simpler to purchase their shares.
• Increased Share Price: By consolidating its shares, the price of the newly created shares should theoretically increase as the per-share value of the company as a whole is also increased.
Disadvantages of a Reverse Stock Split
The primary disadvantage of a reverse stock split is the potential damage to a company’s reputation. By reducing the number of shares, the company might be seen as having serious financial issues in which it must push the price of its stock higher in order to simply survive. This can scare away both potential and existing investors from the company and have a long-term negative effect on the share price.
Additionally, some shareholders may be negatively impacted by the reverse split. Shareholders who have a large number of shares may face increased capital gains taxes should they choose to sell their shares as the share price will have decreased significantly.
Other Considerations
When considering a reverse stock split it is important to consider all potential scenarios and the potential fallout. Companies should carefully assess the potential benefits and risks and weigh them against the potential downside of taking no action. It is also important to consider investor reactions to the move, as a reverse stock split can often be perceived as a sign of desperation.
Finally, companies should make sure to clearly communicate their reasons for undertaking a reverse stock split to their investors. This can help build investor confidence in the company as it will be perceived as taking proactive steps to maintain control of its financials and share price in the long term.
A reverse stock split can be a beneficial tool for a company, but should always be carefully considered. As with any corporate action, there are a number of factors to take into account and the potential fallout should be weighed carefully. Companies should make sure to clearly communicate their reasons for undertaking a reverse stock split to their investors, as this can help build investor confidence in the company. Additionally, it is important to weigh the potential benefits against the potential risks, such as damage to the company’s reputation.
