What Is a Reverse Stock Split?

A reverse stock split is a type of corporate action that consolidates the number of existing shares of stock into fewer, proportionally more valuable, shares. Reducing the total number of outstanding shares in the open market can be pursued for a number of reasons, and often signals a company in distress.

A reverse stock split divides the existing total quantity of shares by a number such as five or ten, which would then be called a 1-for-5 or 1-for-10 reverse split, respectively. A reverse stock split is also known as a stock consolidation, stock merge or share rollback and is the opposite exercise of a stock split, where a share is divided (split) into multiple parts.

Key Takeaways

  • A reverse stock split consolidates the number of existing shares of stock held by shareholders into fewer, proportionally more valuable, shares.
  • A reverse stock split does not directly impact a company's value.
  • It does, however, often signal a company in distress since it raises the value of otherwise low-priced shares.
  • Remaining relevant and avoiding being delisted are the most common reasons for corporations to pursue this strategy.

Understanding Reverse Stock Splits

Depending on market developments and situations, companies can take several actions at the corporate level that may impact their capital structure. One of these is a reverse stock split, whereby existing shares of corporate stock are effectively merged to create a smaller number of proportionally more valuable shares. Since companies don’t create any value by decreasing the number of shares, the price per share increases proportionally.

Per share price bumping is the primary reason why companies opt for reverse stock splits, and the associated ratios may range from 1-for-2 to as high as 1-for-100. Reverse stock splits do not impact a corporation's value, although they are usually a result of its stock having shed substantial value. The negative connotation associated with such an act is often self-defeating as the stock is subject to renewed selling pressure.

Reverse stock splits are proposed by company management, and are subject to consent from the shareholders through their voting rights.

Important

The exchange may temporarily append a suffix (D) to the company’s ticker symbol to indicate that the company is going through a reverse stock split exercise.

Example of a Reverse Stock Split

Say a pharmaceutical company has ten million outstanding shares in the market which are trading at a price of $5 per share. As the share price is lower, the company management may wish to artificially inflate the per share price.

They decide to go for the 1-for-5 reverse stock split, which essentially means merging five existing shares into one new share. Once the corporate action exercise is over, the company will have (10 million / 5) 2 million new shares, with each share now costing ($5 * 5) $25 apiece.

The proportionate change in share price also supports the fact that the company has not created any real value simply by performing the reverse stock split. Its overall value, represented by market capitalization, before and after the corporate action should remain the same.

  • Earlier Market Cap = Earlier no. of total shares * earlier price per share = 10 million * $5 = $50 million
  • New Market Cap = New no. of total shares * new price per share = 2 million * $25 = $50 million

The factor by which the company's management decides to go for the reverse stock split becomes the multiple by which the market automatically adjusts the share price.

Benefits of Reverse Stock Splits

There are a number of reasons why a company may decide to reduce its number of outstanding shares in the market. 

Prevent Removal from Major Exchange

A share price may have tumbled to record low levels, which might make it vulnerable to further market pressure and other untoward developments, such as a failure to fulfill the exchange listing requirements. An exchange generally specifies a minimum bid price for a stock to be listed. If the stock falls below this bid price and remains lower than that threshold level over a certain period, it risks being delisted from the exchange.

For example, NASDAQ may delist a stock that is consistently trading below $1 per share. Removal from a national-level exchange relegates the company's shares to penny stock status, forcing them to list on the Over-the-Counter Bulletin Board (OTCBB) or the Pink Sheets, Once placed in these alternative marketplaces for low-value stocks, the shares become harder to buy and sell.

Attract Big Investors

Companies also maintain higher share prices through reverse stock splits because many institutional investors and mutual funds have policies against taking positions in a stock whose price is below a minimum value. Even if a company remains free of delisting risk by the exchange, its failure to qualify for purchase by such large-sized investors mars its trading liquidity and reputation.

Satisfy Regulators

In different jurisdictions across the globe, a company’s regulation depends upon the number of shareholders, among other factors. By reducing the number of shares, companies at times aim to lower the number of shareholders in order to come under the purview of their preferred regulator or preferred set of laws. Companies that want to go private may also attempt to reduce the number of shareholders through such measures.

Boost Spinoff Prices

Companies planning to create and float a spinoff, an independent company constructed through the sale or distribution of new shares of an existing business or division of a parent company, might also use reverse splits to gain attractive prices. For example, if shares of a company planning a spinoff are trading at lower levels, it may be difficult for it to price its spinoff company shares at a higher price. This issue could potentially be remedied by reverse splitting the shares and increasing how much each of them trade for.

Criticisms of Reverse Stock Splits

Generally, a reverse stock split is not perceived positively by market participants. It indicates that the stock price has gone to the bottom and that the company management is attempting to inflate the prices artificially without any real business proposition.

Additionally, the liquidity may also take a toll with the number of shares getting reduced in the open market.

Real-World Examples of Reverse Stock Splits

Reverse stock splits have been popular in the post dotcom bubble era, when many companies saw their stock price decline to record low levels. In the year 2001 alone, more than 700 companies went for reverse stock splits.

In April 2002, the largest communications company in the U.S., AT&T Inc. (T), announced that it was planning a 1-for-5 reverse stock split, in addition to plans of spinning off its cable TV division and merging it with Comcast Corp. (CMCSA). The corporate action was planned as AT&T feared that the spinoff could lead to a significant decline in its share price and could impact liquidity, business, and its ability to raise capital. 

Other regular instances of reverse stock splits include many small, often non-profitable companies involved in research and development (R&D), which do not have any profit-making or marketable product or service. In such cases, companies undergo this corporate action simply to maintain their listing on a premier stock exchange.