What is a Reverse Stock Split?

A reverse stock split is a type of corporate action which consolidates the number of existing shares of stock into fewer, proportionally more valuable, shares. The process involves a company reducing the total number of its outstanding shares in the open market, 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 stock split, where a share is divided (split) into multiple parts.

Key Takeaways

  • A reverse stock split reduces the number of shares held by each shareholder but with proportionally more valuable shares.
  • A reverse stock split does not directly impact a company's value.
  • A reverse stock split, however, often signals a company in distress since it raises the value of otherwise low-priced shares.
  • The desire to increase share prices to remain relevant and to avoid being delisted are the most common reasons for corporations to pursue this strategy.

Understanding Stock Splits

Understanding Reverse Stock Splits

Depending upon the market developments and situations, companies take several actions at the corporate level which may impact the capital structure of a company. A reverse stock split is one such corporate action through which 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.

Reverse stock splits do not impact a corporation's value but they are usually a result the corporation's stock having lost substantial value. The negative connotation associated with such an act is often self defeating as the stock is subject to renewed selling pressure.

For example, say a pharmaceutical company has ten million outstanding shares in the market which are trading at the price of $5 per share. Outstanding shares refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares. As the share price is lower, the company management may like 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, and each share will now cost ($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.

Such corporate actions are proposed by company management, and are subject to consent from the shareholders through their voting rights. 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.

Why Companies Go for Reverse Stock Splits?

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

A share price may have tumbled to record low levels, which may make it vulnerable to further market pressure and other untoward developments like 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 the price of $1 per share. Such a delisting from a national-level exchange relegates the company's shares to penny stock status, and they are forced to list on the Over-the-Counter Bulletin Board (OTCBB) or the Pink Sheets which are alternative marketplaces for low-value stocks. Once that happens, shares are harder to buy and sell. Therefore, companies go for reverse stock split to maintain a higher per-share price.

Companies also maintain higher share prices through reverse stock splits as 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.

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 reduce the number of shareholders which allow them 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.

Companies which are planning to create and float spinoff, which is an independent company created through the sale or distribution of new shares of an existing business or division of a parent company, may 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. They may first reverse split their shares to increase the per share price, and then create a new company that has better chances of securing a higher share price.

Market Impact 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 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 which is not a positive sign for any listed company.

Real-World Examples of Reverse Stock Splits

Per share price bumping is the primary reason for companies going for reverse stock splits, and the associated ratios may range from 1-for-2 to as high as 1-for-100. Reverse stock splits have been popular in the post dotcom bubble era of year 2000, when many companies saw their stock price declining 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. 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 which do 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.