What is a Reverse Stock Split?
It’s important for investors to understand what a reverse stock split is, especially if the company they are investing in undergoes this type of split. A reverse stock split, in which the number of shares are reduced, can have a variety of effects on the stock, both positive and negative. Understanding the basics of reverse stock splits is key to making educated decisions when investing.
What Happens During a Reverse Stock Split?
A reverse stock split is a corporate action in which the number of outstanding shares on the market is decreased, but the share price is increased. For example, if a company were to do a 1 for 3 reverse stock split, it would mean that for each 3 shares investors own, they would be receiving only one. Using the same example, it would also mean that the price of the stock would be tripled. Therefore, instead of a company’s stock price being $5 per share before the split, after a 1 for 3 split, the stock would then be worth $15 per share.
What Are Some Motivations for Undergoing a Reverse Stock Split?
There are a few motivations that could influence a company to go through with a reverse stock split. These can include the following:
-Meet the Requirements of Certain Exchanges or Investors: Many or even most exchanges or investors have a requirement that a stock must be trading above a certain price to be listed on the exchange, or hold by certain companies as an investor. Reverse stock splits can be done to increase the share price to meet the necessary requirements.
-Control Share Availability: Companies can use reverse stock splits to make sure that the stock doesn’t become too accessible to the public, and that only specific investors can acquire the shares. Making the stock pricier through a reverse split also makes it harder for large amounts of small investors to acquire it.
-Handle Low Share Prices: It’s not uncommon to see low share prices, especially in the beginning stages of a company, or after a big fall. If a company has a low share price, it can be hard to impress investors and the stock might lose people’s interest. To attract more investors, companies employ reverse splits to make sure their investment looks more appealing and has a more desirable share price.
What Are the Potential Benefits for a Reverse Stock Split?
-Increase Stock Price: The most apparent benefit of a reverse split is to increase the share price. As previously mentioned, for every 3 shares owned, 3 for 1 reverse split would increase the value to 3 times the original price. This can be beneficial for a company if the stock had been trading at a low price.
-Attract Investors: A higher share price is more attractive to potential investors, as it looks more profitable and trustworthy. This can be especially beneficial for small companies or companies that have had a low share price.
-Indirectly Boost the Perceived Value of a Company: Because of the lower share price, a company with a reverse split might see an increased stock turnover, or increased trading volume. This, in turn, can boost the perceived value of a company.
What Are Some Potential Drawbacks to a Reverse Stock Split?
-Shareholder Dilution: Although the number of shares is reduced during a reverse split, the overall liquidity of the stock can be reduced as well, because a much higher percentage of all outstanding shares is owned by a smaller number of shareholders.
-Uncertainty: With any corporate action, there is always a certain level of uncertainty that comes with it, which reverse splits are no different. Investors can become concerned and might choose to sell if they don’t understand the reasons why the company is undergoing a reverse split, or what the repercussions of the split might be.
-Negative Perception: If investors perceive that a company has to go through with a reverse split to pump up the share price, it can leave a negative impression. This is because some investors might think the company isn’t doing well and employing an artificial way to make their company look better.
-Tax Implications: Depending on the reason for the reverse split, there might be tax implications. For example, if a company is restructuring and selling, some of the shareholders might face tax consequences.
Reverse stock splits can have both positive and negative consequences for investors. Although it’s a great way to increase the stock price, it might not be the best move if the company isn’t doing well and the share price is low. Understanding the ins and outs of reverse stock splits can help investors make informed decisions when investing in a company who undergoes a reverse split.
