A reverse stock split is a corporate action that reduces the number of outstanding shares of a public corporation. The aim of this is to increase the price per share, which a company might need to do to meet exchange listing rules or make it easier to raise money from new investors.
A reverse stock split is the opposite of a traditional stock split, which increases the number of shares, decreasing the share price. Companies also do this to make it easier for investors to buy and sell shares in the business.
Why do a reverse stock split?
Reverse stock splits are typically used by companies whose stock price has fallen to a level that makes it difficult to attract investors and meet listing requirements for stock exchanges.
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By reducing the number of outstanding shares, a reverse stock split can increase the price per share, making the stock more appealing to investors and potentially improving the company's financial standing.
For example, let's say Company XYZ's stock is trading at $1 per share, and the company decides to do a 1-for-10 reverse stock split. This means that for every 10 shares of stock an investor owns, they will receive one new share.
After the reverse stock split, the number of outstanding shares will be reduced by a factor of 10, and the price per share will increase to $10 - that’s the theory anyway.
However, it’s important to remember while a reverse stock split is designed to increase the price per share of a company, it does not increase the overall value of the company. That depends on what management decides to do after this corporate action. Simply put, shareholders will see the number of shares they own fall, but the percentage of the business they own will remain the same.
So if nothing really changes, why would a company do a reverse split? Put simply, it can make it easier for a company to raise money.
One of the ways public companies can raise money is by issuing new shares to investors. In theory, a corporation can raise money at any share price, but it looks a lot better if a firm only needs to issue 100,000 shares at $10 rather than 1,000,000 shares at $1.
In this scenario, the business is swapping new stock for cash from investors. This cash can then be used for whatever it sees fit, such as paying down debt or funding growth.
There is a big risk with this approach. It could signal to investors the company is in financial trouble and in danger of bankruptcy, leading to a loss of confidence and a weaker share price, undermining management’s efforts to improve the corporation’s finances in the first plan.
Why is it different to a stock split?
Unlike a stock split, which increases the number of shares in issue (and like a reverse split does not change the percentage of the company owned by the investor) a reverse stock split consolidates the number of outstanding shares.
A company might pursue a stock split to decrease its share price - making it easier for investors to buy and sell shares - while the main aim of a reverse split is to increase the share price.
The higher price that results from a reverse split might make it harder for investors to buy and sell shares, but that’s a trade-off the corporation will have to make if it wants to raise more cash to keep the lights on and sales coming through the door.
Jacob is the founder and CEO of ValueWalk. What started as a hobby 10 years ago turned into a well-known financial media empire focusing in particular on simplifying the opaque world of the hedge fund world. Before doing ValueWalk full time, Jacob worked as an equity analyst specializing in mid and small-cap stocks. Jacob also worked in business development for hedge funds. He lives with his wife and five children in New Jersey. Full Disclosure: Jacob only invests in broad-based ETFs and mutual funds to avoid any conflict of interest.
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