A reverse stock split is when a company reduces the total number of outstanding shares by a multiple and increase the share price by the same multiple.
The company will maintain the same market capitalization (share price x outstanding shares) as before. In effect, you start out with 10 shares of stock worth ₹2000 per share and assuming there is a one-for-two reverse split, you will wind up with 5 shares worth ₹4000 per share.
To make this easier to understand, let’s assume for a moment you have two ₹500 bills. Someone offers you a ₹100 bill in exchange for them. You now have one bill worth ₹1000 instead of two that equal the same value.
Company Value and Reverse Stock Splits
The value of a company does not change when stock splits. If a company has 100,000 outstanding shares that are worth $100 each before a stock split the company value is worth ₹10,000,000. If the company does a one-for-two reverse split, they now have 50,000 outstanding shares worth ₹200 each. The value remains the same; ₹10,000,000.
Why Do Companies Do Reverse Stock Splits?
Reverse stock splits increase the value of a single share of company stock. Companies that trade on the National Exchange (NSE) or the Bombay Stock Exchange (BSE) often do this to show a boost in share value. This is often necessary for them to remain a publicly traded stock.
Benefits of Reverse Stock Splits to Company
In some cases, investor may not purchase stock if they feel the price is too low. For example, some people won’t buy stock priced at less than ₹2500 per share. If a company stock has decreased to ₹1200 per share, one option would be to do a one-for-three reverse split. Here’s what happens:
You own 300 shares of stock at a price of ₹1200 per share
Company announces one-for-three reverse split
After split you own 100 shares of stock at ₹3600 per share
Now the company stock is worth ₹3600 per share and more investors are likely to be interested in buying stock which gives the company more money to work with.
Do Reverse Stock Splits Hurt Shareholders?
Initially, a reverse stock split does not hurt shareholders. Investors who have ₹1,000 invested in 100 shares of a stock now have ₹1,000 invested in fewer shares. This does not mean the price of the stock will not decline in the future; putting all or part of an investment in jeopardy.
When Shareholders May Be Hurt
In some cases, a stock split may result in fewer shareholders. For example, if a company does a reverse split of 100 shares to one, any shareholder who has fewer than 100 shares would not get a share. Instead, their shares would be exchanged for cash. For those investors, that means they no longer own a piece of a company.
Who Decides if a Stock Can Do a Reverse Stock Split?
In some cases, the shareholders may have to vote on a possible reverse stock split. However, in some states, a company’s board of directors may vote for the reverse stock split without the approval of shareholders. The SEC does not dictate reverse stock splits; generally, the rules are laid out during initial stock offerings and empowers the board of directors.
What Could Happen When You Do a Reverse Split vs. When You Don’t Do a Reverse Split?
Let’s make some basic assumptions to show what happens if you or don’t do a reverse stock split:
Company is valued at ₹1,000,000
Outstanding shares 500,000
Shares owned by shareholders 500,000
Current Value of Shares ₹2.00
50 shareholders own 1,000 shares each (50,000); 75 shareholders own 5,000 each (375,000), 1,000 shareholders own 75 shares each (75,000)
Now, let’s assume the company decides on a reverse split of one-to-four and any shareholder who has fewer than 100 shares is bought out. Here’s what the change looks like:
Company is valued at ₹1,000,000 (no change)
Outstanding shares 125,000
Shares owned by shareholders 106,250
Current Value of Shares ₹8.00
50 shareholders own 250 shares each (12,500); 75 shareholders own 1,250 shares each (93,750)
As you can see, the company now has 125 shareholders instead of 1,025 and has an additional 18,750 shares on their books. This means if those shares are sold, they get an additional ₹1,50,000 in capital to work with. If the company does not do a stock split, the original assumptions remain the same.
Please note, these numbers are very small for illustration purposes only. In most cases, companies will have far more issued shares.
Be Aware of Fallout After Reverse Stock Splits
Because the value of a company does not change when a reverse stock split is done, there is little downside for the company. However, it is still possible to alienate investors:
Eliminating Investors: If a company has hundreds of investors who own fewer than 100 shares and the stock split eliminates those investors, they may not come back. These shareholders may be upset about the split and losing their shares.
Causing Nervous Reactions: While a reverse stock split does not change the overall value of the company, a reverse stock split may cause some investors worries. This could result in their pulling their investment out of the company. This may cause the stock price to decline in the short-term.
Overpricing After Reverse Split: If a reverse split causes the stock price to increase too much investors may be discouraged. This could mean fewer investors over the short term which can mean the price of the stock could decline.
Do stock splits always result in an even number of shares being reissued?
The simple answer is no.
Sometimes, a reverse stock split means a shareholder has fractional shares. For example, if you have 100 shares before a reverse stock split and the split is one-for-three your shares will be 33.33. In most cases, the company will enter your shares at 33 and you will get the remainder in cash.
Does the total stock issued by a company change with a reverse stock split?
Yes. When a company is formed, they generally authorize the number of shares to be issued. Let’s assume the company agrees to issue 10,000,000 shares. If the company does a one-for-two reverse stock split the authorized shares are reduced by the split. That means the company now has only 5,000,000 authorized shares.
Issuing stock is a complicated process. If your company is considering issuing shares or considering a stock split or reverse stock split, you need to speak with an experienced securities attorney to guide you through the process.