A reverse stock split is a corporate transaction that consolidates shares and therefore increases the individual share price. A company may want to increase its share price to attract investors or to remain in compliance with share price standards on its exchange.
Let’s review how a reverse stock split works, why companies may use them, and what investors should know about them.
Definition and Example of a Reverse Stock Split
Reverse stock splits are when companies consolidate shares, typically to increase the share price. Each share is converted into a fractional share, and the share price is increased by the amount of the reverse split.
For example, say a stock was priced at $1 per share and an investor owned 500 shares. After a 1:10 (one for 10) reverse split, the stock would trade for $10 per share, and the same investor would own 50 shares.
Note
Reverse stock splits and stock splits do not reflect a change in the intrinsic value of the company—only the share price, which adjusts. But the market cap of the company is not directly affected by a reverse split or split.
Companies often reverse split their shares to either increase trading volume by attracting more investors with a higher share price, or to stay listed on a stock exchange by remaining in compliance with the exchange’s share price standards. Exchanges such as the New York Stock Exchange (NYSE) and Nasdaq have listing requirements that include share price and volume staying above certain levels.
A recent example is the 1:8 reverse split that General Electric (GE) underwent in 2021. Shareholders approved the reverse split in May to align GE’s share price and numbers of shares outstanding with similarly sized competitors after the company divested several subsidiaries.
Prior to the reverse split, which took place on August 2, 2021, the stock traded in the low teens. On the day of the split, it traded for around $104 per share. Over the next six months, it traded as low as $92 per share. This illustrates a risk investors face with reverse stock splits, which is that they can lose money as a result of the fluctuations in prices after the split.
Reverse stock splits typically are announced several weeks to months in advance.
How Does a Reverse Stock Split Work?
Reverse stock splits are not governed by the U.S. Securities and Exchange Commission (SEC) like other corporate actions. Generally, the split must be approved by either the board of directors or shareholders, depending on the company’s bylaws and state corporate law.
Note
Public companies that file with the SEC can notify shareholders about an upcoming reverse stock split with a proxy statement on forms 8-K, 10-Q, or 10-K. They may be required to file a proxy statement via Schedule 14A if shareholder approval is needed. If the company is going private as a result of a reverse stock split, the company would need to file a proxy statement on Schedule 13E-3.
On the day of the split, every existing share is converted into a fractional share. When General Electric did its reverse split, each share became one-eighth of a share. In other words, investors received one share for every eight shares they owned. However, the total value of their investment remained the same.
Investors who don’t own a number of shares that are divisible by the reverse split ratio will either have fractional shares as a result, or the company will pay the investor cash for those fractions. The exception to fractional shares is when a company does a reverse split as a mechanism for going private. Businesses can deregister from the SEC if they have fewer than 300 shareholders, and one way to get below that number is with a reverse split that eliminates most marginal holders.
For example, if most shareholders of a stock own fewer than 1,000 shares, the company can do a 1:1,000 reverse split and squeeze out the investors who own fewer shares by paying them for their holdings. Those shareholders would either have to accept that price or buy more shares to total 1,000.
If the company sets a price for small shareholders that is above the current market price (to incentivize investors to sell their stock), there may be an arbitrage opportunity. Using the example above, investors could buy 999 shares at the current market price and make a profit when squeezed out by the reverse split.
Reverse Stock Split vs. Stock Split
A stock split is the opposite of a reverse stock split. In this case, a company that has a high share price increases the number of shares outstanding to reduce the price of the stock. This is often done to keep the stock price affordable for individual investors.
A recent example is Intuitive (ISRG), which had a 3:1 split on Oct. 5, 2021. In this case, investors received three shares for every one share they held.
Note
A stock split is similar to a reverse stock split in that they are both often done to increase investor interest and volume in the stock. One is done because the stock price is too low and the other is done because it is too high. In both cases, the investor maintains their holdings, but with a different number of shares.
What It Means for Individual Investors
Reverse stock splits often occur because a company wants to raise its stock price. Companies with stocks that are priced too low can be excluded from exchanges such as the NYSE or the Nasdaq.
Investors' holdings are not directly affected by a reverse stock split, but resulting fluctuations in the share price that could follow may cause investors to lose money.
Investors should research their investment choices, including a company’s motivation behind a reverse stock split.
Key Takeaways
- Reverse stock splits are done to increase a stock’s price by reducing the number of shares.
- Companies conduct reverse stock splits to attract more interest from investors, to avoid delisting from a stock exchange, or to go private.
- A 1:10 stock split would reduce every existing share to one-tenth of a share and increase the share price tenfold.
