There are Many Reasons for a Reverse Split; All are Designed to Benefit Stakeholders
So far this quarter, there have been 59 reverse stock splits. These include industries as diverse as the apparel company Digital Brands Group (DBGI), which is consolidating its shares today, and Blue Apron (APRN), an e-commerce food prep provider, back on July 8th. In theory, this is a financial arrangement similar to asking for a $100 bill in exchange for five $20 dollar bills. But the reasons are more complicated and diverse. Understanding why a company you own, or are considering buying or shorting shares in, is consolidating ownership units can help you understand if the new shares are more likely to gain or lose value.
Background
As with the exchange of smaller denominated bills for larger ones, a reverse stock split is an action in which a company reduces its total outstanding shares while proportionally increasing the price per new share. It’s done by the company’s registrar by combining a certain number of existing shares into a single new share. For example, a 1-for-10 reverse stock split would result in every 10 shares of the company being converted into 1 new share.
From the shareholder side, their percentage ownership in the company remains unchanged; the value of that percentage will change as market forces revalue those shares.
Reasons for a Reverse Split
A corporate action such as a reverse split is not inexpensive for the company, so if it is conducting one, it must see a benefit. The primary reasons range from crisis management to an attempt to broaden the share’s appeal.
The category of crisis management includes working to prevent delisting from an exchange. The major stock exchanges have minimum share price requirements. If a company’s stock price falls below this minimum, it will be delisted from the exchange. Back in March, Bed Bath and Beyond went to shareholders asking for permission to do a reverse split in order to not be delisted for having a stock price lower than the Nasdaq threshold. The company was criticized as it showed that management did not have confidence that the price would rise on its own. At times when a company is approaching the minimum threshold for being listed on an exchange, they will look to do a reverse split, this can boost the per share price and prevent delisting.
In some cases there isn’t a crisis; management is simply managing perception in an effort to improve the stock’s image. This is because a stock that trades at a low price may be perceived as being risky or unpopular. A reverse stock split can give the appearance of a more valuable stock, which may attract more investors.
Conforming to the requirements of certain buyers, specifically institutional investors may also lead to a reverse split. Many institutional investors have minimum investment requirements. A reverse stock split can help to make a stock more attractive to these investors.
Bringing up the dollar price to simplify trading is another reason. A reverse stock split can make it easier to trade a stock, especially if the shares have a price below one dollar.
The Caution Signs When a Company Undergoes a Reverse Split
There are certainly potential negatives to shareholders when a company has a reverse stock split. For example, a reverse stock split can decrease liquidity, making it less liquid; for example, it may be more difficult to buy or sell.
Some investors may view a reverse stock split as a negative signal about the company’s financial health; if the action isn’t expected to cure the ailment, it may serve to feed into a growing list of things investors don’t like about the company.
Shareholders could wind up owning a lesser portion of the company if the split results in fractional shares. For example, if the stock you own 97 shares in reverse 1 for 10. You’ll receive 9 shares and, most often, the cash equivalent of seven shares.
Ultimately, whether or not a reverse stock split is a good idea for a company depends on the specific circumstances. Investors should carefully consider the pros and cons before making a decision about whether or not to buy or sell a stock that has undergone or is being talked about as considering a reverse stock split. In most cases only board of director approval is required.
Opportunity for Investors?
The opportunities for investors after a reverse stock split depends on the reasons for the split. If the split is done to prevent delisting, it is likely that the stock price will increase in the short term. However, if the split is done for other reasons, such as to improve the stock’s image or to make it more attractive to institutional investors, the long-term impact on the stock price is uncertain. Remember, management presumably got board approval as they thought it was in the best interest of the company; as a shareholder, you are technically an owner and would reap any benefit of it turning out to be a good move.
Take Away
A reverse stock split means the number of shares owned will be reduced, but the ownership level will remain the same. The price per share will increase, but the market capitalization of the company will change little. The reverse stock split may have a negative impact on the liquidity of the stock. It may also be seen as a negative by some investors.
Overall, reverse stock splits are always conducted for with the best interest of the company onwers in mind. But the reasons for the move, and if it will be successful needs to be evaluated by stockholders.
Managing Editor, Channelchek
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