Why Do a Reverse Stock Split & Who Benefits?

Why Do a Reverse Stock Split & Who Benefits?
A reverse stock split may force you to accept cash for your shares in a company.

Stock Splits

Stocks trade in the secondary market at a price per share that is a function of supply and demand. In a regular stock split, the management of a firm has decided to increase the number of outstanding shares. For instance, if there are 10 million shares outstanding that are trading at $148.50 per share, a two-for-one stock split would increase the outstanding shares to 20 million, each priced at $74.25. Each shareholder's number of shares will double and each share's price will be halved. Management undertakes a stock split when it wants to decrease price per share, for instance to make shares more attractive to investors of modest means.

Reverse Stock Splits

A reverse stock split, or stock merger, results when management cancels outstanding shares, consolidates them and issues a fewer number of new shares. For instances, if a company's 50 million shares are selling for $0.75 each, a 1:100 reverse split will result in 5 million outstanding shares selling for $7.50 each. This higher price tends to make a stock more "respectable," and removes the threat of delisting from the stock exchange should the share price fall too low.

Eliminating Small Shareholders

When a stock reverse splits, shareholders who hold less than the specified number of shares will receive cash instead of new shares, ending their status as shareholders. For instance, a 1:500 reverse split will eliminate shareholders who own less than 500 shares, since there is no provision for a fractional share. A large reverse stock split is thus an effective method of lowering the number of shareholders. Cashed-out shareholders may not appreciate losing their stakes in a company. To them, the reverse split is not beneficial.

Corporate Classification

A reverse split can be use to change the classification of a corporation. For example, a Subchapter S corporation is one in which income is passed through directly to shareholders, who then pay income tax on it. A normal (Subchapter C) corporation can be reclassified as Subchapter S if its number of shareholders dips below 100. By setting the reverse split ratio high enough, it is feasible for a corporation to shed enough shareholders to be reclassified.

Forward Split

If a company uses a reverse split to reclassify itself by shedding stockholders, it can undergo the reclassification and then immediately issue a forward split that reverses the reverse split. This reestablishes the share price to pre-reverse-split levels. Forward reverses used in this way are almost always preceded by reverse splits. Management benefits from forward splits by effecting a reduction of shareholders and establishing a more desirable classification without affecting share prices.