Stocks and securities inhabit a world of their own, a place with its own set of nomenclature and rules. A security is one type of ownership of a company (either equity, debt or derivatives), while a stock is a particular type of security, one that falls under the equity heading. These instruments are bought and sold on an exchange, at a price that is determined by the market. As companies grow (or contract), these items can gain or lose value. One of the ways a publicly held company can control the number of outstanding shares (and the price per share) is by employing a stock split.
What Is a Stock Split?
A stock split (commonly referred to as a forward stock split) is when a company boosts its number of shares available, in order to increase the stock’s liquidity. Typical splits are 2-for-1 or 3-for-1, meaning holders of 100 shares would now have 200 or 300 shares, respectively, after the split. Understand that although the number of shares of the company increases due to a stock split, the total value of outstanding stocks does not change the company’s value. Although less common, there is also a reverse stock split, which is explained below.
What Is a Reverse Stock Split?
Exactly as the name would indicate, a reverse stock split is the opposite of a forward stock split. Instead of increasing the numbers of outstanding shares by doubling (or tripling) them, the number of shares is decreased. So, if a shareholder is holding 100 shares of XYZ Company, and there is a 1:2 reverse stock split, the shareholder will have 50 shares. A forward stock split decreases the price of each share of stock; a reverse stock split will increase the price per share.
A recent example of a reverse stock split was General Electric in July 2021. It was a 1:8 split, meaning that if a shareholder was holding 100 shares, they would be left with 12.5 shares after the split. However, if there are no fractional shares offered, the investor would be paid off for the fractional share, meaning that at the end of the day, the shareholder would have 12 shares and cash from the fractional shares left over. Of course, the price on the post-split shares was eight times the pre-split cost; the shareholder was left with eight times fewer shares, but the remaining shares were priced eight times that of the pre-split shares at the time of the split.
Reverse Stock Splits In Action
Similar to announcing a forward stock split, a company’s PR department will release the news that a reverse stock split is pending. The press release will cover all the important details, namely the effective date of the split and the split ratio. In virtually every instance, there is plenty of notice that there is a reverse stock split looming, and the investor has ample time to either sell, buy more or stay put.
How Reverse Stock Splits Are Commonly Used
There are many reasons why companies would implement a reverse stock split. In many instances, it occurs among small-cap companies and startups, which may be in the early development stages, but, of course, in recent times, some large-cap companies have also instituted a reverse stock split, including Citigroup, AIG, Motorola and the aforementioned GE. But, for the most part, the reason for performing a reverse stock split is one of the following.
- To prevent being delisted: Being delisted is the removal of a security from a stock exchange. Typically, when a stock’s price falls below the determined threshold of the stock exchange it’s listed on, it’s in danger of being delisted. A reverse stock split boosts the price-per-share of the stock and allows it to remain listed on the stock exchange.
- To improve the company’s image: Low share prices never bode well for a company’s image, as investors may look at single-digit share prices as penny stocks. Not only do casual investors often avoid penny stocks, but many institutional investors are bound by their charter to avoid securities with a low price per share.
- To remain relevant: If a company’s shares continue to languish near the bottom, the stock often falls off the radar of analysts and institutional investors.
Challenges of Reverse Stock Splits: Are They Splits Good or Bad?
As far as the initial split goes, it’s neither a good or bad thing, really. If you hold 100 shares of XYZ Company at $5/share, your investment is worth $500. A 1:2 reverse stock split would leave you with 50 shares, with each share being worth $10, meaning your investment would still be worth $500. So technically, it’s a wash, with no gain or loss in overall value. But sometimes, a reverse stock split reveals that more is going on behind the scenes.
Of course, the investment world can be a dangerous one, and the fact that a reverse stock split has occurred is quite often a red flag and can paint a negative picture of the company and its stock over the short (as well as long) run. However, astute investors should be looking at other signs that the company is struggling financially, and a reverse stock split shouldn’t be the only indication of financial stress. There are also some indications that a reverse stock split could create opportunities to grow and prosper financially, but since every company and situation is different, it should be viewed on a case-by-case basis and not by the yardstick of one hard and fast rule.
How a Virtual Data Room Is Used in the Reverse Stock Split Process
Any financial activity, along with the due diligence process that inevitably is part of the process, requires a secure, online location where all the parties involved can store and share the required documentation. This location, known as a virtual data room (VDR), contains the tools and features necessary for all parties working on a successful reverse stock split transaction. A VDR should feature high-level admin controls, document and version management, multiple layers of security and customer support available 24/7. In addition, it should include a user-friendly interface with the ability to update and edit files from virtually any part of the globe using any type of computer, phone or tablet.
For any financial transaction that requires secure access to the documentation required, CapLinked is an industry leader in the VDR space. Start a free trial of our VDR solution that will fit your organization’s needs.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
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