Things Investors Need to Know about Reverse Split Stock

A reverse stock split is when a publicly traded company consolidates its existing shares into fewer, proportionally more valuable shares. Sounds counterintuitive, doesn’t it? As with most corporate actions, there’s always a rationale behind the decision.

An insight into the various reasons as to why must corporations pursue this strategy, what is the impact on the shareholders and the overall rationality in following this approach will be discussed in this article.

What Is a Reverse Stock Split?

Let us first define what is a reverse stock split, or sometimes also be called a reverse split.

A reverse stock split is the opposite of a traditional stock split. Instead of dividing shares into multiple smaller units (as in a stock split), a reverse stock split consolidates the number of shares.

How It Works

• The company issues fewer shares to replace the existing shares of stock at a fixed ratio, such as a 5 reverse stock split or a 10 reverse stock split.
• For example, in a 5 reverse stock split, every 5 existing shares are merged into 1 share.
• If you owned 50 shares at £10 each, after the reverse split, you would own 10 shares valued at £50 each.

While the total market capitalization of the company stays the same, the number of total shares and the price per share are adjusted proportionally.

Why Would a Company Undergo a Reverse Stock Split?

1. Prevent Major Exchange Removal

Many exchanges, such as the NYSE or NASDAQ, have a minimum share price requirement for listed companies. A company whose stock price has declined significantly, possibly putting it at risk of delisting, may conduct a reverse stock split to boost its price above the threshold and remain listed.

2. Avoid Penny Stock Status

Stocks trading at extremely low prices are often classified as penny stocks, which can discourage institutional investors and tarnish a company’s reputation. A reverse split can help a company regain investor confidence by positioning its stock as more valuable and stable.

3. Improve Market Perception

A higher share price resulting from a reverse stock split can make the company appear more appealing, which helps it remain relevant in the securities market.

4. Align Share Price with Market Trends

Companies sometimes pursue reverse splits to align their stock prices with those of their peers in the industry. They want to make the company’s shares more attractive to prospective investors.

5. Fund Operations and Future Growth

Reverse stock splits may also be part of a broader financial strategy involving raising capital. This could include a particular combination of debt, equity offerings, or strategic investments to fund ongoing operations and future growth.

6. Prepare for a Spinoff

Companies may implement a reverse stock split when preparing for a spinoff, to gain attractive spinoff prices.

7. Reduce the Number of Shareholders

In various jurisdictions worldwide, a company’s regulatory requirements often depend on the number of shareholders it has, among other factors. By consolidating shares and reducing the total number of shareholders, companies may strategically position themselves to fall under the oversight of a more favorable regulator or legal framework.

Impact of Reverse Stock Splits on Shareholders

1. Share Price Adjustment

A reverse stock split consolidates the number of shares but also increases the share price. So the total value of an investor’s holdings remains the same.

2. Ownership Proportions Stay Intact

Ownership proportions do not change for shareholders. For instance, if you owned 10% of the company before the reverse split, you would still own 10% after.

3. Reduced Liquidity

Since the number of outstanding shares decreases, liquidity may be affected. Fewer shares in the market can lead to wider bid-ask spreads. You may find it harder to buy or sell stocks at your desired prices.

4. Renewed Selling Pressure

Reverse stock splits can sometimes result in renewed selling pressure, particularly if investors perceive the action as a sign of financial distress.

Advantages and Disadvantages of Reverse Stock Splits

Advantages

1. Maintain Exchange Listing: Complies with minimum share price requirements on major exchanges.
2. Better Market Perception: Helps the company appear more stable and attractive to investors.
3. Higher Stock Price: Positions the stock to attract institutional investors who avoid low-priced stocks.

Disadvantages

1. Market Skepticism: Investors may view a reverse stock split as a sign of trouble, resulting in renewed selling pressure.
2. Impact on Liquidity: With fewer shares in the market, trading activity may decline.
3. No Value Creation: The company’s value doesn’t increase; it’s just redistributed among fewer shares.

Examples of A Reverse Stock Split

1. Hemogenyx Pharmaceuticals Plc

The most recent example is Hemogenyx Pharmaceuticals Plc. December 13, 2024, the LSE-listed company executed a 1-for-400 reverse stock split, aiming to streamline its share structure.

2. Struggling Companies

Many struggling companies with declining stock prices undergo reverse splits regularly to improve their standing in the securities market and attract new investors.

How Does Market Perception Affect Reverse Stock Splits?

The success of a reverse split often depends on how it is perceived by the market:

1. Positive Perception:
   • If the company’s fundamentals are strong and the split is seen as a step toward stability, investors may react positively.
   • For example, a company with a solid net profit margin and growth strategy may use the split to attract long-term investors.
2. Negative Perception:
   • When companies with declining financial performance conduct reverse stock splits, it may signal underlying problems, causing a drop in investor confidence.
   • In such cases, share price could fall further due to panic selling.

Regulatory Compliance and Delisting Risks

Minimum Share Price Requirements

Major exchanges often have minimum share price requirements to maintain the quality of listed securities. Companies failing to meet these requirements risk delisting from major exchanges.

Here are the minimum share price requirements for some of the world’s leading stock exchanges:

• New York Stock Exchange (NYSE): $1.00 per share.
• NASDAQ: $1.00 per share on both the NASDAQ Capital Market and NASDAQ Global Market tiers.
• London Stock Exchange (LSE): Does not have a strict minimum share price threshold, but requires listed companies to meet stringent market capitalization and financial standards.
• Toronto Stock Exchange (TSX): C$1.00 per share.
• Hong Kong Stock Exchange (HKEX): HK$0.50 per share.
• Singapore Exchange (SGX): S$0.20 per share for Mainboard-listed companies.

Role of Senior Management

A supervisory group, usually comprising senior management, decides to conduct a reverse stock split. This is to address compliance issues and to prevent imposed windup and dissolution.

FAQ: Reverse Stock Splits

1. Does a Reverse Stock Split Impact Market Capitalization?

No, a reverse stock split doesn’t change the company’s market capitalization, as the value is redistributed among a smaller number of shares.

2. How Does a Reverse Stock Split Affect Shareholders?

Shareholders retain the same proportion of ownership, but their total number of shares decreases. The stock price rises proportionally to maintain the overall value of their holdings.

3. Is a Reverse Stock Split a Sign of Trouble?

Not always. While it can indicate financial distress in some cases, it may also be a strategic move to comply with regulations or improve market perception.

4. How Does a Reverse Stock Split Differ from a Stock Split?

A reverse stock split reduces the number of existing shares, increasing the corporate stock price. In contrast, a traditional stock split divides the existing total shares into smaller units, reducing the price per share.

5. Can Reverse Stock Splits Create Long-Term Value?

Reverse stock splits don’t create intrinsic value, but they can help companies remain relevant to investors and avoid penny stock status, potentially leading to long-term stability.

6. What Happens to Market Volatility After a Reverse Stock Split?

Market volatility may increase temporarily as investors react to the split. Over time, it depends on the company’s performance and market conditions.

7. Are Reverse Stock Splits Common?

Yes, reverse stock splits are relatively common among companies whose share prices have dropped significantly, often as a measure to maintain exchange compliance or improve market appeal.

If you understand reverse stock splits and their implications, you can make informed decisions and assess the underlying company’s potential before committing to any investment.