What is a Reverse Split?

A reverse split is a consolidation of a corporation's shares according to a predetermined ratio.

Example of a Reverse Split

Company XYZ wants to conduct a reverse stock split. It decides that each shareholder will own one share for every five he owns as of a certain date -- say, January 1. This is a one-for-five reverse split, and it means that the shareholder who owns 100 shares on January 1 will own 20 shares after January 1. If there are shareholders who own less than five shares, Company XYZ will probably offer to buy those shares back from the investor.

Although it may seem that the shareholder is getting shortchanged, he isn't. If Company XYZ shares were worth $1 per share before the reverse split and the shareholder owned 100 shares, the shareholder owned $100 of stock. After the reverse split, he owns 20 shares worth $5 each--still $100 of stock. Likewise, Company XYZ's market capitalization is the same after the split.

Company XYZ's board of directors can declare the reverse split without the consent of the shareholders. Company XYZ's articles of incorporation and bylaws will govern the conditions under which it will conduct reverse splits.

Why do Reverse Splits matter?

There are two general reasons an issuer does a reverse split: to avoid delisting or to make the stock seem more valuable than it is. Exchanges have minimum prices at which issuers must trade, and so performing a reverse split can bring the stock price above that minimum requirement. Institutional investors are far less likely to hold stocks that trade at prices below a certain threshold (because of internal company policies, because the shares appear too speculative, or because they cannot be purchased on margin), and so if an issuer wants to attract more institutional trades (and thus more liquidity to its stock), a reverse split can be just the ticket.

Reverse splits typically don't reflect well on the issuer, which is why an issuer's stock price usually suffers after a reverse split. Thus, shareholders need to be wary when an issuer announces a reverse split.