Why Do a Reverse Stock Split & Who Benefits?

Stock shares are the principal forms of equity used by companies to raise capital. A company sells stock through an initial public offering (IPO). The money raised is paid in capital, and is carried on the balance sheet as outstanding stock shares. Shares also trade in a secondary market on stock exchanges. A company can increase or decrease the number of shares outstanding without an IPO through stock splits and reverse splits. In all cases, the beneficiary of reverse split activity is the management of the company performing the reverse split. Shareholders may or may not benefit depending on the specifics of the reverse split.

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.

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.

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.

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.

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.