A reduction in a company's outstanding shares in the market
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A reverse stock split, as opposed to a stock split, is a reduction in the number of a company’s outstanding shares in the market. It is typically based on a predetermined ratio. For example, a 2:1 reverse stock split would mean that an investor would receive 1 share for every 2 shares that they currently own.
Impact of a Reverse Stock Split on Market Capitalization
A reverse stock split does not increase the market capitalization of a company – although the number of shares outstanding decreases, the stock price is adjusted accordingly in that the market capitalization of the company remains unchanged. In other words, shareholder value is unaffected by a reverse stock split. The following diagram illustrates the concept:
As illustrated, market capitalization must remain the same. Therefore, when the number of shares is halved (2:1 reverse stock split), the share price doubles to maintain the pre-reverse stock split market capitalization of $10,000,000.
Example of a Reverse Stock Split
Cathy is a new investor and currently holds 100 shares of ABC Company at $10 (for a total value of $1,000). ABC Company owns 100,000 shares outstanding and announces a 100:1 reverse stock split. Every 100 shares owned by shareholders are now converted to 1 share. How is Cathy’s investment in ABC Company impacted by a reverse stock split?
First, with 100,000 shares outstanding and a share price of $10, the market capitalization of ABC Company is $1,000,000.
Second, with a 100:1 reverse stock split, there are now 1,000 shares outstanding (100,000 / 100 = 1,000) post-split.
Third, we know that the market capitalization is unaffected by a reverse stock split. Therefore, the 1,000 shares now outstanding must add to achieve a total market capitalization of $1,000,000. Therefore, each share is now worth $1,000 ($1,000,000 / 1,000 shares outstanding).
Lastly, Cathy now owns 0.1 share in ABC Company (100 shares / 1,000). With each share being worth $1,000, Cathy’s investment in ABC Company is unchanged.
Reasons for a Reverse Stock Split
There are several reasons why a company would conduct a reverse stock split:
1. Minimum stock price imposed by exchanges
For exchanges, there is a requirement to remain above a minimum share price. On the New York Stock Exchange, a company would risk being delisted if its share price closed below $1.00 for 30 consecutive trading days. Therefore, a reverse stock split may be used by a company to remain listed on exchanges and meet the minimum share price requirement.
2. “Improve” share price
In the United States, stocks that trade at less than $5 per share are considered penny stocks. For investors, shares that trade below $5 are typically deemed not investment grade. Therefore, a reverse stock split may be used to protect a company’s brand image and prevent the negative stigmatization of being labeled a penny stock.
3. Maintaining an acceptable share price after a spinoff
When a company decides to spin off its business, it may do a reverse stock split to maintain its company’s share price post-spinoff. For example, Hilton Hotels planned to spin off two businesses to its shareholders (Park Hotels & Resorts and Hilton Grand Vacations). On the same day, Hilton executed a 3:1 reverse stock split to keep its stock price in the same range as it traded before the spinoff.
Journal Entries for a Reverse Stock Split
The only journal entry required for a reverse stock split is a memorandum entry to indicate that the numbers of shares outstanding have decreased. A journal entry with debits and credits are not needed since the line items on shareholders equity do not change in a reverse stock split.
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