In order to understand what a reverse split is you have to know that each company out there listed on that stock exchange has a fixed number of shares available to trade. When investors and traders are buying and selling shares we are all exchanging shares with each other out of this one collective pool of shares. It could be a hundred thousand shares, two million shares or could be ten billion shares. The company decides this amount based on a number of reasons but just know that this number of available shares, theoretically, doesn’t change. It’s a fixed number. This fixed number of shares is called the outstanding shares. It’s the total amount of shares a company has divided itself into. Now, each of these shares are going to be associated with a price and if we take the total number of shares that a company has and multiply it by the price of one share then we would get the total dollar market value of that company which is called the market capitalization. If a company has 1 million outstanding shares, or in other words total shares, and each share is worth $10 then that is a $10 million dollar company. If a company has 10 billion shares and each share is priced at $30 then that is a $300 billion dollar company. So let’s say that company ABC has 20 million outstanding shares and each share is priced at $5. If they have 20 million shares each priced at $5, what is the total worth of company ABC? It’s going to be $100 million. Now, based on the performance of the company, the public is going to decide what the price of company ABC shares are worth as time goes on. This is how stock prices go up and down. If company ABC is performing really well meaning they are increasing their sales, they are coming out with new and good products and are making money then more investors will want to buy and get a piece of those 20 million shares driving the price of those shares up. But, if company ABC performs very poorly then investors who own shares of this 20 million share pool are going to want to sell them causing the price to go down. So from our example, company ABC had a share price of $5 but let’s say over the years that their performance hasn’t been very good. Maybe their sales revenue is declining, maybe their debt is increasing, maybe they are having tons of legal problems. There could be all kinds of problems going on but in the eyes of investors that’s not a good sign, so in turn, the share price is going to decline. Let’s say that it declines all the way down to 75 cents per share. This would be why a company may decide to do a reverse split. The major exchanges such as the Nasdaq or the New York Stock Exchange have minimum share price rules meaning if a company’s share price does not trade over $1 for a certain period of time then it will be delisted from the major stock exchange. This is not what a company wants. They want to be listed on the major exchanges because that is where the majority of investors are at. Not only do they need to keep the share price up to meet these minimum requirements but many institutional investors are actually prohibited from trading stocks below $5. So in order for the company to meet requirements and also still look attractive to the big investors they need to increase their share price. But if the company is not performing well then investors are not going to be buying its stock and therefore the price isn’t going to go up. So what the company can do is artificially raise the stock price up by performing what is called a reverse split.
So let me explain how this works. At the current moment, company ABC has 20 million outstanding shares and each share is priced at 75 cents. What is the market cap, or the total worth of this company? We multiply the outstanding shares of 20 million by the price per share of 75 cents. Thats going to give equal $15 million dollars. So company ABC at this moment is worth $15 million dollars. We can’t magically turn company ABC into a $40 million dollar worth company overnight. So the market cap can’t change. But what we can change is the number of shares available which in turn will change the price per share because the number of shares in the current price combined still have to reflect the company’s overall value. Let’s say company ABC decides they want to increase the share price by 10 times the current price. They want to go from 75 cents per share to $7.50 per share. Remember, company ABC is still a $15 million dollar company. So in order for the new price of $7.50 to match the company worth the number of outstanding shares has to change. Since they increase the price by a multiple of ten, they need to divide the outstanding shares by ten. So company ABC went from having 20 million shares available to 2 million shares available. Now even though the share price rose to $7.50 the company value didn’t change because the outstanding shares decreased still reflecting a 15million dollar company. So this is how it looks like from an investor’s perspective. If they were holding some shares of company ABC as they perform a reverse split from our example, ABC started with 20 million shares but they divided the total amount of shares by 10 leaving the new total amount of available shares to 2 million. This is what is called a 1 for 10 reverse split. For every 10 shares the company is going to replace them with 1 share. Companies can decide to do a 1 for 2 reverse split meaning they divided the number of current outstanding shares by 2. They can decide to do a 1 to 50 reverse split meaning they divide the current outstanding shares by 50. They can choose whatever number they want but whatever number they choose to divide the outstanding shares with, whether it’s 2, 10, 15, 75, or 100, the total amount of shares you currently hold as an investor will be divided by the same amount. So in company ABC’s case where they divided the current amount of shares by 10 creating a 1 for 10 reverse split, if you had 10 shares before the split you will now have 1 share after the split. If you had 500 shares before the split you will now have 50 shares after the split. A common thought to someone that doesn’t know what a reverse split is is to think, “well that’s not fair. The price gained a 1,000% and I’m missing shares or my broker took shares away from me. I could make so much money if I had my full position. What’s going on?” I know it could be confusing at first, but you have to remember that splits are a way to change the price but still reflect the same value. So everyone that is holding shares of company ABC, the amount of shares they own will decrease but the price will increase to still reflect the same dollar value of their position. If you had 100 shares at 75 cents your total position worth was $75. 100 times 75 cents equals $75. And after the reverse split, you would have 10 shares but the price would be $7.50 leaving you still with a total position worth of $75. The price and the shares change but the value will always stay the same.
It’s important to remember, whenever you get involved in a reverse split they’re not going to affect the investor in a dollar sense but it is important to note that when a company decides to do a reverse split that’s typically a red flag that the company is not doing well. You want to invest in companies that don’t need to rely on reverse splits to keep their share price up. You want to invest in companies where the sales, earnings, the production or basically the overall health gets investors interested and excited wanting to buy the stock and thus drive the price up naturally.