When a stock splits, two new shares are created for every one outstanding, and the price is cut in half. The purpose of a stock split is to make the shares more affordable for "retail" investors, who don't have large amounts of capital to invest. In a reverse split, the opposite happens: the number of shares is reduced, and the share price rises. The basic motivation behind a reverse split is to get the share price up to a respectable level; in most cases, at least above $1. This type of a split has several implications for the company and stockholders.
Reverse splits reduce the share "float," or the number of shares available on the public market. To a potential investor, a reduction in the float is always desirable. With fewer shares outstanding, the earnings-per-share number rises, which in turn supports the share price. A company that is constantly issuing new shares is diluting the worth of its stock and demonstrating, possibly, that it's more interested in drawing in new capital than in rewarding investors with a good return.
Share Price and Dividends
Reverse splits result in a higher share price. For a stock worth just a dollar or two, this may be necessary in order to meet listing requirements on certain exchanges. As of 2013, for example, the New York Stock Exchange required a minimum share price of $4, along with a minimum share float and minimum market capitalization. A company that wants to attain status on the NYSE "Big Board" and get interest from institutional investors may reverse-split its shares to meet these guidelines. In addition, companies that pay dividends simply adjust the dividend to reflect the new, lower number of shares: a $.25-per-share dividend paid by a company that does a 1:3 reverse split becomes a $.75 dividend: three times the old payout.
Mergers and Acquisitions
A company may announce a reverse stock split in order to carry out a merger with or acquisition of another company. A company's articles of incorporation limit the number of shares the company can issue; a common practice of company buyouts is to issue new shares of the acquiring (or new) company to the shareholders of the company being acquired or merged out of existence. If the buyout or merger means the company would break that limit, it may carry out a reverse split to reduce the number of shares it has on the market. An example of this was Duke Energy announcing a one-for-three reverse split for its 2012 merger with Progress Energy. The reverse split allowed Duke to keep within its legal limit of 2 billion shares outstanding.
The Securities and Exchange Commission, which administers securities law, does not require advance warning of a reverse stock split. A company can take this action without the approval of shareholders if its own by-laws allow it. It can formally notify the SEC and investors with a Form 8-K, a "Current Report," or by the annual and quarterly financial reports, if the company is reporting its activities to the SEC.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.