Most investors are familiar with a stock split, in which a company issues additional shares to existing shareholders, and the price per share is reduced proportionately. Less well known are reverse stock splits, also known as share consolidations. Management of a business can benefit in several ways from a share consolidation. However, shareholders may not benefit and in fact may find themselves cashed out of their positions.
A reverse split is initiated by a firm’s management, and affects stock trading in the secondary market – on stock exchanges. Holders of record are notified of the consolidation, which is mandatory. Shareholders have no ability to refuse a reverse split, except perhaps to vote out current management. Of course, shareholders can sell their stock before the split if they so choose.
Reverse splits are often undertaken to increase a firm’s share price. One motivation is that stock exchanges have minimum share prices – if a stock price falls below the minimum price, the shares can be delisted. Delisting raises the cost of capital to a firm by making it harder to raise equity capital. Another motivation is the “respectability” factor – a low share price is considered a sign of weakness by investors, who may tend to avoid the shares. By consolidating shares, the price of each new share is proportionately higher than the old cancelled shares.
In a smaller corporation, the management may decide, for technical taxation reasons, to change from a Subchapter-C to Subchapter-S corporation. To accomplish this, management must reduce the number of shareholders below 100. By implementing a share consolidation with a high ratio, many investors will not have enough old shares to translate into a whole number of new shares, and will therefore be automatically cashed out. This reduces the number of shareholders.
Often, when a reverse split is undertaken to change corporate category, the new shares are immediately re-split after the re-categorization. This is called a forward split, and the end result is new shares that have the same value as the old shares. Management has engineered a re-categorization without a net change to share price.
A 1-for-5 consolidation would start with a vote by a firm’s board of directors. Then, the firm’s transfer agent would prepare to identify shareholders as of consolidation date. On that date, each shareholder would have his old shares cancelled and would either receive new shares or cash. If a shareholder had 500 old shares, after the consolidation he would own 100 new shares. In contrast, a 1-for-1,000 share consolidation would result in the shareholder owning 1/2 a share, which is not allowed and would result in the cashing out of the shareholder.