Reverse stock split is the term which is used in the context of corporate restructuring, it refers to that procedure through which the company reduces the number of shares which are available in the market, the effect of reverse stock split is that it increases the share price of the stock of the company however it leads to decrease in number of shares of the company which are available in the market hence it does not have any effect on market capitalization of the company. Given below are the advantages and disadvantages of reverse stock split
Advantages of reverse stock split
- Due to reverse stock split the shares of company in the market are reduced which in turn makes it harder for any trader to short sell the stock because short selling is done for those stock which are very liquid as it is easy to borrow such stocks and traders have confidence that in case of stock price rise they can square off the position due to good liquidity, however when stock is illiquid they will think 10 times before shorting the stock and hence in a way reverse stock split reduces speculation in the stock price and only serious investors buy or sell the share.
- Reverse stock split is usually done by companies whose stock price has fallen too low for companies comfort so a stock which before reverse stock split was 1 dollar and if company do reverse stock split in the ratio of 1 is to 5 then after the process is complete than everything remaining constant the new share price would be 5 dollar.
- Reverse stock split is helpful when company wants to reduce its shareholder base because a large scattered base of shareholders may lead to delay in decision making as for any scheme to start it needs shareholders approval as they are entitled to vote and a large scattered base will result in divided opinion and hence the delay.
Disadvantages of reverse stock split
- The biggest disadvantage of reverse stock split is that it reduces the liquidity of shares in the market and since illiquid shares are not traded that much it may not lead to proper price discovery of the stock price.
- Small shareholders are left with even less shares and sometimes they receive cash because their shares are insufficient when it comes to reverse stock split and hence it leads to accumulation of stock by big players and small shareholders stands to lose.
- Reverse stock is taken negatively by the markets because it may be a sign that company is doing this for increasing the share price and therefore it may lead lower valuation of the company after reverse stock split.