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A reverse stock split is a transaction in the financial markets that reduces the total number of shares outstanding in a stock, but lifts its per-share price. The way it works is if an investor holds 500 equity shares valued at $10,000 US Dollars (USD), for instance, and the company issues a reverse stock split, this changes the structure of the investor's holding to 250 shares but the holding is valued the same. Although the number of shares held decreases based on the split ratio, the value does not change. It does, however, increase the price barrier to entry for new investors.
Reverse stock split advantages are especially beneficial for the company issuing the transaction. This is true since the split does not impact the financial holding of an investor. A company might pursue a reverse stock split if management believes that investors are undervaluing the stock and that a depressed stock price is preventing new investors from buying in. Since a reverse split raises a stock's per share price by eliminating a percentage of outstanding shares, a result of the reverse split is that it appears demand in a stock went up, which could prompt momentum investors to purchase shares.
Another benefit is keeping shares listed on a stock exchange. Major stock exchanges around the world are organized marketplaces and have standards for the companies that trade there. If a share price has been sold to below that standard and a company therefore faces having its shares delisted, a reverse stock split could prevent that from happening.
Reverse stock splits may also serve as a red flag to investors if there are substantial problems at a company and the reverse split is a last-ditch effort to turn things around. Investors should monitor a company's earnings growth and be wary of a company with excessive debt on its balance sheet. While many stocks have emerged more profitable from a reverse split, there are some companies whose problems are too big to disguise by inflating the stock price.
A consequence of a reverse stock split is that minority shareholders might lose a position in a stock altogether. If the value of a small investor's position is not enough to sustain a reverse split, the investor will receive cash for the shares. Although common shareholders are often entitled to a vote for many major company decisions, a board of directors may pursue a reverse stock split without shareholder approval, according to US regulation.