As a couple of our portfolio companies have gone public this year, we’ve received quite a few questions about stock splits, reverse stock splits, and what they mean for our investors. In the hopes of answering a few common questions we received, we’re exploring what splits and reverse splits are, why they’re done, and their implications.
What is a Stock Split?
Every company that offers equity interests – which may be referred to as shares, stock, units, or interests – has an organizational document that outlines how many and what kinds of shares it may authorize and how many of those shares are outstanding or held by someone other than the company. A stock split occurs when the board of directors of a company decides to increase the number of outstanding shares by issuing additional shares to current shareholders.
For example, imagine that you have purchased 10,000 shares in Company X priced at $10 per share for a total investment of $100,000.
In a two for one split, one additional share is issued for each share held by a shareholder. Therefore, those 10,000 shares priced at $10 per share would become 20,000 shares priced at $5 per share. Even though the shareholder now owns more shares, their total investment is still $100,000.
What is the Purpose of a Stock Split?
Stock splits are typically executed by companies whose price per share has risen too high or too far above that of competitors within their industry. Companies often employ stock splits in an effort to make investment in the company appear more affordable for smaller investors. A recent real-world example of this would be Spotify’s 40-1 stock split. The company began trading at $165.90 per share. If they had not done the split, they would have been trading at $6,336 per share.
The split of a publicly traded company may also trigger an increase in share price after the initial decrease resulting from the split. Because price per share has decreased, smaller investors may buy more stock, theoretically increasing market demand and driving up the price per share.
In the private equity universe, the effect of a stock split may not be fully realized until the next round of funding, whether that be another round, a merger or acquisition, or an IPO.
What is a Reverse Stock Split?
As the name indicates, a reverse split is the opposite of a stock split. In a reverse split, the company’s board of directors will decrease the number of outstanding shares by combining shares existing shareholders already own.
To illustrate this point, we’ll revisit those original 10,000 shares priced at $10 per share for a total investment of $100,000. In a one for two reverse split, those 10,000 shares priced at $10 per share would become 5,000 shares priced at $20 per share. Again, even though the shareholder would now own a fewer number of shares, their total investment still remains $100,000.
What is the Purpose of a Reverse Stock Split?
Usually, companies will opt to do a reverse split if their share prices are lower than they would like. Not only do higher share prices improve optics, but a publicly traded company may need to increase their share price to prevent being delisted from exchanges, which can happen if prices fall below a certain price per share.
Sometimes, a company will reverse split their shares simply because they want to offer their shares at a price that could attract new shareholders, such as institutional investors who may be prohibited from investing in stocks that trade below a certain threshold. In the case of a newly public company, a reverse split could help put their shares on the radar of such investors. A good example of this would be Pinterest’s reverse split pre-IPO. The company’s last round was $7.18 per share, so they opted for a 1 to 3 reverse split, making the effective price for that round $21.54 per share.
Reverse splits are often negatively perceived as bad for investors, but it really depends on the situation. Company size, operating performance, and stock valuation prior to the split all factor into the success (or lack thereof) of the split.
What Do Stock Splits or Reverse Stock Splits Mean for My Investment?
Neither a split nor a reverse split change a company’s valuation. Something else worth noting with a stock split or reverse split is that ownership is not further diluted. After a split or reverse split, all shareholders will still own the same proportionate amount of the company as they did before; i.e., the value of the investment does not change.
The main things you should remember when it comes to stock splits and reverse stock splits are:
- Regardless of increases or decreases in the number of outstanding shares, the market capitalization of a company stays the same.
- Current shareholders are not further diluted by stock splits or reverse splits.
- Reverse splits don’t always indicate trouble.