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We've seen a spate of stock splits in 2022, including from high-profile companies, such as Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL). But while a stock split may too familiar for you, a reverse split is not a very common corporate action. In this article, I shall explain the the what, why, how and when of a reverse split.

What's a Reverse Split?

A reverse split refers to an action by a company to buoy its stock price by consolidating the number of its outstanding shares. Essentially, this phenomenon serves to reduce the number of outstanding shares and the degree of reduction depends on the ratio of the reverse stock split.

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In June, South San Francisco, California-based Calithera Biosciences (NASDAQ:CALA) announced a 1-for-20 reverse stock split. The reverse split went into effect on Jun. 14 and combined 20 pre-split shares into a single post-split CALA stock.

At the end of the March quarter, Calithera had 78,468,000 outstanding shares. While announcing the reverse split, the company said it expects the number to shrink to 4,865,000 shares, excluding outstanding and unexercised stock options and warrants.

What will happen to the fractional shares held by shareholders after all of their holdings are consolidated using the ratio announced by the company? As Calithera said in its release, they get cash in lieu of the fractional shares, with the value calculated based on the stock price that prevailed then.

Why and When Companies Do a Reverse Split

A reverse split is resorted to by companies primarily to regain compliance with listing standards when their stock prices drop below the required minimum. This will help them remain listed on the main exchanges. Staying listed on the main exchanges gives the company visibility, credibility and liquidity. No company worth its salt may want to face the ignominy of delisting, especially for flouting exchange rules.

In Calithera's case, the company intended to bring its stock price back above the $1 minimum bid price requirement for remaining listed on the Nasdaq. Additionally, some companies may do a reverse split to boost their image in a bid to attract investments from large investors.

There is another rationale behind reverse splitting. When a stock of a company trading at depressed levels plans a spinoff, it is most likely to implement a reverse split. This could give leeway for commanding a better spin-off price.

Most corporate actions fall under the regulatory purview of the Securities and Exchange Commission. However, state corporate law and a company's articles of incorporation and by-laws assume a greater control over a company's ability to declare a reverse stock split and whether shareholders need to vet the action.

After a company's board approves the decision to reverse split, it notifies shareholders of the decision either through a press release or a filing on Form 8-K, 10-Q or 10-K. The company has to file a proxy statement on Schedule 14A if shareholders need to approve the action. If the reverse split will result in the company going private, it requires a Schedule 13E-3 filing.

Impacts on Stock Performance

Investors' stakes in a company doing a reverse split does not change, but the number of shares they hold will vary. In other words, intrinsic value of the company does not change, but there is an adjustment in stock price. Therefore, a reverse split does not affect the market capitalization of the company.

Bottom Line on Reverse Splits

A regular stock split sends a confident signal to investors that the stock reflects positive fundamentals and has reached levels that have become unaffordable for retail investors.

On the other hand, investors always take reverse stock splits with a pinch of salt. Invariably, investors associate reverse splits with a struggling company. At least, from the perspective of perception, it is a negative for stocks.

But it doesn't necessarily need to be negative. General Electric (NYSE:GE) implemented a 1-for-8 reverse stock split in August 2021. The company reasoned that over the years, it has divested many of its businesses without any change to the outstanding shares:

"Through these divestitures, we have not reduced our share count proportionally – leaving us in the unusual position of having nearly 8.8 billion shares outstanding, a much higher share count than other industrial companies."

In certain cases, reverse splitting buys time for companies to improve their fundamental performance. It helps improve perception regarding a company before a turnaround actually sets in.

A blanket recommendation of selling a stocks for a  company that has just announced a reverse split does not seem like the right thing to do. Investors may be well advised to do their homework to find out what has prompted the corporate action and how the company is positioned fundamentally before making a call.

On the date of publication, Shanthi Rexaline did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines. 

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