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Consequences of Reverse Stock Split

by kraju

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Finjan Holdings, Inc. a leading online security and technology company which owns a portfolio of patents, related to software that proactively detects malicious code announced on yesterday (21stAugust)  a 12 for 1 reverse stock split of the company’s common stock. The Reverse Stock Split will reduce the number of shares of outstanding common stock to approximately 22,368, 415 shares.

Investopedia defines reverse stock split as “a reduction in the number of a corporation’s shares outstanding that increases the par value of its stock or earnings per share (EPS), the market capitalization, however, remains the same.” Reverse stock splits are more frequent when the price of a stock is less than $ 1, Companies sometimes have to undertake a reverse stock split to avoid being delisted from the exchange they are trade on. Major stock exchanges around the world have standards for the companies that trade there, a company will be in danger of being delisted if it trades below the standard, a reverse stock split prevents that from happening.

For example:

1-4 reverse stock split

Before the reverse stock split

Amount of outstanding shares: 1,000,000

Nominal value per share: £ 0.50

Total value: 1.00, 000 x 0.50 =500,000

After the reverse stock split

Amount of outstanding shares: 250,000

Nominal value per share: £ 2

Total value: 250,000 x 2 = 500,000

A reverse split will result in share holders holding fewer shares in the company, but the stake in the nominal value of the company per share will remain the same. The nominal value per share will increase and the new consolidated shares will carry the same rights as the pre reverse split shares including voting rights and dividend entitlements. On the negative side, multiple reverse splits can cause small shareholders to be cashed out.

For example: If it was a 1-10 reverse split and  share holder owned only 9 shares, then he would be paid the market value of the 9 shares and cease to be a share holder of the company. In another scenario, if a shareholder owned 11 shares, he would be given 1 new share and paid cash value for the remaining shares.

Why is Reverse Stock Split undertaken ?

In times of economic crisis, currency devaluation or if a country has high current account deficit, companies suffer a catastrophic decline in the per share stock price. During the internet bubble many stocks fell by 90 percent or more. If the market price falls far enough the company risks itself from being delisted from the stock exchange. In order to avoid the impending crisis, the board of directors may declare a reverse stock split. Stock Market experts opine that reverse splits only delay the inevitable but not a long term measure to correct its finances. It is also a sign that all is not well within the company; institutional investors do not like to see the number of shares they own decrease, despite the fact the value of the share being unchanged.

What happens if a company is delisted from a stock exchange?

Delisting can be devastating for a stock, the share can still trade over the counter on electronic networks maintained by the brokers and dealers, but once a stock exits an exchange, its value plummets. Large investors such as Banks, hedge funds prefer to deal with only exchange traded stocks, delisting will prompt the institutional investors to  sell their shares which will reduce its prices in the market.

Studies have also shown that reverse splits on a whole correlate with negative abnormal investment returns, which means the post-split share price declines at a faster rate than for those companies who have not done reverse split.

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