A reverse stock split is a reduction of the number of shares outstanding with a corresponding increase in stock price. For example, in a 1-for-10 reverse split, an investor who owns 1,000 shares of a $1 stock will own 100 shares of a $10 stock. A reverse stock split can help a company avoid having its stock delisted or being taken over by a competitor, and in some instances attract institutional investors and raise capital. In a broader sense, a reverse stock split may be a step in a series of measures to turn a failing company around.
XYZ, a once successful company, has fallen on hard times: its sales have declined substantially, it is losing money, and as a result its stock has dropped from $50 to $1 per share. XYZ currently has 1 billion shares outstanding. The company is facing several risks: its stock may be delisted and stop trading, a hostile competitor may take it over by buying the cheap stock, and its present financial condition may force it into bankruptcy. XYZ is a prime candidate for a reverse stock split.
If XYZ does a 1-for-10 reverse split, the number of its shares outstanding will drop from 1 billion to 100 million but the stock price will increase from $1 to $10 per share. This will help XYZ comply with the continuous listing requirements of its stock exchange and save it from delisting, but is not likely to solve other problems such as a hostile takeover or bankruptcy. If it wants to survive as an independent entity, it must turn itself around.
If XYZ is serious about turning itself around, it may get new management to clean house, dispose of money-losing operations and look for ways to invigorate sales and return to profitability. It may need to raise capital. To most investors, a low stock price is an indication of failure. A reverse stock split may make the stock more attractive to institutional investors but they would still want to see additional measures before putting up any more money.
If XYZ succeeds in implementing the turnaround measures, its stock price will rise further, and it will become a less attractive takeover target; if it fails, the stock price will continue to slide even after the reverse split and the old problems will eventually return.