You’ve probably heard the term “stock split” before, but you may not know what the words actually mean when it comes to your company’s shares. A stock split is a process by which each share in your company is divided, most commonly into two shares, and the price for each share decreases proportionately. Essentially, a stock split is an action that will make your company’s stock appear to be more affordable to the buyer and will increase the shares available for purchase. As an employee, this is a great opportunity because you can now own a part of the company that might have been too expensive for you before the split. Additionally, new hires might be more tempted by your company’s offer of employment if the split results in a grant of a higher number of shares being offered as part of their compensation package.
As a founder, you might be wondering whether a stock split will change the value of your company. Stock splits do not affect the valuation of the company as a whole. Rather, they give investors and employees more flexibility by making shares more accessible, due to their lower price. As each individual share becomes cheaper, the total number of shares available for purchase increases proportionately. It helps to think about stock splits in terms of treats—sometimes you aren’t hungry enough to eat all five scoops of ice cream in a Banana Split, yet you still want a taste of the dessert. A stock split essentially divides your Banana Split scoops into several, smaller scoops—so that you can take the bite that’s right for you!
If your company is booming, at some point your Board of Directors might notice that each individual share is becoming too expensive for your employees to purchase. For example, let’s say you own Banana Company, and it’s had an impressive year. Shares are now worth $100 each. At this price, many employees in the company will not be able to purchase the shares they’ve been granted. In this case, the Board of Directors could decide to enact a “stock split.” In doing so, they will agree upon a stock split ratio that makes sense for their company’s particular situation. For the sake of illustration, let us assume that the Banana Board has decided on a “5-for-1” ratio (also written as a 5:1 ratio). Your company can pick any ratio that works for your particular situation. Now, the total number of shares for Banana Company is five times what it was initially (going from 1,000,000 shares to 5,000,000 shares) and each share is worth one fifth as much (from $100 per share to $20 per share). Similarly, if an individual stockholder of the Banana Company owned 1,000 of these shares before the stock split (priced at $100,000 total), after the split they would own 5,000 shares (priced at $100,000 total). As you can see, the Banana split did not change the overall value of the company or the value of the shares an individual owns in the company, but simply changes the number of shares each individual owns.
Now that you know what a “stock split” is, it is time to put the cherry on top and introduce the “reverse stock split.” If a stock split is for companies that have highly priced shares, a reverse stock split is for companies that have many shares, each priced very cheaply. Like the title suggests, a reverse stock split is for companies that have stocks more like mini-ice cream scoops than actual scoops of ice cream. Essentially, a reverse split works exactly like a stock split in the opposite direction.
If your company wants to reduce the number of shares or increase it per share price, it may decide to undergo a reverse split. For Banana Company, this could mean a “1-for-5” split (also written as a 1:5 ratio). In this case, the shares would be combined to increase the price per share (while maintaining the same total value, as discussed above). For a 1-for-5 split, Banana Company’s shares would combine from 5,000,000 to 1,000,000 total, and the price of each individual share would increase by five times (from $20 per share to $100). Therefore, if an individual owned 5,000 shares in Banana Company (priced at $100,000), they would own 1,000 shares after the split (priced at $100,000). Because the decrease in shares is equivalent to the increase in price per share, the overall ownership stays constant.
While a reverse stock split sounds like a great tool for your Board to use, it should be used very infrequently. Undergoing a reverse split can cause skepticism about the success of your business and impact employee morale since overnight they own fewer shares. Therefore, when companies do decide to undergo a reverse split, it is for those that find themselves in unique circumstances and their split normally uses larger ratios (for instance, 1:20 as opposed to 1:5) which ensures a longer timeframe for them to avoid undergoing multiple reverse stock splits.
However, it is not all doom-and-gloom. As you might have already noticed, existing investors remain largely unaffected by stock splits and reverse splits. This action, which must always be approved by your company’s Board of Directors, mainly serves as a signal or incentive for new investors interested in your company. So whether you are making more scoops out of your Banana Sundae, or amassing them into a few big spoonfuls, understanding the appetite of your investors is key—remember, people tend to eat first with their eyes so having a-peel-ing stock prices is crucial to your success!
It should be noted that you should never enact a stock split or a reverse stock split without first speaking with your company’s registered legal counsel.
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