Continuing the theme of the last few articles, today’s subject is one that could affect you when dealing with stock - either through some form of equity-based compensation, or when investing independently (hopefully with a goal of obtaining financial freedom!).
Before jumping right into a definition, let’s start with an example it’s possible you could run into as an everyday investor.
Say some time ago you purchased some stock and for various reasons, the stock’s price has been declining lately.
Recently it’s been trading very low - not more than a couple dollars per share.
Then one day you wake up and suddenly the price seems to have increased tenfold overnight.
You might rejoice and quickly make preparations to sell that stock, but then as you go to sell it you notice something odd - somehow 90% of your shares have disappeared.
Yesterday when the price was around $2/share you had, for example, 100 shares; however, now you find yourself with only 10 shares.
What happened - did someone hack your account and make off with most of your shares?
The answer is: mostly likely not.
What likely happened is the stock you own underwent a reverse split.
This is a process companies can perform to consolidate shares (i.e. combine multiple shares into a single share) and thereby artificially “increase” the price of the shares.
For example: 10 shares trading at $2 now becomes 1 share trading at $20 - the same underlying value; however, to the un-trained eye it might look like the company is doing better simply because the shares don’t have such a low price.
The opposite of this process, aptly named “split”, can also be performed.
This can be done to bring a stock’s price down (something that may be desirable, for example, to make the share price more reasonable to afford for everyday investors).
For example: if you have $200 to invest each paycheck, unless you can purchase fractional shares, it’d take you 3 paychecks of saving to buy a single $600 share - something you might opt to not do and instead invest in a less-expensive stock (or ETF!) to avoid missing out on 1.5 months of market movement).
So, getting back to reverse-splits, in the example above you likely didn’t lose any value, you just had the number of shares adjusted according to the terms of the reverse split (i.e. you “got” one share in exchange for “giving” ten shares - a “1 for 10 split” - the principle is the just the same as if you’d given someone five $20 bills and received a single $100 bill - a “1 for 5 split”).
The possibility of a reverse split occurring is something to keep in mind, particularly when receiving non-liquid equity as part of your compensation, or when investing speculatively.
The reason for this is: owning a large number of shares of “something” may lull you into a false sense of wealth/value.
For example, if you work for a startup “paying” you 1,000/shares a paycheck, you may think “I don’t really know of many stocks trading at less than $5/share (or even $1/share), so I’m essentially making an extra $5,000 (or $1,000)/month (maybe a lot more!) because I’m being given 1,000/shares a month.”
That can be a very dangerous and inaccurate projection - if the company does IPO, it may perform a reverse split prior to IPO to drive the share price up to some artificial threshold (required by the stock exchange they’ll list on, or just to put on a face of being “valuable”).
So, even if the stock does IPO at $5/share, it’s possible that those 1,000 shares/month you’ve been given are reduced to some number significantly less than 1,000 (potentially even less than a single whole share), effectively meaning your “earnings” each month could be much, much lower than you anticipate - possibly not even enough to be counted in whole dollars.
So, when you’re considering equity compensation, keep this in mind.
And, even if you’re not ever considering equity compensation, next time you see a significant stock price movement, you now know about splits and can check to see if the stock’s price really moved, or if it was just adjusted as the result of a split/reverse-split.
Whatever the case, hopefully you now know (or have a little more insight into) something you didn’t a minute ago.