Companies start out as private companies, and sometimes later go public, selling shares on an exchange or over-the-counter. Companies with tradable stock are public, but your local laundromat is probably private. There are a few big private companies like Lego, but it’s rare.
Going Private With a Reverse Split
Sometimes a company goes public, but wants to go back to being private, or at least “go dark” and stop reporting to the SEC. One way to do this is to get down to fewer than 300 shareholders. A quick way to do that is to effect a reverse stock split and pay cash for fractional shares.
Here’s an example of how that would work. A company will look at their list of shareholders and see that only 100 investors hold over 5000 shares. So they do a reverse split at a ratio of 1 to 5000. A shareholder with 10,000 shares would have 2 shares after the reverse split. But anyone who had less than 5000 shares would be left with a fractional share that gets paid out in cash and are no longer shareholders. The remaining 100 investors that had more than 5000 shares are now owners of a private company.
In order to do this transaction, the company pays a premium for the fractional shares, e.g. slightly more than market value. Some investors, aware of the premium, will buy as many shares as possible without becoming an owner of the private company and pocket the difference between the price paid and the cash payout.
Risks of a Reverse Split Going Private Transaction
There are definitely some risks. If too many people try to do this arbitrage, it can get expensive for the company to cash them all out. When the cost of going private outweighs the benefits, they may cancel the deal or amend the terms. Owners may also cancel for some other reason. If the deal is amended or cancelled, share price can drop quickly. That drop can be significant for small investors. For example, if you had 4999 shares of a $1 stock that drops to $0.90, you’re out $500.
An important thing to track is the number of arbitrageurs investing. A significant jump in trading volumes after the deal is announced could suggest too many are participating in the arbitrage and that the company will cancel, amend, or delay the deal. Trades in lots of one share less than the ratio, e.g. orders of 199 shares when the reverse split ratio is 1:200, also suggests excessive arbitrage interest. Extensive discussion of the transaction on social media and investing forums is an additional warning sign.