Updated July 3, 2023
What is a Rights Issue?
The term “rights issue” refers to a capital raising strategy wherein a company offers its existing shareholders the opportunity to invest in it by purchasing additional shares at a discounted price.
The discounted price usually stands for a particular period, after which the fee reverts to the average level. The idea is to raise additional capital from the company’s existing shareholders without resorting to any external financing route. This strategy is mainly used by companies already highly leveraged with external debt.
Some of the key takeaways of the article are:
- It refers to an invitation to the existing shareholders of a company to buy additional shares in it.
- All the current shareholders are offered the right to buy a pro-rata allocation of shares at a discounted price within a particular period.
- The existing shareholders are not forced to exercise the right.
- There are two categories – direct and insured.
How does the Rights Issue work?
In a rights issue offering, the company’s existing shareholders can purchase a pro-rata allocation of additional shares at a discounted price to be exercised within a particular period, usually 16 to 30 days. Effectively, it is an invitation to the existing shareholders to buy additional shares in the company at a discount compared to the market price before a particular future date. However, the shareholders do not need to exercise the rights issue.
Interestingly, the shareholders can trade the rights issue in the market just like any other ordinary share. Provided the trading is done before the exercise date on which the additional shares will be assigned to the holders of the rights issue. The process results in dilution as the company’s net profit spreads over a more comprehensive number of shares. So, the company’s earnings per share (EPS) falls in the case of rights issues due to sharing dilution.
Example of Rights Issue
Let us now look into a simple example to illustrate how it works in the real world.
Let us assume that Mr. Ken is an existing shareholder of XYZ Inc. and currently owns 50 shares of $100 each, which means a total investment of $5,000. XYZ Inc. recently offered the right shares to Ken at a discounted price of $70 per share. It is a 30% discount on the current market price. These shares are on three for every five existing shares. So, Ken is eligible for 30 rights issue shares for $70 each, which will be worth $2,100.
In the current scenario, it may seem that Mr. Ken will benefit from the rights issue if he can sell off all the rights issue shares at the current market price to other interested investors before its expiration date. But on a closer look, the story changes a little bit because there will be a dilution in the share price due to this.
Let us calculate the adjusted share price after incorporating the discounted price of the new additional shares. The average cost calculation for Mr. Ken can be as follows,
Average price = (Existing no. of shares * Current market price) + (Rights issue shares * Discounted price) / (Existing no. of shares + Rights issue shares)
Average Price = [(50 * $100) + (30 * $70)] / (50 + 30)
Average Price = $88.75 per share
So, even if it seems that Mr. Ken will get a discount of 30% on each share of the rights issue, he will get a 12.25% discount on the overall holding post rights issues.
Types of Rights Issue
There are two broad categories:
1. Direct rights issue
No standby purchasers in this type of rights offering can buy the unexercised rights, so the issuer can only sell the number of exercised shares. If it is not with an appropriate subscription, the capital raising initiative may end up in undercapitalization.
2. Insured rights issue
It is a more expensive type of right offering where the third parties or backstop purchasers (such as investment banks) can purchase the unexercised rights. These investors agree to buy before the expiration of the rights offering. It ensures that the issuer doesn’t end up in undercapitalization and their capital requirements are successful.
The following are the significant advantages:
- It allows the existing shareholders to increase their stake in the company at a discount to the current market price.
- It allows the current shareholders to protect their investment in the company from imminent dilution after purchasing the rights issue shares.
The following are the significant disadvantages:
- Once the rights issues shares are in the open market, their market value may fall due to the increase in market supply at a lower rate.
- It can be a risk for unwilling shareholders to buy additional shares, especially in a company experiencing slower growth.
- The market may interpret this as an early warning signal of a company’s financial struggle.
So, this is a crucial financing route for companies where they don’t need to go for external funding if appropriately executed. Besides, its proposition can be equally fruitful for the current shareholders who intend to increase their stake in their respective companies.
This is a guide to the Rights Issue. Here we also discuss the definition, working, example, and types, along with advantages and disadvantages. You may also have a look at the following articles to learn more –