What Does Rights Issue of Shares Mean?

In the world of investing and stock market, the most common terminology is ‘equity shares’.  Equity shares represent a portion of the company’s capital and entitle shareholders to a claim on its assets and earnings.  Equity essentially reflects how much of the business an individual owns.

Among the different types of equity offerings are bonus shares, rights shares, sweat equity shares, and more. Each serves a unique purpose depending on the company’s financial goals. This article focuses on rights shares, a specific type of equity issued through what is known as a rights issue.

Introduction to Rights Issue of Shares

When a company needs to raise additional capital and keep the voting rights of the existing shareholders proportionately balanced, the company issues rights shares. To attract interest, these are usually at discounted rates to the normal share price.

They are often used by companies with cash flow difficulties or in lean times, to raise capital and pay down debt. For those buying rights issues, they represent an opportunity to increase their exposure to the company’s stock for a good price. Rights issues are not the same as ordinary shares because they are invitations only extended to existing shareholders.

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Key Takeaways

• A rights issue of shares is a common method used by companies in need of funds often to reduce existing debt by offering new shares to current shareholders
• Before and up to a specific expiration date, shareholders can buy new shares at a discount
• Until that date, shareholders also may trade their rights in the open market
• Because more shares are issued to the market, the stock price will be diluted
• Shareholders are not obligated to purchase the additional shares

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How Does a Rights Issue work?

Rights issue of shares work by a process of the company offering additional stocks to shareholders, usually to raise capital for various reasons, for example paying down debt or creating liquidity. Each shareholder is offered the right to purchase a pro-rata allocation of these new shares at a specific price within a period of time, usually between 16 and 30 days.

With them, shareholders have the right to do one of three things:

• Taking Up Your Rights – If you decide to take up your rights you will be investing more money in the company in return for more shares in the business. This is also known as exercising your rights.

• Selling Your Rights – Because rights can be separated from existing shares you can choose to sell them to another investor. The buyer can then buy the shares you had originally been allocated at the discounted price. Rights trade separately on the stock market but are generally valued at close to the difference between the current share price and discounted sale price.

• Do Nothing – In this case you let your rights expire without taking them up or selling them. In some cases, the rights issue might have been underwritten by a bank (which buys any shares that go unbought by shareholders) in which case the underwriter might buy the rights off you. Otherwise, the rights will lapse and become worthless.

Types of Rights Offerings

There are two general types of rights offerings: direct rights offerings and insure/standby rights offerings.

• In direct rights offerings, there are no standby/backstop purchasers (purchasers willing to purchase unexercised rights) as the issuer only sells the number of exercised shares. If not subscribed properly, the issuer may be undercapitalised.
• Insured/standby rights offerings, usually the more expensive type, allow third parties/backstop purchase (e.g. investment banks) to purchase unexercised rights. The backstop purchasers agree to the purchase prior to the rights offering. This type of agreement ensures the issuing company that their capital requirements will be met.

Reasons Companies Opt for a Rights Issue

• When a company is planning an expansion of its operations, it may require a huge amount of capital. Instead of opting for debt, they may like to go for equity to avoid fixed payments of interest. To raise equity capital, a rights issue of shares may be a faster way to achieve the objective.
• A project where debt/loan funding may not be available/suitable or is expensive usually makes a company raise capital through a rights issue.
• Companies looking to improve their debt-to-equity ratio or looking to buy a new company may opt for funding via the same route.
• Sometimes troubled companies may issue shares to pay off debt in order to improve their financial health.

Impact on Shareholders & Share Price

The announcement of a rights issue can have immediate and long-term effects on shareholder value. Initially, the market’s reaction to the announcement can lead to fluctuations in the company’s stock price. Investors may perceive the rights issue as a signal that the company needs to shore up its finances, which can be interpreted either positively or negatively.

Participation in a rights issue allows shareholders to purchase additional shares at a discount, which can be financially advantageous. This opportunity can enhance the value of their investment, provided the company uses the raised capital effectively. The long-term impact on shareholder value largely depends on how the company utilises the capital raised. If the funds are deployed in ways that generate growth, improve profitability, or strengthen the balance sheet, the overall value of the company can increase, benefiting all shareholders.

Example of a Rights Issue

Taylor owns 1000 shares of XYZ Ltd. Trading at £10 each. The company then announces a rights issue in the 2 for 5 ratios. The company announces the issue at a discounted price of £6 per share. Therefore essentially, for every 5 shares at £10 each, held by an existing shareholder, the company will offer 2 rights shares at a discounted price of £6.

Taylor’s portfolio value (before rights issue) = 1000 shares X £10 = £10,000

Number of right shares to be received= (1000 X 2/5) =400

Price paid to buy rights shares= 400 shares X £6= £2400

Total number of shares after existing rights issue= 1000+400=1400

Revised value of the portfolio after exercising rights issue= £10,000+£2400= £12,400

Price per share post-rights issue= £12400/1400 = £8.86

In theory, the share price after the rights issue should be £8.86; however, the market value may differ. An uptrend in the share price will benefit the investor, while if the price falls below £8.86, Taylor will lose money.

Pros & Cons of a Rights Issue

Pros:

• They are a fast way for companies to source funds
• Companies can raise these funds without incurring debt as rights issues are purely in the form of equity
• Rights issues incur low costs, as underwriting fees are not required
• Shareholders can maintain the same ownership, because additional purchases allowed are always in proportion to their existing shareholding
• A board of directors cannot misuse a rights offering, as company directors do not have much control over rights issues

Cons:

• Existing shareholding percentage may get diluted
• After a rights issue, dilution can cause a drop in share price
• Unlike a public offering, most stock exchanges restrict the amount that can be raised through a rights offering issue
• Rights offerings are only issued when companies need funds, so a company’s public image can be negatively affected when a rights issue is announced

Conclusion

A rights issue of shares benefits existing shareholders, offering them the advantage of applying for shares at a discounted price and retaining their voting rights.

As an investor it is important to know the reason for the rights issues before making a decision. If you have additional capital, and find the company’s long-term view appealing, then you should consider the added advantages.

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FAQs

• How long does a rights issue take?

The duration of a rights issue can vary depending on the specific circumstances and the regulatory requirements involved. Typically, it may take a few weeks to a couple of months to complete the process.

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• What are the benefits of rights offerings?

The benefits of a rights offering include improving the company’s balance sheet, eliminating debt, injecting new cash flow, raising market interest, attracting new investors, and potentially increasing the share price.

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