Rights issue

What Is a Rights Issue?

A rights issue is a corporate action in which a company offers its existing shareholders the opportunity to purchase additional new shares, typically at a discount to the prevailing stock price. This mechanism falls under the umbrella of Corporate Finance as a method for companies to raise fresh capital. The primary purpose of a rights issue is to secure funding while giving current investors the first chance to maintain their proportional ownership in the company.

Companies issue rights to their shareholders in proportion to their existing holdings. For example, a company might offer shareholders the right to buy one new share for every five shares they currently own. The new shares are offered at a specific subscription price that is usually below the current market price, serving as an incentive for shareholders to participate. A rights issue allows companies to raise funds for various purposes, such as debt reduction, funding expansion plans, or shoring up the balance sheet.

History and Origin

The concept underpinning rights issues, known as pre-emptive rights, has roots in the late 19th century. These rights were developed to protect existing shareholders from the dilution of their ownership and voting power when a company issued new shares. As businesses expanded and sought more capital, concerns grew among existing investors about maintaining their proportionate stake. The principle of pre-emptive rights emerged to address these concerns, offering existing shareholders the first opportunity to purchase additional shares before they were made available to other investors. This legal framework has evolved over time, reflecting changes in corporate governance and market dynamics, but the core protective function remains.⁴

Key Takeaways

A rights issue allows a company to raise additional capital directly from its existing shareholders.
Existing shareholders are offered the chance to buy new shares at a discounted subscription price.
The offer is typically proportional to existing shareholdings, allowing shareholders to maintain their ownership percentage.
Shareholders are not obligated to exercise their rights and may choose to sell them if the rights are transferable.
Failure to participate in a rights issue, if not selling the rights, will result in the dilution of a shareholder's ownership stake.

Formula and Calculation

A key calculation related to a rights issue is the Theoretical Ex-Rights Price (TERP), which estimates the share price after the rights issue has taken place. This formula helps to understand the immediate impact of the rights issue on the stock price, assuming full subscription.

\text{TERP} = \frac{(\text{Existing Shares} \times \text{Current Market Price}) + (\text{New Shares} \times \text{Subscription Price})}{\text{Existing Shares} + \text{New Shares}}

Where:

Existing Shares: The number of shares outstanding before the rights issue.
Current Market Price: The share price before the rights issue announcement.
New Shares: The number of shares offered through the rights issue.
Subscription Price: The price at which new shares can be purchased in the rights issue.

The value of one right can also be calculated, which is the difference between the pre-rights market price and the TERP:

\text{Value of One Right} = \text{Current Market Price} - \text{TERP}

Alternatively, the value of one right can be calculated as:

\text{Value of One Right} = \frac{\text{Current Market Price} - \text{Subscription Price}}{\text{Ratio (number of rights needed for one new share)} + 1}

Interpreting the Rights Issue

A rights issue is typically initiated when a company needs to raise capital for specific purposes, such as reducing debt, financing expansion, or supporting ongoing operations. From an investor's perspective, interpreting a rights issue involves assessing the company's financial health and the stated reason for the capital raise. A company in strong financial standing might use a rights issue to fund a growth opportunity, which could be seen positively. Conversely, a rights issue by a company facing financial distress to pay down debt may signal underlying problems.

Shareholders have several options upon receiving rights. They can exercise their rights to purchase new shares, thereby maintaining their percentage of ownership and avoiding dilution. They can also choose to sell their rights in the market (if the rights are renounceable) or simply let them expire, which would result in their ownership stake being diluted as more shares are issued. The decision often hinges on an individual investor's confidence in the company's future prospects and their personal investment objectives.

Hypothetical Example

Consider ABC Corp., which has 10 million shares outstanding, trading at a stock price of $50 per share. ABC Corp. decides to conduct a rights issue to raise capital for a new product line. The terms are a 1-for-4 rights issue (meaning one new share for every four existing shares held) at a subscription price of $40 per share.

Calculate New Shares: For every 4 existing shares, 1 new share is offered. So, 10,000,000 (existing shares) / 4 = 2,500,000 (new shares).
Total Shares After Issue: 10,000,000 + 2,500,000 = 12,500,000 shares.
Calculate Funds Raised: 2,500,000 (new shares) * $40 (subscription price) = $100,000,000.
Calculate Theoretical Ex-Rights Price (TERP): $\text{TERP} = \frac{(10,000,000 \times \$50) + (2,500,000 \times \$40)}{10,000,000 + 2,500,000} = \frac{\$500,000,000 + \$100,000,000}{12,500,000} = \frac{\$600,000,000}{12,500,000} = \$48$ The theoretical price per share after the rights issue would be $48.
Impact on Shareholder: If an investor owns 400 shares (worth 400 * $50 = $20,000) and exercises their rights, they can buy 100 new shares (400/4) at $40 each, costing $4,000. They would then own 500 shares (400 + 100). The total value of their holding would theoretically be 500 shares * $48 = $24,000. Their initial investment plus the cost of new shares is $20,000 + $4,000 = $24,000, demonstrating how their total wealth is maintained and the dilution of per-share value is offset by acquiring more shares.

Practical Applications

Rights issues are a common tool in equity financing, particularly for companies seeking to raise substantial capital without immediately resorting to debt or a full-scale public offering. They are often seen in several scenarios:

Balance Sheet Strengthening: Companies utilize rights issues to improve their debt-to-equity ratio by repaying existing loans, thereby strengthening their balance sheet and financial stability.
Funding Growth Initiatives: Funds raised can be directed towards significant capital expenditures, such as developing new products, expanding operations, or making strategic acquisitions.
Avoiding Underwriting Costs: Unlike typical public offerings that involve an investment bank for underwriting services, a rights issue can sometimes be conducted directly, potentially reducing fees. However, some rights issues may still involve underwriters to ensure the capital raising target is met.
Maintaining Shareholder Goodwill: By offering existing shareholders the first option, companies can foster goodwill and allow loyal investors to maintain their proportional ownership, preventing immediate dilution. The Securities and Exchange Board of India (SEBI) highlights rights issues as a way for companies to raise capital while allowing investors to maintain their ownership percentage.³

For example, in 2018, Irish food group Aryzta conducted a significant rights issue to raise €790 million as part of a turnaround plan. However, due to complex cross-border arrangements and tight deadlines, many long-term retail investors effectively lost out on their opportunity to participate, highlighting challenges in execution and communication.

²## Limitations and Criticisms

Despite their advantages, rights issues come with limitations and face criticism. A significant concern is the potential for dilution for shareholders who do not exercise their rights. If existing shareholders choose not to purchase additional shares, their percentage ownership in the company decreases once the new shares are issued, even if the total value of the company's equity increases. This can also lead to a decrease in earnings per share (EPS) for non-participating shareholders.

Critics also point out that rights issues can sometimes signal financial distress. While strong companies use them for growth, struggling firms may resort to a rights issue as a last resort to avert bankruptcy when other financing options are unavailable or too expensive. Such announcements can be perceived negatively by the market, potentially leading to a decline in the company's market capitalization. Research indicates that higher shares-to-rights ratios, which imply greater dilution, are often perceived negatively by the market, leading to lower cumulative abnormal returns. M¹oreover, the complexity of rights issues, especially for individual investors, can lead to confusion and missed opportunities, as seen in the Aryzta case.

Rights Issue vs. Secondary Offering

A rights issue and a secondary offering are both methods for companies to issue new shares after their initial public offering, but they differ significantly in who the shares are offered to first.

Feature	Rights Issue	Secondary Offering
Primary Target	Existing shareholders	General public and institutional investors (new and existing)
Priority	Existing shareholders have pre-emptive rights to subscribe.	No inherent priority for existing shareholders; open to all interested investors.
Discount	Typically offered at a discount to the market price.	Price may be at or close to the market price, or a slight discount depending on market conditions.
Dilution Risk	Shareholders can avoid dilution by exercising rights.	Existing shareholders who do not purchase new shares will experience dilution.
Purpose	Primarily for company to raise capital from its existing investor base.	Can be for company to raise capital (primary offering within secondary) or for existing shareholders to sell shares (pure secondary offering).

While a rights issue gives preferential treatment to current shareholders, a secondary offering (often referred to more broadly as a "follow-on offering" if new shares are issued by the company) opens the share sale to a wider pool of investors, including new entrants to the company's ownership.

FAQs

What happens if I don't participate in a rights issue?

If you do not participate in a rights issue and do not sell your rights (if they are renounceable), your percentage ownership in the company will be diluted because new shares will be issued, increasing the total number of shares outstanding. Your existing shares will also likely experience a decrease in per-share value.

Can I sell my rights?

In many cases, yes, rights issued to existing shareholders are renounceable, meaning they can be traded on the stock exchange. If you do not wish to subscribe to the new shares, you may sell your rights to another investor before the expiration date, potentially recouping some value.

Why do companies issue rights issues instead of other financing methods?

Companies often opt for a rights issue to raise capital because it allows them to tap into their existing investor base, potentially faster and with fewer underwriting costs than a full public offering. It also provides existing shareholders with the opportunity to maintain their proportional ownership.

How does a rights issue affect the share price?

The theoretical effect of a rights issue is a decrease in the share price to the Theoretical Ex-Rights Price (TERP), which is a weighted average of the pre-issue share price and the subscription price. In practice, market sentiment and the purpose of the rights issue can influence the actual stock price movement.

Is a rights issue always a sign of financial trouble?

Not necessarily. While some distressed companies use rights issues to raise emergency capital or reduce debt, financially healthy companies may also use them to fund growth initiatives, acquisitions, or significant capital expenditures without incurring new debt. The specific reason for the rights issue is crucial for proper interpretation.