Rights issues

What Are Rights Issues?

A rights issue is an invitation from a company to its existing shareholders to purchase additional shares in the company, typically at a discount to the current market price. This mechanism, a common practice within corporate finance, allows a company to raise fresh capital by offering existing investors the preferential "right," but not the obligation, to buy new shares. The number of new shares an investor can buy is proportionate to their existing holdings, aiming to enable them to maintain their percentage ownership in the company. Rights issues are a form of equity issuance that prioritizes existing shareholders over new ones.

History and Origin

Rights issues have been a method for companies to raise capital for centuries, predating modern securities markets. Their formalization evolved alongside the development of stock exchanges and corporate law, which aimed to protect existing shareholders from undue dilution when new shares were issued. Early regulatory frameworks, such as those that emerged in the United States in the mid-20th century, addressed concerns about market manipulation and fair distribution in such offerings. For instance, a 1949 speech from the U.S. Securities and Exchange Commission (SEC) highlighted the growing popularity of rights offerings and discussed the application of anti-manipulative provisions of the Securities Exchange Act of 1934 to these distributions.⁵ This historical context underscores the long-standing importance of rights issues as a tool for corporate fundraising.

Key Takeaways

Rights issues allow companies to raise additional capital by offering new shares to existing shareholders.
The new shares are typically offered at a subscription price below the prevailing market price.
Shareholders receive "rights" proportionate to their current holdings, allowing them to maintain their percentage ownership.
These rights can often be traded in the open market, providing liquidity for shareholders who choose not to subscribe.
If shareholders do not exercise or sell their rights, their ownership percentage in the company will be diluted.

Formula and Calculation

The theoretical ex-rights price (TERP) is a crucial calculation for a rights issue, representing the expected market price of a share immediately after the rights offering is completed, assuming all rights are exercised. It accounts for the increase in the number of shares outstanding and the additional capital raised.

The formula for TERP is:

TERP = \frac{(S \times P) + (N \times R)}{S + N}

Where:

( S ) = Number of existing shares before the rights issue
( P ) = Current market price per share
( N ) = Number of new shares offered via the rights issue
( R ) = Subscription price per new share

The value of one right (VOR) can also be calculated:

VOR = \frac{P - R}{\frac{S}{N} + 1}

Interpreting the Rights Issue

A rights issue is typically interpreted as a company's move to raise capital without immediately going to the broader public market or incurring debt. For existing shareholders, a rights issue offers an opportunity to either increase their stake or, if the rights are tradable, monetize their entitlement by selling the rights. Investors should evaluate the subscription price relative to the current share price and the company's financial health to determine the attractiveness of exercising their rights. Failing to act on a rights issue, either by subscribing or selling, will lead to a dilution of their percentage ownership in the company and their share of future earnings.

Hypothetical Example

Consider Company XYZ, which has 10 million shares outstanding, trading at a market price of $10 per share. The company announces a rights issue to raise $20 million, offering new shares at a subscription price of $8 per share.

The rights issue is structured as a 1-for-5 offering, meaning for every five shares an existing shareholder owns, they can buy one new share.

Calculate new shares offered: To raise $20 million at $8 per share, Company XYZ needs to issue $20,000,000 / $8 = 2.5 million new shares.
Shareholder entitlement: If an investor owns 1,000 shares of Company XYZ, they would receive rights to purchase (1,000 shares / 5) = 200 new shares.
Cost to exercise: To exercise these rights, the investor would pay 200 shares * $8/share = $1,600.
Theoretical Ex-Rights Price (TERP):
- Total value before issue: (10,000,000 shares * $10/share) = $100,000,000
- Capital raised: $20,000,000
- Total shares after issue: 10,000,000 + 2,500,000 = 12,500,000 shares
- Total market capitalization after issue: $100,000,000 + $20,000,000 = $120,000,000
- TERP = $120,000,000 / 12,500,000 shares = $9.60 per share.

After the rights issue, the investor who exercised their rights would own 1,200 shares (1,000 original + 200 new) with an average cost of (( (1,000 \times $10) + (200 \times $8) ) / 1,200 = ( $10,000 + $1,600 ) / 1,200 = $11,600 / 1,200 = $9.67) per share, close to the TERP.

Practical Applications

Rights issues are primarily used by companies as a method of raising capital. This fundraising strategy is seen across various sectors for different purposes:

Debt Reduction: Companies facing significant debt burdens or seeking to improve their debt-to-equity ratio may use rights issues to generate cash for debt repayment.
Funding Growth/Acquisitions: Financially healthy companies might undertake a rights issue to fund expansion plans, acquire other businesses, or invest in new projects without taking on more debt.
Strengthening Balance Sheet: A rights issue can bolster a company's equity base, improving its financial stability and resilience.
Avoiding Public Offering Costs: Compared to a full public offering to new investors, a rights issue can sometimes be a less expensive and faster way to raise funds, as it targets existing shareholders directly. While some rights issuances may involve underwriting to guarantee the amount of capital raised, others may not, reducing associated fees.
Major Capital Projects: In some cases, companies undertaking large-scale infrastructure projects or significant investments may turn to rights issues. For example, National Grid, a major energy utility, announced a substantial £7.0 billion rights issue in 2024 to fund a significant increase in capital investment for energy network infrastructure.
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Regulatory bodies, such as the SEC and major stock exchanges, have specific rules governing rights offerings to ensure transparency and fairness to shareholders. These rules cover aspects like disclosure requirements, minimum offering periods, and procedures for listing rights for trading.,³
²

Limitations and Criticisms

While rights issues offer a way to raise capital, they come with certain limitations and criticisms:

Perception of Distress: Rights issues are sometimes perceived as a "last resort" financing option, especially if a company is struggling to secure traditional debt financing or prefers not to dilute new investors. This perception can negatively impact the company's share price and market confidence.
¹* Shareholder Non-Participation: Not all shareholders may have the financial capacity or desire to participate in a rights issue. If they do not exercise their rights (or sell them if transferable), their ownership percentage will be diluted, potentially leading to a loss in the value of their original holding. Research indicates that wealth-constrained shareholders may experience more dilution and lower payoffs even if they sell their rights.
Dilution of Earnings Per Share (EPS): Even if all shareholders participate, the increase in the number of outstanding shares will spread the company's earnings over a larger base, thus reducing earnings per share (EPS), assuming net income remains constant.
Market Impact: The announcement of a rights issue, especially if the subscription price is heavily discounted or the market perceives financial weakness, can lead to a short-term drop in the stock's market price.
Underwriting Risk: While some rights issues are not underwritten, many are, involving an investment bank that guarantees the sale of unsubscribed shares. This underwriting comes with fees, adding to the cost of raising capital.

Rights Issues vs. Follow-on Offering

Rights issues and follow-on offerings are both methods for companies to issue new equity shares and raise capital after their initial public offering (IPO). However, they differ significantly in their approach:

Feature	Rights Issues	Follow-on Offering (or Secondary Offering)
Target Investors	Exclusively existing shareholders	Can be existing shareholders, new investors, or a mix
Pre-emptive Right	Yes, existing shareholders have a pre-emptive right to subscribe.	No inherent pre-emptive right; shares are typically sold to the broader market.
Pricing	Usually at a discount to the current market price to incentivize participation.	Typically priced close to the current market price, sometimes with a slight discount.
Dilution Impact	Shareholders can avoid percentage dilution by exercising their rights.	Almost always results in dilution of existing shareholders' percentage ownership if they do not participate.
Tradability	The "rights" themselves may be tradable as a separate financial instrument.	No separate tradable "rights" are typically issued.
Purpose	Often used to raise capital while maintaining shareholder relations and control.	Broadly used for capital raising, can also be for selling existing shares by large investors.

The key distinction lies in the pre-emptive right granted to existing shareholders in a rights issue, allowing them to maintain their proportional ownership, whereas a follow-on offering usually involves selling shares to a wider pool of investors, potentially diluting existing stakes.

FAQs

What happens if a shareholder does not exercise their rights?

If a shareholder does not exercise their rights in a rights issue, their percentage ownership in the company will be diluted when the new shares are issued. This means their stake will represent a smaller portion of the company's total outstanding shares. In some cases, if the rights are transferable, they may be able to sell these warrants on the open market before they expire, recouping some value.

Are rights issues always a good opportunity for investors?

Not necessarily. While the discounted subscription price might seem attractive, investors should assess the reason for the rights issue and the company's financial health. A rights issue can signal that the company is in distress or struggling to raise capital through other means. The potential for dilution and the impact on the stock's market price should also be considered.

How do rights issues affect a company's stock price?

The announcement of a rights issue can lead to a drop in the company's stock price. This is due to the anticipated dilution of existing shares and the perception that the company needs to raise capital, which can sometimes be viewed negatively by the market. However, the theoretical ex-rights price (TERP) attempts to estimate the adjusted share price post-issue.

Are rights issues common?

Rights issues are a common corporate action for companies globally when they need to raise additional capital. Their frequency can vary depending on market conditions, regulatory environments, and the specific needs of companies in different regions.