A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing holdings.
A rights issue is, therefore, a way of raising new cash from shareholders – this is an important source of new equity funding for publicly quoted companies.
Why issue shares to existing shareholders?
Legally a rights issue must be made before a new issue to the public. This is because existing shareholders have the “right of first refusal” (otherwise known as a “pre-emption right”) on the new shares.
By taking these pre-emption rights up, existing shareholders can maintain their existing percentage holding in the company.
However, shareholders can, and often do, waive these rights, by selling them to others. Shareholders can also vote to rescind their pre-emption rights.
How are the shares sold in a rights issue priced?
The price at which the new shares are issued is generally much less than the prevailing market price for the shares. A discount of up to 20-30% is fairly common.
Why would a business offer new shares at a price well below the current share price?
The main reason is to make the offer relatively attractive to shareholders and encourage them either to take up their rights or sell them so the share issue is “fully subscribed”.
The price discount also acts as a safeguard should the market price of the company’s shares fall before the issue is completed. If the market share price were to fall below the rights issue price, the issue would not have much chance of being a success – since shareholders could buy the shares cheaper in the market than by taking up their rights to buy through the new issue.
Do existing shareholders have to take up their rights to buy new shares?
No. Shareholders who do not wish to take up their rights may sell them on the stock market or via the firm making the rights issue, either to other existing shareholders or new shareholders. The buyer then has the right to take up the shares on the same basis as the seller
Other factors to consider in rights issues
In addition to the price at which a rights issue is offered, there are several other factors that need to be considered:
Issue Costs
Rights issues are a relatively cheap way of raising capital for a quoted company since the costs of preparing a brochure, underwriting commission or press advertising involved in a new issue of shares are largely avoided.
However, it still costs money to complete a rights issue. Issue costs are often estimated at around 4% on equity funds raised of around 2 million raised. However, as many of the costs of the rights issue are fixed (e.g. accountants and lawyers fees) the % cost falls as the sum raised increases.
Shareholder reactions
Shareholders may react badly to firms continually making rights issues as they are forced either to take up their rights or sell them. They may sell their shares in the company, driving down the market price
Control
Unless large numbers of existing shareholders sell their rights to new shareholders there should be little impact in terms of control of the business by existing shareholders
Unlisted companies
Unlisted companies often find rights issues difficult to use, because shareholders unable to raise sufficient funds to take up their rights may not have available the alternative of selling them where the firm’s shares are not listed. This could mean that the firm is forced to rely on retained profits as the main source of equity, or seek to raise venture capital or take on debt.
What happens to the share price of the company involved?
It depends. This is the theory:
An investor holds 200 shares of Rights Co. The market price of the shares stand at 100 INR and the company then announces a “one for four” rights issue. The subscription price for the extra shares is set at 80 INR.
The value of the holding before the rights issue was:
200 shares at 100 INR = 20,000.00 INR
To take up all the rights, the investor will have to purchase 50 new shares at a price of 80 INR, so the total amount of money that will pass from the investor to Rights Co is:
50 shares at 80 INR = 4,000.00 INR
So, after the shares go ex-rights (usually a few weeks after the initial announcement and meaning that anyone buying them no longer has the right to buy the new shares) the share price, known as the ex-rights share price, will be:
Total value of investment 20,000.00 + 4,000.00
_______________________ = _________________ = 96 INR
Total number of shares held 200 + 50
That’s the theory, all things being equal. But as mentioned earlier, a rights issue is accompanied by corporate news over why the capital is to be raised. And thus the stock market will take into account that information too. If the money is to be put to really good use, then the share price may rise, even though the prospect of extra shares has a dilutive effect.
What happens if I don’t take up my rights?
Using the above example, assume the investor doesn’t take up any of the rights. The investor will remain holding 200 shares at a theoretical ex-rights price of 96 INR. The total holding value will be:
200 shares at 96 INR = 19,200.00 INR
So, it appears the investor has lost 800.00 INR, having had a holding of 20,000.00 INR originally.
But the rights are usually tradable, meaning you can buy and sell them through a broker, just like you can with ordinary shares. Each right will be worth (in theory) the difference between the subscription price and the ex-rights share price; in this example:
Rights price = 96 INR – 80 INR = 16 INR
So, if we ignore costs, by selling the 50 rights, the investor will recoup his 800.00 INR:
50 rights at 16 INR = 800.00 INR
Alternatively, our investor could do nothing and let the rights issue lapse. And the end of the process, the company takes all the lapsed rights and sells them. Any money raised is returned to the shareholders who let their rights lapse. The disadvantage of this approach is that the price could move against you in the meantime. If the share price had fallen to 92 INR for example, the rights price would be 12 INR and the total amount received would be 600 INR.
Another option is to sell part of your rights. You can even use the proceeds to take up your remaining rights. In the above example, our investor could have sold 42 rights at 16 INR and raised 672 INR. This would have enabled him to buy the remaining 8 shares he was entitled to at a cost of 640 INR (8*80). This process is known as “swallowing your tail”.
OTCWIRE 