What are rights issues and why do companies offer them?

What are rights issues?

Rights issues are an offer by a company to its shareholders to buy more of their stocks at a specific price by a stipulated deadline. 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 aren’t the same as ordinary shares because they’re invitations only extended to existing shareholders.

How do rights issues work?

Rights issues 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, which is usually between 16 and 30 days.

With them, shareholders have the ‘right’ to do one of three things: purchase additional shares; sell these rights to someone else or do nothing at all.

Up to the date when the new shares can be bought, shareholders may trade the rights on the market the same way that they would trade ordinary shares. The rights issued to a shareholder have value, therefore compensating current shareholders for the future dilution of their existing shares' value.

If shareholders decide not to buy additional shares or they sell their rights to someone else, then their share in the company will be diluted. This is because new shares are being issued while their proportion of owned shares does not change.

Dilution occurs because a rights offering spreads a company’s net profit over a wider number of shares, therefore the company’s earnings per share (EPS) falls as the allocated earnings experience share dilution.

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Types of rights offerings issues

There are two types of rights offerings:

• Direct rights offerings
• Insured (or standby) rights offerings

What is the difference between a direct rights offering and an insured rights offering?

The number of rights issues sold in a direct offering is only the amount that shareholders have expressed interest in buying. This means that, if the stockholders who wanted to purchase rights issues don’t, or don’t purchase the amount they were thinking of, the rights offering issuer may be undercapitalised.

On contrast, insured or standby rights offerings rights allow third parties or ‘backstop’ purchasers (such as investment banks) to buy ‘leftovers’ unexercised by the shareholders. The backstop buyers agree to the purchase before the rights offering and this agreement assures the issuing company that their capital requirements will be met.

A direct rights offering is cheaper than an insured rights offering because there are no fees associated with providing the backstop commitment.

In some cases, rights issued aren’t transferable and are known as ‘non-renounceable rights’. Some beneficiaries of rights issues choose to sell them to another party.

How does a rights issue affect the share price?

Rights issues can affect the share price by diluting its value and also by affecting trading volumes. Stock prices become diluted by the introduction of more shares and there may be a downward trend in the valuation of the shares.

Quite often, rights issues also significantly impact trading activity on the day of their announcement as they often represent an increased interest in (and increased trading volumes on) those shares.

Accurate and timely information about rights issues can help investors make crucial financial decisions and therefore impact their strategy going forward.

Pros and cons of a rights issue

It’s important to know the share issue advantages and disadvantages when deciding on which company and which shares to choose. Rights issue benefits offer many advantages to both parties: the company and the investor.

Pros of a rights issue

• They’re 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 aren’t required
• Shareholders can maintain the same ownership, because additional purchases allowed are always in proportion to their existing shareholding
• A board of directors can’t misuse a rights offering, as company directors don’t have much control over rights issues

Cons of a rights issue

• 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

What are rights issues summed up

• A rights issue is an invitation by a company to its shareholders to buy additional stocks at a discounted rate at a certain time
• Stockholders can use a rights offering as an opportunity to increase their exposure to the company, sell these rights to someone else or do nothing at all
• There are two types of rights issues: a direct offering and insured or standby rights offering
• You cannot buy rights issues with us