What it means
Imagine a company that wants to raise fresh funds by selling new shares. Instead of offering them to the world, it first gives each current shareholder the right to buy a certain number of new shares at a set price, usually below the market price.
This protects existing owners from having their stake shrunk, since they can buy their share of the new issue. The right is a type of option.
It has a subscription price (the price at which new shares can be bought), an expiry date, and a ratio, for example one new share for every four held. If the market price is above the subscription price, the right has positive value and can be sold to someone else.
Investors have three choices. They can exercise the rights and buy the shares, sell the rights on the market for cash, or let them lapse, which is almost always the worst option because the value is lost.
A holder who sells the rights gets cash to offset the fall in the share price that comes with the extra shares being issued. For the company, a rights offering is a way to raise equity with a high chance of success, particularly if the subscription price is set at a clear discount.
It also avoids the fees and uncertainty of a public offering to new investors. On the other hand, it dilutes the holdings of anyone who does not take part, so communication with shareholders is important.
The nuance is that share purchase rights are also used defensively. Under a shareholder rights plan, rights are triggered when an outside buyer acquires more than a set percentage of the shares, letting everyone else buy shares cheaply and watering down the bidder.
The same instrument can therefore be a financing tool or a takeover shield, and the reading depends on the context.
In practice
Real-world examples.
Example
A mid-sized listed manufacturer needs $60,000,000 to repay debt. It offers its existing shareholders the right to buy one new share for every five held at a discount to the market price, and a majority of the offer is taken up.
Example
A shareholder in a property company receives rights but does not want to put in more money. She sells her rights on the market, collecting cash that offsets the dilution in the value of her existing shares.
Example
A board adopts a rights plan after a rival begins quietly buying its shares. If the rival crosses the set ownership threshold, the rights let all other shareholders buy additional shares at a steep discount, which would sharply reduce the rival's percentage stake.
Formula
Calculation
Theoretical value of one right = (market price - subscription price) / (rights needed per new share + 1)
Suppose a share trades at $50, and the company offers one new share at $40 for every four rights held. The value of one right is (50 - 40) / (4 + 1) = 10 / 5 = $2. As a check, the ex-rights share price would be (4 x 50 + 1 x 40) / 5 = 240 / 5 = $48, and 50 - 48 = $2. An investor holding 400 shares receives 400 rights, which are worth 400 x 2 = $800 in total.Case study
Seen in the real world.
Harbourview Shipping is an illustrative, fictional company with 20,000,000 shares trading at $10. It needed to raise $30,000,000 to buy two vessels and announced a rights offering at $6 per new share, with one new share for every two held.
The offer would issue 10,000,000 new shares and raise 10,000,000 x 6 = $60,000,000, so the board reduced the ratio to one new share for every four held. This issued 5,000,000 shares at $6, raising the required $30,000,000.
The finance director calculated the ex-rights price at (4 x 10 + 6) / 5 = $9.20 and the value of each right at $0.80. The illustrative result was a successful offer where holders who took part kept their percentage ownership, and those who sold their rights were compensated for the dilution.
Watch out
Common mistakes.
- Letting rights lapse without selling or exercising them, which wastes their value.
- Assuming a rights offering is free money, when the share price typically falls to reflect the new shares and the lower subscription price.
- Confusing share purchase rights with employee stock options, when rights are usually issued to all shareholders in proportion to their holdings.
Questions
People also ask.
What is a rights offering?
It is an offer to existing shareholders to buy additional shares, usually at a discount, in proportion to the shares they already hold.
Can share purchase rights be traded?
Often yes, especially in a rights issue on a stock exchange, where the rights trade for a limited period before they expire.
How does a rights plan protect against takeovers?
If a bidder passes a set ownership threshold, the rights let other shareholders buy shares cheaply, which dilutes the bidder and makes the takeover more expensive.
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