What it means
When a company issues new shares, existing owners find their stake diluted, meaning each owner holds a smaller share of the whole. Subscription rights protect against this by letting existing shareholders buy the new shares first, in proportion to what they already own.
Rights are usually described by a ratio. In a one-for-four offer, a shareholder receives one right for each share held, and four rights entitle the holder to buy one new share at the subscription price.
The price is normally set below the current market price so that using the right is attractive. Each right has a market value, because it lets the holder buy at a discount.
Shareholders who do not wish to invest more money can sell their rights, often on the stock exchange during the offer period, and use the proceeds to offset the fall in the value of their existing shares. Rights have an expiry date, and rights not used by that date become worthless.
Missing the deadline is a common and costly mistake, so shareholders should read the offer documents carefully and decide in good time. There is a cost to the company side as well.
A rights issue is usually underwritten by banks, who guarantee that the full amount will be raised even if some shareholders do not take part, and they charge a fee for that promise. A deeper discount makes success more likely but dilutes the existing owners more if they do not participate.
In some countries, shareholders have legal pre-emption rights, which require a company to offer new shares to existing owners first, unless they vote to waive that protection. Companies use rights issues to raise money when they need to strengthen the balance sheet, repay debt or fund an acquisition, while keeping existing owners in control.
In practice
Real-world examples.
Example
A listed manufacturer needs $40,000,000 to repay a loan and offers existing shareholders the right to buy one new share for every five they hold. Those who take part keep their percentage of the company, and those who sell their rights receive cash instead. The company announces a record date, so only holders on that date receive the rights.
Example
A retail investor holds 1,000 shares and receives 1,000 rights in a one-for-four issue. She can buy 250 new shares at the subscription price or sell her rights to someone else.
Example
A founder-led company wants to avoid bringing in a new large investor. It offers new shares to existing owners only, so no outsider receives a stake. The owners who cannot afford to take part may sell their rights to the others, which lets control stay inside the family.
Formula
Calculation
The price of a share after the rights offer, and the value of each right, are found as follows:
Theoretical ex-rights price = (Old shares x Market price + New shares x Subscription price) / (Old shares + New shares)
Value of a right = Market price - Theoretical ex-rights price
A company offers a one-for-four rights issue at $16 when shares trade at $20. For every four old shares, one new share is sold, so the ex-rights price is (4 x $20 + 1 x $16) / 5 = ($80 + $16) / 5 = $19.20. Each right is worth $20 - $19.20 = $0.80.Case study
Seen in the real world.
Crestline Hotels is an illustrative, fictional company that needed $30,000,000 to refurbish its properties. It offered a one-for-three rights issue at $9.00 a share when the market price was $12.00.
The theoretical ex-rights price was (3 x $12 + 1 x $9) / 4 = $11.25, so each right was worth $0.75. A shareholder who owned 3,000 shares received 3,000 rights and could buy 1,000 new shares for $9,000.
In this illustrative story, one shareholder ignored the offer and let the rights expire, losing the value they represented. Another sold her rights for $2,250 and used the cash to cover the fall in the share price, so her total wealth was unchanged. The company raised the full $30,000,000 and used it to complete the refurbishment within eighteen months.
Watch out
Common mistakes.
- Letting the rights expire without using or selling them, which wastes their value.
- Assuming the discount to the market price is a free gain, when the share price falls once the new shares are issued.
- Confusing a subscription right with a stock option, which a company grants to staff as an incentive.
Questions
People also ask.
Can subscription rights be sold?
Often yes, because they are tradable on an exchange during the offer period, although it depends on the rules of the market and the company.
Why is the subscription price below the market price?
The discount encourages shareholders to take part and helps the company sell all the new shares, even if the market price drops while the offer is open.
Does a rights issue change the value of my holding?
The share price adjusts after the issue, but if you take up or sell your rights, your overall wealth should be broadly unchanged.
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