What is a Rights Issue of Shares?
The rights issue refers to the opportunity that companies offer their existing shareholders whereby they are allowed to buy the firms’ additional shares directly from them at a discounted price without having to access the secondary market. Once the shareholders receive this right, they can exercise it on a predetermined future date.
The rights issue feature helps these shareholders to gain increased exposure to the stock market at a rate lower than the market price. This facility is normally offered when businesses plan to expand their reach or suffer from a shortage of cash funds.
- The rights issue is when a company taps into the existing shareholders for additional capital and issues its shares at a discount.
- The firms opt for this option when it runs short of cash or plans to grow and expand its horizon.
- It is up to the shareholders to accept or deny the rights issue share options offered by the companies.
- It is one of the fastest ways of raising funds for companies.
Rights Issue Explained
Rights issue of shares gives the existing shareholders the right to buy additional shares directly from the companies on a predetermined date at a discounted rate. The shareholders do not have to deal in a secondary market when the companies provide such an opportunity. It comes with a significant benefit as the shareholders can buy as many shares as they desire at a price lower than the market price. Plus, it helps them get enough exposure in the stock market.
The firms decide to offer this feature to the existing shareholders under two scenarios:
- When they face a cash shortage, and they don’t want to go to another bank or financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. to raise money, especially when they are already in debt. They prefer asking their existing stakeholders to buy extra shares to gather sufficient cash.
- When the firms plan to grow and expand, they opt for it. It is not necessary that only companies facing financial crisis choose this option. There are firms with smoothly flowing finances that offer the issue of rights for shares. For the companies, approaching the existing shareholders is an easier and better way of raising funds than asking new investors to do so.
The shareholders are on the profit side as they can buy the shares at a future date, which might be the period when companies perform well. In such a scenario, the returns they are likely to receive would be more. On the contrary, firms not exhibiting proper growth might not attract many shareholders to accept this invitation. Hence, the rights issue procedure may or may not be accepted by the shareholders, given the company’s performance, growth, and returns.
Let us take a rights issue example where John, an existing shareholder of Company TMC, owns 20 shares of $200 each. It issues the right of shares to John and offers a discount of 30% and allows him one share for every two existing shares. As a result, John can buy ten right-issue shares for $140 each.
In this scenario, John benefits from the issue, and if he sells all these shares at a market price to another investor before the expiration date, he is likely to enjoy a little profit.
Thus, the total worth of the shares that John owns is calculated as follows:
[(20 * $200) + (10 *140)] = ($4000 + $1400)
Hence, the cost of one share here will be:
$5400/30 = $180
When looked closely, it is observed that if John gets a discount of 30%, i.e., $60 off from each share of the rights issue, he only gets $20 off per share.
Advantages & Disadvantages
The meaning of the rights issue can be better understood if both the good and bad sides of it are explored and analyzed. This, in turn, also helps shareholders determine whether to accept or deny the proposal. Let us have a look at the advantages and disadvantages:
|Existing shareholders become major controllers.
|Limited capital raising
|The company’s reputation betters as it exhibits growth and shows long-term commitment towards serving customers by introducing a rights issue feature.
|If lack of cash is the reason behind the rights issue, it hampers the company’s reputation.
|Fastest way of raising capital
Rights Issue vs Private Placement
Rights issue and private placement are two ways in which companies issue shares to existing and new shareholders to raise capital. However, these two methods of raising funds differ greatly. So, let us look at the differences between the two:
- The rights issue is when companies invite existing shareholders to buy additional shares at a discounted rate. On the other hand, private placement, as the name suggests, is where firms sell stock privately.
- The former is an invitation to existing shareholders, while the latter is concerned with selling shares to accredited investors.
- A rights issue is more regulated than a private placement.
- Each shareholder’s stake is the same in the case of the former, while it differs for those who transact stocks using private placement.
In addition, the shareholders, in both cases, can buy new shares as desired without any restrictions.
Frequently Asked Questions (FAQs)
It is an invitation that companies give to existing shareholders, giving them a chance to buy additional shares. However, the shareholders are free to decide if they want to buy those shares or if they would like to skip them, given the performance of the firms and the value of the shares involved.
One can sell it to other investors by transferring the entitlements for the shares either through the stock exchange’s entitlement trading or an off-market deal. It could be done for either a part of it or the complete set as decided by the shareholders.
Normally, the shares are credited within two working days and before the closing date of the issue. However, it is credited to the shareholders’ account as soon as the deals are finalized.
This has been a guide to what is Rights Issue. Here we explain it along with examples, advantages, disadvantages, and its differences with the private placement. You may also have a look at the following recommended articles to learn more –