When it comes to raising capital, companies take various corporate actions. One of them is offering rights shares to their shareholders.
A rights share, also known as a Rights issue, is an offer given to the extant shareholders of a company to purchase additional shares. Under this offer, the company provides its shareholders with securities called rights.
The shareholders then use these rights to buy additional company stocks on a stipulated date at a price lower than the market price.
To be more precise, rights shares are a form of discount offer given to the extant shareholders to increase their exposure to a company’s stocks.
According to Sec. 81(1) of the Companies Act, 1956, such offer of shares to the existing shareholders must be pro-rata.
For example, if a company offers 1:2 Rights shares, the shareholders can purchase one additional share for every two shares they already own. The rate of the new stocks bought by the shareholders will be much lesser than the current market price or will be available at a discount.
Key Takeaways
- Right shares are new shares offered to exist shareholders in proportion to their current shareholding.
- Right shares are offered at a discounted price to the current market price.
- Right shares allow existing shareholders to maintain their proportionate ownership in the company.
Why does a company offer Rights shares?
A company may choose to offer Rights shares for any of the following reasons:
- To raise capital for business expansion as debts cannot generate such a vast amount of money at a shorter notice.
- Raising capital for costly projects for which taking a loan is not without risk.
- To acquire a new company or to enhance the debt-to-equity ratio.
- Restore a company’s financial health by eliminating all its debts and losses.
How do Rights shares work?
The invitation for the Rights shares is given in the form of a notice. The notice must contain all the details related to the offered shares and reach the shareholders at least 15 days before the stipulated date of acceptance of such an offer.
When the shareholders receive the offer of Right shares, they can either accept or reject it or avail of any of the following options.
- Accept the right in full and apply for available shares.
- Accept the offer in full and apply for eligible and additional shares. However, the availability of this option will depend on the subscription status.
- Ignore the offer and let the rights expire. However, this is not recommended, as the issuance of additional shares by the company can dilute the current shares of a shareholder.
- Partially accept the rights and let the remaining portion of the rights expire.
- Partially accept the rights and sell the remaining portion to other interested investors. This process is known as ‘renunciation of rights’, and the rights that can be sold are called ‘renounceable rights’ instead of ‘non-renounceable rights’ that cannot be traded. Once a renounceable right has been sold, it is known as a ‘nil-paid right.’
- Sell the entire rights to other interested investors.
If a shareholder rejects an offer of Rights shares, the concerned shares are then offered to new members.
Types of Rights shares
A company issues two kinds of Rights shares:
- Direct Rights shares: Here, a company sells only exercised rights. Consequently, there is no place for standby or backstop purchasers (buyers ready to acquire unexercised rights) in these offers. The company may fail to generate the necessary capital if not adequately subscribed.
- Standby/Insured Rights shares: This is more expensive and allows standby purchasers like investment banks to buy unexercised rights. An agreement is made between the company and the interested backstop purchaser before the issuance of rights shares. Consequently, the company remains assured that its capital requirements will be satisfied.
Advantages of Rights shares
For the company
- Offering Rights shares is the fastest way a company can raise capital.
- It is a cost-effective event as the companies do not have to pay for advertisements and underwriters.
- Offering additional shares at a discount helps a company retain its extant shareholders’ confidence.
- Rights shares help a company to raise capital without raising its debt burden.
For the shareholders
The offer of Rights shares allows extant shareholders to gain more stocks in a company at a much lesser price.
Disadvantages of Rights shares
- Rights shares entail issuing additional shares, which results in the dilution of the current shares of the extant shareholders.
- Lack of capital is a significant reason a company issues Rights shares. Consequently, when a company takes such a step, wrong signals are sent to the investors regarding the financial health of a company.
- Issuance of Rights shares reduces a company’s earnings per share (EPS) as the profits are dispensed among the increased number of shares.
- https://www.sciencedirect.com/science/article/pii/S0929119901000542
- https://www.jstor.org/stable/2327051
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The most obvious advantage of Rights shares is that it allows existing shareholders to maintain their proportionate ownership in the company. The company’s confidence is retained because it retains its extant shareholders’ confidence.
Your point about rights shares issue being cost-effective and the fastest way for companies to raise capital is very interesting. And a downside is certainly that the dilution of the current shares of the extant shareholders happens.
The issuance of additional shares by the company can dilute the current shares of a shareholder, so my concern would be the percentage of rights held by the owner falling due to the dilution.
Rights shares are essential for companies to raise capital avoiding increasing its debt, even if it leads to dilution of the current shares.
The company can regain financial health with rights shares, which definitely is a major benefit. The drawbacks are significant, too: the dilution of the current shares and potential negative signals to investors.
It is one of the fastest ways a company can raise capital, and is a cost-effective event as the companies do not have to pay for advertisements and underwriters.
I think the offering of right shares is the fastest way a company can raise capital, without putting the company at the risk of increasing its debt burden. On the downside, however, the current shares can get diluted.
It’s interesting to note that the company is able to maintain extant shareholders’ confidence by offering additional shares at a discount. However, a major downside is the dilution of the current shares of the extant shareholders.
In the light of recent events, the lack of capital issue reached a whole new level. This includes the risk of the company failing to generate the necessary capital if not adequately subscribed.
Right shares are quite useful for existing shareholders: they can gain more stocks in a company at a much lesser price. However, a concern might be that it can lead to dilution of the current shares.
The right shares help the company to bypass the cost of advertisements and underwriters, and allows shareholders to maintain proportionate ownership in the company. Despite this, the dilution of the current shares happens.