What are Right Shares? | Definition, Types, Issue, Pros and Cons

When it comes to raising capital, companies take a variety of corporate actions. One of them is offering rights shares to their shareholders.
Rights share, also known as the 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 stocks of the company on a stipulated date at a price that is lower than the market price.

To be more precise, rights shares are a form of discount offers 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 made on a pro-rata basis.

For example, if a company offers 1:2 Rights shares, it means the shareholders can purchase one additional share for every two shares they already own in the company. 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.

Why does a company offer Rights shares?

A company may choose to offer Rights shares for any of the following reasons:

  1. To raise capital for business expansion as debts cannot generate such a vast amount of money at a shorter notice.
  2. To raise capital for some costly projects for which taking a loan is not without risk.
  3. To acquire a new company or to enhance the debt-to-equity ratio.
  4.  To restore the financial health of a company by getting rid of all its existing 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 must 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.

  1. Accept the right in full and apply for available shares.
  2. Accept the offer in full and apply for eligible as well as additional shares. However, the availability of this option will depend on the status of the subscription.
  3. 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.
  4. Partially accept the rights and let the remaining portion of the rights to expire.
  5. 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’ as opposed to ‘non-renounceable rights’ that cannot be traded. Once a renounceable right has been sold, it is known as ‘nil-paid right.’
  6. Sell the entire rights to other interested investors.

If a shareholder chooses to reject an offer of Rights shares, the concerned shares are then offered to new members.

Types of Rights shares

A company generally issues two kinds of Rights shares:

  1. 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. If not adequately subscribed, the company may fail to generate the necessary capital.
  2. Standby/Insured Rights shares: This one 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

  1. Offering Rights shares is the fastest way through which a company can raise capital.
  2. It is a cost-effective event as the companies do not have to pay for advertisements and underwriters.
  3. Offering additional shares at a discount helps a company to retain its extant shareholders’ confidence.
  4. 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

  1. Rights shares entail issuing of additional shares which results in dilution of the current shares of the extant shareholders.
  2. Lack of capital is one of the significant reasons behind a company issuing Rights shares. Consequently, when a company takes such a step, wrong signals are sent to the investors regarding the financial health of a company.
  3. Issuance of Rights shares reduces the earning per share (EPS) of a company as the profits are dispensed among the resultant increased number of shares. 

References

  1. https://www.sciencedirect.com/science/article/pii/S0929119901000542
  2. https://www.jstor.org/stable/2327051
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