Advantages and Disadvantages of Right Issue of Shares

Table of Content:

Definition of Right Issue of Shares
Advantages (Pros / Benefits) of Right Issue of Shares
Disadvantages (Cons / Drawbacks) of Right Issue of Shares
Example of Right Issue
Key Features of Rights Issues
Steps of How a Rights Issue Conducted
Right Issue Types
What will happen for the share price fall after the rights issue?
Why Companies Conduct the Right Issue of Shares?
What happens if an investor don’t buy the rights issue?
FAQs of Right Issue

Definition of Right Issue of Shares

A right issue of shares (rights offering) is where a company provides an offer to their existing shareholders to purchase additional shares at a discounted price in a particular ratio proportionate to their present shareholding. Equity capital can be fulfilled using a rights issue.

The rights issue gives the option to the existing shareholders to purchase shares at a lower price on or before a specified date, to retain their existing shareholding percentage.

Advantages (Pros / Benefits) of Right Issue of Shares

1. The right issue is a fast source of raising funds

Issuing rights is the fastest method and the cheapest source of raising capital for a firm. Our shareholders can buy new shares at a discount for a certain period on the right issue. The right issue involves less rigorous rules and regulations as it is more of an internal matter in the company.

2. The right issue incurs low cost

A company can initiate the rights issue process to its existing shareholders at indigent times without incurring underwriting fees. The company also saves money that is spent on advertising, underwriting fee, etc. The company does not have to incur such expenses compared with raising fresh equity from an IPO.

3. The right issue provides an option for the shareholders to maintain the same ownership

The number of additional share purchases allowed to an existing shareholder is always in proportion to his existing shareholding. Shareholders have the option to maintain their original proportion of share ownership.

Existing shareholders will have more certainty of getting shares, when a fresh issue is made to the existing shareholders, instead of the general public. The share price of the right issue will be less than the current share price which attracts the existing shareholders.

4. Raise funds without a form of debt

The right issue is a process to raise capital wherein the company can raise capital without any increase in debt. The company can raise the capital from its existing shareholders without altering the shareholder’s holding percentage. The scope of the right issue is purely in the form of equity and it eliminates any scope for debt.

5. The board of directors can not misuse share issuing option

The board cannot misuse the opportunity of issuing new shares at a lower price. The right issue shares offered proportionately to the existing shareholders according to their existing holdings. Directors do not have much control over the right issue.

6. Enhanced financial flexibility

The company strengthens its financial position and flexibility by raising capital through a rights issue. The additional funds can be utilized for various purposes such as funding expansion projects, retiring debt, investing in research and development, or meeting working capital requirements. This can improve the company’s ability to seize growth opportunities and navigate economic downturns.

7. Provides positive signal to investors

The decision to undertake a rights issue can be perceived as a positive signal by investors, indicating the company’s confidence in its future prospects. It demonstrates management’s commitment to strengthening the company’s financial position and pursuing growth opportunities, which can enhance investor confidence and attract potential investors to the stock.

Disadvantages (Cons / Drawbacks) of Right Issue of Shares

1. The existing shareholding percentage may get diluted

Existing shareholders have the option either to ‘subscribe’ to the right issue or ‘ignore’ to the right issue. If a shareholder ‘ignore’ the right issue then their shareholding percentage will get diluted. This is due to the extra shares issued by the company if it is ‘ignore’ by existing shareholders. If more shareholders ‘ignore’ the right issue then there are chances of stake dilution of the existing shareholders. As the existing shareholder percentage gets reduced with the initiation of new shareholders, it could be a troublesome situation for the existing shareholders.

2. Share price gets decrease after rights issue

After the right issue, a certain percentage of shares will be newly introduced at a discounted price. This results in a dilution of the previous share price. Dilution occurs because a new large number share spreads the company’s net profit.

3. Limitation of fund raise

Most of the stock exchanges have put certain limits or restrictions on the amount of a company could raise through a rights issue. This limit is usually decided based on the existing equity value of the firm. The company cannot raise an amount compared to an IPO (Initial Public Offering). Raising funds through the right issue might create pressure on the company if a company has undervalued stocks.

4. The negative effect of the company’s public image

The right issue is an indication of liquidity crises that a company suffers. Generally, companies will practice the right issue option in the case of a financial crisis. The brand name of the company could negatively be effected when the right issue is announced. In another way, the shareholders also could assume that the company is struggling to run its business and could tend to sell their shares, which could then reduce the share price further.

5. Potential under-subscription

There is a risk of under-subscription in a rights issue if existing shareholders are unwilling or unable to subscribe to the new shares. If the company fails to raise the intended amount of capital through the rights issue, it may need to explore alternative financing options or scale back its expansion plans, which could impact its growth prospects and financial performance.

6. Complexity and potential administrative burden

Rights issues involve a complex process of determining the subscription price, issuing new shares, and managing shareholder rights and preferences. The administrative burden associated with conducting a rights issue, including legal and regulatory compliance, shareholder communications, and coordination with financial intermediaries, can be time-consuming and resource-intensive for the company’s management team.

7. Limited access to new investors

Rights issues are limited to existing shareholders unlike public offerings or private placements, which allow companies to attract new investors and expand their shareholder base. This means that the company may miss out on the opportunity to bring in fresh capital from external investors who could provide additional resources, expertise, and support for the company’s growth initiatives.

Example of Right Issue

As an example, let’s say Mr. Charles is an existing shareholder of PQR Company. He owns 100 shares. The current market price per share of PQR Company is $500.

PQR Company decided to issue the right shares at a discount of 20% on the market price of the share. Rights issues shares are on 1 for every 4 existing shares. As a result, Charles can buy 25 right-issue shares for $400 each.

Charles can either buy these shares or sell these to another. If Charles buys these shares his shareholding percentage remains the same. But if Charles sells these shares to another, he will get the cash flow, but the shareholding percentage will be reduced.

Key Features of Rights Issues

1. Offered Exclusively to Existing Shareholders

Rights issues are offerings of new shares that are exclusively available to the company’s existing shareholders. This means that only shareholders who currently own shares in the company are eligible to participate in the rights issue.

2. Proportional Allocation of New Shares

In a rights issue, shareholders are typically offered the opportunity to purchase new shares in proportion to their existing holdings. This ensures that each shareholder has the chance to maintain their proportional ownership stake in the company.

3. Subscription Price at a Discount

The subscription price for the new shares offered in a rights issue is usually set at a discount to the prevailing market price of the company’s shares. This discounted price incentivizes existing shareholders to participate in the rights issue and helps attract new capital to the company.

4. Limited Subscription Period

Rights issues have a specified subscription period during which existing shareholders can exercise their rights to purchase the new shares. This period is determined by the company and typically lasts for several weeks, allowing shareholders sufficient time to consider their options and make investment decisions.

5. Transferability of Rights

Rights issued to existing shareholders are tradable securities that can be bought and sold on the stock exchange during the subscription period. Shareholders who do not wish to participate in the rights issue have the option to sell their rights to other investors in the secondary market.

6. Flexibility for Shareholders

Shareholders have the flexibility to decide whether to exercise their rights to purchase new shares, sell their rights in the market, or allow their rights to expire. This allows shareholders to tailor their investment decisions based on their individual financial circumstances and investment objectives.

7. Purpose of Fundraising

Companies conduct rights issues to raise additional capital for various purposes such as financing growth initiatives, reducing debt, funding acquisitions, or meeting working capital requirements. The proceeds from the rights issue are typically used to support the company’s strategic objectives and enhance its financial position.

8. Regulatory Compliance

Rights issues are subject to regulatory requirements and oversight to ensure transparency, fairness, and investor protection. Companies must adhere to applicable securities laws and regulations when conducting rights issues, including disclosure requirements and shareholder approval processes.

Steps of How a Rights Issue Conducted

Step 01: Board Approval

The decision to conduct a rights issue is typically initiated by the company’s board of directors. They evaluate the company’s financial position, capital requirements, and strategic objectives to determine the need for additional capital and the terms of the rights issue.

Step 02: Shareholder Approval

Once the board approves the rights issue, the company seeks approval from its shareholders. This may involve convening a general meeting of shareholders to vote on the proposed rights issue and obtain their consent.

Step 03: Formulate Terms of the Rights Issue

The company determines the terms of the rights issue, including the number of new shares to be issued, the subscription price (usually at a discount to the current market price), the subscription ratio (how many new shares can be purchased for each existing share), and the duration of the subscription period.

Step 04: Prepare Offering Documents

The company prepares offering documents, including a prospectus or offering circular, detailing the terms of the rights issue, the purpose of the fundraising, the rights of existing shareholders, and other relevant information. These documents are filed with regulatory authorities and distributed to shareholders.

Step 05: Announcement to Shareholders

The company announces the rights issue to its shareholders through regulatory filings, press releases, and other communication channels. Shareholders are informed about the terms of the rights issue, the subscription period, and how they can participate.

Step 06: Record Date

The company establishes a record date, also known as the ex-rights date, which determines the shareholders eligible to participate in the rights issue. Shareholders on record as of this date are entitled to receive rights to purchase new shares.

Step 07: Subscription Period

The rights issue opens for subscription, allowing eligible shareholders to exercise their rights to purchase new shares. The subscription period typically lasts for several weeks, giving shareholders sufficient time to consider their options and make investment decisions.

Step 08: Subscription and Payment

Shareholders who wish to participate in the rights issue submit their subscription forms along with payment for the new shares to the designated receiving agent or financial intermediary. Payment methods may include cash, check, or electronic funds transfer.

Step 09: Allotment of New Shares

At the end of the subscription period, the company determines the total number of new shares subscribed for and allocates the new shares to participating shareholders based on their subscription amounts and the subscription ratio.

Step 10: Listing of New Shares

The newly issued shares are listed on the stock exchange and become tradable securities. Shareholders who subscribed to the rights issue receive their allotted shares and can trade them in the secondary market.

Step 11: Utilization of Proceeds

The company utilizes the proceeds from the rights issue for the intended purposes, such as funding growth initiatives, reducing debt, or meeting working capital requirements, in accordance with the terms outlined in the offering documents.

Step 12: Regulatory Compliance

Throughout the rights issue process, the company ensures compliance with regulatory requirements and oversight, including disclosure obligations, shareholder rights, and other applicable securities laws and regulations.

Right Issue Types

There are some common types of rights issues that companies may undertake to raise additional capital while providing existing shareholders with the opportunity to participate in the fundraising process.

1. Renounceable Rights Issue – In a renounceable rights issue, shareholders have the option to exercise their rights to purchase new shares, sell their rights to other investors, or let their rights expire. The rights are tradable securities that can be bought and sold on the stock exchange during the subscription period. This type of rights issue provides flexibility to shareholders and allows them to monetize their rights if they choose not to participate.

2. Non-Renounceable Rights Issue – In a non-renounceable rights issue, shareholders do not have the option to transfer or sell their rights to other investors. They can only choose to exercise their rights to purchase new shares or let their rights expire. Non-renounceable rights issues are typically simpler to administer and may be used when the company wants to limit the transferability of rights.

3. Underwritten Rights Issue – An underwritten rights issue involves the appointment of an underwriter, such as an investment bank or financial institution, to guarantee the sale of the new shares in case of undersubscription by existing shareholders. The underwriter agrees to purchase any unsubscribed shares, ensuring that the company receives the intended amount of capital. In return, the underwriter receives a fee or commission for providing this guarantee.

4. Standby Rights Issue – A standby rights issue is similar to an underwritten rights issue but involves existing shareholders as the underwriters. Shareholders commit to purchasing any unsubscribed shares in proportion to their existing holdings, thereby ensuring that the company raises the necessary capital. Standby rights issues demonstrate shareholder support and commitment to the company’s growth initiatives.

5. Deep Discount Rights Issue – The subscription price for the new shares is set at a significant discount to the prevailing market price of the company’s shares in a deep discount rights issue. This discounted price incentivizes existing shareholders to participate in the rights issue and provides them with the opportunity to acquire new shares at a favorable price. Deep discount rights issues may be used when the company needs to raise capital urgently or when market conditions are unfavorable.

6. Nil-Paid Rights Issue – A nil-paid rights issue allows shareholders to exercise their rights to purchase new shares by paying only a portion of the subscription price upfront. The remaining balance is payable at a later date, typically after the new shares have been allotted and listed on the stock exchange. Nil-paid rights issues provide shareholders with flexibility in managing their cash flow while participating in the rights issue.

Usually the share price will fall after conducting a rights issue. There will be several factors contribute to this scenario as following,

1. Dilution Concerns: Shareholders may perceive the rights issue as dilutive, especially if the number of new shares issued significantly increases the company’s outstanding shares. This dilution could lead to a reduction in earnings per share (EPS) and the proportional ownership stake of existing shareholders, which may cause the share price to decline.

2. Market Sentiment: Negative market sentiment or investor perception about the company’s financial health or growth prospects could lead to a decrease in the share price. If investors believe that the rights issue was necessary due to financial difficulties or poor performance, they may sell their shares, causing the price to fall.

3. Supply and Demand Dynamics: The increased supply of shares resulting from the rights issue may outweigh demand from investors, leading to downward pressure on the share price. If shareholders who acquired rights choose not to exercise them or if there is under-subscription, the remaining unsold shares could further depress the price.

4. Discounted Issue Price: Rights issues often offer new shares at a discounted price compared to the prevailing market price. If investors perceive this discounted price as undervaluing the company’s shares, they may sell their existing shares to take advantage of the higher market price, causing the share price to drop.

5. Market Conditions: External market factors such as economic conditions, industry trends, or changes in investor sentiment can also influence share prices. If broader market conditions are unfavorable or if there is negative sentiment towards the sector in which the company operates, the share price may decline irrespective of the rights issue.

It’s essential to note that a decline in share price after a rights issue does not necessarily indicate a negative outcome for the company in the long term. The success of the rights issue depends on various factors, including how effectively the raised capital is utilized, the company’s future performance, and investor confidence in its growth prospects. Investors should carefully consider the reasons behind the share price movement and assess the company’s fundamentals before making investment decisions.

Why companies conduct the right issue of shares

A rights issue is an additional capital-raising method for companies. A company can raise capital by providing the right for its existing shareholders to subscribe to newly issued shares in proportion to their existing holdings.

What happens if an investor don’t buy the rights issue?

If an investor chooses not to buy the rights issue, they essentially forfeit their right to purchase the new shares offered at the discounted price. Here’s what usually happens in such a scenario,

1. Rights Expiration: Each rights issue comes with a specified subscription period during which existing shareholders can exercise their rights to purchase the new shares. If an investor decides not to buy the rights issue within this period, their rights expire, and they lose the opportunity to acquire the discounted shares.

2. Rights Trading: Alternatively, investors who do not wish to participate in the rights issue can choose to sell their rights in the secondary market. Rights issued by the company are tradable securities that can be bought and sold on stock exchanges during the subscription period. By selling their rights, investors can still potentially realize some value from their investment without actually purchasing the new shares.

3. Dilution of Ownership: If an investor does not buy the rights issue and does not sell their rights, their ownership stake in the company will be diluted. This is because the company will issue new shares to other shareholders who choose to exercise their rights, increasing the total number of outstanding shares. As a result, the proportionate ownership of non-participating shareholders decreases.

4. Impact on Share Price: The decision of investors not to buy the rights issue may have implications for the company’s share price. If a significant number of shareholders opt not to participate, it could indicate a lack of confidence in the company’s prospects or dissatisfaction with the terms of the rights issue, which could lead to downward pressure on the share price.

5. Loss of Investment Opportunity: By not participating in the rights issue, investors miss out on the opportunity to acquire additional shares at a discounted price. Depending on the future performance of the company and the success of the rights issue in raising capital, this decision could result in missed investment gains or opportunities for portfolio diversification.

Ultimately, the decision whether to buy or not buy the rights issue depends on the individual investor’s assessment of the company’s prospects, the terms of the rights issue, and their own investment objectives and risk tolerance. It’s important for investors to carefully evaluate the potential benefits and risks before making a decision.

FAQs of Right Issue

Q1. What is a rights issue of shares?

A rights issue is a way for a company to raise additional capital by offering existing shareholders the right to purchase new shares at a predetermined price, usually at a discount to the current market price.

Q2: How can I participate in a rights issue?

To participate in a rights issue, shareholders need to follow the instructions provided in the subscription offer, which may involve completing and returning a subscription form, transferring funds to purchase the new shares, and meeting any other requirements specified by the company.

Q3: How does a rights issue work?

In a rights issue, existing shareholders are offered the opportunity to purchase new shares in proportion to their existing holdings. Shareholders receive a subscription offer detailing the number of rights they are entitled to and the subscription price. They can choose to exercise their rights by purchasing the new shares or selling their rights in the market.

Q4: What happens if I don’t participate in a rights issue?

You can either sell your rights in the market or allow them to expire worthless if you choose not to participate in a rights issue. Your ownership stake in the company will be diluted as a result of the issuance of new shares to other shareholders who do participate.

Q5: How is the subscription price determined in a rights issue?

The subscription price in a rights issue is typically set at a discount to the current market price of the company’s shares. The discount is determined based on factors such as market conditions, the company’s financial position, and the purpose of the rights issue.

Q6: Can I sell my rights in a rights issue?

Yes, rights issued to existing shareholders can be traded on the stock exchange like any other security. If you choose not to exercise your rights to purchase new shares, you can sell your rights to other investors in the market.

Q7: How long do I have to decide whether to participate in a rights issue?

The subscription period for a rights issue is typically specified in the subscription offer, which outlines the deadline by which shareholders must decide whether to exercise their rights to purchase new shares.

Q8: What are the benefits of participating in a rights issue?

Participating in a rights issue allows shareholders to maintain their proportional ownership in the company, potentially acquire additional shares at a discounted price, and support the company’s growth initiatives.

Q9: What are the risks associated with a rights issue?

Risks associated with rights issues include dilution of ownership for existing shareholders who do not participate, potential undersubscription leading to insufficient capital raised, and negative market reactions that could impact the company’s stock price and investor sentiment.

Key Takeaways

Shareholders can keep their percentage of ownership the same.
Shareholders can buy new rights-issue shares for less than the market price of a share.
If a shareholder does not want to exercise the right then it is possible to sell the right. If so, their existing shareholding will be diluted after the right issue of shares.
Existing shareholders can also choose to ignore the rights. Their existing shareholding will be diluted after the right issue of shares.

Learn more about Right Issue of Shares,

Understanding Right Issue of Shares: Features, Examples, Definition, Pros, Cons