Right Issue: Meaning, Types, Advantages and Disadvantages

After getting to know about corporate actions like bonus issues and stock splits, it is clear that companies take several steps to boost their business, improve the credibility of their stocks, and increase the volume of investment in their organisation. Among these is another corporate action that plays a vital role in the stock market- the rights issue. 

A rights issue is an offer that allows existing shareholders to purchase additional shares from the company at a discounted price. It is also known as rights offering and companies use it to raise capital. 

Are you curious about how it works? How does a company raise capital if the stock price is discounted?

Read on to learn more about how a rights issue works.

How Does a Rights Issue Work in India?

A rights issue is a strategic way for a company to raise capital from existing shareholders while offering them preferential treatment. Companies may use the capital raised through rights issues for various purposes such as paying off debt, funding expansion, or other financial needs. A common reason behind this decision is to avoid increasing debt or to prevent excessive dilution of shares. Rights issues also allow companies to raise capital without changing the existing ownership proportions significantly.

A rights issue offer is typically made via a distribution of subscription rights. These rights can often be traded in the stock market, similar to regular shares. When a rights issue happens, shareholders can choose between fully subscribing to their rights, ignoring their rights (which might lead to dilution of their holdings), and selling their rights to other investors.

Rights issues may also be underwritten by financial institutions. An underwriter guarantees that the company will raise the desired amount of capital. In this process, they commit to purchase any shares not taken up by the shareholders.

The introduction of new shares at a discounted price can lead to a decrease in the company's earnings per share (EPS). This is because profits are now divided among a higher number of shares. However, the impact on the share price can vary based on several factors, including market perception and how the company will use the raised capital.

It is noteworthy that the success of a rights issue depends on various factors, including the company's financial health, the attractiveness of the discount offered, and market conditions.

Types of Rights Issues

Rights issues come in several forms. Each type of rights issue offers different levels of flexibility and security to both the company and its shareholders. The choice of which type to use depends on the company's specific needs, market conditions, and the strategic goals of the capital-raising exercise. Here's a more detailed look at the various types of rights issues:

• Traditional Rights Issue

This is the most common form of a rights issue. In a traditional rights issue, existing shareholders are offered the opportunity to purchase additional shares at a predetermined price, usually at a discount to the current market price. In this type, the ratio of new shares available to existing shareholders is typically proportional to their current holdings.

• Renounceable Rights Issue

In a renounceable rights issue, shareholders have the flexibility to sell or transfer their rights to other investors in the open market. This type of issue is notable for the tradability of the rights, which means shareholders can monetise their rights by selling them if they choose not to exercise the rights themselves.

• Non-Renounceable Rights Issue

As opposed to the renounceable rights issue, in a non-renounceable rights issue, shareholders are not allowed to sell or transfer their rights to anyone else. They must decide whether to exercise the rights by purchasing additional shares or to let them expire, without the option of transferring these rights to others.

• Standby Rights Issue

In a standby arrangement, the rights issue is underwritten by a third party, typically a financial institution. The underwriter agrees to buy any shares that are not subscribed to by shareholders, thereby ensuring that the company raises the required amount of capital.

Important Dates in Rights Issue

There are several dates associated with a rights issue. These are generally specified at the time of announcement. They are below:

Announcement Date: The day on which the company officially announces its intention to issue new shares through a rights issue is known as the announcement date.

Record Date: The record date signifies the day specified by the company to identify eligible shareholders entitled to receive the rights.

Ex-Rights Date: The date on which the company's shares start trading without the rights attached is called the ex-rights date. Investors who purchase shares on or after this date are not eligible for the rights issue.

Entitlement Date: The date on which the company calculates and announces the specific number of rights shares each eligible shareholder is entitled to based on their existing holdings.

Subscription Period: The time frame during which eligible shareholders can subscribe to the rights issue by purchasing additional shares at the predetermined price is known as the subscription period.

Closing Date: The last day of the subscription period, after which no further applications for rights shares will be accepted is called the closing date.

Allotment Date: The date on which the company allocates and announces the allotment of rights shares to subscribing shareholders is called the allotment date.

Listing Date: The date on which the newly issued rights shares are officially listed and begin trading on the stock exchange is referred to as the listing date.

Why Companies Issue a Rights Offering?

Here are some common reasons why companies decide to conduct a rights issue:

• Raising capital:

Companies most commonly issue rights shares offering to raise additional capital. A company may need extra capital to meet its current financial obligations such as debt repayment, funding expansion projects, research and development, acquisitions, or working capital requirements.

• Reducing debt:

Troubled companies typically use rights issues to pay down existing debt, especially when they are unable to borrow more money.

• Expansion:

When a company is planning an expansion of its operations, it may require a huge amount of capital. Instead of opting for debt, they may like to go for equity to avoid fixed payments of interest. To raise equity capital, a rights issue may be a faster way to achieve the objective.

• Mergers and Acquisitions:

If a company is planning to acquire another business, it may conduct a rights issue to raise the necessary funds. This can be a way to avoid taking on excessive debt to finance an acquisition.

• Balance Sheet Strengthening:

Companies might opt for a rights issue to strengthen their balance sheet, improving financial ratios and providing a more solid financial foundation.

Understanding the Options in Rights Offerings

Shareholders typically have three choices regarding how to utilise a rights issue:

• Subscribe to the rights issue in full:

By choosing to subscribe to the rights issue in full, a shareholder commits to purchasing the additional shares offered at the discounted price. This option allows the shareholder to maintain or increase their ownership stake in the company.

Let's take an example.

Suppose you own 1,000 shares in XYZ Ltd. at ₹15 each. Below is how your portfolio will look:

• Portfolio Value = 1,000 shares x ₹15 = ₹15,000
• The company then announces a rights issue in the 2-for-5 ratio. The company announces the issue at a discounted price of ₹8 per share.
• Number of rights shares you can acquire:
• (1,000 x 2/5) = 400 shares.
• Cost to acquire rights shares: 
• 400 shares x ₹8 = ₹3,200.
• Total number of shares after exercising rights issue:
• 1000 + 400 = 1,400.
• Revised portfolio value after rights issue = ₹15,000 (original) + ₹3,200 (rights issue) = ₹18,200.
• Price per share post-rights issue = ₹18,200 / 1400 = ₹13.

In theory, the share price after the rights issue should be ₹13. However, the market value may differ. An uptrend in the share price will benefit the shareholder, whereas a downtrend will cause a loss.

• Choosing not to exercise your rights:

A shareholder may decide not to exercise their rights and not participate in the rights issue. In this case, their ownership stake in the company will be diluted. The company will issue additional shares to those who subscribed, and the existing shareholder's percentage ownership will decrease proportionally.  

• Sell the rights to someone else:

Shareholders can also choose to sell their rights to other investors in the market. The price of these rights is determined by market demand and supply conditions. If the market values the rights higher than the subscription price, selling them can result in a profit for the shareholder. Conversely, if the market values the rights lower than the subscription price, the shareholder may experience a loss.

Advantages of Rights Issues

Below are some advantages that a rights issue unlocks:

• Fast Fund Sourcing:

Rights issues provide a quick and efficient way for companies to raise funds. The process involves offering additional shares to existing shareholders, allowing the company to access capital swiftly.

• Debt-Free Capital:

Since rights issues involve the issuance of equity, companies can strengthen their financial position using a rights issue without increasing their debt burden.

• Low Costs:

Rights issues are cost-effective compared to other methods of raising capital. They typically incur lower costs because underwriting fees, which can be substantial in other forms of fundraising, are not necessarily required.

• Maintaining Ownership:

The additional shares that can be purchased through a rights issue are typically offered in proportion to each shareholder's existing shareholding. This way, shareholders have the opportunity to maintain their proportional ownership in the company. 

• Directorial Control:

In a rights issue, the power of company directors is somewhat restrained, ensuring they don't have undue influence over the rights issue process. This limitation helps in minimising the potential for any misuse of the process. The terms and conditions governing the rights issue are largely influenced by market forces and the collective decisions of the existing shareholders.

Disadvantages of Rights Issue

Just like any other corporate actions, rights issues are not without cons. Some of them are below:

• Share Price Decline Post-Dilution:

Following a rights issue, the dilution effect may lead to a decline in the company's share price. This can affect the value of existing shares held by shareholders.

• Restrictions on Fundraising Amount:

Unlike public offerings, many stock exchanges impose limitations on the amount that can be raised through a rights issue. This restriction can be a disadvantage when companies seek substantial funding.

• Negative Impact on Public Image:

Rights issues are typically initiated when a company requires funds, and the announcement of a rights issue may negatively influence the public perception of the company. This can impact its public image and reputation and thus share prices.

Bottom Line

Rights issues are a key way for companies to get funds, and for current shareholders to keep their fair share of ownership. It's a cost-effective way to get money that benefits both the company and its shareholders.

Understanding how rights issues work helps investors make smart choices, take advantage of good opportunities, and play a role in the growth of the companies they believe in.

That brings us to the end of this chapter. In the next chapter, we shall learn about buyback of shares as part of corporate actions.