Most companies raise extra cash from time-to-time – either by borrowing money or by selling new shares.
Rights issues are one fairly common way companies raise money by selling new shares.
What’s a rights issue?
In a rights issue existing shareholders are given the opportunity to buy a set number of new shares in the company they own. These new shares are often available at a discount to the existing share price, to encourage investors to take part.
The money raised from the sale of new shares could be used for any number of purposes – it could be to buy a rival, invest in a new product or even pay down debt to shore up a creaky balance sheet.
So how does it work in practice? Well, take the example below.
ABC Plc has decided to raise money from its shareholders via a rights issue. Its shares currently trade for £10 each. The company has given each shareholder the opportunity, or right, to buy one new share in ABC plc for every two they already hold. Those new shares will cost £5 each.
There’s quite a lot going on here so let’s unpack it a bit.
Firstly this is what’s known as a 1-for-2 rights issue – every two existing shares you own in ABC Plc lets you to buy one new share. The ratio of new shares to old shares is decided by the company when the rights issue is announced, and is the same for all shareholders.
Secondly the new shares are available at a deep discount to the market price – half the price in fact. Again, the price of the new shares is set by the company and is the same for all shareholders. The discount encourages shareholders to buy the new shares, but also means the “right” to buy the shares has a value all of its own.
What makes rights issues a bit more complicated is that it’s possible to separate the right to buy new shares from the old share themselves. Investors can sell the “right” to new shares, while keeping hold of their old shares.
What does a rights issue mean for investors?
When a company you’re invested in announces a rights issue you have three choices. You can take up your rights, sell your rights or do nothing and let your rights lapse.
- Taking up your rights – if you decide to take up your rights you will be investing more money in the company in return for more shares in the business.
- Selling your rights – because rights can be separated from the existing shares you can choose to sell them to another investor. The buyer can then buy the shares you had originally been allocated at the discounted price. Rights trade separately on the stock market, but are generally valued at close to the difference between the current share price and the discounted sale price.
- Do nothing – in this case you let your rights expire without taking them up or selling them. In some cases the rights issue might have been underwritten by a bank (which buys any shares that go unbought by shareholders) in which case the underwriter might buy the rights off you. Otherwise the rights will lapse and become worthless.
Why buying shares through a rights issue is different
An important distinction between buying shares through a rights issue and buying them on the stock market is that, in a rights issue, you’re not increasing your share of the company. Because all shareholders are offered new shares in proportion to their current investment, investors who take up all their rights end up with the same share of a bigger pie, rather than a bigger slice of the same pie.
If you decide not to take up all your rights, you will end up owning a smaller portion of the company.
Going back to our ABC example. The table below sets out the situations if an investor does and doesn’t exercise their rights.
|Number of shares before rights issue||Number of shares after all rights exercised||Percentage of all shares owned|
|Total number of shares in ABC Plc||1,000||1,500||100%|
|Number of ABC Plc shares owned by an investor who exercised all their rights||100||150||10%|
|Number of ABC Plc shares owned by an investor who didn’t exercise their rights||100||100||6.7%|
Should I take up my rights in a rights issue?
Seeing your share of a business shrink is never comfortable – and that leaves many investors feeling they have to take up their rights.
However, the reality is that every rights issue is different, and you should judge each on its own merits. You might not be increasing your share of a business by taking up your rights, but you are increasing the proportion of your money invested in that company.
As with any investment that could turn out to be a good or bad decision. If the company uses the money it’s raised wisely, your extra investment could generate a good return. But there’s also the risk you end up throwing good money after bad.
We would generally suggest investors separate the investment decision from the novelty of a rights issue.
If you would be happy to buy shares at the current market price then a rights issue could be a good opportunity to increase your investment in the business. Equally, if you wouldn’t have considered investing more money before the rights issue then it might not be a good idea to invest more now, and you might be better off selling your rights.
This article is not personal advice. As always, if you’re unsure about an investment decision you should ask for advice.
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