What is a Rights Issue in Simple Terms?

Rights Issue, also called Rights Offering, is another way for a company to raise capital. It is a part of the series where we are learning about various ways a company can raise money.

In the last sessions, we have talked about IPO or Initial Public Offering, and FPO or Follow – on Public Offering. I would recommend you go through the posts first to understand the Rights Issue better.

You know that a company can raise capital in two ways. It can be Debt Financing or Equity Financing.

In Debt Financing, companies approach banks to take loans. But, banks may reject their loan applications. It happens with startups or companies that are small in size. Similarly, they have to repay the loan from the next month in case they get loan approvals. Thus, it is not a preferable way to raise capital.

In Equity Financing, companies raise capital through the sale of shares. In other words, they sell their ownership to collect money from the public and other investors. IPO, FPO, and Rights Issue are some of the examples of Equity Financing.

For short-term capital requirements, they prefer Debt Financing, but they prefer Equity Financing for the long term. The reason for that is simple. Equity Financing needs time, money, lots of paperwork, and approvals from concerned authorities.

Now, it is clear that the Rights Issue is a type of Equity Financing. Let’s explore it.

What is the rights issue?

In a Rights Issue, companies give their shareholders the right to buy additional shares at a discounted price. It is in proportion to their existing holdings. Further, it has a fixed period and a fixed ratio.

Thus, companies offer additional shares to its existing shareholders only. It is not open to the public like IPO or FPO. But why do companies not open it for all?

Suppose you have started a partnership firm with some of your friends.

After some time, you need to inject some additional capital. Whom would you approach? Will you ask your existing partners or approach others?

I think you will ask your existing partners first if they are interested in investing more capital. And it is what companies do. They ask their existing shareholders or partners to buy additional shares at a discounted price.

Further, the Rights Issue is less expensive, needs less paperwork, and can come in less time than an FPO. It is a strong reason.

Another reason is the burdensome debt. If the debt to equity ratio of a company is more than 1, it becomes difficult to raise capital through Debt Financing. You can use debt to equity ratio to measure the indebtedness of a company.

The next important thing in the Rights Issue is pricing. For example, the existing shareholders will show interest in investing more in the company only if it comes at an attractive price. Thus, companies must have to set the issue price below its current market price.

Further, the company sets a fixed period to receive bids. It can range from 15 days to 30 days. However, it notifies the dates and other details to its shareholders through an offer letter.

Key Points

  • A public company can only bring a rights issue.
  • It may need capital to expand its business or clear off its debts.
  • The company issues additional shares only to its existing shareholders.
  • The rights issue comes with a discounted price to its current market price.
  • Further, it has a subscription period, and shareholders need to apply to exercise their rights within the period.
  • Rights Issue comes up with a ratio, e.g., 2:5. It means existing shareholders of the company who have five shares can apply for two additional shares.
  • As a shareholder, you can subscribe to the rights issue, transfer the rights to others, or ignore it. It depends on you.

How Does A Rights Issue Work?

Let’s understand the whole process with a simple example.

Suppose you have 100 shares of ABC Company. You bought each share at Rs 100.

The ABC Company brings a rights issue at Rs 50, and at a ratio of 1:1.

Now, you have three options.

Options in a rights issue
Options in a rights issue

Let’s analyze each option in detail.

Exercise rights.

It means you participate in the rights issue.

You have 100 shares of the company at Rs 100 per share.

Further, the issue comes with a 1:1 ratio. It means one new share for each share you hold. Thus, you are eligible for 100 new shares (100*1/1).

[100 is the number of shares you hold, multiplied by the rights issue ratio]

Now, you have to pay only Rs 50 per share. Thus, you need Rs 5000 to acquire 100 new shares.

Once you apply for the rights issue during the subscription period and get additional shares, your total number of shares becomes 200, and your overall investment amount becomes Rs 15000.

So, what is the average price per share post-rights issue?

ParticularsNo. of sharesPrice per share (in Rs)Total investment (in Rs)
Before the Rights Issue10010010,000
Rights Issue100505,000
Post-Rights Issue200?15,000
TABLE 1

You need to divide the total investment amount by the number of shares you have. It is Rs 75 (Rs 15000 / 200 shares).

However, it may not be beneficial for you as the stock exchanges have to adjust the share price post the rights issue.

Share Price Adjustment Post Rights Issue

 In this section, we will find out what will be the ex-right price.

 To know the ex-rights price, you need the following data.

  1. Market Value-Before Rights Issue (X)
  2. Exercise Price of Rights (Y)
  3. Rights Ratio – Numerator (a)
  4. Rights Ratio – Denominator (b)

 And, the formula is (bX + aY) / (b + a)

 Let’s take the above example and calculate its ex-right price.

  1. Market Value-Before Rights Issue (X) = 100
  2. Exercise Price of Rights (Y) = 50
  3. Rights Ratio – Numerator (a) = 1
  4. Rights Ratio – Denominator (b) = 1

 Thus, (bX + aY) / (b + a) = (1*100 + 1*50) / (1+1) = 150 / 2 = 75.

It is equal to your average share price after you exercise your rights. Thus, theoretically, you neither make a profit nor lose. However, the share price can go in any direction after the adjustment.

Renounce rights.

Once a company announces a rights issue, you, as a shareholder, have the right. However, you are not obliged to participate. Thus, if you do not wish to participate in the rights issue for some reason, you can transfer your rights to others. We call it renouncing the rights.

Further, you can also sell part of your rights to others and apply for the remaining portion. 

But, how to sell your rights to others?

You can do it using your brokers trading platform. It comes with a RE (Right Entitlement) symbol after the name of the company. For example, Reliance Industries had come up with a rights issue in May 2020. And, it was trading as RIL-RE.

Note: RIL is the symbol of Reliance Industries Ltd.

However, you can sell the number of REs that you are eligible for. For example, Reliance Industries brought its Rights Issue at a ratio of 1:15. It means you can sell one RE for every 15 shares you hold. However, there is no restriction on the number of RE you can buy.

The company announces a specific period to buy REs. It stops after that. Thus, if you don’t possess the company’s shares, it is an easy option to participate in its rights issue.

Once you possess REs in your Demat account, you can apply for the rights issue.

How is the price of the RE decided?

It is generally, the previous closing price of the stock minus the rights issue price. For example, in the above case of ABC company, we see that the stock price is Rs 75 after the price adjustment. However, its issue price is Rs 50. Thus, it may trade at Rs 25.

However, it can go in any direction, depending on the demand and supply.

How does it benefit the seller?

Suppose you are a shareholder of ABC Company and decides to renounce it. It means you will sell your Right Entitlement (RE) to others.

You sold 100 REs at Rs 25 each in the stock market. Thus, you earn Rs 2500 in total. Further, it will average out the share price indirectly.

For example, you have 100 shares at Rs 100 per share. It means your total investment is Rs 10000. However, you got Rs 2500 by selling REs.

Thus, your average share price becomes Rs 75.

Rs 10000 – Rs 2500 = Rs 7500 / 100 = Rs 75.

Further, sellers can get more benefits if they can sell their REs at a premium price.

However, you might be in a loss if you did not execute your rights or renounce it because the current market price of the share has become Rs 75, whereas your average price is Rs 100.

How does it benefit the buyer?

It is a simple calculation. The buyer buys 100 REs at Rs 25 per share and applies for the rights issue. Then, he is eligible to purchase 100 more shares at Rs 50 per share.

So, let’s calculate his average price per share.

100 REs at Rs 25 each = Rs 2500

100 new shares for Rs 50 each = Rs 5000

Total Investment = 7500 for 100 shares.

Thus, the average price per share is Rs 75 post the rights issue.

Thus, both the seller and buyer have the same average share price after the rights issue. And it is a win-win situation for both parties.

However, buyers can get more benefits if they can buy REs at a lower rate. That will lower their cost of acquisition.

Ignore rights

It is the last option for you in a rights issue.

When you ignore the rights, you do nothing. For example, you neither exercise your rights nor renounce it. Thus, is it a good idea to ignore the rights?

No, it is not a good idea. It is due to share dilution. Let’s understand this with a simple example.

XYZ Company

PARTICULARSMr. AMr. BMr. CMr. DMr. ETOTAL
Number of Shares4015151515100
Shareholding (In %)40%15%15%15%15%100%
TABLE 2

XYZ Company has 100 shares. It has five shareholders. Mr. A is the promotor of the company and holds 40 shares. It is 40% ownership in the company. On the other hand, others possess 15 shares each and thus have 15% ownership.

RIGHTS ISSUE @ 1:1

Now, XYZ Company brought a rights issue to raise further capital in the ratio of 1:1. It means those who have one share is eligible for another one. However, Mr. E ignored the rights issue.

Others participated in the issue. Moreover, Mr. A, the promotor of the company, bought the unsubscribed portion also. Thus, have a look at the new shareholding pattern.

PARTICULARSMr. AMr. BMr. CMr. DMr. ETOTAL
Number of Shares9530303015200
Shareholding (In %)47.50%15%15%15%7.50%100%
TABLE 3

You can observe that Mr. E suffered due to stock dilution. His ownership went down to only 7.5% post-rights issue, which was 15% before. On the other hand, Mr. A took advantage of the rights issue and increased his stake.

Thus, if you are confident about the company and its prospects, it is better to take advantage of the rights issue to get future benefits, both in the form of capital appreciation and dividends.

Types of Rights Issue

There are four types of rights issues in general. They are as follows.

  • Direct Rights Issue – In such type of issues, companies don’t have a backup plan. Thus, if the Issue goes undersubscribed, the company is not able to raise the required capital. It is simple and less expensive.
  • Insured Rights Issue – The company comes with a backup plan. In other words, it is insured or underwritten. Thus, there is an agreement with the Investment Banks or Merchant Banks that they will buy the undersubscribed portion. It helps the company to meet its capital requirements. It is a little bit complex than the previous ones and expensive.
  • Renounceable Rights Issue – You can renounce or transfer your rights to others. The company states it clearly if the rights issue is a renounceable one or not.
  • Non-renounceable Rights Issue – You cannot renounce or transfer your rights to others.

Closing Thoughts

The rights issue provides you an opportunity to buy shares at a discount price than the market price. It looks like an attractive deal. However, it would be best if you looked onto the other side of the coin also. For example, you have to find out the main reason behind the Issue.

Generally, cash-trapped companies bring rights issue as it is an easy way to raise capital. For example, 14 companies have raised money since February this year. It includes several big names like Reliance Industries, Aditya Birla Fashion, Shriram Transport Finance, PVR, M&M Financial Service, etc.

Most importantly, you will observe that the above NBFC companies are having a tough time, whereas others are loaded with debt.

However, the case is different with Reliance Industries. For example, by the end of March 2020, its borrowing was 354,552 Crore. However, Mukesh Ambani was able to clear off debt worth of Rs 161,035 crore since March this year. He achieved this by selling around 25% stake of Reliance-Jio to strategic investors like Facebook Inc. and raising funds through the rights issue.

Further, he has announced to make Reliance Industries Ltd., a debt-free company by the end of March 2021. It shows his confidence and leadership quality.

Thus, it would help if you did not jump to exercise your rights or buy rights whenever a rights issue hits the market. It would be best if you dug a little bit more. However, you need not be right all the time, but most of the time.

I have tried hard to keep things simple for you. However, you can comment below or WhatsApp me if something gets complex for you.

Thanks and regards,

finguru@finlessons.com

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Disclaimer

I am not a SEBI registered financial advisor. Thus, all the views and opinions expressed by me in the posts are from my research and experience. Further, the posts are intended for educational purposes only.

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