A rights issue is an issue of new shares to investors that gives existing shareholders preferential, transferable rights to buy the new shares. Only if they don’t want to take up their rights will other investors get a chance to join in.
Rights issues are usually carried out at a share price that is lower than the prevailing market price. The company wants to make sure that it will raise the money it is looking for so it offers investors a bargain that is hopefully too attractive to turn down.
However, because the new shares are being issued at a discount, a transfer of value will occur from the holders of shares before the rights issue takes place to the incoming investors. To prevent existing shareholders from being diluted, they are given the first option to buy the new shares, in proportion to their existing holding, and if they cannot or won’t take up the offer, they can sell on the right to buy the new shares to someone who is interested.
For example, say there is a company with 1,000 shares valued at £1 each and it wants to raise £500. It could launch a rights issue that offered every holder of one share the right to buy one more (a one-for-one rights issue) at 50p. That 50p price is a long way below the £1 price before it made the announcement. That makes this a “deeply discounted right issue”.
As a holder of 100 shares (10%), if I took up my rights, I would pay the company £50 (100 x 50p) and end up with 200 shares. They would theoretically be worth about 75p each or £150 as I still own 10% of a company that was worth £1000 in total before the rights issue and now has £500 more of assets, so £1,500 in total, but there would now be 2000 shares, so £1,500/2000 = 75p per share.
That 75p has a technical name – the theoretical ex-rights price.
As you can see from this, the value of my original 1,000 shares has fallen from £100 to £75, but I have made that money back on the rights that I took up, so net, I come out of this even.
But what if I didn’t want to take up my rights? Well, in theory, I could sell my right to buy 100 shares at 50p each to someone who did want to take up the rights. That person ought to be willing to pay up to £25 for them (or 25p per right) – the theoretical profit that they are going to make on those shares. In theory then, I would be no worse off, my original shares would be worth less but I would have cash to make up the loss.
The rights change hands as “nil paid rights” and usually, for the brief time that they exist, they trade on the stock exchange as a separate class of shares. In the way that they are priced, they are a lot like warrants or subscription shares.