Last Updated on Aug 27, 2021 by Kushal Dudheria
Your mom has cooked a large yummy pie. Of course, you as a family member, get the first ‘right’ over it before the pieces are distributed among the neighbourhood kids. Something similar is observed when companies take corporate measures to raise additional capital and make the rights issue. Existing shareholders get the first dibs on the issue before it is thrown open in the secondary markets. In this article we dive deep into what is a right issue and its features.
Table of Contents
The article covers:
- What is a rights issue?
- Types of right issue
- Why do companies undertake the right issue?
- Why do shareholders buy the right shares?
- Example to understand right issue
- Features of right issue
- Procedure for right issue
- Downsides of right issue
What is a rights issue?
A rights issue is a way of raising additional capital from the shareholders of a company. In a rights issue, the company first extends an invitation to its existing shareholders to purchase the shares before it is opened up for take in the secondary markets.
The right issue is only an invitation and not a compulsion. However, it is imperative to note that existing shareholders of the company have an opportunity to purchase the additional shares at a discount to the market price on a stated future date.
Also, the rights issue happens on a proportional basis to existing shareholding. For example, a 2:5 rights issue means that an existing shareholder can purchase 2 shares for every 5 shares they hold.
In the case of a right issue, the shareholders willing to buy additional shares in the company can exercise their rights on a stipulated date and at a price asked by the company. If the shareholders don’t exercise their rights within the stipulated period, their preemptive right gets lapsed, and the shares are offered in the secondary market.Rights issue gives you a right to buy more of a company's stocks at a discounted price Click To Tweet
Types of right issue
Rights issued are classified based on various parameters as discussed below.
Right issue based on payment terms
Issue of fully-paid right shares: the shareholders must pay the whole of the issue amount upfront at the time of allotment.
Issue of partly-paid right shares: where the entire issue amount is not demanded upfront. Instead, only a part of it is asked upfront, and the rest is paid in subsequent calls.
Right issue based on the transferability of rights
Issue of renounceable right share: the shareholders can sell their rights in the open market to other investors if they don’t wish to exercise their rights.
Issue of non-renounceable right shares: the option of transferability is not at the disposal of shareholders. Either they can subscribe to the shares, or the right will lapse post the record date.
Why do companies undertake the right issue?
- Companies might look to realign their debt-equity ratio by securing additional equity capital.
- Companies may issue rights shares to arrange capital for their expansionary motives. For example, when the company is looking to step into an untravelled business landscape or to add more versatility to their existing products or services, they may require heavy capital infusion. A rights issue helps the company access funds quickly.
- To pay off the existing debts owed by the company and thereby fostering the company’s financial health.
- To arrange funds for a project or a venture for which the company cannot undertake debt financing. The reason for no further scope for debt financing can be the optimum debt financing limit being already utilized by the company.
Why do shareholders buy the right shares?
Right issue is not a million-dollar shortcut to get rich, but indeed a cue for the shareholders to consider increasing their stake in the company. Moreover, shareholders are offered the shares at a discounted price – lower than the price at which the shares are offered in the open market.
Shareholders have the option to renounce their rights to other investors if they don’t wish to subscribe to any further shares. By trading the rights, the shareholders can secure a cut for themselves!
Example to understand right issue
Mr. B is holding 100 shares @ Rs 100 each in QPR Limited. The company decides to undertake the right issue and offers the right shares in the ratio 1:2, @ Rs 75 per share. This means each existing shareholder is given the right to buy 1 share for every 2 shares held. Mr. B accordingly gets the right to buy 50 at a discounted price of Rs 75 for the 100 shares he holds.
Now Mr. B has the following options at his disposal:
- First, fully exercise the right allotted to him.
- Ignore the right issue, and the option will lapse.
- Exercise the right in part, and the remaining right shares will lapse in this case.
- Renounce the entire option or a part of it to investors in the market.
If Mr. B decides to exercise the right, his new holding in the company would be 150 shares @ Rs 91.67. ( 100*100 + 50*75 / 100+50 )
Features of right issue
- By means of a right issue, the company increases its paid-up capital.
- The company’s needs for funds are satisfied without incurring the underwriting commission as the case with fresh issue of shares.
- Right issue is generally offered in the proportion of shares held by existing shareholders.
- Right issue is not obligatory for the shareholders, it is only an offer and not a compulsion for the existing shareholders. Therefore, shareholders may decide to ignore their rights.
- If the right issue lapses, it will result in dilution of existing shareholdings and voting rights.
Procedure for right issue
It’s not a complex procedure. For the shareholders, it’s pretty straightforward.
The company holds its board meeting post serving a notice at least 7 days before the meeting to pass the resolution for the right issue of shares.
The shareholders are sent the intimation via a ‘ letter of offer’ of the right issue. The shareholders are expected to subscribe to the shares before the ‘ ex-record date,’ generally 15-30 days.
If the shareholders fail to respond to the letter of offer, the offer is deemed declined. Note: the offer must be open for at least 3 days post the disbursement of the letter of offer.
The company files MGT-14 within 30 days from the board meeting. The company asks for the application money and is required to allot shares within 60 days from allotment money. The company then holds the second board meeting to pass the resolution for the allotment of shares.
Required forms to be filed with ROC are filed, and the share certificates are issued.
Downsides of a right issue
Going for the right issue might be construed by investors as a sign that the company is facing a financial crunch and passes on a negative message to the shareholders and would-be shareholders. This deteriorates the goodwill and the share price of the company. This need not necessarily be true though.
The holdings of the existing shareholders are diluted to a fair extent post the right issue. Dilution of shareholdings results in loosening of control of the shareholders over the company.
Right issue increases the total number of shares issued by the company, and thus the earnings made by the company would be distributed among the increased number of shares. This will decrease the earnings per share.
Right issue is not a new weapon in the artillery; companies have been welcoming to right issues in the past. It enables companies to meet their fund requirements, pay off their debts, infuse a positive cash inflow, and most importantly, serves as a tool to bridge the gap between debt and equity. The investors should not fall for the lucrative price discounts offered by companies and should only invest after exploring the company in and out.