Companies need money
. There are many ways in which a company can get money
. Most companies get most their money by borrowing
. The money they borrow is in addition to the equity
they have raised when they were formed.
There are limits to the amount of money a company can borrow at a reasonable interest. In general, when a company has more equity, it can borrow more money. So, if a company wants to borrow more, it may need to raise equity. One of the ways it can do so is by means of a rights issue. This is the subject of this node.
What is a rights issue?
A rights issue is an issue of rights to the shareholders of the company to buy more shares, at a (steep) discount to the current price of the shares, at or before a certain time. As such, they behave as call warrants. For instance, a company might be trading at 10 euros. It may issue the right to buy one more share at 5 euros for each share you have.
Now, with shares trading at 10, this is of course a bargain. So, let us assume everyone exercises their rights. This means everyone sinks 5 euros in the company, and is now holding the exact same fraction of the company he or she had before, only now in the form of 2 shares instead of 1. The value of the company has of course gone up as well, as it now has the value of the original company, plus 5 euros per share. As such, the 2 shares are theoretically worth 5 plus 10 = 15 euros, so 7.5 euros a share.
At the moment the rights issue is perfomed,, the share price will - in theory - drop to 7.5 euros. You will be holding a claim that is worth 2.5 euros to buy a share that is worth 7.5 at 5 euros. So, the math balances out.
What just happened is in essence the exact opposite of a dividend. Instead of getting money because you own part of a company, you now have to pay for that privilege.
Consequence of a rights issue
There are two broad reasons why companies do a rights issue: to do a large take-over, or to save them from bankruptcy. As such, the price of the shares changes not just because of the rights issue, but also because the market digests the news that a company needs the capital. In principle, the decision to raise equity by means of a rights issue can be seen as a Good Thing or a Bad Thing, so the actual share price can deviate from the theoretical value.
In principle, a rights issue is good news for bond holders. Even though shareholders are (practically) forced to chip in to keep their stake in the company, bond holders just see that the chance their loans get paid back increases. In fact, the possibility that a company will do a rights issue, especially one at a steep discount and/or for a large amount of equity, is one of main reasons even deeply subordinated debt is less risky than shares.
Another consequence is that the price of shares goes down. Imagine for instance a company worth 8 euros per share, issuing 10 rights to buy a share at 80 cents. In this scenario, the sum of the value of the shares is 8 + 10 * 0.8, or 16, and this is divided over 11 shares, so one share should be worth 1.45 euros. Note that this drop in share price from 8 to 1.45 was necessary to just double the capital. Often, a company will consider a reverse stock split. In this case, if the company does a 5:1 reverse stock split, your shares would be worth 7.45 again. You'd now have 2.2 shares for each old share you had, and paid 8 euros for that.
What should I do if the company whose shares I own announces a rights issue?
Sometimes, it is possible to sell the claims
. Otherwise, you should always exercise them, unless the value of the shares drops below the claim value. This should normally happen only rarely, but if it does, a company cannot raise equity
, and is likely in a lot of trouble
. Essentially, it means that the market is not even willing to buy sharess
at the much lower level of the rights issue
A rights issue is one of the ways in which a company can raise more equity. It awards call warrants to current shareholders proportional to the number of shares they hold. These rights allow the shareholder to buy the stock at a discount, allowing the company to have more capital, but diluting the value of one share: the company is now essentially divided in (many) more shares. If one is confronted with a rights issue, one should either sell the right or exercise it, provided that the price at which one can buy the shares is lower than the current market price.
Standard disclaimer: This is meant as general background information, not as investment or trading advice. Don't take financial advice from random anonymous strangers on the Internet.