A rights issue is a corporate action through which companies can raise additional capital from their existing shareholders. Shareholders are invited to purchase stocks by issuing rights, and these stocks can be bought at a discounted price. This means that the price of shares offered during a rights issue is lesser than the market price at which the shares will trade in the secondary market on a future date.

The shareholder is under no obligation to mandatorily take up this offer. They can choose to participate in this corporate action after understanding what the rights issue entails and what it could mean for the company in question. 

Rights issue could be done to fund expansion, improve the debt-to-equity ratio and pay off existing debt. They can let the opportunity lapse, claim the offer in part or in full, or sell their existing shares to others when such an offer is announced.

Why do companies offer rights issues to their shareholders?

Rights issue a method through which companies can raise additional capital. This capital could be required for a number of reasons. Let’s have a look at some of them –

– Rights issue may also improve the debt-to-equity ratio, therefore, giving companies better leveraging opportunities. 

– Once the debt-to-equity ratio reduces, the company can raise debt more easily.

When should an investor participate in a rights issue?

Often, companies offer rights issues to expand their operations. In this case, since the funds raised by the company aid expansion, participating in a rights issue could potentially promise more rewards later. However, shareholders can only participate in a rights issue if they pass the eligibility criteria for it. Here’s how –

Rights issues are given to shareholders in proportion to the number of shares already held by them. However, these stocks should be in the shareholder’s possession before the record date and ex-date.

Record date: The day on which the company assesses its records to check which shareholders qualify for the rights issue is called the record date.

Ex-date: Shares bought on or after the ex-date, a day before the record date, are not eligible for the rights issue. When you buy shares, it takes T+2 days for the stock exchange to settle the transaction. So, shares that are bought on the ex-date or after will not reflect in your account on the record date, making you ineligible for the rights issue.

What are the benefits of participating in a rights issue? 

While offering a rights issue has many advantages for a company, it also offers some benefits to the shareholders. Here are a few –

–  Shareholders can get more stocks of the company at a discounted price, thereby increasing their stake in the company for cheaper than the prevailing market price.

–  Without giving up their rights in favour of new shareholders and diluting the shareholding, the existing shareholders can retain the control of the company.

–  Shareholders are imbibed with a sense of confidence in the company when shares are offered at a discounted price in a rights issue.

–  The company raises more funds without the burden of more debt, which is better for its financial health.

What are the disadvantages of a rights issue? 

The reasons for a rights issue could be several, but they come with certain drawbacks. The disadvantages of a rights issue could be particularly felt when the company opts for a rights issue when it is in financial trouble –

Since companies often raise funds through rights issues if they are strapped for cash, it could be a warning signal for investors. 

– The information that a company is strapped for cash negatively affects its reputation and lowers the share price.

– The overall number of shares issued by the company could increase, thereby spreading the profit across these shares and dealing a blow to earnings per share (EPS).

– When sold in the open market, the value of shares issued in a rights issue could dilute because of an increased market supply.

– Shareholders may view a rights issue as a sign of a struggling company and sell their shares, which could bring down the share price.

– In the case of companies that are growing at a slow rate, a rights issue could find few takers.

Conclusion

Before participating in a rights issue, shareholders should do their due diligence and find out why the company has chosen this method to raise funds. A rights issue introduces additional shares in the market. The value of the stock, as a result, dilutes. However, if the capital raised from a rights issue is used for the expansion of businesses, it could lead to the growth of the company, and, subsequently, more potential returns for the investors.