Rights issues: a beginner's guide

A rights issue is a way for a company to raise new capital by issuing new shares. Company law states that, in most cases, existing shareholders should have first refusal for these shares, known as pre-emption rights, so the new shares will be offered to investors in proportion to their existing holding.

The usual reason for a company to launch a rights issue is either to fund expansion (by acquisition or capital investment) or to repair the balance sheet. The issue will be accompanied by a prospectus, similar to that for a stock market flotation, outlining the reasons for the issue and the risks attached.

The new shares will invariably be offered at a discount to the current market price, to encourage shareholders to take them up and to protect the issue against any market falls before the issue closes: the riskier the issue is perceived to be, the bigger the discount.

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Rights issues are usually underwritten, which means an investment bank guarantees to buy any shares not taken up by the company’s shareholders and places these with institutional shareholders. There is a fee for underwriting, so there have been attempts to reduce the costs of rights issues by offering such a deep discount to the existing shares that shareholders would be bound to take it up.

Today, however, companies generally both offer a sizeable discount and have the issues underwritten. That reflects the reluctance of investors to commit new money to the stockmarket in the uncertain economic climate.

The price of the company’s shares generally falls after the rights shares have been issued, reflecting the fact that new shares have been issued at a discount. Analysts will calculate a theoretical ex-rights price to help them assess whether it is worth subscribing to the new issue. This is worked out by adding the value of the existing shares to the amount required to subscribe for the new ones, then dividing that by the increased number of shares in issue.

For example, if you hold 100 shares priced at £10, and are offered one new share for every 10 held, priced at 700p, the theoretical ex-rights price will be calculated as £1,000 (100 x £10) plus £70 (10 x £7) divided by 110 (100 existing shares plus 10 new ones), or £9.73. If the theoretical ex-rights price drops below the rights price, there would be no point subscribing for new shares.

If a company you are investing in has a rights issue, you have four main options:

Subscribe for the new shares, which means you have to invest more money in the company;

Do nothing and let your rights lapse, although you should be aware that by doing so you will be diluting your stake in the company, including your entitlement to future dividend payments. If you do this, your rights will be offered for sale to other investors and you will be sent any proceeds by the company’s share registrar;

Sell your rights to take up the shares in the market. The company’s registrar may offer this service as part of the rights issue process;

A combination of 1 and 3 under which you sell enough of your rights to finance the take-up of the remainder.

What to be aware of

Your decision on which option to take will depend both on your financial situation and on the reception of the rights issue. If the company’s existing shares fall below the price the new ones are being offered at – as happened with the rescue rights issues launched by banks such as Royal Bank of Scotland at the height of the financial crisis – there is no point subscribing, as you can buy the shares more cheaply on the stock market. An issue to finance expansion by the company is likely to be less heavily discounted and better received than a rescue, or refinancing, issue.

If the rights issue is large, the company’s share price may be depressed for some time afterwards as the market adjusts to the new supply.

Other corporate actions

Demerger

A demerger means splitting a company in two. This is usually undertaken because the parts of the business do not have much in common and the management has come to the belief that keeping them together means that one or both parts of the business are not being correctly valued by the stock market.

Consolidation

A share consolidation is used to reduce the number of shares in issue, typically where the share price has fallen substantially. Existing shareholders end up with fewer shares, but their stake in the company and their share of the dividends will be the same as before.

Share split

The opposite of a consolidation, a share split can be used when the price of a share has increased so much that buying just one share is very expensive. Investors end up holding more shares, but again their effective stake in the company remains the same.

Scrip or bonus issue

The issue of new shares to all shareholders, indicating the company is in good health and has excess capital that it can return to shareholders.

We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.