Rights Issue: Raising Capital from Existing Shareholders

Key Takeaways

• A rights issue gives existing shareholders the pre-emptive right to buy new shares at a 20–40% discount to market price.
• The theoretical ex-rights price (TERP) formula shows the stock price after distribution lies between the old price and the subscription price.
• A shareholder who neither subscribes nor sells their rights loses the TERP-to-subscription-price spread for nothing.
• Participating pro-rata preserves your ownership percentage but all per-share metrics still dilute as the share count rises.

What It Is

In a rights offering, every shareholder on the record date receives subscription rights. A typical structure might be "one new share for every four held, at a subscription price of $8, when the stock trades at $10." If you own 400 shares, you get 100 rights, and you can use them to buy 100 new shares at $8 each.

Rights are usually valid for two to four weeks. At the end of that window, the rights expire worthless if unused. In most European markets and in many US structures the rights are transferable, meaning they trade separately on the exchange. If you do not want to put up the cash, you can sell the rights to another investor who does.

The subscription price is almost always set at a meaningful discount to the prevailing market, typically 20 to 40 percent. The discount is not a gift. It is a buffer that ensures the offering gets fully taken up even if the market drifts down during the subscription period.

The Intuition

A rights issue solves two problems at once. The company raises equity without going to new outside investors, and existing shareholders get a pre-emptive chance to protect their ownership percentage.

Without a rights issue, the alternative is a follow-on offering sold to new buyers, which mechanically dilutes existing holders. With a rights issue, a shareholder who participates pro-rata ends the process owning exactly the same percentage of the company they started with, just at a lower per-share price. A shareholder who does not participate and does not sell their rights is the one who pays the dilution cost. That cost is paid to the participating shareholders and, if rights are tradable, to whoever bought the rights in the open market.

Rights issues are more common when a company needs capital and its existing owners are the most credible source. Banks recapitalising after losses, REITs funding acquisitions, and smaller firms with deep-pocketed anchor holders are frequent issuers.

How It Works

Three numbers drive the arithmetic: the current price, the subscription price, and the ratio of new shares to existing shares.

The theoretical ex-rights price (TERP) is the weighted-average price the stock should trade at on the first day it trades without the rights attached.

TERP = ((existing shares * market price) + (new shares * subscription price))
       / (existing shares + new shares)

TERP lies between the old market price and the subscription price. The value of a single right, if tradable, is approximately:

right value = TERP - subscription price

On the ex-rights date, the stock typically opens near TERP. That drop is mechanical, not a judgement on the business. If you subscribe, you give up cash and receive new shares at the subscription price. If you sell the rights, you receive cash that roughly offsets the mechanical price drop on the shares you already held. If you do nothing, you bear the full dilution.

In the US, registered rights offerings are filed with the SEC on Form S-3 or S-1 and governed by the Securities Act of 1933. Prospectuses on SEC EDGAR set out the subscription ratio, the price, the record date, the transferability of the rights, and any over-subscription privilege that lets participating holders buy shares left unsubscribed by others.

Worked Example

A company trades at £9.00 and announces a 1-for-10 rights issue at £7.00. If you hold 100 shares, you receive 10 rights, each allowing you to subscribe for one new share at £7.00.

TERP works out as follows:

TERP = ((100 * 9.00) + (10 * 7.00)) / (100 + 10)
     = (900 + 70) / 110
     = 970 / 110
     = 8.82

The stock should open around £8.82 on the ex-rights date. If you exercise all 10 rights, you spend £70 and end with 110 shares at a theoretical value of 110 * £8.82 = £970. Your total wealth is £970 in stock plus £70 cash spent, matching the £900 you had before plus the £70 you contributed.

If you sell the rights instead, each right is worth roughly £8.82 - £7.00 = £1.82. Selling all 10 yields £18.20. Your 100 shares drop from £900 to £882, a £18 fall, broadly offset by the £18.20 you collected. If you do nothing and the rights lapse, you lose that £18.20 of value for no reason.

Common Mistakes

1. Letting rights lapse without acting. If you neither subscribe nor sell, you take the dilution and get nothing in return. Brokers are required to notify holders of corporate actions, but messages are easy to miss. Check every email and statement for a rights-offering deadline.

2. Assuming every rights issue is bad news. Some rights issues fund distressed recapitalisations, but others fund accretive acquisitions or growth projects. The market reaction depends on the use of proceeds and the credibility of the plan, not on the structure itself.

3. Confusing TERP with the actual ex-rights price. TERP is a theoretical anchor. The market can open above or below it depending on how it interprets the signal behind the raise. Treat TERP as a benchmark, not a forecast.

4. Ignoring dilution when you do subscribe. Participating pro-rata preserves your percentage ownership but still lowers each share's claim on future earnings. EPS, book value per share, and dividend per share are all diluted by the larger share count. The subscription price matters: the deeper the discount, the greater the per-share dilution.

Frequently Asked Questions

Q: What is a rights issue in simple terms? A rights issue is a company selling new shares to its existing shareholders at a discount before offering them to anyone else. Each holder receives "rights" proportional to their current stake, which they can use to buy shares at the discounted price, sell to another investor, or let expire worthless.

Q: How does a rights issue affect investment decisions? If you participate pro-rata your ownership percentage is preserved, but your total investment increases. If you do neither subscribe nor sell your rights, you are diluted and lose the rights' embedded value for free. The discount is not a gift, it ensures the offering is attractive enough to complete even if the market dips.

Q: What is a real-world example of rights issue pricing? A company trading at £9.00 announces a 1-for-10 rights issue at £7.00. The TERP, what the stock should open at on the ex-rights date, is £8.82. Each right is worth approximately £1.82. Letting rights lapse gives away that £1.82 per right at no benefit.

Q: How can investors handle a rights issue correctly? Act before the deadline: either subscribe using the rights to maintain your percentage, or sell the rights on the open market. Never let them lapse. Check whether the company is raising capital for growth or distress, since the signal behind the raise matters more than the mechanics.

Q: How is a rights issue different from a secondary offering? A rights issue gives pre-emptive priority to existing shareholders at a discount, letting them avoid dilution by participating first. A secondary offering (follow-on) typically goes to all investors at a small discount with no pre-emptive window, which is why it dilutes existing holders automatically.

Sources

1. Mayer Brown (practitioner primer on SEC free writings site). "What's the Deal? Rights Offerings." https://www.freewritings.law/wp-content/uploads/sites/24/2020/06/WTD-Rights-Offerings.pdf
2. Winston & Strawn. "Equity Rights Offering Considerations As Maturity Cliff Looms." https://www.winston.com/en/insights-news/equity-rights-offering-considerations-as-maturity-cliff-looms
3. Finance Strategists. "Theoretical Ex-rights Price (TERP): Meaning and Calculation." https://www.financestrategists.com/wealth-management/stocks/theoretical-ex-rights-price-terp/
4. SEC EDGAR. "Sample Subscription Rights Prospectus (Rule 424(b) filing)." https://www.sec.gov/Archives/edgar/data/1490281/000149028123000129/a424b5-11212023.htm

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.