When a listed company needs to raise a large sum of money, it has a few options. It can borrow, sell assets or ask its shareholders for more cash. A rights issue is the last of these, and in the UK it is a familiar way for companies to raise money, especially in difficult times. For a shareholder, the news can be unsettling, so it helps to understand what is actually being offered and why the share price often reacts the way it does.
The basic idea
In a rights issue, a company offers its existing shareholders the right to buy new shares, usually at a discount to the current market price. The offer is made in proportion to what they already own. A one-for-four rights issue, for example, gives shareholders the right to buy one new share for every four they hold.
The word rights matters. Shareholders are not forced to buy. They can take up their rights, sell them to someone else, or in many cases do nothing and let them lapse.
Why companies do it
Companies use rights issues for many reasons. Some need to repair their balance sheet after a difficult period, reduce debt or shore up their finances. Others want to fund a large acquisition or a major investment that is too big to finance from their own cash.
The reason matters a great deal to how investors react. A rights issue to fund a promising expansion can be received quite differently from one forced by losses or lenders. In the UK, rights issues rose sharply during the financial crisis, when several banks needed to rebuild their capital, which is one reason the term can carry a negative feeling.
Why the discount exists
New shares are usually offered below the market price to encourage shareholders to take part and to give a cushion in case the share price falls during the offer period. Large rights issues are often underwritten by investment banks, which agree to buy any shares not taken up, in return for a fee.
What happens to the share price
When a rights issue is announced, the share price often falls. Part of that is simple arithmetic. If a company issues many new shares at a discount, the value of the business is spread across more shares, and the price tends to move towards a blended level known as the theoretical ex-rights price. Part of it is sentiment, because investors may read the need for fresh cash as a sign of weakness, or worry about how the money will be used.
Shareholders who do not take part see their ownership diluted. Their percentage of the company shrinks because new shares have been created and bought by others. Our guide to earnings per share explains why more shares can mean a smaller slice of profit for each one, at least until the new money starts generating returns.
The choices a shareholder faces
Taking up the rights means paying for the new shares and keeping your ownership percentage the same. This only makes sense if you are comfortable putting more money into the company.
Selling the rights is possible because, during the offer period, the rights themselves usually trade on the stock market. Selling them can compensate partly for the dilution.
Doing nothing is an option too. In many UK rights issues, rights that are not taken up are sold on the shareholder’s behalf and any proceeds above the offer price are passed back, but the details vary and it is worth reading the company’s documents carefully.
How it differs from a placing
Companies can also raise money through a placing, where new shares are sold to a selected group of institutional investors rather than offered to everyone. Placings are faster and cheaper to arrange, but existing shareholders may not get the chance to take part, which can cause more dilution for smaller investors.
Why traders watch rights issues
A rights issue can move a share price sharply, both on the announcement and during the offer period. Sometimes the news arrives after a profit warning, when the company has already disappointed investors. Large moves can also leave a price gap on the chart when the market opens.
The takeaway
A rights issue gives existing shareholders the chance to buy new shares at a discount so the company can raise money. It can strengthen a business, but it also dilutes those who do not take part, and the reason for the cash call often matters more than the discount.
If you want to understand how corporate events move share prices, our free trader assessment can help you see what to learn next.
