Rights Offerings

An often overlooked means of raising new capital is through a rights offerings or rights
issuance. Rights issues occur when a firm sells new shares to those investors who have
"rights." Rights give their holders the right to buy the new shares at the subscription
price. To see how these work, an example is necessary.

The first step is to determine how much the firm needs to raise. For our example suppose
a firm needs to raise $50 million dollars. Currently they have 22 million shares
outstanding at a price of $25 a share. The next step is to determine a subscription price.
The subscription price is the price at which the rights holders purchase the new shares. In
this case let the subscription price be $15/share.

In the United States it is common to give a right for each share. So there will be 22
million rights granted. How many shares must you sell?

Number of new shares = (Amount you need to raise) / (subscription price)

So in this case:

$50,000,000/$15=3,333,334 new shares

How many rights will be needed to buy a single new share?

(Number of rights granted) / (Number of shares being sold)

22,000,000 / 3,333,334

6.6 rights / new share

The next logical question is what each right is worth. Unfortunately that is not quite as
easy to answer. The first thing that must be done is to calculate the price of the stock
after the issue and after the new shares have been sold. To do this we make some
assumptions. Notably we assume that the everyone will exercise their rights (we can relax
this later but it is generally a very good assumption), and more importantly that the
investment opportunities will not change and further that the rights issuance does not
change the operations of the firm. If this is true, then pricing is quite simple:

Overall equity value after issuance = Equity value before issuance + amount raised

= (shares * Price) + amount raised

= 22,000,000* $25 + $50,000,000

= $600,000,000
Total number of shares (post issuance)

Number of shares outstanding before the issuance + new shares issued

22,000,000 + 3,333,334

25,333,334

Price per share = new total market value / new number of shares

= $600,000,000 / 25,333,334

= $23.68

Now we can calculate the value of each right.

New price = subscription price + [(number of rights needed) * ( value of each right)]

$ 23.68 = $15.00 + [( 6.6) * (value of each right)]

Solve for the value of each right

Right = $1.315

Note that ex-right price plus value of right = old stock price.

23.68 + 1.315 = 24.995= $25.00

This can also be found by

Right price = (Old price - subscription price) / (number of rights per new share + 1)

=($25.00 - 15.00) / (6.6 + 1)

=($10.00)/(7.6)

= $1.315

If these rights are deemed as transferable, they can be sold on the secondary market. Most
rights offerings involve transferable rights.
 FAQ
My company just had a rights issue my rights, what should I do with
them?You should always either sell or exercise your rights. If you sell your rights, your
percentage ownership will drop but your wealth will be unaffected. If you exercise your
rights you will both your wealth and your percentage ownership will be unaffected. (of
course you will have less cash).

To see this, lets go back to our earlier example but also assume that you own 3,300 shares
or .00015 of the company.

Three days before the rights issue suppose you have $100,000 in your portfolio. This is
made up of $82,500 in the company and $17500 in cash. Now supposing no stock price
reaction and the rights issue is transferable you could

a. Exercise the rights:

As you have 3300 rights you could buy 500 new shares. These
shares would cost you 500*the subscription price of $15 or $7500
total

After you (and everyone else exercises) you would have 3800 shares worth 23.68 each
for a total of $89,984. You would also have $10,000 in cash remaining. Thus you would
have $99,984 which is approximately $100,000. (The difference is due to rounding since
you can not issue fractional shares (by assumption). .

Note that your percentage ownership has not changed either. You now own 3,800 /
25,333,334 or .00015% the same as before.

A. Sell your rights:

If you do not want to put more money into the firm, you could sell
the rights. In this case you would sell 3,300 rights at $1.315 per
right for a total of $4,339.50.

In this case your portfolio would be compose of 3300 shares at

$23.68 each for a total of $78144 plus cash of $17500 from before
and $4,339.50 from the rights sale for $99,984. (again the
difference is due to rounding).
 Note that if you do sell your rights, you will lose your percentage
ownership. In this case you would be left with only 3,300/
25,333,334 or .00013 of the entire firm.

B. Do nothing

Obviously it is your right to do nothing. However, in this case you would be losing
money. For example if you do not sell nor exercise your rights, you would be left with
3,300 shares * $23.68 for $78144 plus your original $17500 for a portfolio total of only
$95,600.

Conclusion: always exercise (good advice for life as well!) or sell your transferable rights
or else you will be subsidizing the portfolios of other shareholders.

Obviously this is well known and the vast majority of shareholders do follow this advice
which is why most people participate in rights offerings.

Does the subscription price matter?

No. At least not to any great extent. You can make it more likely to get exercise (ie force
people to take action by making the subscription price low enough). Try setting the
subscription price at $10 a share and see what happens if you do not exercise (hint it will
be a bigger loss).

Why are poison pills sometimes called Shareholder Rights Plans?

Poison Pills are merely rights offerings that are restricted. The shareholder that has
caused the pill to be enacted (the hostile acquirer) is not allowed to participate. This hurts
the acquirer. Note also the subscription price in a poison pill rights issue is extremely
low, often zero.

Who uses rights issues to raise new money?

Any firm can use rights issues. Closely held firms are more likely to do these. This is
especially true if there are large insiders willing to buy new shares. That more firms do
not use rights issues has been the subject of speculation. Cliff Smith (in Alternative
Methods of Raising Capital: rights vs. underwritten offerings: JFE 1977) reports that
direct costs of a rights issue are between 3 to 30 times less than the an underwritten issue.
In spite of this cost savings, underwritten issues are much more common. Why? Best
explanation is that the investment banker provides valuable monitoring.

Support for this monitoring can be found looking at closed end mutual funds. (Miles and
Peterson 1997). Rights issues are particularly common in the closed end investment
industry (closed-ends mutual funds). As the closed-end fund manager is using the
proceeds to invest in financial assets, it is highly unlikely that there are positive NPV
projects available. However, fund managers can set the subscription price low enough to
force exercise thus increasing the assets under management and subsequently managerial
fees and compensation.

An alternative explanation for the scarcity of rights issues is that investment bankers do
not like them and that they have been successful in campaigning to public issues.

What is an underwritten rights issue?

Firms that choose to do a rights issue can market the rights themselves. This is cheaper
but the firm assumes any risk of the shares not selling. (see above about forcing exercise).
In an underwritten rights issue an investment banker guarantees a minimum amount of
proceeds, thus protecting the firm from under-subscription.

Do stocks fall in value on announcement of rights issue?

Sometimes. Early studies suggested yes, for example Rao reports Hanson's paper of a
fall of approximately 4% (1989) in Review of Financial Studies. More recent papers
have the fall being less. For example Eckbo and Masulis report minor loses for non-
underwritten issues.