Rights Offering (Issue) Definition, Types, Pros and Cons

What Is a Rights Offering (Issue)?

A rights offering (rights issue) is a group of rights offered to existing shareholders to purchase additional stock shares, known as subscription warrants, in proportion to their existing holdings. These are considered to be a type of option since they give a company's stockholders the right, but not the obligation, to purchase additional shares in the company.

In a rights offering, the subscription price at which each share may be purchased is generally discounted relative to the current market price. Before the shareholder has paid for the new shares, they are known as nil-paid shares. Once they pay for the shares, they are referred to as fully paid rights. Rights are often transferable, allowing the holder to sell them in the open market.

How a Rights Offering (Issue) Works

In a rights offering, each shareholder receives the right to purchase a pro-rata allocation of additional shares at a specific price and within a specific period (usually 16 to 30 days). Shareholders, notably, are not obligated to exercise this right. 

A rights offering is effectively an invitation to existing shareholders to purchase additional new shares in the company. More specifically, this type of issue gives existing shareholders securities called "rights," which, well, give the shareholders the right to purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price.

But until the date at which the new shares can be purchased, shareholders may trade the rights on the market the same way that they would trade ordinary shares. The rights issued to a shareholder have value, thus compensating current shareholders for the future dilution of their existing shares' value. Dilution occurs because a rights offering spreads a company’s net profit over a wider number of shares. Thus, the company’s earnings per share, or EPS, decreases as the allocated earnings result in share dilution.

Types of Rights Offerings

There are two general types of rights offerings: direct rights offerings and insured/standby rights offerings. 

• In direct rights offerings, there are no standby/backstop purchasers (purchasers willing to purchase unexercised rights) as the issuer only sells the number of exercised shares. If not subscribed properly, the issuer may be undercapitalized. 
• Insured/standby rights offerings, usually the more expensive type, allow third parties/backstop purchasers (e.g. investment banks) to purchase unexercised rights. The backstop purchasers agree to the purchase prior to the rights offering. This type of agreement ensures the issuing company that their capital requirements will be met. 

Advantages and Disadvantages of Rights Offerings

Advantages

Companies generally offer rights when they need to raise money. Examples include when there is a need to pay off debt, purchase equipment, or acquire another company. In some cases, a company may use a rights offering to raise money when there are no other viable financing alternatives.

Other significant benefits of a rights offering are that the issuing company can bypass underwriting fees, there is no shareholder approval needed, and market interest in the issuer's common stock generally peaks. For existing shareholders, rights offerings present the opportunity to purchase additional shares at a discount.

Disadvantages

Sometimes, rights offerings present disadvantages to the issuing company and existing shareholders. Shareholders may disapprove because of their concern with dilution. The offering may result in more concentrated investor positions.

The issuing company, in an attempt to raise capital, may find that additional required filings and procedures associated with the rights offering are too costly and time-consuming; the costs of the rights offering may outweigh the benefits (cost-benefit principle). 

The Bottom Line

Rights offerings are additional shares of company stock offered to existing shareholders who are not obligated to buy the additional shares. The shares are offered at a discount, which is an incentive used to entice shareholders to buy stock. Companies issue rights offerings in order to raise capital for various reasons.