WHEN companies require cash for their expansion, diversification or acquisition they raise the same by means of rights issues. It means offering shares to their existing shareholders in proportion to their shareholding, generally at a discount to the current market price. However, before accepting such right offers, it is essential to weigh the offer made by the company.
Under Section 62(1) of the Companies Act, 2013 if the company decides to issue fresh shares, these should be offered to existing shareholders in proportion to their existing holding of equity shares. The ultimate objective is to ensure equitable distribution of shares and maintain the same proportion of voting rights.
As this is a right and not an obligation, shareholders can choose to exercise their right by buying the shares within the stipulated date or they can do nothing or decide to sell their right to another person who may or may not be an existing shareholder of the company. Let us suppose that you own 1,000 shares in ABC Tech, each of which is worth Rs 3.50. The company has a large debt and decides to retire the same. It announces a rights offering, in which it plans to raise Rs 30 million by issuing 10 million shares to existing shareholder at a price of Rs 3 each. So, this issue is a three-for-ten rights issue. In other words, for every ten shares you hold, ABC is offering you another three at a discounted price of `3 contrary to the market price of Rs 3.50. This price is 14% less than the current market price.
The benefit to a company of raising money through a rights issue is that it can save significant amount of time and flotation costs such as underwriting fees and other allied costs. Generally, companies go for rights issue during economic slowdowns or when banks are reluctant to lend to them. The benefit of a rights offering to shareholders is that shares are generally offered at a discount to the prevailing market price.
Factors to be checked
Before subscribing to a rights issue, shareholders need to understand the rationale provided by the company for the rights issues. Reasons such as repayment of debt so that the company can save on interest and improve on its liquidity, purchase of new equipment, acquisition of another company, capacity expansion, diversification, etc., are the right reasons to subscribe to the rights offer made by the company.
Dilution of equity
Rights issue, in fact, dilutes the value of existing shares as the number of shares outstanding in the market goes up after the completion of rights issue. The stock market could see the issuance of rights issue by a company as an evidence of a cash crisis. Rights issues are a less common way to raise requisite capital than through a follow-on public offer (FPO) as probably it could signal a lack of demand for shares in the open market.
Shareholders might also be worried about the reduction in the value of their shares. However, they need not worry about the dilution because only existing shareholders are given the opportunity to buy additional shares. This is unless shareholders decide to sell their rights. At the same time, a rights issue sends a signal to the market that the company encourages more long-term ownership of shares as existing shareholders are increasing their investment in the company. To conclude, one should not simply subscribe to the rights offer made by the company as they are generally offered at a discount to the prevailing market price. As a shareholder, you need to look at the rationale offered by the company for such an offer and other allied factors.
The writer is professor of finance & accounting, IIM Shillong