You may be well-versed in the differences between stocks and bonds or how exchange-traded funds (ETFs) work, but a rights offering is one investing term you may not be as familiar with. A rights offering allows a company’s shareholders the right to buy additional shares or sell those rights to another investor on the open market. Also referred to as a rights issue, this scenario isn’t one you may encounter often. But if you do, it’s important to understand how it works. Whether you’re contemplating a rights offering or not, a financial advisor can provide invaluable guidance on selecting securities that fit your goals, timeline and risk profile.
What Is a Rights Offering?
In simple terms, it’s a way for companies to raise money. Aside from booking profits, companies can raise money in two ways, either borrow it or they can sell ownership stakes in the company. Doing the former issuing bonds (IOUs); the latter means issuing shares. When a company decided to raise money by selling moneyThey do so by approaching existing shareholders and offering them the opportunity to buy more shares of stock in the company for a limited time, which can be anywhere from a few weeks to a few months. Companies can offer investors an incentive to purchase more shares by selling them at a discount.
In a sense, rights offerings are similar to trading stock options. With options, you have the ability to buy or sell shares of a stock, but you’re not required to. It’s the same with rights issues. You can buy more shares of the company’s stock, but you don’t have to exercise your right. If you’d prefer, you can sell your rights to buy the shares to another investor. Keep in mind that in some instances, the company initiating the rights offering may make rights non-transferable. A rights offering that’s not transferable is known as a non-renounceable rights issue.
How a Rights Offering Works
The process sounds complicated but in reality, it’s fairly straightforward. Companies notify shareholders that a rights issue is on the table and that they can buy a set number of shares at a specific price. They’d also specify a deadline for exercising the right offering to buy additional shares at said discount.
Shareholders then have a decision to make. They can either take advantage of the rights offering to purchase the additional shares, sell their rights to buy the shares to someone else or do nothing at all. Deciding what to do in that scenario may depend on several factors, including the:
- Number of additional shares you’re able to buy
- Discount the company is offering on those shares
- Financial health of the company
- Estimated profit you’d potentially realize by purchasing new shares vs. selling your rights to someone else
Keep in mind that the company extending the rights issue wants you to take them up on their offer and buy more shares. But if you decide not to buy more shares or you sell your rights, then your share in the company will be diluted. This happens because new shares are being issued while your proportion of owned shares doesn’t change.
Why Do Companies Offer a Rights Offering?
Generally, a rights offering happens because the company wants or needs to raise capital. For example, if the company is carrying a substantial amount of debt on its balance sheet, a rights offering could raise money to pay down some of those obligations.
That’s not the only scenario in which a company might do this. A rights issue could also be used to create capital for expansion plans or to acquire another business. For example, the money could go toward developing new products and lines of service or opening new business locations. This could be a funding solution if the company isn’t able to secure financing through business loans or funding from venture capital firms or an angel investor.
Pros of a Rights Offering
Being able to purchase additional shares in a company has some advantages. For starters, you can effectively get the stock on sale. Assuming those shares increase in value, along with the other shares you already own, a rights issue could end up being profitable for you.
The same is true if you decide to sell your rights to buy the shares to another investor. Whether you’re able to realize a significant gain depends on the stock’s current market price and the discounted price. You also have to factor in the number of shares you’d be able to transfer. Generally, the amount of shares an investor can buy through a rights offering is proportionate to the number of shares they currently own.
Rights issues can yield benefits to the company by allowing them to raise capital. If a company is struggling financially, this kind of move could help them to improve their balance sheet by eliminating debt or injecting new cash flow into the business. A rights offering can also raise market interest in the company, resulting in new investors buying in and potentially driving the share price up.
Cons of a Rights Offering
The main downside of buying stocks this way is that your shareholder position becomes diluted. Even though you got your new shares at a discount, your ownership stake in the company shrinks because now there are more shares to go around.
A rights issue can also be risky from an investor perspective if it causes speculation about the company’s financial health. If the market perceives the rights offering as a desperate move to raise capital, it could make what may be an already shaky stock even more wobbly. The stock could begin to lose value, translating to losses for the shareholders.
How to Decide a Rights Issue Is the Right Move
If you’re presented with this kind of offer, consider every angle before deciding whether to buy, sell or do nothing. For example, look at the company as a whole. Is it carrying a large amount of debt? How have revenues trended the last few years? What does the earnings per share ratio look like? Is the company going through a growth phase or does growth seem to be tapering off?
Asking these kinds of questions can give you a better sense of why the company is offering investors the chance to purchase more shares at a discount. Speaking of the discount, consider how much of a deal you’re really getting. Go back to the company’s fundamentals and consider how likely it is that the share price will rise in the future. Compare that number to what you might make in profit by selling your rights to buy the shares to help with your decision.
The Bottom Line
A rights offering is largely motivated by the company’s needs and it may present an opportunity to expand your portfolio. However, it’s important to consider the pros and cons to determine how it fits within your broader investment strategy. Getting a bargain may backfire if it doesn’t help you to reach your investment goals.
Tips for Investors
- Remember that individual stocks are just one part of a well-rounded portfolio. Stocks, mutual funds, ETFs and real estate are a few of the ways you can diversify your investments. This is important for managing risk with your investments.
- Consider talking to a financial advisor if you’re presented with a rights offering and aren’t sure how to handle it. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/Eva-Katalin, ©iStock.com/deepblue4you, ©iStock.com/Bet_Noire