What is Right to Issue of Shares?

When companies seek additional funds for expansion, growth, or financial restructuring, they have several options available—one such effective method is the rights issue of shares. A rights issue enables current shareholders to acquire extra shares directly from the company, typically at a lower price, in proportion to their existing ownership.

This practice not only maintains the shareholders' equity but also ensures the company can raise capital without resorting to external debt or diluting existing ownership significantly.

What is Right to Issue of Shares?

The Right to Issue of Shares, commonly known as "rights shares," is a corporate action where a company offers its existing shareholders an opportunity to purchase additional shares at a specific price and within a stipulated time. Shareholders have the choice to either subscribe to the new shares or renounce their rights, transferring them to other investors in exchange for monetary gain. This method helps companies raise capital efficiently and allows existing investors to retain control over their proportionate ownership.

Features of Right Issue of Shares

1. Discounted Share Price: Companies offer fresh shares to current shareholders at a price lower than the prevailing market rate, making the offer attractive and encouraging participation.  

2. Proportional Allocation: The number of additional shares a shareholder can purchase is typically proportional to their current holdings. For instance, in a 1-for-5 rights issue, a shareholder with 500 shares can buy 100 additional shares.  

3. Specific Exercise Period: Shareholders are granted a defined timeframe to exercise their rights. If they do not act within this period, the rights may expire, and the opportunity to purchase additional shares at the discounted price is forfeited.  

4. Tradeable Rights (in Some Cases): Certain rights issues allow shareholders to trade their rights on the stock exchange. This provides flexibility for shareholders who choose not to subscribe, enabling them to sell their rights to other investors.  

5. Purpose-Specific Fund Utilization: Funds raised through a rights issue are often earmarked for specific purposes, such as business expansion, debt reduction, or enhancing working capital, aligning with the company's strategic objectives.  

6. Impact on Share Value: Introducing additional shares can lead to dilution of existing shares' value. However, if the capital raised is effectively utilized, it can potentially enhance the company's overall value in the long term.

How does Right to Issue of Shares Work?

The process for a rights issue is systematic and involves several clear steps:

Step 1: Board Approval and Resolution

The board of directors passes a resolution approving the rights issue, specifying the number of shares, price, and ratio in which the shares will be offered.

Step 2: Shareholders' Approval

The rights issue proposal must receive approval from the existing shareholders during a general meeting. This typically requires a simple majority vote.

Step 3: Notification and Offer Letter

Following approval, shareholders receive a notification and offer letter detailing their rights, including the subscription price, ratio of rights offered, and the subscription period.

Step 4: Acceptance or Renunciation

Shareholders have the choice to accept (subscribe to) the new shares or renounce their rights by selling them. If they accept, they pay the prescribed price within the offer period.

Step 5: Allotment of Shares

At the conclusion of the subscription period, the company allocates shares to the shareholders who exercised their rights and issues certificates or electronic credit to their demat accounts.

Step 6: Listing of Shares

The new shares are subsequently listed and traded on the stock exchange, increasing the liquidity and capital base of the company.

Reasons for a Right Issue of Shares - Why Companies Do It?

Companies undertake a rights issue primarily for:

1. Raising Capital: Provides an effective means of raising fresh capital directly from existing shareholders, significantly increasing available funds for operational needs.

2. Debt Reduction: Raising capital through rights issues can help pay down high-interest debt, thereby reducing financial strain.

3. Expansion and Growth: Financing new projects, expansions, or acquisitions.

4. Strengthening Balance Sheet: Improving financial metrics and ensuring adequate working capital.

5. Preserving Control: Maintaining control within existing shareholders, preventing external dilution.

Types of Right Issue of Shares

Companies typically adopt one of four types of rights issues based on their specific financial strategies and objectives:

1. Renounceable Rights Issue

This is the most common type of rights issue. It allows shareholders the flexibility to either subscribe to the offered shares or sell their rights to other investors if they choose not to subscribe. This flexibility provides shareholders an opportunity to generate monetary value even if they don't participate directly.

2. Non-Renounceable Rights Issue

Under a non-renounceable rights issue, shareholders must either subscribe to the new shares or forfeit their rights completely. Unlike renounceable rights issues, these rights cannot be traded or transferred to others, resulting in potential financial loss if shareholders choose not to participate.

3. Standby Rights Issue

In a standby rights issue, the company secures an underwriting agreement where a third party, usually a financial institution or an investment bank, commits to purchasing any unsubscribed shares. This guarantees the company that it will achieve its desired capital, even if some shareholders do not exercise their rights.

4. Traditional Rights Issue

A traditional rights issue does not involve any underwriting. The company offers additional shares exclusively to existing shareholders at a discounted price. If the issue is undersubscribed, the company raises less capital than initially planned, which could limit its ability to achieve strategic objectives.

Advantages of Right Issue of Shares

1. Increased Ownership: Allows shareholders to increase their stake.

2. Discounted Pricing: Offers shares at lower prices, attracting investor participation.

3. Maintains Proportional Ownership: Helps shareholders maintain their ownership percentage.

4. Supports Business Growth: Provides essential capital to fund company expansion and operations.

5. Quick Capital Access: Enables companies to quickly raise funds to meet immediate financial needs.

Disadvantages of Right Issue of Shares

1. Ownership Dilution: Shareholders not participating risk reduced ownership percentage.

2. Price Volatility: Announcements of rights issues may temporarily impact share prices negatively.

3. Oversubscription Risk: Investors might not receive the full amount of shares they intended to purchase.

4. Negative Market Perception: Rights issues can be perceived negatively, potentially harming investor confidence.

5. Adverse Market Reaction: A significantly lower offer price could temporarily decrease the stock's market value.

Conclusion

The Right to Issue of Shares (rights issue) provides a critical channel for companies to raise additional funds by leveraging existing shareholders' loyalty and commitment. It presents a balanced opportunity to achieve corporate goals while preserving shareholder value and control. Understanding the dynamics, processes, and implications of rights issues helps investors make informed decisions and enables companies to utilize this financial tool effectively.