Rights Issue
A rights issue is a mechanism by which a publicly listed company raises new equity capital by offering existing shareholders the right—but not the obligation—to purchase additional shares at a specified subscription price, typically set at a discount to the prevailing market price, in proportion to their current holdings. It allows the company to raise capital while giving existing shareholders the opportunity to maintain their proportionate ownership stake.
Key takeaways
- Rights issues are dilutive to non-participating shareholders; existing owners who decline to exercise their rights see their ownership percentage reduced.
- The subscription price is typically set 20–40% below the current market price to ensure adequate take-up.
- Shareholders can sell their rights on the open market during the subscription period if they do not wish to invest additional capital.
- The theoretical ex-rights price (TERP) represents the fair value of shares after the new capital is incorporated.
- Rights issues signal that management is raising equity—often perceived as dilutive and interpreted cautiously by the market unless the capital use is clearly value-accretive.
Explanation
A rights issue is one of the primary methods through which companies raise seasoned equity. Unlike a secondary offering to institutional investors, a rights issue preserves the participation rights of all existing shareholders by first offering new shares to them on a pro-rata basis. This preemptive right is legally mandated in many jurisdictions (notably the UK and continental Europe under the EU Prospectus Regulation) and is considered a standard shareholder protection device.
The mechanics of a rights issue typically proceed as follows: the company announces the terms (number of rights per share held, subscription price, record date, and subscription period). During the subscription period—usually two to four weeks—shareholders may exercise their rights, sell them on the secondary market, or allow them to lapse. If a shareholder sells their rights, they receive cash compensation for the dilution they would otherwise absorb by not subscribing. The subscription price is set at a meaningful discount to incentivize participation and reduce the risk that market price volatility during the subscription period renders the offer uneconomic.
The theoretical ex-rights price (TERP) is computed as a weighted average of the existing share price and the subscription price, weighted by the proportion of old to new shares. After the rights issue closes and new shares begin trading, the market price should theoretically converge to the TERP—though in practice, investor reaction to the capital deployment plan and market conditions drive further price discovery. Companies undertaking rights issues often simultaneously announce the purpose of proceeds: deleveraging after an acquisition, funding capex, meeting regulatory capital requirements, or strengthening the balance sheet during financial stress.
From an investment perspective, rights issues present shareholders with a binary economic decision: subscribe and maintain ownership, or sell rights and accept dilution. The economic value of the right itself is equal to the difference between the pre-rights share price and the TERP, times the number of new shares entitled per right. Shareholders who neither subscribe nor sell their rights destroy value by allowing them to lapse.
Index managers face operational challenges from rights issues, as index tracking requires purchasing newly issued shares and adjusting weights on a defined schedule. Event-driven hedge funds frequently analyze rights issues for arbitrage opportunities—buying rights in the market if they trade below intrinsic value, or shorting the existing shares against subscriptions when a meaningful gap exists between market price and subscription price.
Formula
TERP = (N × P_market + M × P_subscription) / (N + M); Right Value = TERP - P_subscription
Example
A UK-listed bank trading at £5.00 per share announces a 2-for-5 rights issue at a subscription price of £3.50. An investor holds 5,000 shares worth £25,000. Under the terms, they are entitled to purchase 2,000 new shares (2 for every 5 held) at £3.50 each, requiring an outlay of £7,000. The TERP is calculated as: (5,000 × £5.00 + 2,000 × £3.50) / 7,000 = (£25,000 + £7,000) / 7,000 = £4.57. Each right is worth £4.57 - £3.50 = £1.07. If the investor declines to subscribe and sells their 2,000 rights at £1.07, they receive £2,140—compensating for the dilution of their existing position, which is now worth 5,000 × £4.57 = £22,857 (versus original £25,000). Total value: £22,857 + £2,140 = £24,997 (essentially unchanged).
Related terms
Arbitrage Balance Sheet Basis Deleveraging Dividend Equity Event Driven Index Tracking Intrinsic Value Preferred Stock Price Discovery Reaction