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Home > Financing Best Practice > Equity Issues by Listed Companies: Rights Issues and Other Methods

Financing Best Practice

Equity Issues by Listed Companies: Rights Issues and Other Methods

by Seth Armitage

Table of contents

Executive Summary

  • A rights issue is a method by which a listed company can issue new shares. The principle of a rights issue is that stockholders are offered new shares in proportion to their existing holdings. If stockholders do not want to buy the new shares, they can sell their rights on the stock market.

  • The main alternative issue methods are the firm-commitment offer, the private placement or placing, and the open offer. These methods have been replacing rights issues in several countries.

  • The average reaction of a company’s share price to firm commitments is negative, but it is positive for placements and open offers. The reaction to rights issues varies by country.

  • The aim for a company is to have a smooth issue that raises the intended amount of capital for a competitive fee and at a minimum discount.

Introduction

This article is about issues of shares to investors by companies that are already listed on a stock exchange. Such issues are often called rights issues, although in fact the rights issue is only one of several issue methods used. Other methods will also be discussed here. A generic term for issues by listed companies is seasoned equity offers (SEOs).

Types of Offer

Rights Issue

The principle of a rights issue is that the company offers the new shares to its existing stockholders in proportion (pro rata) to the number of shares owned by each stockholder. In most countries this is a requirement of company law. The stockholder’s right of first refusal over the new shares is known as the preemption right. If a stockholder does not want to buy some or all of the new shares to which he or she is entitled, he or she can sell the rights to them on the stock market during a prescribed offer period. In the United Kingdom this period is three weeks.

The offer price of the new shares is usually set at a large discount to the market price of the existing shares just before the issue is announced. This discount means that the rights are likely to be worth something during the offer period. A numerical example is helpful in understanding the rights issue mechanism:

Company X: 
Number of existing shares10 million
Number of new shares5 million
Price of existing shares before offer is announced$12
Offer price$9

In this example, Company X is issuing one new share for every two existing shares in what is known as a “one-for-two” issue. The new equity to be raised is $45 million. The offer period starts on the ex-rights date, when the existing shares cease to carry the one-for-two entitlement to the new shares. If the underlying value of the company does not change, the share price will fall to the theoretical ex-rights price (TERP) on the ex-rights date. The TERP is the weighted average value of the old and the new shares. In the example, the TERP is $11:

(10 million × $12 + 5 million × $9) ÷ 15 million = $11

At this market price, each right to one new share will be worth $2; that is, $11 − $9.

An important point about rights issues is that a stockholder is as well off whether or not he sells the rights. If he does not sell, and he buys the new shares, he loses $10 per old share when they go ex-rights, but gains $2 per new share because the offer price is $2 below the market price ex-rights. If he sells the rights, he still loses $10 per old share but gains $2 in cash per new share. However, this ignores the cost of selling rights, which can be substantial if the company’s shares are illiquid.

The majority of rights issues are underwritten. This means that the investment bank arranging the issue will find sub-underwriters, usually investing institutions, to buy the shares at the offer price, or will buy them itself if necessary. The deeper the discount, the less likely it is that the underwriters will be called upon.

Firm-Commitment or Public Offer

In the United States, rights issues by commercial companies (as opposed to investment companies) have been rare since the 1970s. The standard method for larger issues is the firm-commitment offer. After the issue is announced, there is a book-building period of about one month, during which a syndicate of investment banks invites applications for the new shares and the share registration document is finalized. With a shelf offering, the new shares will already have been registered with the Securities and Exchange Commission. There is no pro rata offer to existing stockholders.

The offer price is set the day before the shares are issued. The offer price used to be the same as, or very close to, the prevailing market price. But, during the 1990s, it became common to set the offer price at a discount to the market price of about 2.5%. Firm-commitment offers are underwritten by the syndicate of investment banks that market the issue. Non-underwritten public offers are known as “best efforts” offers. Both rights issues and firm commitments are accompanied by a prospectus—a marketing document and memorandum that contains information required by the relevant regulatory authority.

In recent years, a variant known as the accelerated bookbuilt offer has become more common. The offer is announced and bids from investors are invited very quickly, often by the end of the same day. Accelerated bookbuilding tends to be used by large companies to raise small amounts in relation to their size.

Private Placement or Placing

A third type of offer is the private placement. In the United States, private placement refers to the sale of a block of shares by private negotiation, usually to one or two investors only and for a fairly small amount (a few million dollars). Placements are less onerous to arrange than firm commitments, because the shares are not offered to investors in general and no prospectus is required. Most placements are made at a discount, the average being around 15% in the United States. Many placements are now private investment in public equity (PIPE) issues, in which the shares placed can be resold more quickly than in a conventional placement. In the United Kingdom the term “placing” is used for any sale of shares that does not involve a pro rata offer to existing stockholders. Larger placings will have 20 or 30 placees.

Open Offer

An open offer combines a pro rata offer to existing stockholders with a private placing. Although stockholders retain their preemption rights, the rights cannot be traded and are therefore worthless unless the stockholder chooses to buy new shares. This type of offer is now standard in the United Kingdom but appears to be unique to that country.

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Further reading

Book:

  • Eckbo, B. Espen, Ronald W. Masulis, and Øyvind Norli. “Security offerings.” In B. Espen Eckbo (ed). Handbook of Corporate Finance: Empirical Corporate Finance. Vol. 1. Amsterdam: Elsevier, 2007; 233–373. A thorough review of research on SEOs.

Article:

  • Myers, Stewart C., and Nicholas S. Majluf. “Corporate financing and investment decisions when firms have information that investors do not have.” Journal of Financial Economics 13:2 (June 1984): 187–221. Online at: dx.doi.org/10.1016/0304-405X(84)90023-0

Report:

  • Myners, Paul. “Pre-emption rights: Final report.” UK Department of Trade and Industry, February 2005. Online at: www.berr.gov.uk/files/file28436.pdf. The pros and cons of rights issues from a practitioner’s perspective.

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