What is a share rights issue and why all the fuss about it?

by Manshu on September 6, 2011

in Investments

This is another post from the Suggest a Topic page, and this time we’re going to take a look at rights issues, and as the commenter put it – the fuss about them.

A rights issue is when a company issues new shares, but offers it to their existing shareholders first. The existing shareholders then have an option to either buy the new shares or pass the offer. So, recently when the SBI rights issue was in the news, it was often said that the government is willing to subscribe to the rights issue, and that’s because they own 59.4% of SBI, and if any shares are issued without the government participating in the offer then their shareholding in the company will come down.

This will be clear with an example, so let’s look at the latest rights issue – that of Velan Hotels Limited. They are issuing 2,67,35,500 (2.67 cr) new shares as part of the rights issue at Rs. 23 per share, and the ratio is 69:20.

69:20 means that for every 20 shares that you currently own – you can subscribe up to 69 new shares. The rationale for this seemingly weird allocation ratio will be clear in a minute.

The number of outstanding shares in the company before the rights issue were 77,50,000 and when you add the 2,67,35,500 new shares to the existing shares you get a total of 3,44,87,500 shares.

Equity shares prior to the issue  77,50,000.00
New Shares to be issued  2,67,37,500.00
Total shares after the issue  3,44,87,500.00

Now, when you divide the number of new shares to be issued (2,67,37,500) by the number of equity shares prior to the issue (77,50,000) you get 3.45.

Guess what you get when  you divide 69 by 20?

Exactly right – you get 3.45.

Now do you see where the weird ratio of 69:20 come from?

If the rights issue is offered in that ratio and if all existing shareholders subscribe fully to the rights issue then their ownership in the company will remain exactly the same as it was before the issue.

The issue of new shares doesn’t dilute their ownership in the company at all!

This will be clearer if we look at how the promoter stake changes in this issue with the rights issue, and what would have happened if there weren’t a rights issue, and a simple IPO to issue shares.

Before this issue, the promoters owned 56.35% of Velan Hotels, which means they had 43,67,426 shares in all.

Promoters own  43,67,426.00
Equity shares prior to the issue  77,50,000.00
Ownership Percentage 56.35%

Suppose this were a FPO or a fresh issue of shares, and the promoters didn’t subscribe to the fresh issue in the FPO. If that were to happen then the promoters will only own 12.66% of the company as seen from the numbers below.

Promoters Own  43,67,426.00
Total shares including the new ones  3,44,87,500.00
Ownership Percentage 12.66%

As you can see that would not be a good scenario for the promoters, and in fact other shareholders also. Their existing shareholding will be diluted by quite a bit.

However, the ratio of 69:20 means that the promoters by virtue of their 43,67,426 will have the option to buy 1,50,67,620 additional shares (43,67,426 x 3.45), and take the total shares they own to 1,94,35,046, which is 56.35% of the new total outstanding shares, and thus the rights issue doesn’t affect their ownership in the company at all.

Promoters Own  4,367,426.00
Additional shares they can buy (3.45 times current holding)  15,067,620
Total shares they own  19,435,046
Total number of shares after the issue 34487500
Promoter stake in the company after the rights issue 56.35%

The fuss is essentially about retaining the same ownership in the company even after the issue of fresh issue of shares.

For small shareholders – the issue of ownership control doesn’t arise, but the earnings per share will reduce since there are now more shares for the same earnings, and so will the dividends so whenever a company comes out with a rights issue you have to evaluate it to see whether it makes sense for you to subscribe or if you are better off with getting rid of the existing position or should you do nothing at all. Right now I’m unable to think of any factors that need to be considered apart from of course the financial situation of the company, and the price at which the rights issue is being offered but if we ever discuss a live rights issue in the future, we will weigh in on those factors then.

The last thing about subscribing to the rights issue is that you can choose to subscribe to all of the shares you are eligible for, or a part of them. If you don’t do anything then no new shares will be subscribed to you.

The procedure to apply for new shares is that they send in a form to your address, and you have to fill in your details and submit that form to a collection center before the last date. You have to follow this process even if you do everything else online – to the best of my knowledge this process hasn’t been made online yet.

So, to summarize, rights issue is when a company issues fresh shares, but offers them to their existing shareholders in a pre determined ratio first. The existing shareholders can subscribe to these shares, and that helps them own the company in the same percentage that they did prior to the fresh issue.

{ 12 comments… read them below or add one }

Kiran September 6, 2011 at 7:35 AM

And as you will observe from history, rights issue rarely (and this is very strange) has any impact on the stock price of the company (Indian markets, US markets etc). Its almost as if the existing shareholders have ignored the effect of dilution (and that’s probably because they think the existing shareholders subscribed 100% to the rights issue – maybe, and that’s my rationalizing angle).
No dilution for promoters, hardly any effect on the stock price – I wonder why more companies haven’t come up with rights issues?

Reply

Manshu September 6, 2011 at 7:53 PM

Probably because the promoters will have to pay a lot of money from their own pockets as well.

The new thing I saw while looking at this issue was that the promoters in this company had some shares pledged, and then after the issue the shares pledged as a percentage of total shares will come down by a bit.

So, at one hand they pledge shares which indicates that they need funds, then on the other hand they issue such a large number of shares for which they need to cough up a lot of their own money.

It’s a bit contradictory.

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Furqan September 6, 2011 at 10:26 AM

To summarise:
• The rights may be renounceable or non-renounceable.
With renounceable offering the shareholders are entitled to sell their rights to other investors if they do not wish to buy the shares themselves.
While with non-renounceable offering shareholders must either buy the rights shares or let the offer lapse.

• Rights issue helps existing shareholders to maintain their pro-rata share in the earnings & surplus of the company as well as the voting power as before.

• The goodwill of the company increases in the eyes of existing shareholders.
• Normally the rights shares are offered at discount to the prevailing market rate.
• The management is relieved of the bother to sell the shares to outsiders.

• Pros & Cons of Rights issue: http://bit.ly/n4TJeR

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Manshu September 6, 2011 at 7:55 PM

That’s a good article, thanks for sharing.

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vamsi September 6, 2011 at 8:37 PM

Hi Manshu.. very informative post. I’m confused with the share division pattern in a company. Can you please throw some light on what outstanding shares and total share capital mean?

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Manshu September 7, 2011 at 1:13 AM

Thanks Vamsi – when a company is formed, they have to list down something called authorized share capital. Theoretically, these are the maximum number of shares a company can ever issue, but in practice it can be changed if the need arises.

So, if you start a company you could say that the authorized share capital of my company is Rs. 10 crores, and that becomes the maximum shares you can raise. You can decide that you don’t want to raise all of that and you just need Rs. 10 lacs, which becomes your outstanding shares.

Then there is something called as free float which is how many shares are easily traded. If you own 50% of the company’s shares then that much is reduced from the exchanges since that’s not freely traded. This company’s free float will then be half of the outstanding which is Rs. 5 lacs.

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vamsi September 7, 2011 at 2:23 AM

Thanks Manshu. Forgive my ignorance… as per the above example, how are the earnings distributed if more shares are issued.. how should we calculate the diluted earnings. why do the earning get diluted in the first place.

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Manshu September 7, 2011 at 4:12 AM

Great questions Vamsi and I”m sure a lot of other people have them too. When I say earnings get diluted what I really mean is the Earnings Per Share gets diluted. When you buy a share in a company you have a stake in the earnings of the company to the extent of the shares you own. So, if the net profit of your company is Rs. 10 lacs and the outstanding shares are 10 lacs then the EPS will be Rs. 10, but if you issue additional 10 lacs then the profit remains the same but it gets distributed among 20 lac shares now, and the earnings reduces to Rs. 0.50, which is what I meant by earnings getting diluted.

I guess I should make a post out of this thread…..do you have any other questions to include as part of that post?

Thanks for your questions and giving me this idea to create a post!

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vamsi September 7, 2011 at 12:06 PM

Thanks Manshu. What I dint get is where are the new shares issued from? For ex. If I start a co with 10L capital and if I divide it into 1L shares of INR 10 each. The total capital of the company is already divided rt? And.. if I need to create and issue more shares will I be sub-dividing the existing shares? My question is where do the new shares come from?

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Manshu September 11, 2011 at 5:22 AM

Sorry for the delayed response, I got tied up with some other stuff.

The new shares can be created from thin air so to speak. If you have people willing to subscribe to the shares and pay for them then you can issue new shares. This will affect the percentage ownership of the current shareholders so they need to be on board with that, but other than that if there is a demand for the shares and you think you can raise money then you can create new shares.

Any initial limits are artificial to that extent.

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Subodh Gupta September 6, 2011 at 8:52 PM

Very detailed and well written. It reminds me of SBI rights issue that is awaited.

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Manshu September 7, 2011 at 1:13 AM

Yeah news articles about that issue was what triggered the original comment 🙂

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