Rights Issues and Follow-On Offerings

When companies raise capital by issuing new shares, existing shareholders face a binary outcome: participate and maintain your ownership percentage or don't participate and get diluted. The typical rights issue discount of 20-40% below market price sounds like a gift until you realize that non-participants see their ownership shrink permanently. Meanwhile, the stock price falls toward the Theoretical Ex-Rights Price (TERP) regardless of whether you exercise. The practical antidote isn't fearing dilution. It's understanding the math, making a deliberate choice, and knowing you can often sell the rights if you won't exercise them.

Rights Issues (The Mechanics)

A rights issue gives existing shareholders the option to buy new shares at a discount, proportional to their current holdings.

Example: Company has 10 million shares at $50. Board announces a 1-for-5 rights issue at $40 (20% discount).

What you receive:

• You own 100 shares
• You get rights to buy 20 new shares (100 / 5 = 20)
• Price per new share: $40 (vs. $50 market)

Your decision:

1. Exercise: Pay $800 (20 x $40), own 120 shares
2. Sell rights: Receive cash for rights value, own 100 shares (diluted)
3. Do nothing: Rights expire worthless, own 100 shares (diluted)

The point is: Rights are valuable. Letting them expire is like throwing away money.

TERP: Theoretical Ex-Rights Price (The New Equilibrium)

After a rights issue, the stock price adjusts to reflect the diluted share count. TERP is the weighted average of old and new share prices.

The formula:

TERP = (S0 x P0 + S1 x P1) / (S0 + S1)

Where:
S0 = Existing shares
P0 = Current market price
S1 = New shares issued
P1 = Subscription price

Example:

• S0 = 10 million shares at P0 = $50
• S1 = 2 million new shares at P1 = $40
• TERP = (10M x $50 + 2M x $40) / (10M + 2M)
• TERP = ($500M + $80M) / 12M
• TERP = $48.33

What this means:

• Stock will trade around $48.33 after the rights issue (all else equal)
• Existing shareholders at $50 see paper loss of $1.67 per share
• But if they exercise, they buy at $40—$8.33 below TERP

Rights Value Calculation

Value of one right:

Rights Value = (TERP - Subscription Price) / Number of Rights Needed

Or simplified:
Rights Value = (Market Price - Subscription Price) / (Rights Ratio + 1)

Using our example:

• Market = $50, Subscription = $40, Rights ratio = 5 (need 5 old shares for 1 new)
• Rights Value = ($50 - $40) / (5 + 1) = $10 / 6 = $1.67 per right

The durable lesson: If you own 100 shares, your rights are worth approximately 100 x $1.67 = $167. That's real value whether you exercise or sell.

Why Non-Participation Hurts

Scenario: You don't exercise or sell

Before rights issue:

• You own 100 shares out of 10 million = 0.001% of company
• Value: 100 x $50 = $5,000

After rights issue (without participating):

• You own 100 shares out of 12 million = 0.000833% of company
• Value: 100 x $48.33 = $4,833

Dilution cost: $167 (matching the rights value you forfeited)

Scenario: You exercise

Before: 100 shares worth $5,000 Investment: 20 new shares x $40 = $800 After: 120 shares x $48.33 = $5,800

Net position: $5,800 - $800 invested = $5,000 maintained ownership + proportional stake in new capital raised

Your percentage ownership stays at 0.001%. No dilution.

Follow-On Offerings (The Public Alternative)

Not all secondary equity issuances come with rights. Follow-on offerings (also called seasoned equity offerings) sell new shares to any buyer, not just existing shareholders.

Types:

Dilutive (primary) offering: Company sells newly created shares. Share count increases. Your percentage ownership decreases.

Non-dilutive (secondary) offering: Existing shareholders (insiders, early investors) sell their shares. No new shares created. Your percentage ownership unchanged.

Key difference from rights issues: No discount offered to existing holders. No rights to sell. You face dilution with no mitigation option except buying more in the open market (competing with everyone else).

The practical read: Follow-on offerings are more dilutive for passive shareholders. Rights issues at least give you a choice.

When Companies Use Each Method

Rights issues are common when:

• Company needs capital but values existing shareholder base
• Regulatory or corporate governance requirements favor pro-rata treatment
• Market conditions favor giving shareholders subscription option
• Company wants to signal that management believes stock is fairly valued (offering discount only to existing holders)

Follow-on offerings are common when:

• Speed matters more than existing shareholder protection
• Company wants to broaden shareholder base
• Underwriters prefer marketing to new investors
• Stock is perceived as expensive (outsiders willing to pay full price)

The signal: A rights issue at deep discount can indicate distress (company desperately needs cash, existing shareholders are the only willing buyers). A follow-on at minimal discount suggests strong demand.

Option Adjustments for Rights Issues

The OCC adjusts option contracts for rights offerings that distribute tradeable rights.

Typical adjustment:

• Strike price reduced by rights value per share
• Deliverable may change to include rights (if rights are tradeable during option life)

Example: Stock at $50, option strike $50. Rights worth $1.67 per share issued.

• Adjusted strike: $50 - $1.67 = $48.33
• Economic value preserved

Why this matters: If you hold options through a rights issue, your contract terms change. Check OCC announcements before trading.

The Discount Trap (Why Deep Discounts Aren't Free Money)

Rights issues at 20-40% discounts sound like guaranteed profits. They're not.

The math:

• Discount is from current market price
• But market price immediately adjusts toward TERP
• The "discount" is really just compensation for dilution

Example thinking trap:

• "I'm buying at $40 when the stock is at $50! That's $10 free!"
• Reality: Stock will trade at ~$48.33 post-rights
• Your "profit" is $8.33 per share ($48.33 - $40), not $10
• And you had to invest new capital to capture it

The point is: The discount compensates you for your existing shares declining toward TERP. There's no arbitrage—just a choice between participating (maintaining ownership) or not (accepting dilution).

Detection Signals (How You Know Dilution Is Affecting You)

You're mishandling equity issuances if:

• You let rights expire without exercising or selling (forfeiting value)
• You assume follow-on offerings don't affect you because you didn't participate (dilution still happens)
• You treat rights issue discounts as "free money" without calculating TERP
• You don't know your ownership percentage before and after capital raises
• You ignore rights issue announcements in your portfolio

Mitigation Checklist (Tiered)

Essential (high ROI)

These 4 items prevent 80% of dilution-related value loss:

• Never let rights expire unexercised if they have value
• Calculate TERP before making exercise/sell decision
• If not exercising, sell rights in the market (if tradeable)
• Track ownership percentage changes after any equity issuance

High-Impact (workflow + automation)

For investors who want systematic protection:

• Set alerts for corporate action announcements on your holdings
• Understand your broker's default handling of rights (some auto-exercise, some let expire)
• Check option positions for adjustment notices around rights issues

Optional (good for concentrated holders)

If you hold significant positions in individual stocks:

• Model dilution impact of potential capital raises in your thesis
• Review company's capital structure for future issuance capacity
• Monitor debt covenants that might force equity raises

Timing Considerations Under T+1

NYSE 2024 guidance confirms that T+1 settlement affects rights timing:

• Ex-date now equals record date
• You must own shares at least 1 business day before ex-rights date to receive rights
• Advance notice required for any corporate action affecting listed securities

The practical implication: Rights issue windows are tighter. Missing the purchase deadline by one day means missing the rights entirely.

Case Study: The Decision Framework

Your situation: You own 500 shares of XYZ at $100 (cost basis $40,000). XYZ announces 1-for-4 rights issue at $70 (30% discount).

Step 1: Calculate TERP

• S0 = 1,000 shares outstanding at $100
• S1 = 250 new shares at $70
• TERP = (1,000 x $100 + 250 x $70) / 1,250 = $94

Step 2: Calculate rights value

• You get rights to buy 125 shares (500 / 4)
• Rights value per share = ($100 - $70) / 5 = $6
• Total rights value = 500 x $6 = $3,000

Step 3: Compare scenarios

The durable lesson: Exercising or selling rights preserves your $50,000 economic position. Doing nothing costs $3,000.

Decision factors:

• Exercise if: You want to increase position and have cash available
• Sell if: You want to maintain current cash position without dilution loss
• Never: Let tradeable rights expire

Next Step (Put This Into Practice)

Check your brokerage settings for corporate action handling.

Questions to answer:

1. Does your broker notify you of rights issues automatically?
2. What's the default action if you don't respond? (Some brokers sell rights; some let them expire)
3. How do you submit exercise instructions?

Action: If you hold individual stocks (not just funds), ensure you're set up to receive and respond to rights issue notifications. The decision window is typically 2-4 weeks—missing it costs money.

For current holdings: Calculate what percentage change in share count would occur from a hypothetical 1-for-5 rights issue. Understand your dilution exposure before it happens.

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Rights issues involve investment decisions with tax implications. This article provides general education, not investment or tax advice. Consult appropriate professionals for your specific circumstances.