Finance / Fundamental Analysis · February 13, 2022

4 Reasons Why Companies Go For Rights Issue

What is rights issue

Rights issue is an offer made by the company to its existing stakeholders to provide a right, but not an obligation to participate in re-investing in the company.

It is to be noted that only the existing shareholders get the opportunity to participate for investing in the company through rights issue.

It is a right of a stake holders, but not an obligation, which means that it is the wish of the investor if he decides to invest. He may either refrain from participation or sell off his rights to other entity.

Benefits of raising money through rights issue

Protect dilution of holding

There are 2 ways for a company to raise money against equity. Sell the shares to existing shareholders or sell the share to new shareholders.

When the shares are sold to new shareholders, the proportional holding of existing shareholders get diluted.

For example, a corporation may have 10 lakhs shares Rs.10 each, totaling Rs. 1 crore in issued and paid-up capital. Because the issued and paid-up capital has doubled, if it issues another 10 lakh shares to new investors to raise capital, the proportion held by existing shareholders will drop by half.

Providing an opportunity for existing stakeholders

This is an opportunity for existing stakeholders to increase their shareholding in the company. It provides a unique platform to allow the only the existing investor to participate in the issue. In this way the stakeholders will get a lucrative opportunity to invest in the business they trust.

The shares are sold at a reduced price to the investors. This allows the current shareholders to grow their ownership in the company at a reduced price, lowering their holding price average.

In the rights issue, even the promoters can infuse in money through the secondary source to raise their equity portion in their company.

Reward the existing stakeholders

Rights gives an opportunity to the investors to re-invest in the company for a value lower than the market value of the company. This haircut can be anywhere from 10 – 25%. This provides a lucrative opportunity for investors to generate quick returns on their investment.

The rights issued by the company are not an obligation for the investors to re-invest. They can either not involve in the participation or sell the rights to some other person. On temporary basis, these right issues are traded on the stock exchange and people can buy / sell their rights to other investors.

Raising capital for:

Company acquisition

There are times when the company decides to buy growth companies in the same category for competitive advantage.

Acquiring companies is an age old practice to eliminate the competition for the market. It is also a way to be an active participant in the company’s growth and take a profit share of their business.

For example, Coca-Cola acquired ThumsUp for competitive advantage. It also ensured that the company acted independently under the same parent company and participated in the profit sharing.

Diversification

This is one of the main reasons why large cap companies raise money. The parent business established by them is already in the state of stagnant growth. Thus, there are lesser opportunities to further grow in the business.

The big players in this case try to diversify their business in multiple sectors to create a new revenue stream for the parent company.

Paying off loans and other debts

Sometimes the companies are well to do, but major chunk of their profits are gone for paying the interest and principal to the bank. This can be dangerous for the company in the long term.

In this case, the company can raise money through rights issue and pay off the debts it owes the banks. This is an ideal scenario as the company equity will be in the hands of the existing stakeholders and the capital will be raised simultaneously.

Scaling the company

Growth company’s are looking for multiple options for scalability. They want to grow their customer base from national to international. This process, however requires intensive capital for marketing and managing a proper distribution network.

Thus, an ideal way for raising capital by issuing rights can be a helpful option for scaling the business.

Conclusion

There are many other ways to raise money for the company for achieving its goals. Some of them being raising money through loans, issuing corporate bonds, FPO (Further Public Offer) and many more.

At the end, it is the decision of the company management to take a call on which method they need to adopt to raise capital.

Also Read: 5 Reasons Why Companies Buy Back Their Own Shares