When a company requires external financing there are three main options;
- Borrow from a bank (usually from pre-existing bank facilities)
- Borrow from investors (issue corporate bonds)
- A rights issue
The above are listed in order of preference for the company given their relative costs. Rights issues are perceived to be the most expensive given the cost of equity. This begs the question; why use this form of financing? The answer is often; as a last resort.
Struggling businesses who are strapped for cash will dip into bank facilities and issue debt as first and second attempts to dig themselves out of their predicament. However, if this fails there comes a point at which either there is no-one left to lend them money via debt, or the resulting interest payments would become too large such that the profitability of the company may not recover. It is at this point when the debt-to-equity ratio, or ‘gearing’, needs to be addressed.
There are some occasions when rights issues are used by healthier businesses to fund acquisitions where circumstances preclude them to use other sources, such as debt. However, one should be mindful of those that do this too often. By and large, rights issues are seen as a last resort and any decision as to whether to participate should not be taken lightly.
During a rights issue, existing shareholders are offered additional shares, in proportion to how many they hold already, in exchange for handing over more money. The offer is usually priced at a discount to the current share price in order to incentivise investors to participate, or ‘take up the rights’. In theory, if every shareholder agrees then the company raises its target amount, thereby bolstering its equity reserves and reducing gearing, whilst each shareholder’s proportional interest in the company is maintained.
However, if you decide not to take up the rights, because you disagree with the proposed use of capital or you simply do not have the cash available, your shares will be worth proportionally less after the issuance; your interest will be diluted.