Question

Why would company consider raising equity via a rights offering rather than via a general cash offer? What are the disadvantages?

Answer 1

A rights offering takes place when a company needs to raise more money. Rather than offer shares to anyone, it gives current shareholders a chance to buy more stock during a fixed period.

This method lets shareholders keep their current level of ownership in the business while the company gets more capital. In most rights offerings, the existing shareholders get a discounted price for new stock purchases.

When a shareholder doesn't want to buy additional stock, he can transfer the rights on the open market, giving someone else a chance to buy company stock at a discounted price. Since the offering rate is low, the company is likely to sell most or all of its newly available stock.

For example, a shareholder owns 100 shares in Company A, and each share is worth $6 at the current market price. The company extends a rights offering to raise $40 million to cover outstanding debt. The rights offering issues 10 million stock shares available at $4 per share with a "four-for-10" rights issue. "Four-for-10" means that for every 10 shares of stock a shareholder owns, he can purchase four shares at the discounted price of $4 per share.
Shareholders have three available options in response to the rights offering. The first option is to accept the rights offering in full or in part, purchasing as many $4 shares as they wish, up to the total number of shares they are entitled to under the terms of the offering. The second option is to ignore the rights offering and let the rights expire without purchasing any additional shares. The third option is to transfer or sell their rights to another party.

Following are the disadvantages of rights offering :-

When a company needs more money, it has other options other than a rights offering. Outsiders will view this discounting of shares as a sign that the company has cash flow problems. Otherwise, it wouldn't sell more stock at a discounted rate.

Some shareholders also don't like a rights offering. Their two options are to buy more stock or to have their current ownership interest reduced.

Rights offerings and warrants aren't as popular as additional stock offerings. A healthy company usually sells more stock on the open market. That's why analysts view rights offerings as a sign of weakness.

Finally, companies can make mistakes during rights offerings. When that happens, they give away a larger share of ownership without gaining anything in return. Accurate filings are crucial during a rights offering.