Cash-strapped companies can turn to rights issues to raise money when they really need it. In these rights offerings, companies grant shareholders the right but not the obligation to buy new shares at a discount to the current trading price. In this article, we'll explore how rights issues work and what they mean for the company and its shareholders.

A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. More specifically, this type of issue gives existing shareholders securities called "rights," which, well, give the shareholders the right to purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price. (For more, watch the Stock Rights Issue video.)

But until the date at which the new shares can be purchased, shareholders may trade the rights on the market the same way that they would trade ordinary shares. The rights issued to a shareholder have value, thus compensating current shareholders for the future dilution of their existing shares' value. Dilution occurs because a rights offering spreads a company’s net profit over a wider number of shares. Thus, the company’s earnings per share, or EPS, decreases as the allocated earnings result in share dilution.

Companies most commonly issue a rights offering to raise additional capital. A company may need extra capital to meet its current financial obligations. Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money.

However, not all companies that pursue rights offerings are in financial trouble. Even companies with clean balance sheets may use rights issues to raise extra capital to fund expenditures designed to expand the company's business, such as acquisitions or opening new facilities for manufacturing or sales. If the company is using the extra capital to fund expansion, it can eventually lead to increased capital gains for shareholders despite the dilution of the outstanding shares as a result of the rights offering. 

For reassurance that it will raise the finances, a company will usually, but not always, have its rights issue underwritten by an investment bank. 

So, how do rights issues work? The best way to explain is through an example.

Let's say you own 1,000 shares in Wobble Telecom, each of which is worth $5.50. The company is in financial trouble and needs to raise cash to cover its debt obligations. Wobble, therefore, announces a rights offering, in which it plans to raise $30 million by issuing 10 million shares to existing investors at a price of $3 each. But this issue is a three-for-10 rights issue. In other words, for every 10 shares you hold, Wobble is offering you another three at a deeply discounted price of $3. This price is 45% less than the $5.50 price at which Wobble stock trades. For further reading, see Understanding Stock Splits.

As a shareholder, you have three options with a rights issue. You can (1) subscribe to the rights issue in full, (2) ignore your rights or (3) sell the rights to someone else. Below we explore each option and the possible outcomes.

1. Take up the rights to purchase in full

To take advantage of the rights issue in full, you would need to spend $3 for every Wobble share that you are entitled to purchase under the issue. As you hold 1,000 shares, you can buy up to 300 new shares (three shares for every 10 you already own) at the discounted price of $3, giving a total price of $900.

However, while the discount on the newly issued shares is 45%, it will not stay there. The market price of Wobble shares will not be able to stay at $5.50 after the rights issue is complete. The value of each share will be diluted as a result of the increased number of shares issued. To see if the rights issue does, in fact, give a material discount, you need to estimate how much Wobble's share price will be diluted.

In estimating this dilution, remember that you can never know for certain the future value of your expanded holding of the shares since it can be affected by any number of business and market factors. But the theoretical share price that will result after the rights issue is complete – which is the ex-rights share price – is possible to calculate. This price is found by dividing the total price you will have paid for all your Wobble shares by the total number of shares you will own. This is calculated as follows:

So, in theory, as a result of the introduction of new shares at the deeply discounted price, the value of each of your existing shares will decline from $5.50 to $4.92. But remember, the loss on your existing shareholding is offset exactly by the gain in share value on the new rights: the new shares cost you $3, but they have a market value of $4.92. These new shares are taxed in the same year as you purchased the original shares and carried forward to count as investment income, but there is no interest or other tax penalties charged on this carried-forward, taxable investment income.

2. Ignore the rights issue

You may not have the $900 to purchase the additional 300 shares at $3 each, so you can always let your rights expire. But this is not normally recommended. If you choose to do nothing, your shareholding will be diluted thanks to the extra shares issued by the company. For more on dilution, please read The Dangers of Share Dilution.

3. Sell your rights to other investors

In some cases, rights are not transferable. These are known as "non-renounceable rights." But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors or the underwriter. Rights that can be traded are called "renounceable rights," and after they have been traded, the rights are known as "nil-paid rights."

To determine how much you may gain by selling the rights, you need to estimate a value on the nil-paid rights ahead of time. Again, a precise number is difficult, but you can get a rough value by taking the value of the ex-rights price and subtracting the rights issue price. So, at the adjusted ex-rights price of $4.92 less $3, your nil-paid rights are worth $1.92 per share. Selling these rights will create a capital gain for you. For more on capital gains, please read Capital Gains Tax 101.

It's easy for investors to get tempted by the prospect of buying discounted shares with a rights issue. But it is not always a certainty that you are getting a bargain. Besides knowing the ex-rights share price, you need to know the purpose of the additional funding before accepting or rejecting a rights issue. Be sure to look for a compelling explanation of why the rights issue and share dilution are needed as part of the recovery plan. Sure, a rights issue can offer a quick fix for a troubled balance sheet, but that doesn't necessarily mean that management will address the underlying problems that weakened the balance sheet in the first place. Shareholders should be cautious.

For additional reading, see Investing in Stock Rights and Warrants.