Equity Securities - Rights Of Common Stockholders

As an owner of common stock, investors are owners of the corporation. As such, investors have certain rights that are granted to all common stock holders.

Preemptive Rights

As a stockholder, an investor has the right to maintain their percentage interest in the company. This is known as a preemptive right. Should the company wish to sell additional shares to raise new capital, they must first offer the new shares to existing shareholders. If the existing shareholders decide not to purchase the new shares then the shares may be offered to the general public. When a corporation decides to conduct a rights offering, the board of directors must approve the issuance of the additional shares. If the number of shares that are to be issued under the rights offering would cause the total number of outstanding shares to exceed the total number of authorized shares, then shareholder approval will be required. Existing shareholders will have to approve an increase in the number of authorized shares before the rights offering can proceed.

TEST FOCUS!

Number of Existing Shares

Number of New Shares

Total Shares After Offering

100,000 100,000 200,000
10,000 10,000 20,000
= 10% ownership =10% of offering =10% ownership

In the example above, the company has 100,000 shares of stock outstanding and an investor has purchased 10,000 of those original shares. As a result, they own 10% of the corporation. The company wishing to sell 100,000 new shares to raise new capital must first offer 10% of the new shares to the current investor (10,000 shares) before the shares may be offered to the general public. So if the investor decides to purchase the additional shares, as is the case in the example, the investor will have maintained their 10% interest in the company.

A shareholder’s preemptive right is ensured through a rights offering. The existing shareholders will have the right to purchase the new shares at a discount to the current market value for up to 45 days. This is known as the subscription price. Once the subscription price is set, it remains constant for the 45 days, while the price of the stock is moving up and down in the market place.

There are three possible outcomes for a right. They are:

Exercised:

The investor decides to purchase the additional shares and sends in the money, along with the rights to receive the additional shares.

Sold:

The rights have value and if the investor does not want to purchase the additional shares, they may be sold to another investor who would like to purchase the shares.

Expire:

The rights will expire when no one wants to purchase the stock. This will only occur when the market price of the share has fallen below the subscription price of the right and the 45 days has elapsed.

Characteristics of a Rights Offering

Once a rights offering has been declared, the company’s common stock will trade with the rights attached. The stock in this situation is said to be trading “cum rights”. The company’s stock, which is the subject of the rights offering, will trade “cum rights” between the declaration date and the ex date. After the ex date the stock will trade without the rights attached or will trade “ex rights”. The value of the common stock will be adjusted down by the value of the right on the ex rights date. During a rights offering, each share will be issued one right. The subscription price and the number of rights required to purchase one additional share will be detailed in the terms of the offering on the rights certificate. During a rights offering, the issuer will retain an investment bank to act as a standby underwriter and the investment bank will stand by, ready to purchase any shares that are not purchased by the rights holders.

Determining The Value Of Rights
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