Renounceable Right: What it is, How it Works

A renounceable right is an offer issued by a corporation to shareholders to purchase more shares of the corporation's stock, usually at a discount. This offer usually coincides with the company's decision to issue a new round of stock, which would dilute the shareholders' equity in the company. The renounceable right compensates the shareholders for that dilution.

Also called a rights offering, renounceable rights have a value and can be traded separately from the original shares held. 

Key Takeaways

  • A renounceable right is an offer issued by a corporation to shareholders to buy more shares of the company's stock, usually at a discount.
  • A renounceable right offering rewards shareholders, compensating them for the share dilution that's associated with a new issuance.
  • Companies typically perform a renounceable right when they're looking to generate capital to buy assets or pay down debt.

Understanding a Renounceable Right

During a rights offering, existing common stock shareholders are allowed to purchase newly issued shares at a discount to the price that will be offered to the public at a later date.

The “right,” which is given to the owner of outstanding shares is similar to a stock option. Each holder of rights has the option to purchase a specified number of new shares of the company’s stock at a specified purchase price on a certain date.

A renounceable right is an invitation to a company's existing shareholders to buy additional new shares in the company. Shareholders have the "right" to increase their investment exposure in the company's stock. However, shareholders can renounce that right, meaning that they can trade those rights on the open market. The number of additional shares that are offered to shareholders is typically in proportion to their existing shares owned.

Why Companies Offer a Renounceable Right

Companies typically perform a renounceable right when they're looking to generate capital or money. The money raised as a result of the offering could be used to invest back into the company by purchasing fixed assets, such as equipment, machinery, or a new building. Companies also use the funds from a rights offering to pay down debt, particularly if the company could not obtain any more credit from their bank. The offering also prevents the company from having to pay interest expense on the debt had they borrowed the funds from a bank or issued bonds to investors. 

Issuing additional shares could also be a faster way to raise cash versus applying for a borrowing facility. Companies that are financially struggling might use this method of raising capital to improve their balance sheet and financial viability. Companies also avoid any underwriting fees that are typical with new stock issuance, and there is no need for shareholder approval for making a renounceable right offer.

Renounceable Rights and Share Dilution

Companies might issue a rights offering to reward existing shareholders and entice them to buy more shares. It also compensates existing shareholders for the share dilution that's associated with a new offering.

Share dilution occurs when a company issues additional stock and the net income or profit is divided by the increased number of outstanding shares. If there are an increased number of shares, the profit gets spread out or divided into smaller increments on a per-share basis called earnings per share. Investors want to see a company's earnings per share rise since it means the company is generating more profit with the money they received for issuing the stock. If EPS falls, it's considered unfavorable. Share dilution waters down the earnings since there's an increase in the number of shares with no change in profit. As a result of dilution, EPS falls, and typically the stock gets sold off by existing shareholders.

A rights offering helps to prevent the sell-off in the stock by compensating the shareholders for the potential dilution that might occur. By setting the purchase price below market value, existing shareholders may find the rights offering an attractive enough proposition to offset ownership dilution.

A renounceable right allows each share to maintain a proportional ownership stake in the business but also allows shareholders to receive cash from the sale of the right if so preferred. Also called preemptive rights, renounceable rights can be transferred or sold to another party. This is similar to the transfer of a stock option.

Renounceable Right vs. Non-Renounceable Right

A non-renounceable rights issue also offers shares to existing shareholders at a discount. However, a non-renounceable rights issue does not allow the rights to be traded while conversely, a renounceable right does allow the trading of the rights. Companies might offer non-renounceable rights issues if there's an urgent need for cash.

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