The right issue of shares is a significant method for listed companies to raise capital. When a company faces liquidity challenges, it calls upon its existing shareholders to contribute additional funds in exchange for a discounted issuance of shares. This process is known as a right issue, where the company offers shares at a price lower than their market value. In this blog, we will explore the advantages and disadvantages of right issue of shares.
Key Features of a Rights Issue
Before going into the details of advantages and disadvantages of right issue of shares, let us see its key features. A rights issue of shares possesses distinct characteristics that define its nature and operation within a company:
1. Trading Period for Existing Shareholders:
Existing shareholders are granted a specific period during which they can trade their rights with other interested participants. This period extends until a specified date when the new shares become available for purchase. The trading of rights is similar to the trading of equity shares.
2. Preferential Treatment for Existing Shareholders:
The company conducting a rights issue provides preferential treatment to its current shareholders. This privilege allows shareholders to purchase additional shares at prices that are usually more affordable than prevailing market rates before a designated date.
3. Proportional Allotment of Additional Shares:
The number of additional shares an existing shareholder can purchase through a rights issue is directly proportional to their existing shareholding in the company.
4. Potential for Shareholding Dilution:
Should a shareholder choose not to purchase the additional shares offered in the rights issue, their existing shareholding in the company may become diluted once the additional shares are issued.
5. Leverage to Decline the Rights Issue:
Existing shareholders have the option to decline participation in the rights issue if they choose not to purchase additional shares. This choice allows them to avoid the potential dilution of their shareholding.
6. Timely Initiation and Cost-Efficiency:
Companies are typically allowed to initiate rights issues during specific periods or when the company is in need. During a rights issue, companies can issue new shares to existing shareholders without incurring underwriting fees, making it a cost-efficient method of raising capital.
Advantages of Right Issue of Shares for a Company
Now, let us come to the advantages and disadvantages of right issue of shares. The right issue of shares offers numerous benefits to both companies and their shareholders. This method creates a mutually beneficial scenario by providing the company with essential funds while enabling shareholders to purchase shares at reduced prices based on their ownership percentage. Mentioned below are the advantages of right issue of shares as a means of fundraising:
1. Fastest Method of Raising Capital
Compared to public offerings, the right issue offers a quicker and less regulatory-intensive approach to raising capital. It primarily involves internal processes, with the main requirement being that listed companies submit a letter of offer to SEBI and stock exchanges for public comments and approval before issuing new shares.
2. Inflation of Promoter Shareholding
A significant advantage of the right issue is its ability to assist promoters in increasing their shareholding. Shareholders have the opportunity to subscribe to the ‘unsubscribed portion’ of the issue, thereby augmenting their shareholdings in the company.
3. Record Date and Pricing
To determine eligible shareholders who can participate in the rights issue, companies declare a record date. This mechanism allows companies to issue rights at lower prices, thus providing shareholders with an incentive to participate. Additionally, it facilitates raising the necessary capital through maximum subscriptions.
4. No Scope for Debt
The right issue stands out as the most secure method of fundraising. It serves as a favourable avenue for capital expansion, enabling companies to grow their businesses without incurring additional debt. Through the right issue, companies raise the required funds from existing shareholders without altering the terms of their ownership percentages, effectively eliminating the need for debt financing.
Disadvantages of Right Issue of Shares for a Company
In discussing the advantages and disadvantages of right issue of shares, let us now the disadvantages of right issues of shares. While the right issue is indeed a cost-effective method for a company to secure the necessary funds, it is not without its downsides. Some common disadvantages of right issues of shares for a company are:
1. Restricted Capital Raise
A notable limitation of a right issue is that it constrains the capital a company can generate, particularly when compared to Initial Public Offerings. Stock exchanges usually set restrictions on the maximum capital a company can raise through a right issue, often tied to the company’s current equity value. Consequently, if a company’s stocks are undervalued, raising funds through a right issue could burden the company financially.
2. Share Value Dilution
When a company issues more equity shares to raise capital, there’s a potential risk of diluting the ownership stakes of current shareholders. As new shareholders obtain shares, the proportion of ownership held by existing investors decreases. This dilution can be worrisome for present shareholders, as it could lessen their control and ownership in the company.
3. Negative Impact on Public Image
In many cases, the decision to issue right shares can be interpreted as a sign of financial distress or liquidity crises within a company. When a reputable firm resorts to a right issue, it can create negative sentiment in the market. Shareholders and investors may perceive the company as struggling to maintain smooth business operations, potentially harming the company’s public image and stock performance.
Final Thoughts
The right issue of shares presents a swift and cost-effective means for companies to raise capital, providing both advantages and disadvantages of right issue of shares. This method allows companies to access funds efficiently while enabling existing shareholders to acquire additional shares at discounted prices, thereby maintaining their stake in the company. Moreover, the right issue offers advantages like inflating promoter shareholding, strategic pricing through record dates, and a debt-free approach to expansion.
But there are limitations that must be considered. Companies may face restrictions on the amount of capital they can raise through right issues, causing financial strain if stocks are undervalued. Shareholders may also experience dilution of their ownership stakes, and the perception of a liquidity crisis can impact a company’s public image. Therefore, companies must weigh these advantages and disadvantages of right issue of shares as well as their unique financial circumstances when opting for a right issue.
