I’m writing this to inform investors about the effects of a rights offering on their holdings before and after the completion of one. I recently invested in a business that has a history of using rights offerings to raise money and I spent a lot of time thinking about what they mean for the investor. Here are my thoughts.
Rights offerings are one of many ways for companies to raise capital and it is structured in a very strange way. Typically, current shareholders are all offered rights on a per-share basis; meaning the more shares they own, the more rights they will end up with (depending on the ratio selected by management). These rights allow an owner to buy additional stock in the company at a price below the current market price. It effectively raises capital for the business and allows investors to place a larger stake in the company they own (in terms of a percentage of their portfolio). However, what got me thinking was why a company would offer something like this if all owners end up with the same ownership percentage in the company after the offering if they all participated? The answer I came across was the “oversubscription privilege”.
Typically, not all owners will participate in a rights offering. Perhaps the institutional investors have large stakes and cannot place any larger percentage of their portfolio into the company because their charter doesn’t allow it. Maybe the investors aren’t very sophisticated or don’t understand these rights that were given to them by the company. Whatever the reason, not all rights offerings are fully subscribed to. The oversubscription privilege allows investors to subscribe to additional rights if other shareholders didn’t subscribe to them. Effectively, they are using the rights that are afforded to their fellow shareholders who didn’t partake in the offering. Those shareholders who use the oversubscription privilege can add to their stake in the company at prices below the market listing.
Here is the math for if all shareholders subscribe to the offering:
1,000,000 shares * $10/share = $10 MM market cap
Shareholder: 500 shares * $10/share = $5,000 investment
Rights offering: 2:1 payout of rights and for purchase price of $5/share
500,000 rights * $5/share = $2,500,000 cash raised
Shareholder Rights: 250 rights * $5/share = $1,250 additional investment
New Capital Structure: 1,500,000 shares * X/share = $12.5 MM market cap
X = $8.33/share (assuming efficient market, not that market is efficient but just for this exercise)
Shareholder: 750 shares * $8.33 = $6,250 total investment
Now, to give a quick rundown of this math, the company started with 1 MM shares and offered another 500,000 in the offering. Assuming everyone partook in the offering, the shareholder in question ends up investing $6,250 in company ($5,000 in stock, $1,250 in rights offering) with the end result of having a stake in the company worth exactly $6,250. However, this can change drastically if not all shareholders partake in the offering. Here is the math:
Shareholder: 500 shares * $10/share = $5,000
Offering: 250 shares * $5/share = $1,250
Oversubscription privilege: 250 shares * $5/share = $1,250
Total shares = 1,000, total investment: $7,500
1,000 shares * $8.33 (from exercise above) = $8,333 holding
So, with invested capital of $7,500, the shareholder here ends up with a holding in the company worth $8,333 through the rights offering. I found this very interesting and important for all shareholders to be aware of; rights offerings only benefit those who subscribe to them as much as possible, and if you ignore one, you will be diluted out of your stake. Here’s the math:
Shareholder: 500 shares * $10/share = $5,000
After offering: 500 shares * $8.33/share = $4,165
By simply ignoring the offering, the shareholder here loses almost 20% of his stake in the company; this is no small amount!
The business I mentioned before that I own stock in is Hallmark Financial. They have used rights offerings twice now in the last 10 years to raise capital. The Chairman of the Board owns about 40% of the company and has used the oversubscription privilege as much as possible. It hasn’t done much for him because most shareholders subscribed to it (from what I can tell), but that isn’t to say he hasn’t tried! He could easily increase his stake in the company by having another offering if his shareholders didn’t understand the implications of it. I find this type of behavior self-serving and I feel it puts management’s interests ahead of shareholders, especially if they are doing it to take advantage of the unsophisticated ones. When you see this behavior, perhaps you should think about whether your Chairman is on your side or if they are looking to make money at your expense.
So, in summary, if you ever see a rights offering by a company you own, pay attention and subscribe to it!