SERIES 7 PREP | FINANCIAL REGULATION COURSES
A rights offering is a capital-raising transaction in which a publicly traded company issues short-term options — called subscription rights or preemptive rights — to its existing shareholders, giving them the opportunity to purchase newly issued shares at a specified subscription price that is typically set below the current market price, in proportion to their existing holdings, before those shares are offered to outside investors. Rights offerings are structured to protect existing shareholders from dilution — a shareholder who exercises their rights maintains their proportionate ownership percentage in the company despite the issuance of new shares, while a shareholder who declines to exercise is diluted but typically receives tradeable rights that have economic value they can sell. The rights offering is one of the primary mechanisms through which publicly traded companies raise equity capital from their existing shareholder base rather than from new outside investors, and it is directly tested on the Series 7 examination in the context of corporate finance, equity securities, and the primary market.
The Preemptive Right — The Underlying Legal Concept
The rights offering derives from the concept of preemptive rights — the legal right of existing shareholders to maintain their proportionate ownership in a company by purchasing newly issued shares before those shares are offered to outside investors. In the United States, preemptive rights are not automatic for public companies — they are not a statutory default for public corporations under most state corporate laws, including Delaware. Rather than arising by statute, preemptive rights for shareholders of United States public companies are established through the company's certificate of incorporation or bylaws, or are created ad hoc through the board's election to conduct a rights offering when capital is needed.
In European and many Asian markets, preemptive rights are a statutory default under company law — publicly traded companies in the United Kingdom, European Union member states, and numerous other jurisdictions are generally required by law to offer newly issued equity to existing shareholders first before placing shares with outside investors. This legal requirement makes rights offerings the dominant capital-raising mechanism for European public companies and far more common internationally than in the United States, where companies more frequently use fully marketed follow-on offerings sold directly to institutional investors.
The Mechanics of a Rights Offering — The Five Key Terms
Every rights offering is defined by five terms that collectively determine the economics and logistics of the transaction.
The record date is the date on which the company's shareholder register is examined to identify which shareholders are entitled to receive rights. Only shareholders of record on the record date receive subscription rights. The company must set the record date and provide notice to shareholders in advance — the notice must include the subscription ratio, the proposed subscription price, and the record date, allowing shareholders to make participation decisions before the rights are distributed.
The subscription ratio specifies how many rights a shareholder receives per share owned and how many rights must be exercised to purchase one new share. If a company has ten million shares outstanding and wishes to issue two million new shares, each shareholder receives one right for every share held, and five rights are required to purchase one new share — a one-for-five rights offering. A shareholder owning five hundred shares receives five hundred rights and may purchase one hundred new shares by exercising all five hundred rights at the subscription price.
The subscription price is the fixed price at which rights holders may purchase new shares — set at a discount to the prevailing market price to provide an economic incentive for shareholders to exercise and to ensure the offering is successfully subscribed. The magnitude of the discount varies by transaction, but typical discounts range from ten to twenty-five percent below the market price at the time the offering is announced. The subscription price remains fixed throughout the subscription period regardless of subsequent market price movements — if the market price falls below the subscription price during the offering period, the rights lose their economic value because shareholders can purchase shares more cheaply in the open market.
The subscription period — sometimes called the offering period — is the window of time during which rights holders may exercise their rights by submitting the subscription form and payment to the company's subscription agent. Subscription periods typically range from sixteen to thirty days, though there is no federal securities law requirement establishing a minimum or maximum subscription period. Rights that are not exercised before the expiration date at the end of the subscription period expire worthless.
Transferability — whether rights can be sold — is the fifth determining characteristic. Transferable rights — the more common structure — may be sold in the open market during the subscription period, providing economic value to shareholders who prefer not to participate directly. A shareholder who receives rights but does not want to invest additional capital can sell those rights to another investor who wishes to acquire exposure to the company at the discounted subscription price. Non-transferable rights — sometimes used in simpler structures — may only be exercised or allowed to expire, with no mechanism for the holder to recover value from unwanted rights.
The Value of a Right — Theoretical Pricing
Each right has a calculable theoretical value that can be derived from the subscription price, the market price, and the subscription ratio. Understanding this valuation is directly tested on Series 7 examinations.
The theoretical value of a right equals the market price per share minus the subscription price per share, divided by the number of rights required to purchase one new share plus one.
Theoretical right value equals market price minus subscription price divided by rights required per share plus one.
A concrete example illustrates the calculation precisely. A company whose stock trades at fifty dollars announces a one-for-four rights offering — shareholders receive one right per share and four rights are required to purchase one new share — at a subscription price of forty dollars.
Theoretical right value equals fifty minus forty, divided by four plus one — equalling ten divided by five — equalling two dollars per right.
The practical interpretation is straightforward. A shareholder holding four rights can exercise them to purchase one new share at forty dollars — a ten-dollar saving relative to the fifty-dollar market price. That ten-dollar benefit is distributed across the four rights required, producing two dollars of value per right. Any rights trading in the open market at a price materially below two dollars represent a potential arbitrage — buying rights and exercising them to purchase below-market shares. Competition among arbitrageurs drives the market price of rights toward their theoretical value.
After the ex-rights date — the date on which the stock begins trading without the right attached — the stock price should theoretically decline to reflect the dilution from the new shares being issued. The theoretical ex-rights price equals the sum of the current market value of all existing shares plus the proceeds from the new shares at the subscription price, divided by the total number of shares outstanding after the offering. This adjustment is analogous to the stock price reduction that occurs on the ex-dividend date.
SEC Registration and Disclosure Requirements
Rights offerings by publicly traded companies are subject to the Securities Act of 1933 because they constitute a public offering of new securities. Unless an exemption applies — which is rare for widely held public companies distributing rights broadly to all shareholders — the company must file a registration statement with the SEC covering the new shares issuable upon exercise of the rights.
For seasoned public companies already registered under the Securities Exchange Act of 1934 — those that have been SEC reporting companies for at least twelve months and have timely filed all required reports — the rights offering may be registered using Form S-3, the short-form shelf registration statement that incorporates by reference the company's existing public disclosure record. This incorporation by reference allows the registration statement to be filed quickly, often completing the SEC review and becoming effective within days rather than the weeks required for a full-form S-1 registration, making Form S-3 eligibility a critical determinant of whether a rights offering is operationally feasible on the timeline the company needs.
The prospectus delivered to rights holders must describe the terms of the offering — subscription ratio, subscription price, subscription period, transferability of rights, and the company's intended use of proceeds — and include the company's financial statements and all material information required under Regulation S-X.
The Standby Underwriter — Backstopping the Offering
A critical risk in any rights offering is that existing shareholders may choose not to exercise their rights — particularly if the market price falls toward or below the subscription price during the offering period, eliminating the economic incentive to exercise. A rights offering that is only partially subscribed raises less capital than planned and may leave the company short of its funding objective.
To protect against this risk, companies frequently engage a standby underwriter — typically an investment bank — that agrees to purchase any shares not subscribed by shareholders through the exercise of their rights. The standby underwriter provides the company with certainty that the full amount of the rights offering will be funded regardless of how many shareholders elect to exercise. In exchange for this underwriting commitment, the standby underwriter receives a standby fee — a percentage of the total offering amount — plus a flat engagement fee.
The standby arrangement converts the rights offering from a best-efforts transaction — where the company raises only as much as shareholders choose to subscribe — into an effectively firm commitment transaction — where the company is guaranteed to receive the full offering proceeds. The standby underwriter bears the economic risk that they will end up holding shares purchased at the subscription price that subsequently trade below that level in the open market.
Oversubscription Privilege
Many rights offerings include an oversubscription privilege — the right for a shareholder who has fully exercised all of their subscription rights to subscribe for additional new shares beyond their pro-rata allocation, up to a specified additional amount. The oversubscription privilege allows shareholders who want to increase their percentage ownership beyond maintaining their current proportion to do so without a separate market purchase, subject to the availability of unsubscribed shares.
If the offering is oversubscribed at the basic subscription level — meaning more shareholders wish to exercise their basic rights than there are new shares available — the basic subscriptions are honoured in full and the oversubscription requests are filled on a pro-rata basis among all oversubscription requestors or through another allocation methodology specified in the prospectus.
Dilution — The Non-Participating Shareholder's Perspective
A shareholder who receives rights but chooses neither to exercise them nor to sell them — allowing the rights to expire worthless — suffers dilution of their percentage ownership without receiving any economic compensation. The new shares issued to exercising shareholders increase the total share count, reducing the non-participating shareholder's percentage of the total from what it was before the offering.
This is distinct from the experience of a shareholder who sells their rights in the open market. That shareholder does not exercise — and therefore does not maintain their ownership percentage — but receives the market value of the rights as cash compensation for the dilution they accept. The theoretical value of the rights represents the economic equivalent of the dilution suffered, so a rights sale produces a shareholder who has received fair value for their proportionate claim to the discounted shares.
Examination Relevance and Key Takeaways
Rights offerings are tested on the Series 7 examination in the context of corporate capital raising, primary market transactions, the calculation of rights value, shareholder dilution, and the Securities Act registration framework.
The key points to retain are these.
A rights offering is a primary market transaction in which a public company issues subscription rights to existing shareholders allowing them to purchase new shares at a discount to the current market price in proportion to their existing holdings. The five defining terms are the record date — determining which shareholders receive rights; the subscription ratio — how many rights are received per share and how many are required to purchase one new share; the subscription price — the discounted fixed purchase price; the subscription period — the window for exercise typically ranging from sixteen to thirty days; and transferability — whether rights can be sold in the open market.
The theoretical value of a right equals the market price minus the subscription price divided by the number of rights required per share plus one. Rights offerings by publicly traded companies require SEC registration under the Securities Act of 1933 — seasoned issuers file on Form S-3 which incorporates by reference existing public filings, enabling rapid effectiveness. Shareholders who exercise rights maintain their proportionate ownership and avoid dilution. Shareholders who sell rights receive fair compensation for the dilution they accept. Shareholders who allow rights to expire worthless suffer dilution without compensation — the economically inferior outcome. Standby underwriters backstop the offering by committing to purchase any shares not subscribed through rights exercise, converting the transaction from best-efforts to effectively firm commitment in exchange for a standby fee. Oversubscription privileges allow fully exercising shareholders to purchase additional shares beyond their pro-rata allocation subject to availability of unsubscribed shares.
