Common and Preferred Stock Financing
(Part B)
by
Charles Lamson
 |
The Right to Purchase New Shares
In addition to a claim to residual income and the right to vote for directors, the common stockholders may also enjoy a privileged position in the offering of new securities. If the corporate charter contains the preemptive right provision, holders of common stock must be given the first option to purchase new shares. While only two states specifically require the use of preemptive rights, most other states allow for the inclusion of a rights offering in the corporation charter. The preemptive right provision ensures that management cannot subvert the position of present stockholders by selling shares to outside interests without first offering them to current shareholders. If such protection were not afforded, a 20 percent stockholder might find his or her interest reduced to 10 percent through the distribution of new shares to outsiders. Not only would voting rights be diluted, but proportionate claims to earnings per share would be reduced. The Use of Rights in Financing Many corporations also engage in a preemptive rights offering to tap a built-in market for new securities---the current investors. Rights offerings are used by many U.S. companies, and are especially popular as a fundraising method in Europe. It is quite common in European markets for companies to ask their existing shareholders to help finance expansion. To illustrate the use of rights, let's look at the Lamson Corporation, which has 9 million shares outstanding and a current market price of $40 per share (the total market value is $360 million). Lamson needs to raise $30 million for new plant and equipment and will sell 1 million new shares at $30 per share. As part of the process, it will use a rights offering in which each old shareholder receives a first option to participate in the purchase of new shares.  Each shareholder will receive one right for each share of stock owned and may combine a specified number of rights plus $30 cash to buy a new share of stock. Let us consider these questions:
Rights Required Since 9 million shares are currently outstanding and 1 million new shares will be issued, the ratio of old to new shares is 9 to 1. On this basis, the old stockholder may combine 9 rights plus $30 cash to purchase one new share of stock. A stockholder with 90 shares of stock would receive an equivalent number of rights, which could be applied to the purchase of 10 shares of stock at $30 per share. As indicated later in the discussion, stockholders may choose to sell their rights, rather than exercise them in the purchase of new shares. Monetary Value of a Right Anything that contributes toward the privilege of purchasing a considerably higher-priced stock for $30 per share must have some market value. Consider the following two-step analysis.  Nine old shares sold at $40 per share, or for $360; now one new share will be introduced for $30. Thus we have a total market value of $390 spread over 10 shares. After the rights offering has been completed, the average value of a share is theoretically equal to $39.  The rights offering thus entitles the holder to buy a stock that should carry a value of $39 (after the transactions have been completed) for $30. With a differential between the anticipated price and the subscription price of $9 and 9 rights required to participate in the purchase of one share, the value of a right in this case is $1.  Formulas have been developed to determine the value of a right under any circumstance. Before they are presented, let us examine two new terms that will be part of the calculations---rights-on and ex-rights. When a rights offering is announced, a stock initially trades rights-on; that is, if you buy the stock, you will also acquire a right toward a future purchase of the stock. After a certain period (say 4 weeks) the stock goes ex-rights---when you buy the stock you no longer get a right toward future purchase of stock. Consider the following:  Once the ex-rights period is reached, the stock will go down by the theoretical value of the right. The remaining value ($39) is the ex-rights value. Though there is a time period remaining between the ex-right date (April 1st) and the end of the subscription period (April 30), the market assumes the dilution has already occurred. Thus, the ex-rights value reflects precisely the same value as can be expected when the new, underpriced $30 stock issue is sold. In effect, IT projects the future impact of the cheaper shares on the stock price.  The formula for the value of the right when the stock is trading rights on is:  These are all theoretical relationships, which may be altered somewhat in reality. If there is great enthusiasm for the new issue, the market value of the right may exceed the initial theoretical value (perhaps the right will trade for 1%) . Effect of Rights on Stockholder's Position At first glance a rights offering appears to bring great benefits to stockholders. But is this really the case? Does a shareholder really benefit from being able to buy a stock that is initially $40 (and later $39) for $30? Don't answer too quickly!  Think of it this way: Assume 100 people own shares of stock in a corporation and one day decide to sell new shares to themselves at 25 percent below current value. They cannot really enhance their wealth by selling their own stock more cheaply to themselves. What is gained by purchasing inexpensive new shares is lost by diluting existing outstanding shares. Take the case of Stockholder A, who owns 9 shares before the rights offering and also has $30 in cash. His holdings would appear as follows:  If he receives and exercises nine rights to buy one new share at $30, his portfolio will contain:  Clearly he is no better off. A second alternative would be for him to sell his rights in the market and stay with his position of owning only nine shares and holding cash. The outcome is shown below.   As indicated above, whether he chooses to exercise his right or not, the stock will still go down to a lower value (others are still diluting). Once again, his overall value remains constant. The value received for the rights ($9) exactly equals the extent of dilution and the value of the original 9 shares. The only foolish action would be for the stockholder to regard the rights as worthless securities. He would then suffer the pains of dilution without the offset from the sale of the rights.  Empirical evidence indicates this careless activity occurs 1 to 2 percent of the time (Block & Hirt, p. 513). Desirable Features of Rights Offerings You may ask, if the stockholder is no better off in terms of total valuation, why undertake a rights offering? There are a number of possible advantages.  As previously indicated, by giving current stockholders of first option to purchase new shares, we protect their current position in regard to voting rights and claims to earnings. Of equal importance, the use of a rights offering gives the firm a built-in market for new security issues. Because of this built-in base, distribution costs are likely to be lower than under a straight public issue in which investment bankers must underwrite the full risk of distribution. Also, a rights offering may generate more interest in the market than would a straight public issue. There is a market not only for the stock but also for the rights. Because the subscription price is normally set 15 to 25% below current value, there is the "nonreal" appearance of a bargain, creating further interest in the offering. A last advantage of a rights offering over a straight stock issue is that stock purchased through a rights offering carries lower margin requirements. The margin requirement specifies the amount of cash or equity that must be deposited with a brokerage house or a bank, with the balance of funds eligible for borrowing. Though not all investors wish to purchase on margin, those who do so prefer to put down a minimum amount. While normal stock purchases may require a 50 percent margin (half cash, half borrowed), stock purchased under a rights offering may be bought with as little as 25 percent down, depending on the current requirements of the Federal Reserve Board. Poison Pills During the last three and a half decades a new wrinkle was added to the meaning of rights when firms began receiving merger-and-acquisition proposals from companies interested in acquiring voting control of the firm. The management of many firms did not want to give up control of the company, and so they devised a method of making the firm very unattractive to a potential acquisition-minded company. As you can tell from our discussion of voting provisions, for a company using majority voting, a corporate raider needs to control only slightly over 50 percent of the voting shares to exercise total control. Management of companies considered potential takeover targets began to develop defensive tactics in fending off these unwanted takeovers. One widely used strategy is called the poison pill.  A poison pill is a rights offer made to existing shareholders of Company X with the sole purpose of making it more difficult for another firm to acquire Company X. Most poison pills have a trigger point. When a potential buyer accumulates a given percentage of the common stock (for example, 25 percent), the other shareholders may receive rights to purchase additional shares from the company, generally at very low prices. If the rights are exercised by shareholders, this increases the total shares outstanding and dilutes the potential buyer's ownership percentage. Poison pill strategies often do not have to be voted on by shareholders to be put into place. Many institutional investors are opposed to the pill. They believe it lowers the potential for maximizing shareholder value by discouraging potential high takeover bids. *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 510-514* end |
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