We’ll cover rights and warrants in this section. Both are equity-related securities that let you purchase common stock at a fixed price. They’re similar in some ways, but the differences show up often on the exam.
Authorized shares are set when a business incorporates (officially forms as a corporation). This is the maximum number of shares the company is allowed to sell to investors. For example, if a company authorizes 1 million shares, it can sell up to 1 million shares of stock. Companies give up ownership (stock) in exchange for capital (money).
Most companies don’t sell all of their authorized shares during their initial public offering (the first public sale of their shares). That leaves room to raise additional capital later by selling the remaining authorized shares.
The number of shares a company sells during its initial public offering (IPO) is called issued shares. Once shares are issued, they trade in the secondary market among investors.
Assume a company authorizes 1 million shares but issues only 500,000 shares. If you purchase 50,000 shares, you own 10% of the outstanding shares.
Now assume several years pass and the company needs to raise additional capital. It still has 500,000 authorized shares available to sell, so it decides to sell all of them. If you don’t buy any of the new shares, your ownership percentage is diluted from 10% to 5%.
| Shares owned | Shares outstanding | Percent ownership | |
|---|---|---|---|
| Before | 50,000 | 500,000 | 10% |
| Diluted | 50,000 | 1,000,000 | 5% |
Your ownership percentage drops because the total number of shares outstanding increases while your share count stays the same. That also reduces your voting power.
To protect existing stockholders from this kind of dilution, companies generally can’t issue new shares without first offering them to current stockholders.
This protection is the pre-emptive right. It gives current stockholders the right to buy newly issued shares before they’re offered to the public. In our example, you owned 10% of the company before the new issuance, so you’ll have the opportunity to buy 10% of the new offering to maintain your ownership percentage.
Here’s how the process works:
Since you owned 50,000 shares, you receive 50,000 rights. Each right has a specific value because it can be used (often in combination with other rights) to buy new shares at a set price. For example, you might need 5 rights to buy 1 new share. You won’t be asked to derive that ratio on the exam - questions will provide it.
For this rights distribution, we’ll keep it simple and assume:
Rights have intrinsic value, meaning they have immediate value at issuance. Each right lets a stockholder buy 1 new share for $40 when the market price is $50. That’s a $10 discount, so the right is issued with $10 of intrinsic value.
One reason companies can offer this discount is that they may avoid hiring an underwriter.
You learned about underwriters when you prepared for the SIE exam. As a reminder, underwriters help organizations market and sell securities to the public. For example, when Facebook went public in 2012, they hired Morgan Stanley, JP Morgan, and Goldman Sachs as their lead underwriters.
As a social media company, Facebook didn’t have the resources or distribution network to sell its stock broadly in the financial markets. That’s why it hired large investment banks (underwriters). Underwriters are expensive; Facebook’s underwriters collected hundreds of millions of dollars for their services.
If a company sells new shares primarily to current stockholders through a rights offering, it may not need an underwriter. In that case, some of the cost savings can be passed to stockholders through a discounted subscription (exercise) price.
When you receive rights, you typically have three choices:
Rights don’t last forever. They typically expire within 60-90 days of issuance. If you let them expire, you receive no benefit.
Warrants are similar to rights because they give you the right to purchase shares from a publicly traded company at a fixed price. We’ll look at the key characteristics of warrants first, then compare them directly to rights.
Assume a company’s stock is trading at $50. A warrant will have a fixed exercise price, but it’s typically set above the current market price (at a premium). For example, a warrant might be issued with an exercise price of $60. At issuance, it usually doesn’t make sense to exercise the warrant because you could buy the stock in the market for $50 instead of paying $60.
Warrants have time value, meaning their value comes largely from the time remaining until expiration. Warrants often last five years or more. The $60 exercise price stays fixed during that period, but the market price can change. If the market price rises to $80 after a few years, exercising at $60 becomes attractive. That potential is what gives warrants value over time.
Warrants are often issued as a sweetener when selling another security. For example, if a company is having trouble marketing a new bond, it may attach a warrant to make the bond more appealing.
The issuance of warrants is a dilutive action. If the warrants are exercised, new shares are created and outstanding shares increase. Because this can dilute existing stockholders, issuing warrants requires stockholder approval.
In conclusion, warrants are similar to rights but have important differences. Here are the key points to know for the exam:
Rights
Warrants
Additionally, here’s a video that will help you understand the type of question to expect on rights and warrants:
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