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 look similar on the surface, but the differences show up often on exams.
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 sell stock (ownership) 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 actually sells in its IPO is called issued shares. Once shares are issued, they trade among investors in the secondary market.
Assume a company authorizes 1 million shares but issues only 500,000 shares. If you buy 50,000 shares, you own 10% of the company’s outstanding shares.
Now suppose several years pass and the company needs more capital. It still has 500,000 authorized shares available to sell. If it issues all 500,000 additional 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 share count didn’t change, but the total shares outstanding doubled - so your percentage ownership was cut in half. That also means your voting power is cut in half.
To protect existing stockholders from this kind of dilution, companies generally can’t issue new shares to the public without first offering them to current stockholders.
This protection is called 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 started with 10% ownership, so you’d have the opportunity to buy 10% of the new offering to keep your ownership percentage the same.
Here’s how the process works:
You owned 50,000 shares, so you receive 50,000 rights. Each right has a value. For example, you might need 5 rights to buy 1 new share. (You won’t be expected to guess this - exam questions provide the needed information.)
For this rights distribution, we’ll keep it simple:
Rights have intrinsic value, meaning they’re worth something immediately. With each right, you can 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, it hired Morgan Stanley, JP Morgan, and Goldman Sachs as lead underwriters.
Facebook didn’t have the distribution network to sell its stock directly into the public markets, so it used large investment banks (underwriters). Underwriting is expensive - Facebook’s underwriters collected hundreds of millions of dollars for their services.
If a company sells new shares only to current stockholders through a rights offering, it may not need an underwriter. The cost savings can show up as a discounted purchase price for stockholders.
When you receive rights, you typically have three choices:
Rights don’t last forever. They typically expire within 60-90 days of issuance.
Warrants are similar to rights because they also give you the right to purchase shares from a publicly traded company at a fixed price. The key differences are how they’re priced, how long they last, and why they’re issued.
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. For example, a warrant might have an exercise price of $60.
At issuance, exercising that warrant doesn’t make sense: why pay $60 through the warrant when you can buy the stock in the market for $50?
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, but the market price can change. If the stock rises to $80 in a few years, exercising at $60 becomes attractive. That potential is what gives warrants value.
Warrants are often issued as a “sweetener” to help sell 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.
Issuing warrants is a dilutive action. If warrants are exercised, the company issues new shares, increasing shares outstanding. Because this can dilute existing stockholders, issuing warrants requires stockholder approval.
In conclusion, rights and warrants both allow the purchase of new shares at a fixed price, but they differ in value at issuance, time horizon, and typical use. Here are the key exam points:
Rights
Warrants
Additionally, here’s a video that will help you understand the type of question to expect on rights and warrants:
Sign up for free to take 12 quiz questions on this topic