We’ll cover rights and warrants in this section. Both are equity-related securities that let you buy common stock at a fixed price. They look similar on the surface, but the differences show up often on the exam.
As we discussed in the common stock review, authorized shares are set when the company is formed. This is the maximum number of shares the company is allowed to sell to investors. 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 500,000 shares. Now assume you purchase 50,000 shares. That’s a 10% ownership position because you own 50,000 out of 500,000 outstanding shares.
Several years later, the company needs to raise additional capital. It still has 500,000 authorized shares available to sell, so it decides to issue 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 percent ownership fell from 10% to 5% simply because more shares were issued. That also reduces your voting power. To prevent this kind of dilution without giving current owners a chance to maintain their stake, companies must offer the new shares to existing stockholders first.
This is the pre-emptive right: current stockholders have the right to buy newly issued shares before they’re offered to the public. In our example, you owned 10% of the outstanding shares. Before the public sale, you’ll have the opportunity to buy 10% of the new offering so you can keep the same ownership percentage.
Here’s how it works:
You owned 50,000 shares, so you receive 50,000 rights. Each right has a value because it lets you buy stock at a discount.
For this rights distribution, assume:
Rights have intrinsic value, meaning they’re worth something immediately. Each right lets you buy one 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 shares at a discount in a rights offering is that they may avoid using an underwriter.
You learned about underwriters when you prepared for the SIE exam. As a refresher, 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 financial 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 primarily to current stockholders through a rights offering, it may not need an underwriter. The cost savings can show up as a discounted subscription (exercise) price.
When you receive rights, you have a few choices:
Rights don’t last forever. They typically expire within 60-90 days of issuance. If you let them expire, you receive no benefit from them.
If an investor wants to trade rights in the secondary market, two formulas are used to estimate the value of a right.
If the stock is trading cum-rights (with rights; before the ex-date for rights), use:
Trading cum-rights means the stock still includes the rights. In the case study above, this formula applies prior to May 13, 2020 (the ex-date for the rights distribution).
With the record date being May 13th, the investor must purchase the stock by May 12th to receive the rights (T+1 settlement). If the stock is purchased on May 13th (ex-date), the investor will not receive the rights.
Using the case study information:
What is the value of the right (cum-rights)?
Answer: $0.15
On the ex-date for the rights distribution, the stock price typically falls because the stock no longer includes the rights. The formula changes to reflect that the stock is now trading ex-rights (without rights):
The only difference between the formulas is whether you add 1 in the denominator.
Assuming the market price falls slightly, try an ex-rights calculation:
What is the value of the right (ex-rights)?
Answer: $0.15
The value of a right won’t always be exactly the same from cum-rights to ex-rights, but it can happen.
Try to keep these formulas as simple as possible. The key difference is whether 1 is added to the denominator. A quick memory aid is word association: “cum” is Latin for “with,” and “ex” is Latin for “without.” In the cum-rights formula, add 1 (with). In the ex-rights formula, don’t add 1 (without).
By offering pre-emptive rights, companies give stockholders a way to maintain their percent ownership of outstanding shares. If a stockholder exercises all their rights, their ownership percentage is not diluted.
Warrants are similar to rights because they also give the holder the right to purchase shares from a publicly traded company at a fixed price. Let’s look at the key characteristics of warrants, then compare them with 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. For example, a warrant might have 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 how long they last. Warrants often don’t expire for five or more years. The $60 exercise price stays fixed, but the market price can change. If the market price rises to $80 after a few years, the right to buy at $60 becomes valuable.
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 attractive. The idea is similar to a “bonus item” in a promotion: buy the bond, and you also receive a warrant.
Issuing warrants is a dilutive action. If the warrants are exercised, new shares are created, which can dilute existing ownership. Because of that, issuing warrants requires stockholder approval.
In conclusion, warrants are similar to rights but have important differences. 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 8 quiz questions on this topic