We’ll discuss rights and warrants in this section, which are equity-related securities allowing the purchase of common stock at a fixed price. Both have similarities and differences, which are tested commonly on the exam.
As we discussed in the common stock review, authorized shares are established when the company is founded, which is the number of shares a company can sell to investors. If a company authorizes 1 million shares, it may sell up to 1 million shares of stock. Companies give up ownership (stock) in return for capital (money).
Most companies do not sell all of their authorized shares during their initial public offering (first public sale of their shares), allowing the opportunity raise additional capital later by selling “leftover” authorized shares.
The number of shares a company sells during its initial public offering (IPO) is referred to as issued shares. Once shares are issued, they trade in the secondary market among investors. Assume a company authorizes 1 million shares but decides to issue 500,000 shares. Let’s assume you purchase 50,000 shares, which is a 10% ownership position. Simply stated, you own 10% of the outstanding shares of this company.
Several years pass and the company needs to raise additional capital. They still have 500,000 authorized shares to sell, so let’s say they decide to sell all of them. This action would dilute your 10% ownership down to 5%.
As you can see, your percent ownership of the outstanding shares fell from 10% to 5% just because the company wanted to sell more shares. When you vote now, your vote is worth half as much. Doesn’t seem fair, does it? Good news for you: the company cannot do this without offering the new shares to you and the other current stockholders first.
This is called the pre-emptive right, which gives current stockholders the right to buy the new shares the company is issuing before they’re publicly offered. In our example, you owned 10% of the outstanding shares in the beginning. Prior to the public sale of these new shares, you’ll have the opportunity to purchase 10% of the offering to maintain the same ownership percentage.
How exactly does this work? The company issues pre-emptive rights to its current stockholders to purchase these new shares. Investors receive one right for every share of stock owned.
You owned 50,000 shares in the beginning, so you’ll gain 50,000 rights. Each right will have a specific value - for example, you may need 5 rights to purchase 1 full new share. Don’t worry about doing any math to figure this out, though. The questions you’ll see on the exam will give you this information.
For this rights distribution, we’ll keep it simple. Let’s assume the following:
Rights have intrinsic value, which means they have immediate value. For each right that a stockholder has, they can purchase 1 new share from the company for $40, which is $10 cheaper than its current market value of $50. This is another way of saying the right is issued with $10 of intrinsic value. The company automatically provides this value because they’re saving money by avoiding the services of an underwriter.
You learned about underwriters when you prepared for the SIE exam. To refresh on the topic, underwriters are hired to help organizations market and sell their 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 required resources or network to sell its stock in the financial markets. That’s why they hired large investment banks (underwriters). Underwriters are not cheap; Facebook’s underwriters collected hundreds of millions of dollars for their services.
If the company only sells new shares to current stockholders, an underwriter isn’t needed. Essentially, the savings are passed on to stockholders by offering shares at a discounted price.
When receiving rights, investors have a few options. Investors can exercise them and purchase the new shares at the exercise price. If an investor doesn’t want to buy the new shares, they may sell the rights in the market. Remember, rights have intrinsic value and another investor would be happy to purchase them for the right price. Last, investors can let the rights expire. Rights don’t last forever and typically expire within 60-90 days of issuance. Although it wouldn’t be smart, an investor could let them expire and not gain anything from them.
If an investor wants to trade rights in the secondary market, there are two formulas that can be used to determine the value of a right. If the stock is trading cum-rights (with rights; before the ex-date for rights), this is the formula used:
Trading cum-rights means the stock is trading with rights. In the case study above, this formula would be used prior to May 12, 2020, which is the ex-date for the rights distribution. With the record date being May 13th, the investor must purchase the stock by May 11th to obtain the rights (T+2 settlement). If the stock is purchased on May 12th (ex-date), the investor will not receive the rights.
Let’s assume the same information provided in the case study:
Can you find the value of the right (cum-rights)?
On the ex-date for the rights distribution, the stock value will fall. The stock is worth slightly less as it no longer provides rights to investors. The formula adjusts slightly to factor out the falling stock price:
The only difference between the formulas is whether or not 1 is added in the denominator. Assuming the market price falls a little, let’s try an ex-rights calculation:
Can you find the value of the right (ex-rights)?
The value of. a right won’t always be exactly the same cum-right to ex-right, but it certainly can occur.
Try to simplify these formulas as much as possible. The only difference between the two is whether 1 is added to the denominator. An easy way to remember is with 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 provide stockholders the opportunity to maintain their percent ownership of outstanding shares. If a stockholder exercises all their rights, their ownership is not diluted.
Warrants are very similar to rights as they provide the right to purchase shares from a publicly traded company at a fixed price. We’ll first discuss the characteristics of warrants, then compare and contrast them with rights.
Assume a company’s stock is trading at $50. If a warrant is issued, it will have a fixed exercise price, but at a premium to the market price. For example, let’s say a warrant is issued with an exercise price of $60. Up front, it makes no financial sense to exercise the warrant. Why would you purchase stock at $60 through a warrant, when you can just go to the market and purchase shares at $50?
Warrants have time value, meaning the length of time they exist gives them value. Sure, buying stock at $60 when the market price is $50 isn’t smart. However, warrants typically don’t expire for five or more years. The $60 exercise price remains fixed over that time, but the market price won’t. If the market price rises to $80 after a few years. Now, that exercise price of $60 sounds much better. This is why warrants can be valuable over time.
Warrants are usually issued as a “sweetener” during the sale of another security. For example, a company that’s having trouble marketing a new bond can make the offering more attractive by attaching a warrant to the bond. Remember those infomercials that offer a bunch of extra items? Buy this TV and we’ll give you a toaster for free! It’s kind of like that - buy this bond and we’ll give you a warrant for free!
The issuance of warrants is a dilutive action. If a publicly traded company issues warrants, they’re giving out new shares, but not to everyone. Therefore, the issuance of warrants requires stockholder approval.
In conclusion, warrants are similar to rights but have some distinct differences. Here’s a breakdown of the important points to know for the exam:
Additionally, here’s a video that will help you understand the type of question to expect on rights and warrants:
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